Essay: Should Centcom or TTL Group LLC onsolidate Britel under GAAP

To evaluate whether Centcom or TTL Group LLC should consolidate Britel under GAAP, we considered two conditions. First, Britel has to qualify as a Variable Interest Entity by either being unable to secure its own finance without additional subordinated support or lacking the obligation to absorb the losses or the right to receive the expected residual returns of the entity. Second, Centcom or TTL Group has to qualify as Britel’s primary beneficiary by having both the power to direct the activities of Britel and the obligation to absorb the losses or right or receive returns from Britel’s operations.
Before discussing whether Centcom or TTL Group should consolidate Britel, we need to examine if Britel qualifies as a Variable Interest Entity. The terms of the management agreement indicate that Britel is a Variable Interest Entity since it cannot secure its own finance without additional subordinated support. The balance sheet of Britel shows a shareholder’s deficit, a negative shareholder’s equity, of ‘30,000. If equity is less than 10% of total assets, the entity is considered to be unable to finance itself. Thus, Britel’s negative equity signifies that it is qualified as a Variable Interest Entity. Moreover, the agreement indicates that if ‘Britel’s operations do not generate the required cash flow to satisfy Britel’s debt obligations, Centcom will be required to fund any shortfall’. Britel lacks the risk of losses or the right to return which further highlights Britel’s qualification as a Variable Interest Entity.
We now examine whether Centcom or TTL Group will qualify as Britel’s primary beneficiary and consolidate Britel. In order to qualify as Britel’s primary beneficiary, the enterprise must both have the power to direct the activities of the variable interest entity and the obligation to losses or right to returns. TTL may seem like it has power over Britel with five members on board while Centcom only has one. However, TTL Group cannot exercise its power to engage in major expansions without Centcom’s approval since ‘major expansion transactions ‘require unanimous approval of the board’. Thus, TTL Group is unable to influence Britel’s operations without Centcom’s approval. Moreover, TTL Group will not reimburse losses incurred from Britel’s operations and has ‘no responsibility to fund Britel’s operations’. TTL Group is not influenced by Britel’s gain or loss and does not qualify as Britel’s primary beneficiary.
On the other hand, Centcom has the power to direct the activities of Britel as it would ‘manage the administrative and operational activities of Britel, including hiring and terminating employees’. In addition, ‘Centcom plans to integrate Britel’s activities into its own operations’ which suggests that Centcom is treating Britel’s activities as its own. Centcom certainly has the power to direct the activities of Britel that most significantly impact the entity’s economic performance. Centcom also has the obligation to losses or right to returns as indicated by terms of the management agreement. Centcom would ‘receive 80 percent of Britel’s EBTIDA’contingent on sufficient cash being generated from Britel’s operations’ and ‘Centcom will be required to fund any shortfall’ of Britel’s operations. Depending on Britel’s performance, Centcom could incur either gain or losses which clearly indicate that Centcom has the right to returns and obligation to losses. Since Centcom meets the two conditions of a primary beneficiary, it needs to consolidate Britel.
Under the IFRS, ‘a reporting entity must consider the indicators of control in both IAS 27 and SIC-12 to determine whether consolidation is appropriate. Under this model, a reporting entity should consider which party controls an entity on the basis of an evaluation of both governance indicators (IAS 27) and economic indicators (SIC-12).’ We will first take a look at the governance indicators pertaining to Centcom and TTL Group. IAS 27 defines control as ‘the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.’ Centcom has the power to govern the financial operating policies because ‘Centcom plans to integrate Britel’s activities into its own operations, through consolidating finance, accounting and customer services departments, by terminating the majority of Britel’s employees.’ Even though Centcom has the power to govern the policies, ‘major expansion transactions would require unanimous approval of the board.’
Additionally, under IAS 27, the entity must have ‘potential voting rights that are currently exercisable when determining whether control is present.’ Centcom meets this requirement because they are allowed to ‘select one member on the six-member board of directors.’ Even though Centcom has less than 50% of control within the board of directors, IAS 27 is still effective for Centcom since ‘control may occur without a majority ownership of the voting power of an entity.’ Similarly, TTL Group also meets this requirement seeing that they would ‘would select the remaining five’ on the six-member board of directors. As you can see, both Centcom and TTL Group meet the IAS 27 requirements.
On the other hand, SIC-12 “an entity must consolidate a special purpose entity (“SPE”) when, in substance, the entity controls the SPE.” ‘The control of an SPE by an entity may be indicated if the SPE conducts its activities to meet the entity’s specific needs’ and the ‘entity is exposed to the SPE’s business risks.’ Centcom meets this specification since they are responsible for Britel’s cash flows. ‘In the event that Britel’s operations do not generate the required cash flow to satisfy Britel’s debt obligations, Centcom will be required to fund any shortfall.’ Thus, Centcom is exposed to the SPE’s business risks, since ‘shortfalls are not reimbursable by Britel or TTL Group.’ TTL Group does not meet this specification, because’TTL Group has no responsibility to fund Britel’s operations as a result of the agreement.’ Secondly, ‘the control of an SPE by an entity may be indicated if the entity has decision-making powers to obtain the majority of the benefits of the SPE’s activities.’ Centcom also meets this requirement because Centcom is allowed ‘to receive 80 percent of Britel’s EBTIDA during the agreement period,’ but it is limited to ‘the payment of the management fee is contingent on sufficient cash being generated from Britel’s operations.’ Considering Centcom is allowed to receive 80% of Britel’s EBTIDA, Group TLL is not able to obtain the majority of the benefits of the SPE’s activities. Under the SIC-12 requirements, Centcom qualifies while TTL Group does not.
Centcom should consolidate Britel under both GAAP and IFRS. TTL Group should not consolidate Britel under both GAAP and IFRS.

Source: Essay UK - http://ntechno.pro/essays/finance/essay-should-centcom-or-ttl-group-llc-onsolidate-britel-under-gaap/


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