Consolidated Financial Statements shall be prepared by an entity if it has control over another entity. ‘Control’ under IFRS, being power to govern the financial and operating policies, covers within its purview even those entities that have been excluded under Indian GAAP. This article attempts to analyse the meaning and scope of the term — Potential Voting Rights — when determining control.
India, in the year 2011, joins the global accounting revolution : International Financial Reporting Standards (IFRS). It’s being defined as a revolution by many, because significant conceptual level changes are envisaged. One such concept that is evidenced in the piece that follows is substance over form. Recognising the core substance of the transaction over its legal form will indisputably bring an evolution in financial decision making.
It’s not that Indian GAAP does not recognise the importance of substance over form, but its true application will happen only under IFRS. One such instance is consideration of potential voting rights to determine existence of ‘control’ for the purpose of consolidation.
What is Potential Voting Rights ?
An entity may own securities 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.
Some of the key instruments that are considered to have potential voting rights are as under :
1. Equity share warrants
2. Share call options
3. Convertible preference shares
4. Convertible debts
Defining control :
Under IFRS, International Accounting Standard (IAS) 27 Consolidated and Separate Financial Statements defines Control as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.
As per Indian GAAP — Accounting Standard (AS) 21 Consolidated Financial Statements, Control means
(i) the ownership, directly or indirectly through subsidiary(ies), of more than one-half of the voting power of an enterprise; or
(ii) control of the composition of the board of directors in the case of a company or of the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities
The above definition is in line with that given under the Companies Act, 1956.
As per S. 4(1) of the Companies Act, 1956, a company shall be deemed to be a subsidiary of another if, but only if, :
(i) that other controls the composition of its Board of directors; or
(ii) that other :
- where the first-mentioned company is an existing company in respect of which the holders of preference shares issued before the commencement of this Act have the same voting rights in all respects as the holders of equity shares, exercises or controls more than half of the total voting power of such company;
- where the first-mentioned company is any other company, holds more than half in nominal value of its equity share capital; or
(iii) the first-mentioned company is a subsidiary of any company which is that other’s subsidiary.
Here, the expression ‘nominal value of its equity share capital’ means paid-up value of the equity shares and not its face value. The meaning is clear when it is read in conjunction with S. 87(1)(b) of the Companies Act, 1956 which provides that the voting rights in respect of a member holding equity shares in a company shall be in proportion to his share of the total paid-up value of equity shares of the company.
Exclusion of Potential Voting Rights under Indian GAAP :
From the above definition, it can be seen that the Companies Act, 1956 considers nominal value of equity share capital and not potential shares/voting rights.
Although AS 21 does not specifically exclude potential voting rights, Explanation to paragraph 4 of AS 23 Accounting for Investments in Associates in Consolidated Financial Statements states that the effects of potential voting rights are not to be considered for the purpose of determining control.
Based on the above analysis and in light of law prevailing over standards, potential voting rights are not considered for determining control under Indian GAAP.
However, the scope of IAS 27 is much wider as it considers the effects of potential voting rights.
Determining whether potential voting rights exist :
In assessing whether potential voting rights contribute to control, the entity examines all facts and circumstances (including the terms of exercise of the potential voting rights and any other contractual arrangements whether considered individually or in combination) that affect potential voting rights, except the intention of the management and the financial ability to exercise or convert. The intention of the management and the financial ability of an entity to exercise or convert does not affect the existence of power.
Example : An entity holding 35% voting rights in another entity, but having options to acquire another 20% voting interest, would effectively have 55% current and potential voting interests. This may lead to consolidation as per IAS 27.
Currently exercisable or convertible:
An entity has control when it currently has the ability to exercise that power, regardless of whether control is actively demonstrated or is passive in nature. The existence and effect of only those potential voting rights that are currently exercisable or convertible, including potential voting rights held by another entity, are considered when assessing whether an entity has the power to govern the financial and operating policies of another entity. Potential voting rights are not currently exercisable or convertible when they cannot be exercised or converted until a future date or until the occurrence of a future event.
