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Financial Reporting

What Constitutes Control?

A revised FASB ED may fianlly provide a long-sought answer.

By Brian Henry
June 1999
EXECUTIVE SUMMARY
  • FASB ISSUED A REVISED ED SEEKING TO DEFINE what constitutes control of an entity. Under current rules, the condition for a controlling financial interest is ownership of a majority voting interest--unless control is temporary or does not rest with the owner of the majority voting interest. FASB's goal is to provide CPAs with better tools for analyzing complex corporate structures.

  • SOME BELIEVE THE REVISED ED GIVES CPAs A BETTER working definition of what constitutes control than a 1995 ED, which FASB did not approve. Observers generally agree the ED will pass but not all are certain it will solve the current problems.

  • THERE IS NOT GENERAL AGREEMENT THAT A NEW standard is needed. Only a few companies may be taking unfair advantage of the current rules. And because the current standard draws bright lines, CPAs find it less subjective and are more comfortable with it. More subjective rules might create conflicts between financial statement preparers and auditors.

  • OTHER COUNTRIES ALSO ARE SEEKING A BETTER definition of control. In New Zealand, for example, where the current standard is nearly identical to the United States, standard setters are trying to replace the bright-line rule with new and better guidance.
  • IF FASB PASSES A NEW STANDARD, CPAs STILL FACE the complex task of consolidating an entity into the accounts of the controlling entity in much the same way they do at present. In many consolidation projects, the setup is where most of the work takes place.
BRIAN HENRY is a freelance business writer based in Brooklyn, New York.

ithin a charged political atmosphere, the Financial Accounting Standards Board issued a revised exposure draft to clarify consolidation policy after its 1995 ED failed to obtain board approval. This effectively rekindles controversy fueled by critics of existing FASB guidance—particularly in-vestor advocates—who have been strident in their complaints about the poor quality of quarterly corporate earnings reports. Adding his criticism, SEC Chairman Arthur Levitt recently said, "Too many corporate managers, auditors and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation." There is a wide diversity of opinion on when and if one company "controls" another and how FASB should respond to renewed pressure to create standards that will improve financial reporting and provide CPAs with better guidance.

THE MEANING OF CONTROL

The issue of when a subsidiary is sufficiently controlled by a parent to merit consolidated financial reporting goes back many years (see "A History of Consolidation Policy," below).

In the most recent step, FASB is trying to calm concerns by defining what constitutes control of an entity which, it says, will provide CPAs with better tools with which to analyze complex corporate structures. But is such a definition what critics really want? Some CPAs and other financial professionals believe existing standards are sufficient and adding more detail will only confuse financial report users.

That's not the opinion of FASB's Ronald Bossio, who is spearheading the drive for a new ED to define when entities should be included in consolidated financial statements. "We're trying to move away from the 'bright-line' mentality. It has been an arduous process, says Bossio, one he describes as "grinding." Jack Albert, associate to the SEC chief accountant, which has oversight responsibility for FASB, calls the push for a new ED "a work in progress," but adds, "it's safe to assume implementation guidance will be coming."

Under the rule CPAs currently follow, commonly called the bright-line rule, the condition for a controlling financial interest is ownership of a majority voting interest--unless control is temporary or does not rest with the owner of the majority voting interest. But the existing standard, FASB Statement no. 94, Consolidation of All Majority-Owned Subsidiaries , doesn't define control, temporary or otherwise. "The notion of control has always been in the literature, but it was never defined," says Larry Dodyk, a partner at PricewaterhouseCoopers.

The revised ED, Dodyk says, will give CPAs a better working definition of what constitutes control. "The new wording is certainly crisper than the original 1995 version, which almost suggested that the 50% threshold for control was moving lower; that was something some did not want to see happen," he says.

For several reasons, including the one Dodyk cites, the October 1995 ED failed to get FASB approval. But will the new ED get the required supermajority of five on the seven-member board? Patricia McConnell, a senior managing director at Bear, Stearns & Co., thinks so. "The new wording makes the exposure draft more operational, especially the wording on general partnerships," she says. "I would say there's a high probability this new wording will pass."

COMPARING OLD AND NEW

John Brozovsky, an associate professor of accounting at Virginia Tech, has examined the differences between the new ED and the old one and is optimistic the revision will meet FASB criteria. "In general," he says, "the new proposal is not as detailed as the 1995 exposure draft. It is more theoretical, relying more on the accountant's judgment."

