Commenting on the defintion of control - IAS 27

IAS 27 GUIDANCE ON CONTROL

Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. [IAS 27(2008).4]. Financial and operating policies are not defined in IAS 27. 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 dividend policies, budget approvals, credit terms, issue of debt, cash management, capital expenditures and accounting policies.

Policies and benefits

The definition of control encompasses both the notion of governance and the economic consequences of that governance (i.e. benefits and risks). Governance relates to the power to make decisions. In the definition of control, the phrase ‘power to control’ implies having the capacity or ability to accomplish something – in this case, to govern the decision-making process through the selection of financial and operating policies. This does not require active participation or ownership of shares. In situations where one entity has the power to govern another entity’s policies, but derives no benefits from its activities, there is a presumption that control does not exist. 

Presumption of control

Control is generally presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity. In exceptional circumstances, however, it may be possible to clearly demonstrate that such ownership does not constitute control. Control also exists when the parent owns half or less of the voting power of an entity when there is:

[IAS 27(2008).13]

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 an 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.

The definition and guidance on control is intended to identify whether an entity has sole control over one or more other entities. Where two entities have joint control under a contractual agreement (i.e. they are able to exercise control by cooperating, but neither can unilaterally exercise control without the agreement of the other), then the arrangement will not fall within the scope of either IAS 27 or IFRS 3, but will fall within the scope of IAS 31.

Potential voting rights

An entity may own instruments (e.g. share warrants, share call options, debt or equity instruments that are convertible into ordinary shares) 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 (potential voting rights).

a) Where potential voting rights are currently exercisable or convertible, they are considered when assessing whether an entity has the power to govern another entity’s financial and operating policies. [IAS 27(2008).14]

b) Where potential voting rights are not exercisable or convertible until a future date or until the occurrence of a future event, they are not considered in making that assessment. [IAS 27(2008).14]

c) However, the proportions of profit or loss and changes in equity allocated to the parent and non-controlling interests are determined on the basis of present ownership, and do not reflect any exercise or conversion of potential voting rights. [IAS 27(2008).19]

In assessing whether potential voting rights contribute to control, all of the facts and circumstances that affect those rights should be considered (including the terms of exercise of the rights and any other contractual arrangements), except the intention of management and the financial ability to exercise or convert such rights. [IAS 27(2008).15]

The effect of these requirements is that where one entity, by using the threat of exercise or conversion of potential voting rights, is able to ensure that its wishes are followed, then it has the power to direct the actions of others who are affected by a change in voting power.

I am convinced based on the above notes that even if a company has a share certificate reflecting ownership of 51 shares out of 100 but is unable exercise their majority rights as contemplated by such a percentage ownership they do not have the “POWER’” as discussed above and it would not be able to consolidate the investment in which the 51% investment is held. The owners of the 51% are what could commonly called “lame duck” and have no capacity to influence the board of directors of the investee in any manner. It is the directors who run the company on behalf of the shareholders. Directors can make various decisions by themselves without shareholder approval however every time shareholder approval would be legally needed the 51% shareholder cannot exclusively authorise the directors to conduct operations whether economically or financially. Every shareholder approval requires approval from 24% of the remaining shareholders. This in essence means that the 51% shareholder does not control the company by virtue of not controlling the board.