Example: Company H issues Foreign Currency Convertible Bonds (FCCB) with the condition that they are redeemable or convertible only after a period of 3 years. In this case, potential voting rights shall be assumed to exist only after completion of the 3 year lock-in period.
When potential voting rights exist, the proportions of profit or loss and changes in equity allocated to the parent and minority interests are determined on the basis of present ownership and do not reflect the effects of potential voting rights. That is, potential ownership may necessitate consolidated financial reporting, but income or loss allocation is still to be based on actual, not potential, ownership percentages.
Can one subsidiary have two parents?
Potential voting rights are capable of changing an entity’s voting power over another entity – if the potential voting rights are exercised or converted, then the relative ownership of the ordinary shares carrying voting rights changes. Consequently, the existence of control is determined only after considering the existence and effect of potential voting rights. The definition of control in IAS 27 permits only one entity to have control of another entity. Therefore, when two or more entities each holding significant voting rights, both actual and potential, the factors are reassessed to determine which entity has control.
Whereas, under Indian GAAP, Explanation to paragraph 10 of AS 21 Consolidated Financial Statements states that both the entities should consolidate the financial statements of the controlled entity.
Potential voting rights held by others:
Thus, an entity will not be able to conclude that it controls another entity after considering the potential voting rights held by it without considering the potential voting rights held by other parties. Consequently, an entity considers all potential voting rights held by it and by other parties that are currently exercisable or convertible when determining whether it controls another entity.
As can be seen above, Company B holds 45 lakhs current and 15 lakhs potential voting rights in Company O. Thus, company B holds in all 60 lakhs voting rights. Company D, in turn, holds SS lakhs current voting rights in Company O. However, this fact alone shall not lead to a conclusion that company B is the controlling entity. Company B must also consider the potential voting rights held by company D, if any.
Can non-convertible Preference Share Holders have potential voting rights?
A combined impact of IFRSs and legislations like the Companies Act may give rise to unique circumstances. For instance, in the Indian scenario, non convertible preference shares may have a role to play in determining control, as described below.
As per S. 87(2)(b) of the Companies Act, 1956, every member of a company limited by shares and holding any preference share capital therein shall, in respect of such capital, be entitled to vote on every resolution placed before the company at any meeting, if the dividend due on such capital or any part of such dividend has remained unpaid:
i) in the case of cumulative preference shares, in respect of an aggregate period of not less than two years preceding the date of commencement of the meeting; and
ii) in the case of non-cumulative preference shares, either in respect of a period of not less than two years ending with the expiry of the financial year immediately preceding the commencement of the meeting or in respect of an aggregate period of not less than three years comprised in the six years ending with the expiry of the financial year aforesaid.
As per S. 87(2)(c) of the Companies Act, 1956, where the holder of any preference share has a right to vote on any resolution in accordance with the provisions of this sub-section, his voting right on a poll, as the holder of such share, shall, subject to the pro-visions of S. 89 and Ss.(2) of S. 92, be in the same proportion as the capital paid-up in respect of the preference share bears to the total paid-up equity capital of the company.
Also, one must not forget that a security will be considered to have potential voting rights only if it is currently exercisable or convertible. As the cumulative/non-cumulative preference shares will have right to exercise voting power only on default by the company, as mentioned above, the shares shall be considered for the purpose of ‘control’ only when they are entitled to vote. In short, the cumulative/ non-cumulative preference shareholders shall not be considered to be having potential voting rights till they actually are eligible to vote.
Takeaways:
As defined above, ‘Control’ is the power to govern financial and operating policies of an entity. Voting rights cannot be considered in isolation to determine control. There are several other factors, not having been touched upon by this article, which may deserve consideration to zero in on the entity that has power to govern policies.
To conclude, there are three important takeaways:
1. An entity has control when it currently has the ability to exercise that power
2. An entity shall consider all potential voting rights held by it and by other parties that are currently exercisable or convertible while determining whether it controls another entity
3. Income or loss allocation between parent and minority interests is still to be based on actual, not potential, ownership percentages.
