Issue 1/2006 BDO International 17 January 2006 Status: Final Effective date: Immediate Accounting impact: May affect the classification of investments as being in subsidiaries International Financial Reporting Bulletin Definition of control under IAS 27 Consolidated and Separate Financial Statements Background IAS 27 Consolidated and Separate Financial Statements includes guidance for the identification of subsidiary undertakings which, subject to certain exemptions in IAS 27, are required to be included in an entity s consolidated financial statements. A subsidiary is defined as being an entity which is controlled by another entity (known as the parent). Control is defined as: The power to govern the financial and operating policies of an entity so as to obtain benefit from its activities. (emphasis added) IAS 27.13 notes that control is presumed to exist where the parent owns, directly or indirectly through subsidiaries, more than 50% of the voting power of an entity unless in exceptional circumstances it can clearly be demonstrated that such ownership does not constitute control. Control also exists when there is: a) power over more than half of the voting rights by virtue of an agreement with other investors; b) power to govern the financial and operating policies of the entity under a statute or agreement; c) power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or d) power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body. Consideration is also required of potential voting rights, which may affect the analysis in one of two ways: 1. Where an entity currently owns 50% or less of the voting power of another entity but has the current ability to acquire additional voting rights and increase its holding above 50%; and
2. Where another party has the current ability to reduce an entity s percentage of voting rights to less than 50%. IAS 27 includes implementation guidance to assist in determining the impact of potential voting rights, including a number of illustrative examples. These indicate that the question of whether an entity controls another is based very much on an analysis of contractual rights (and therefore legal form), rather than on an analysis of substantive, non-contractual control. Questions have arisen over the guidance included within IAS 27, and its interpretation, in particular where an entity owns 50% or less of the voting rights in another entity, but where the other shares are held by a large number of other shareholders, none of whom own a significant proportion of the voting rights and are not anticipated to act together and cast an overall majority vote. The International Accounting Standards Board recently issued a public statement that is inconsistent with illustrative examples in IAS 27 and not wholly consistent with the contractual rights approach which many preparers of IFRS financial statements have followed to date. The contractual rights approach which many preparers have followed to date is illustrated in the example below. Example Company A owns 48% of the voting rights of Company B. The other 52% of Company B s voting rights are held by a large number of individuals, none of whom owns a significant proportion. At past general meetings of Company B, no more than 30% of voting rights held by these other shareholders have been represented. There are no agreements in place that result in Company A being granted power over the financial and operating policies of Company B, nor does Company A have the ability to appoint or remove the majority of the members of the Board. An analysis under IAS 27 indicates that Company A does not control Company B and, in consequence, Company B is not its subsidiary. This is due to the size of its shareholding (48%) and the lack of either: any options to acquire additional voting rights; or any agreements with other shareholders that formally transfer control. Even if Company A did in practice carry out much of the day to day management of Company B, it would (in theory) be possible for the other shareholders to combine and block any decisions that they did not support. While it might be argued that Company A, due to its substantial holding, would have control in practice (or de facto control ) if the other shareholders, as expected, did not combine their voting rights if they object to Company A s decisions, the analysis indicates that Company A would not have the power to control due to the ability of the other shareholders to exert that control if they wished. 2
Statement by the International Accouting Standards Board The IASB considered the question of de facto control recently, and included the following statement in its October 2005 edition of IASB Update: The Board has recently become aware of differences in how IAS 27 might be applied in the circumstances in which an entity owns less than half the voting power in an entity. The Board discussed the definition of control in IAS 27 and decided to make a statement outlining its views on de facto control. That statement is reproduced below: Control under IAS 27 Consolidated and Separate Financial Statements IAS 27 contemplates that there are circumstances in which one entity can control another entity without owning more than half the voting power. During its deliberations on its control project, the Board confirmed its view that an entity holding a minority interest can control another entity in the absence of any formal arrangements that would give it the majority of the voting rights. For example, control is achievable if the balance of holdings is dispersed and the other shareholders have not organised their interests in such a way that they exercise more votes than the minority shareholder. This is sometimes referred to as de facto control. During those deliberations, the Board made it clear that, in its view, the control concept in IAS 27 includes de facto control. The Board also acknowledged that professional skill and judgement is required in applying the control concept including determining if de facto control exists. The Board has recently become aware that some who apply IFRSs hold the view that, in the circumstances described, IAS 27 requires an entity to have legal control over a majority of the voting rights to control another entity. The Board accepts that it would have been helpful if IAS 27 had included guidance to assist preparers in exercising the judgement to apply the control concept. Without that guidance, there is a greater risk that two entities faced with the same set of circumstances might reach different conclusions on whether they control another entity. The Board is aware that differences in the application of IAS 27 might also be influenced by the practices followed in jurisdictions before adopting IFRSs. The Board has made progress on its project on control and it could issue an exposure draft to propose amending IAS 27 by adding guidance on de facto control. However, the Board prefers to address comprehensively issues related to control in any possible proposal to amend or replace IAS 27. The Board acknowledges that this approach means that differences in how IAS 27 is applied might persist until its project on control is completed. 3