A more rigorous guideline would certainly please some in the accounting world, who argue the 50% rule opens the door for creative accounting. "Some companies have 'gamed' to this bright-line rule extremely well," says Jack Ciesielski, a Baltimore-based adviser to FASB and editor of the Analysts' Accounting Observer . "If they need to get debt off their balance sheet, they get their equity ownership in a subsidiary under 50%. If the sub blossoms, they turn around and get that sub on the other side of the bright line."

In a similar vein, Albert Meyer, a CPA and investment analyst with David Tice and Associates in Dallas, says he prefers the SEC approach, which emphasizes substance over form. "The intent is to ensure that only gains or losses on arm's-length transactions are recognized," says Meyer. "A transaction between a parent and a controlled entity amounts to self-dealing."

Meyer has analyzed publicly traded corporations where the current guidance does not always appear to recognize the true nature of the relationship between parent companies and their affiliates. Although he welcomes the FASB initiative, he is somewhat pessimistic that the new ED—if passed—will solve all problems. "No matter how carefully they draft the rules," he says, "loopholes will be found by those seeking to circumvent their spirit and intent. Vigilance is needed on the part of investors, regulators and auditors to ensure a level playing field, which is, after all, what FASB is trying to accomplish."

IS A NEW STANDARD NECESSARY?

Some of the interested parties adopt a much more laissez-faire approach than Meyer, pointing out that the case has never been made for a new standard. "I don't know if a million companies are using the bright-line rule to their advantage, or just one," says Joe B. Hoyle, CSX Professor of Management and Accounting at the University of Richmond and author of an advanced accounting textbook that covers consolidated financial statements extensively. "If it's just one, the problem is not really critical."

Louis W. Matusiak, Jr., report review partner for Olive LLP in Indianapolis, is even more blunt. "The proposed standard was undertaken to cure one or two abusive situations," he says. "We have not had any problems with the current standard, precisely because it draws bright lines, which accountants are comfortable with. Once you issue a standard that is subjective, you set yourself up for confrontations between the financial statement preparers and auditors." Adds James P. McComb, director of finance for CSX Corp., "As a preparer, I think the old model is fine and just needs a bit of fine-tuning."

THE WORLD VIEW

Such differences of opinion as to what constitutes control are not confined to the United States; they are especially common in countries that rely on bright-line rules. Timothy S. Doupnik, professor of accounting at the University of South Carolina, says New Zealand is in the midst of trying to replace its bright-line rule with a new standard (see "How the World Defines Control," page 42). According to Doupnik, New Zealand's current standard, whereby ownership of more than 50% of the voting power is needed to achieve control, is nearly identical to that of the United States.

Hilton Shuttleworth, a consolidation policy specialist for Deloitte & Touche, New Zealand, says "the criterion for identifying a subsidiary is control--meaning unilateral power and benefits--which both derive from ownership." He adds, "This is conceptually correct because the consolidated financial statements include all resources and operations controlled by the group. However, there are issues yet to be addressed in New Zealand, such as when directors of the investor personally hold shares and voting rights in the investee."

That the problems of finding a one-size-fits-all definition persists is not new to Benjamin S. Neuhausen, who first addressed the vexing issue of consolidation policy in the Journal in 1982. (See "Consolidation and the Equity Method—Time for an Overhaul," JofA, Feb.82, p. 54.) Partly as a result of this article, many of the big questions involving consolidation were resolved by Statement no. 94 in 1987. "The initiative now being undertaken by FASB is really reaffirming Statement no. 94," maintains Neuhausen, who is a partner with Arthur Andersen. "So it's possible the board will not pass this latest project."

REALITY TESTING

Putting theory into practice is never an easy sell when it comes to moving away from concrete rules—so has FASB done its job in testing the proposal? That question worries Lee Knight, professor of accounting at Samford University in Birmingham, Alabama, who wants to see more field tests done before any big changes are put to a vote. "Theoretically, we think the new ED could be wonderful, and yet in practice it may not produce the intended results," Knight says. "It may be that it can't be implemented."

