The concept of control in consolidated financial statements: convergence of U.S. and international accounting rules.

International Accounting Rules for Consolidation

The FASB's recent efforts in issuing new and proposed rules for consolidation have moved U.S. GAAP into closer (not exact) alignment with rules required under international accounting standards (IASs), which are now issued as international financial reporting standards (IFRSs) by the IASB, as next explained.

International accounting consolidation rules are included in International Accounting Standard 27 (Revised 2003), Consolidated and Separate Financial Statements (IAS 27) and Standing Interpretations Committee 12, Consolidation--Special Purpose Entities, an interpretation relating to IAS 27 (SIC 12), which provides further indicators of control over SPEs.

IAS 27 prescribes the requirements for preparing and presenting consolidated financial statements for entities under the control of a parent, among other things. Under IAS 27, as amended by IFRS 5, Non-current Assets Held for Sale and Discontinued Operations, in 2004, consolidated financial statements should include all subsidiaries (including not-for-profit entities, which are exempted from consolidation under ARB 51 but not the proposed Statement). From an international perspective, the concept of control is much broader than under ARB 51, but includes many of the characteristics presented in the FASB's proposed Standard and FIN 46(R). According to paragraph 4 in IAS 27, control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. Operating policies generally would include those policies that guide activities such as sales; marketing; manufacturing; human resources; and acquisitions and disposals of investments. Financial policies generally would be those policies that guide accounting policies; budget approvals; credit terms; dividend policies; issuance of debt; cash management; and capital expenditures [2:Question IAS 27:4-2].

The definition of control encompasses both the notion of governance as well as the economic consequence of that governance (i.e., benefits and risks). Governance relates to the power to make decisions through the selection of financial and operating policies. This does not require active participation or ownership of shares. Benefits may relate to current or future cash inflows either remitted to the controlling enterprise or remaining in control of the controlling enterprise or may encompass non-monetary increases in value to the controlling enterprise. Risks may relate to current or future cash or non-monetary outflows either paid by the controlling enterprise or through assets controlled by the enterprise. This concept of risk and reward also plays a significant role in determining who the primary beneficiary is under FIN 46(R). Ultimately, the assessment of whether or not an entity controls another is a matter of careful judgment, based on all relevant facts and circumstances [2:Question IAS 27:4-1].

Control is presumed to exist when an investor owns more than 50% of voting power of an investee, either directly or indirectly. However, it may be possible to demonstrate that such ownership does not signify control, especially when a significant minority interest exists or when another party has the ability to dominate the board of directors of the entity. The substance of the arrangement must be considered, as it may provide evidence to rebut the presumption. In addition, control can exist even when an entity owns less than 50% of an entity's voting share capital (or equity capital) when one or more of the following conditions exist:

* Power over more than half of the voting rights by virtue of an agreement with other investors

* Power to govern the financial and operating policies of the entity under a statute or an agreement

* 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

* 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

Exhibit 1 provides a few illustrative investment scenarios involving the concept of control; significant influence; or no significant influence. In addition to the control indicators in IAS 27.13, the potential voting rights identified in IAS 27.14 also should be considered in evaluating whether or not control exists. Potential voting rights are when an entity owns share warrants, share call options, debt or equity instruments that are convertible into ordinary shares or other similar instruments that have the potential, if exercised or converted, to give the entity voting power or reduce another party's voting power over the financial and operating policies of another entity. It is important to note, in order to be considered in determining control, the potential voting rights must be currently exercisable or convertible.

The Concept of Control for Special Purpose Entities (SPEs)--SIC 12

SIC 12, an interpretation relating to IAS 27, provides further indicators for control as they apply to SPEs and explains when such entities should be consolidated by a reporting entity under the provisions in IAS 27. Basically, an entity should consolidate a SPE when, in substance, the entity controls the SPE. The concept of control in IAS 27 that is applied to SPEs by SIC 12 requires an enterprise to have the ability to direct or dominate the decision making power of the entity, accompanied by the ability to obtain benefits from the SPE's activities. This is very similar to an important aspect of the concept of control defined in the FASB's proposed Statement on consolidation policy, discussed earlier. SIC 12 provides the following examples of indications of when control of an SPE may exist:

* The SPE is involved in activities on behalf of the reporting entity.

