New consolidation accounting rule may pose some challenges for companies

SINGAPORE - The impending new financial reporting standard (FRS) on consolidation, FRS 110, claimed its first victim recently, when United Overseas Bank (UOB) took steps at the end of last month to wind up its associate, United International Securities (UIS).

Under the new standard, which redefines the entities to be consolidated, UIS would need to be consolidated into UOB's accounts; the move would incur additional costs that the group would prefer to avoid.

FRS 110 will become effective for annual periods beginning on or after Jan 1, 2014. The looming adoption date begs the questions: Are companies fully prepared for the change? And just how will the new standard affect financial statements and the companies they belong to?

The Accounting Standards Council (ASC), which issues the standards here, actually held back the implementation of FRS 110 by a year, after receiving feedback that this and other FRSs due to be introduced at the same time were posing a greater challenge to stakeholders than anticipated.

Accounting experts agree that, given the extra preparation time, FRS 110 should not present that much of a challenge to most companies on its own. But they also agree that the increased complexity of the new standard and the greater judgment needed to apply it will present some issues.

Sim Hwee Cher, Assurance leader at PwC Singapore, points out: "For example, in the case of the option to purchase further shares, such as warrants - before FRS 110, the assessment of whether these options lead to consolidation was less complex and focused mainly on whether the option holder has the current power to exercise his option.

"Under FRS 110, the assessment will be much more complex, involving the consideration of a melting pot of factors including whether and how far the option is in the money, the purpose and design of the option, an assessment of the wider arrangement that led to the acquisition of the option, etc."

Reinhard Klemmer, partner and head of Accounting Advisory Services at KPMG in Singapore, says the initial adoption of the standard where market practices have not been set will prove difficult. "For example, does a company with shares of less than 50 per cent control another company when the former is by far the largest shareholder? Such decisions are hard to make without historical precedent.

"Another requirement of the FRS 110 is to determine the significant activity of a company that may require consolidation - which was not something that the accounting standards required previously. The activity may not be straightforward enough to determine, which makes it hard for the finance function to judge on its own."

There are also operational issues a company will face in applying FRS 110. Shariq Barmaky, Assurance and Advisory partner at Deloitte Singapore, believes one of the biggest challenges will be the need for the parent company or investor to continually assess if it controls an investee when facts and circumstances indicate there are changes to the elements of control defined by the standard. "We anticipate challenges in executing the assessment continually, particularly where very often the assessment of control is one that requires consideration of other market factors as well as other parties to the investee."

Mr Sim points out that other operational issues include "managing stakeholders with regard to the impact on capital ratios, key performance indicators (KPIs), effects on key items such as revenue - due to consolidating additional revenue or vice versa - training finance teams to understand the new approach, implementing internal controls to identify judgmental areas of consolidation, and so on".

The adoption of the standard will also be trickier for certain types of companies or entities.

Tan Seng Choon, Assurance partner at EY, says: "Companies that will face significant challenges in adopting FRS 110 would likely be those who invested in special-purpose entities and fund/asset managers who are directing the activities of the fund that they manage, as these are the areas where (the) judgment involved would be significant."

Mr Barmaky points out that "Reits (real estate investment trusts) and business trust structures need to exercise judgment in determining if they are principal or agent to the structure".

"Among others, the assessment of principal-agent, and whether the rights are substantive or protective in nature, may not be a straightforward assessment," he adds.

Mr Klemmer believes two distinct categories of companies will face the greatest challenges: large conglomerates with a wide variety of relationships and operations in a number of foreign countries; and smaller companies that may lack the manpower to dedicate their most knowledgeable resources to deal with the adoption issues.

He adds: "The other group that may struggle are some of the users of financial instruments, for example, lenders who have financial ratios they monitor; such ratios may significantly change if additional companies are being consolidated into the borrower . . . (Also,) as consolidation has an implication not just on one or a few line items on the financial statements, analysing its impact will require significant effort."

Still, despite these, it is important not to lose sight of the fact that FRS 110 was introduced to improve on the current situation. It is meant to deal with the current diversity in practice in applying FRS 27, and with off-balance sheet vehicles, such as the securitisation vehicles that posed such a risk during the global financial crisis.

Mr Barmaky says: "The debate continues as to whether FRS 110 will bring about more or less consolidation but, in essence, the new standard is intended to bring about more appropriate consolidation that better reflects the relationship between a reporting entity and an investee."

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