FASB conducted tests for the original ED, putting two multinational corporations through a battery of tests, with no problems. For the revised ED, FASB also sought actual situations that might serve as test cases. As the deadline for submitting cases had not yet passed at press time, FASB's Bossio expressed his hope that there would be some "really tough and hard cases," referring to joint ventures for which the question of control has been especially complicated.

A COMPLEX PROBLEM

Even if FASB does pass the new standard, CPAs will still have to deal with the enormous complexity of consolidating an entity into the accounts of the controlling entity in much the same way they do now.

For example, CSX's McComb says his company recently acquired Conrail jointly with Norfolk Southern Corp. (CSX bought 42% of Conrail for $4.1 billion; Norfolk Southern owns the remaining 58%). As the two companies divide Conrail, McComb notes that the accounting teams are working hand in hand with the CSX technology group. The accountants develop the logic for a database software package, and the programmers write the code to implement it. The database will be used to consolidate the designated entities, saving countless hours of work.

"It's in the setup of a consolidation project that most of the work comes in," says McComb. "It's the accountants' job to go through the Conrail accounts and determine which are going to be split between Norfolk Southern and CSX. Then we have to translate the accounts that are part of our share of the acquisition." Once the accounts have been integrated, the CSX accountants input selected data for testing and validation. "We test the data, and we make sure the logic works. We can deal with the exceptions afterward if something doesn't translate correctly," McComb says. "External auditors will come in later to validate the data translation."

BUYER BEWARE

At the end of the day, everyone agrees that the standard-setting process has served the investment community well. FASB sets the standards; the external auditor, with an unbiased and independent mindset, attests to client compliance; and the SEC provides further guidance and oversight for publicly traded companies.

Unfortunately, there will always be a few participants in the process who will actively seek to exploit the inevitable ambiguities that arise. Investors still have a duty to exercise care when analyzing reported financial results. It is still possible that a company could report its financial results using the equity method, even though some investors believe the consolidation method may have been more appropriate. If SEC Chairman Arthur Levitt's concern about the quality of earnings is taken to heart by investors, they should heed the old advice: Let the buyer beware.

Revised ED

On February 23, 1999, FASB issued a revised exposure draft on consolidation policy, Consolidated Financial Statements: Purpose and Policy . If finalized, the ED would be effective January 1, 2000 for calendar year companies.

A History of Consolidation Policy

1959: AICPA committee on accounting procedure issued Accounting Research Bulletin no. 51, Consolidated Financial Statements , which established the bright-line rule of 50% plus one voting interest for determining whether a subsidiary's statements should be consolidated into the parent's. It also created certain exceptions to this rule, such as allowing a parent not to consolidate a captive-finance subsidiary.

1978: The AICPA issued a paper, Reporting Finance Subsidiaries in Consolidated Financial Statements , that questioned the practice of not consolidating captive-finance subsidiaries.

1987: FASB passed Statement no. 94, Consolidation of All Majority-Owned Subsidiaries , which said companies must consolidate the financial statements of all their 50%-plus-one-owned subsidiaries. This was passed in response to the enormous growth in the number of captive-finance subsidiaries.

1991: FASB issued a discussion memorandum, Consolidation Policy and Procedures , that addressed the basic issue of control, or which entities should be included in consolidated financial statements.

1994: FASB published its Preliminary Views on Major Issues Related to Consolidation Policy , which was largely devoted to the meaning of control of an entity.

1995: FASB issued Exposure Draft on Consolidated Financial Statements: Policy and Procedures . This document arrived at a definition of control and outlined procedures for CPAs to use in preparing consolidated financial statements. FASB received 162 comment letters; 26 of the respondents participated in a 1996 public hearing. Opposition to the ED was strong enough to cause FASB to vote it down.

1997: FASB postponed discussions on consolidation procedures to focus instead on consolidation policy.

1998: FASB issued a revised definition of control of an entity, which was sent out for comment to a 12-member project task force. In addition, FASB revised its implementation guidance, which was contained in appendix B of the 1995 ED.