* The reporting entity has decision-making powers over the SPE, and

* The reporting entity has rights to the majority of the benefits and exposure to significant risks of the SPE.

The last indicator presented above reflects FIN 46 (R)'s guidance which must be used to determine the primary beneficiary of a VIE, which must consolidate the entity.

Conclusion

Convergence of U.S. and international consolidation standards has moved forward, although progress has been less rapid than in other areas, such as stock-based compensation, earnings per share, business combinations, etc. These convergence efforts will promote the global cross-border movement of the capital that is necessary to sustain economic growth. The progress made to date has led to more consistent and translucent financial statements that should enhance investor confidence in domestic and international financial reporting, however more work still needs to be done. The FASB and IASB have taken many steps toward the development of a global set of accounting standards that will accommodate the needs of all investors and creditors. A significant step in that direction will be complete when the FASB finalizes its proposed standard on consolidation policy so that its rules are more in line with international accounting standards.

Additional/Further Reading

American Institute of Certified Public Accountants (AICPA). Accounting Research Bulletin No. 51, "Consolidated Financial Statements.". AICPA, New York, August, 1959.

American Institute of Certified Public Accountants (AICPA). Accounting Principles Board Opinion No. "The Equity Method of Accounting for Investments in Common Stock" AICPA, New York, March, 1971.

Deloitte & Touche, "Consolidation of Variable Interest Entities," Case 4 in 2003 Partners, Directors, and Senior Managers Technical Excellence Seminar. Deloitte & Touche, Wilton, Connecticut, 2003.

Deloitte & Touche, "FASB Interpretation No. 46(R) Questions and Answers," February, 2004.

Deloitte & Touche's Technology, Media, & Telecommunications (TMT) Group. "Through the SPE Looking Glass: Improving the Transparency of Special-Purpose Entities," For the Record, Deloitte & Touche, Wilton Connecticut, May/June, 2002.

Deloitte & Touche's 2003 Technical Excellence Seminar, Case 4, "Variable Interest Entities,", Accounting Services Department, Deloitte & Touche LLP, Wilton Connecticut, September, 2003.

Financial Accounting Standards Board (FASB). Proposed Statement on Financial Accounting Standards, "Consolidated Financial Statements: Purpose and Policy: Revision of Exposure Draft issued October 16, 1995." FASB, Norwalk, Connecticut, 1999.

Financial Accounting Standards Board (FASB). FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, An Interpretation of ARB No. 51 (Revised December 2003),". FASB, Norwalk Connecticut, 2003.

Hartgraves, A.I L. and G.eorge J. Benston. "The Evolving Accounting Standards for Special Purpose Entities aAnd Consolidation,". Accounting Horizons, Vol. 16, No. 3, September 2002.

International Financial Aaccounting Standard Board, IAS 27 (Revised) "Consolidated and Separate Financial Statements,", IASB, London, UK, 2004.

Standards Interpretations Committee, "SIC 12 Consolidation-Special Purpose Entities), Revised,", SIC, London, UK, 2004.

Zion, D. and B. Carache. "FIN 46: New Rule Could Surprise Investors," Credit Suisse/First Boston Equity Research, June 24, 2003.

References

1. Casabona, P.A. and D.J. Gannon "Global Movement Towards Principle-Based Reporting Standards." Global Business and Technology Association, Navigating Crisis and Opportunities in Global Markets: Leadership, Strategy and Governance. Cape Town, South Africa, June 8-12, 2004.

2. Deloitte & Touche, International Accounting Manual, various sections, 2004.

3. Gannon, D. J. and A. Ashwal. "Financial Reporting Goes Global," Journal of Accountancy, Vol. 198, Issue 3, p43, 5p, September 2004.