Determining the scope of consolidation
The scope of consolidation: the concepts of control, of control percentage and interest percentage
This article is the first in a series on topics about account consolidation. Taken together, the upcoming articles will help you understand the different steps of the process as well as the importance of working with professionals and of investing in effective, high-performance software tools.
The process of determining the scope of consolidation is not immune from the diversity of accounting standards. The items covered in this article are based on IFRS rules which are currently evolving with respect to consolidation. With the publication in May 2011 of the final versions of IFRS 10 “Consolidated Financial Statements”, IFRS 11 “Joint Arrangements” and IFRS 12 “Disclosure of Involvement with Other Entities” and their mandatory application starting on 1 January 2013, it’s likely that the scope of certain groups will undergo some significant changes.
Defining the scope is probably the most significant task of the overall process for the simple reason that it determines which companies in the group will be consolidated and, if there is consolidation, which method will be used. We should point out that the use of consolidation software can greatly facilitate the calculation of control and interest percentages and the accounting application of ad hoc consolidation methods.
There are four categories of holdings:
Direct holdings (1)
Indirect holdings (2)
Cross holdings (3)
Circular holdings (4)
There are several types of control possible for these different holdings:
Exclusive control is the power to direct the financial and operating policies of an entity to obtain benefits from its operations. IAS 27 indicates that there is a (refutable) assumption of exclusive control when the consolidating entity directly or indirectly holds more than 50% of the voting rights. When a consolidating entity controls no more than 50% of the voting rights, there is control if the entity has:
- The power to nominate or remove the majority of the members of the board of directors or of the equivalent governing body, if control of the entity is in the hands of this board or body
- The power to cast the majority of votes in board of director or equivalent governing body meetings, if control is in the hands of this board or body.
- Power over more than half of the voting rights by virtue of an agreement with other investors
- The power to direct the financial and operating policies of the entity by virtue of a regulatory text or contract.
Joint control is the power to jointly direct the financial and operating policies of another company with one or more companies that are not included in the consolidation. This type of control results in a limited number of shareholders or associates sharing control and in a contractual arrangement as to the exercise of joint control between these shareholders or associates.
More precisely, IAS 31 stipulates that joint control consists in sharing control over an economic activity. It only exists on condition that the strategic financial and operating decisions of the jointly controlled entity are taken by unanimous agreement of the parties or venturers sharing control. The key issue is, therefore, the existence of a contractual arrangement. Without this arrangement, there is no joint control and, as a result, it will no longer be a matter of a joint venture but, more likely, of significant influence.
According to IAS 28, significant influence is the power to participate in the financial and operating policy decisions of the held company without, however, exercising exclusive or joint control over these policies. It is also assumed that there is significant influence when at least 20% of voting rights are held. This assumption is refutable because it’s possible that a company with a 20% holding in another company does not have significant influence over it. Likewise, there can be significant influence with an 18% holding.
A series of factors can play a part in demonstrating significant influence. Among these are:
- Participation in the company’s policy-making process
- Representation on the board of directors or equivalent governing body
- Significant transactions
- An interchange of managerial personnel
- The provision of essential technical information.
In consolidation terms, the general principle states that, regardless of the level of control, all companies controlled or under significant influence must be included within the scope of consolidation. However, there are a few exceptions to this rule.
Exclusions from the scope of consolidation also depend on the accounting standard used for consolidation. The different possibilities for IFRS are:
- Although IFRS does not exclude immaterial subsidiaries formally, we believe that they can be excluded from the scope of consolidation based on the principle of materiality mentioned in IAS 8 and defined in IAS 1. Caution is required because the concept of materiality is not an accounting policy but can be considered when accounting policies are applied. In addition, materiality must be understood globally when there is only one immaterial subsidiary.
- Severe and durable restrictions on funds transfers to the consolidating company are not a criterion for automatic exclusion from the scope of consolidation (contrary to what is seen in some other GAAP). In fact, in order to exclude an entity from the scope, loss of effective control must be demonstrated. Severe and durable restrictions can be demonstrating factors but are not sufficient in themselves to prove loss of control.
- Subsidiaries held solely for sale should not be excluded from the scope of consolidation They must be included in the scope until the actual date of loss of exclusive control. The answer is less clear cut for associates and joint ventures since they can be excluded from the scope if they comply with strict classification rules for non-current assets held for sale in compliance with IFRS 5. Otherwise, they must be included in the scope of consolidation.
Allocation of a level of control to each company included in the scope and, therefore, of a consolidation method, requires calculation of the control percentage.
The control percentage is the cumulative percentage of voting rights held and, under certain conditions, potentially held, by the consolidating entity, either directly or indirectly. Indirectly means via the intermediary of entities under exclusive control. This percentage is only useful for the determination of the scope and of the consolidation method. The latter is a necessary criterion but is not sufficient since de facto situations and contractual arrangements can contradict the first conclusions of control percentages with respect to the level of control.
Different consolidation methods are used depending on the level of control:
- Exclusive control → Full consolidation
- Joint control → Proportionate consolidation or equity method
- Significant influence → Equity method
In brief, full integration consists in including the entire balance sheet and profit and loss account of the consolidated entity in the consolidated accounts after required adjustments and eliminations. The portion of shareholders’ equity and of income which do not belong to the consolidated entity will be allocated to minority interests. Proportionate integration includes the balance sheet and the income account of the consolidated entity but only up to the level held by the consolidating company. The equity method consists in substituting the book value of the securities held with the share of shareholders’ equity of the equity-accounted entity.
In all three methods, the difference between the cost of acquisition of the holding and the total value of its assets and liabilities on the date of acquisition is either “goodwill” (positive acquisition difference) or “badwill” (negative acquisition difference).
The interest percentage, which may be different from the control percentage, enables calculation of the share of assets held directly or indirectly by the mother company in the different companies of the group. The calculation process is different because, contrary to the control percentage, the interest percentage is obtained by using the sum of the percentages of financial rights held. Contrary to some other GAAP, international standards stipulate that only interest percentages held indirectly by subsidiaries must be included in the percentage calculation.
We now know a little more about the concepts of control and control and interest percentages. In conclusion, we should point out that using good consolidation software enables maximum automation of scope determination, of the calculation of control and interest percentages, of consolidation methods and of the resulting accounting processing. Adjustment to methods as a result of new elements in the scope and the management of scope simulations are also greatly facilitated.