1999: On February 23, FASB issued a revised exposure draft on consolidation policy, Consolidated Financial Statements: Purpose and Policy . As of December 1998, FASB's wording on consolidation policy was as follows:

  • A parent shall consolidate each entity (subsidiary) that it controls unless control is temporary at the date it is acquired or otherwise obtained. Once a subsidiary is consolidated, it shall continue to be included in the consolidated financial statements until the parent ceases to control it.
  • Control of an entity is defined as the ability to direct the policies and management that guide the ongoing activities of another entity so as to increase the benefits and limit the losses from those activities. It involves two essential characteristics: a parent's decision-making powers that are not shared with others and a parent's ability to use that power to increase the benefits it derives and limit the losses it suffers from the activities of its subsidiary.
  • That first essential characteristic—nonshared decision-making ability—requires that a parent have the ability by itself to

1. Direct the use of and regulate access to another entity's assets, generally by having the power to set the policies that guide how the assets are used in ongoing activities.

2. Hold the management of that other entity accountable for the conduct of its ongoing activities, including the use of that entity's assets, generally by having the power to select, terminate, and determine the compensation of the management responsible for carrying out the directives of the parent.

  • For purposes of implementing the definition of control, the board has decided to retain and clarify four of the exposure draft's presumptions of control. Situations that would lead to a presumption of control in the absence of evidence to the contrary are those in which an entity

1. Has a majority voting interest in the election of a corporation's governing body or a right to appoint a majority of the members of its governing body.

2. Has a large minority voting interest in the election of a corporation's governing body and no other party or organized group of parties has a significant voting interest.

3. Has a unilateral ability to (1) obtain a majority voting interest in the election of a corporation's governing body or (2) obtain a right to appoint a majority of the corporation's governing body through the present ownership of convertible securities or other rights that are currently exercisable at the option of the holder and the expected benefit from converting those securities or exercising that right exceeds its expected cost.

4. Is the only general partner in a limited partnership and no other partner or organized group of partners has the current ability to dissolve the limited partnership or otherwise remove the general partner.

  • Control of a newly acquired subsidiary shall be considered temporary if at the date of acquisition the parent either has committed to a plan to relinquish control of that subsidiary or is obligated to do so and it is likely that loss of control will occur within one year. An exception to that one-year rule is that control also shall be considered temporary if at the date of acquisition circumstances beyond management's control are likely to require more time to complete the ultimate disposition.

How the World Defines Control

Australia. Accounting Standards Board, AASB 1024, Consolidated Accounts, paragraph 9, defines control as: "The capacity of an entity to dominate decision-making, directly or indirectly, in relation to the financial and operating policies of another entity so as to enable that other entity to operate with it in pursuing the objectives of the controlling entity." It also says "capacity means ability or power, whether direct or indirect, and includes ability or power that is presently exercisable as a result of, in breach of, or by revocation of, any of or any combination of the following: (a) trusts; (b) relevant agreements; and (c) practices; whether or not enforceable."

Canada. Institute of Chartered Accountants, section 1590, Subsidiaries, paragraph 1590.03(a), defines a subsidiary as "an enterprise controlled by another enterprise (the parent) that has the right and ability to obtain future economic benefits from the resources of the enterprise and is exposed to the related risks." Paragraph 1590.03(b) defines control of an enterprise as "the continuing power to determine the strategic operating, investing and financing policies without the cooperation of others."

France. According to Professor Doupnik, France has the following definition of control: "All companies over which the parent company has exclusive control should be consolidated. There are three methods of ascertaining exclusive control: (1) direct or indirect majority voting power; (2) direct or indirect voting power of 40% if no other shareholder has more than 40% voting power; or (3) control via a management or other agreement (and the parent must have an equity interest in the subsidiary)."

International Accounting Standards Committee. Statement no. 27, paragraph 6, defines control as the power to govern the financial and operating policies of an enterprise so as to obtain benefits from its activities.

New Zealand. In June 1998, the Institute of Chartered Accountants of New Zealand released an exposure draft, ED-84 Consolidating Investments in Subsidiaries , that proposed "Control by one entity over another exists where the first has the capacity to exercise a power of an ownership form, or has previously exercised a power of an ownership form which has established an irreversible mechanism, to direct the policies that guide the activities of the second entity in circumstances where the first entity has a current or future entitlement to a significant level of the net ownership benefits that arise from the activities of the second entity." [paragraph 4.10]

United Kingdom. Accounting Standards Board, FRS no. 5, Reporting the Substance of Transactions , paragraph 8, defines control of another entity as the "ability to direct the financial and operating policies of that entity with a view to gaining economic benefits from its activities."

United States. At present, U.S. GAAP does not define what constitutes control.

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