Effect and authority of the IASB s statement The IASB s statement introduces uncertainty over the appropriate accounting approach that should be adopted where an entity holds 50% or less of the voting rights of another, but where the structure of the other shareholdings, and behaviour of the shareholders, is such that de facto control might exist. Questions may be raised regarding the authority of a statement by the IASB. While the IASB has a formal due process for the issuance of accounting standards and interpretations, this does not extend to cover public statements that the IASB might make. In addition, although IAS 8 does include a hierarchy of guidance to be considered where IFRS does not include specific guidance, the status of an IASB statement that has not been subject to any form of due process is not clear. In contrast, US auditing standards include a hierarchy of five official levels to be followed when applying US GAAP. The most authoritative level is comprised of the issued US GAAP accounting standards; the fourth and fifth levels consist of Q&As published by the FASB staff, and other accounting literature such as textbooks and articles respectively. In the absence of any specific guidance covering IAS 27, some regulators might seek to apply a specific interpretation in their jurisdiction. Impact, and action required Consolidation where de facto control exists is consistent with requirements under a number of national GAAPs, and with the dominant influence criterion which is included within the EU 7th Directive. These should be among the factors that management consider when assessing the existence of control. It is important to note that the IASB has not amended IAS 27 and has instead simply emphasised that judgement is required in determining whether or not de facto control exists. No additional guidance has been provided, with the IASB simply acknowledging that differences in interpretation may arise in practice. In consequence, it is possible that otherwise identical groups might include different subsidiary companies in their consolidated financial statements. In view of the inconsistency in approach that might arise in practice, it is appropriate that, where the issue is relevant in the analysis of control under IAS 27, an entity should develop a clear accounting policy setting out the approach that it follows consistently in relation to de facto control, and should disclose that policy in its financial statements. Where an entity considers that it does have de facto control over another, it would be appropriate for additional information to be given in the notes to the financial statements, indicating why de facto control is considered to exist. In the absence of further developments on the issue and associated guidance, it would appear difficult to support a subsequent change in accounting policy before the IASB has completed its project on control and any related amendment to, or replacement of, IAS 27. It will be important, in particular for first time adopters of IFRS, to consider in addition the views of any primary or secondary regulator when concluding on the accounting policy to be adopted. 4
Existing IFRS preparers In the light of the IASB s statement that the determination of control may include more than existing legal ownership of shares and potential voting rights, entities may wish to review their accounting policies that define subsidiaries, in particular of how control is assessed. Where it is concluded that additional subsidiaries should be consolidated, the accounting should be applied on a fully retrospective basis to the date on which control was obtained as required by IAS 8, together with associated disclosures. It will be important to apply the appropriate accounting standards, with IAS 22 being followed up to the date of adoption of IFRS 3. First time adopters In a similar way to existing IFRS preparers, first time adopters of IFRS may wish to revisit their accounting policy on consolidation. Many first time adopters for accounting periods commencing on/after 1 January 2005 will already have published interim financial statements, and opening balance sheets, as adjusted for the impact of IFRS. However, a decision that is taken now to consolidate a subsidiary based on de facto control would not represent a change in accounting policy, as the accounting policy will be applied for the first time in the forthcoming annual IFRS financial statements. These will be the first financial statements in which an explicit and unreserved statement of compliance will be given, as anticipated in IFRS 1 (paragraph 3). The comparative figures in the following year s interim statement would need to be adjusted for the change in accounting policy. A first time adopter that did not previously consolidate a subsidiary where de facto control exists, but will consolidate that subsidiary under IFRS, might wish to take advantage of the exemption in IFRS 1 from the requirement to restate business combinations which took place prior to the date of transition to IFRS. BDO International BDO International is a world wide network of public accounting fi rms, called BDO Member Firms, serving international clients. Each BDO Member Firm is an independent legal entity in its own country. The network is coordinated by BDO Global Coordination B.V. incorporated in the Netherlands, with an offi ce in Brussels, Belgium, where the Global Coordination Offi ce is located. The information in this bulletin is for general guidance only and is not a substitute for professional advice. The BDO Member Firms accept no responsibility for any actions taken or not taken on the basis of the information in this bulletin. BDO Global Coordination B.V. 2006. 5