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July 2009

Gaps in GAAP

By Dolphy D’Souza, Chartered Accountant
Reading Time 4 mins

Accounting Standards

Can an entity be consolidated when the ‘parent’ has the
ability in practice, but not the legal right to exercise control over the
entity ?  e.g., Entity A owns 40% of the voting power in Entity B
and the remaining 60% of shares are widely dispersed, such that Entity A may
exercise de facto control.

‘Control’ is defined in IAS 27 as : “the power to govern
the financial and operating policies of an entity so as to obtain benefits from
its activities”. It follows from this definition that control involves : 
(a) decision-making ability that is not shared with others; and (b) the ability
to give directions with respect to the operating and financial policies of the
entity concerned, with which directions the entity’s directors are obliged to
comply. In order to meet the definition of control, an investor must govern the
financial and operating policies of an entity for the purpose of obtaining
benefits from the entity’s activities. A trustee or other fiduciary with
decision-making powers that are limited to directing the on-going activities of
an entity for the benefit of others does not meet the IAS 27 definition of

In order to have the ability to govern the financial and
operating policies of an entity, an investor must be able to hold the management
of the entity accountable. It is therefore unlikely that de facto control
over an entity can exist unless the investor has the power to appoint and remove
a majority of its governing body (i.e., normally the board of directors
in the case of a company). This power is normally exercisable by holders of the
voting shares in general meeting.

Since the concept of control is defined in terms of
decision-making ability and not how power is actually exercised,
it is theoretically possible for control to be exercised passively as well as
actively. However, any determination of whether de facto control
exists will always have to be made based on the particular circumstances
it is unlikely to be sufficiently certain that de facto control exists
until actions have been taken that provide evidence of control, i.e.,
control must have been actively exercised

This will be evidenced by participation and voting at the
Annual General Meeting, where strategic decisions are put to the vote – e.g.,
director nominations. Evidence will be required that the entity was able to vote
in a director of their choice or make decisions that indicated an alignment with
their own business and purpose. In general, the more the legal or
contractually-based powers that are held in relation to an entity fall short of
50% of the total, the greater will be the need for evidence of actively
exercised de facto control.

In practice, de facto control is most likely to be
evidenced where a minority voting interest holder is able to (re) nominate its
nominee to an entity’s board of directors and its votes exceed 50% of the votes
typically cast in the entity’s election of directors. For example, if typically
only 70% of the eligible votes are cast on resolutions for the appointment of
directors, a minority holding of 40% might give de facto control,
provided that if the remaining shares are widely held (such that, for example,
no party has an interest of sufficient size either of itself or with a small
number of others to block decisions).

The October 2005 issue of IASB Update states, “an entity
holding a minority interest can control another entity in the absence of any
formal arrangements that would give it a majority of the voting rights.
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 holder.”

At this moment it appears that there is a mixed practice with
regards to consolidation based on de facto control under IFRS. This is
because the IASB has not come up with any detailed guidance on this issue. Until
such time as the IASB issues detailed guidance to assist preparers in exercising
the judgment required to apply the control concept, there will be differences in
how IAS 27 is applied.

In India, under Indian GAAP, the general practice is not to consolidate
entities based on de facto control. That may change once India adopts

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