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Definition of a subsidiary
Extract from FRS102: Section 9.4-9.6 and Section 9.8A
9.4 A subsidiary is an entity that is controlled by the parent. Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.
9.5 Control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity. That presumption may be overcome in exceptional circumstances if it can be clearly demonstrated that such ownership does not constitute control. Control also exists when the parent owns half or less of the voting power of an entity but it has:
(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
9.6 Control can also be achieved by having options or convertible instruments that are currently exercisable or by having an agent with the ability to direct the activities for the benefit of the controlling entity.
9.6A Control can also exist when the parent has the power to exercise, or actually exercises, dominant influence or control over the undertaking or it and the undertaking are managed on a unified basis.
9.8 A subsidiary is not excluded from consolidation because its business activities are dissimilar to those of the other entities within the consolidation. Relevant information is provided by consolidating such subsidiaries and disclosing additional information in the consolidated financial statements about the different business activities of subsidiaries.
OmniPro comment
Appendix I of FRS 102 defines a parent as ‘an entity that has one or more subsidiaries’. A subsidiary can be a company, a partnership, a trust or other unincorporated entity.
In order for an entity to have control it must have:
- The power over the financial and operating policies; and
- Benefits must be obtained as a result of that power from the entities activities
Section 9.5 makes it clear that control is presumed where greater than 50% of the voting power is held by an entity. However control can also exist when the parent owns 50% or less of the voting power but it has:
- power over more than half of the voting rights by virtue of an agreement with other investors; or
- power to govern the financial and operating policies of the entity under a statute or an agreement; or
- power to appoint or remove the majority of members of the board of directors or equivalent; or
- power to cast the majority of votes at meetings of the board of directors; or
- having options or convertible instruments which are exercisable at the date of acquisition.
Although FRS 102 does not define what the strategic, financial and operating decisions would cover, these are generally understood to include areas such as budgeting, capital expenditure, treasury management, dividend policy, production, marketing, sales and human resources, decisions of acquiring or disposal of significant assets, a right to block customary or expected dividends, decisions over liquidation of the company, issuance and repurchase of equity shares. The most important here is the control over distributions and the reinvestment decisions.
In relation to the benefit test, this does not specifically mean the benefits from ownership but also relates to other benefits such as brand related goodwill generating more customers, cost savings, access to new customers etc.
In determining control, the key thing to consider is whether the entity has the power to govern the entity, it is irrelevant whether they exercise this control or not.
Example 1: Exercise of dominant influence
Company A owns 60% of the voting rights of Company B. However Company A allows the other investor who owns the remaining 40% to run Company B with little or no input from Company A. In this case although Company A is not getting involved in the financial and operating policies this is irrelevant when assessing control, as the key point is that they have the ability if Company A wanted to prevent the other investor from making decisions.
Potential voting rights
When assessing whether control exists, an entity should not only review all shares/rights held at that point in time but also options/rights which are exercisable at that point in time. If voting rights cannot be converted or exercised until a future date these are not considered in determining whether control exists.
Example 2: Potential voting rights
Company A owns 40% of the share capital and voting rights of Company B. It also hold 100% preference shares in Company B which provide a right to a dividend of 5% per annum. These preference shares can be converted at the option of Company A into ordinary shares after 3 years time which would result in the Company obtaining more than 50% of the voting rights (assume 70%).
With regard to the convertible rights here, these cannot be considered by Company A in the control test until after 3 years. So for the first three years assuming Company A does not have the ability to control the composition of the board, Company A would not control Company B and therefore it is not a subsidiary.
However after year 3, even if Company A does not exercise its right to convert at that time, in assessing whether control exists, these exercisable rights should be taken into account and therefore Company B would be a subsidiary of Company A from that date. Note if the option is not exercised after the three years in the consolidated financial statements 60% of the net assets would be allocated to non-controlling interests as that is what the NCI owns at that point in time as the options have not been exercised.
Where the rights are exercisable/convertible in the very near future they may be taken into account so if this is the case judgement will need to be exercised. In addition consideration should be given as to whether an entity will be able to exercise dominant influences i.e. do they have the financial resources etc. to convert rights into shares.
Less than 50% of share capital held but still have control
Example 3: Ability to control composition of the board
Company A owns 40% of Company B with the remaining 60% held by another party. However, Company A also holds one golden share which gives Company A the right to control the composition of the board of directors.
In this situation as the board of directors dictate the financial and operating policies of the company since Company A has the ability to appoint or force directors to resign this gives Company A control and therefore Company B is a subsidiary of Company A. In the consolidated financial statements 60% of the net assets would be allocated to non-controlling interests.
Greater than 50% of share capital owned but still not have control
Even where an entity owns greater than 50% of the ordinary shares, where an agreement is entered into whereby unanimous agreement is required from all shareholders, then this would indicate that an entity does not have control, instead this should be treated as a joint venture and be accounted for under Section 15 of FRS 102.
Where agreements are entered into with other shareholders whereby the other shareholders give another shareholder their rights to vote, then in this instance all the voting rights given must be considered.
Example 4: Agreements with other shareholders
Company A owns 40% of Company B. Company A has also entered into an agreement with other shareholders who own 20% of the shares whereby they agree that they will always vote in line with Company A.
As a result of this agreement Company A effectively has 60% voting rights and therefore has control of Company B. In the consolidated financial statements 60% of the net assets would be allocated to non-controlling interests.
Subsidiaries excluded from consolidation
Extract from FRS102: Section 9.9-9.9B
9.9 A subsidiary shall be excluded from consolidation where:
(a) severe long-term restrictions substantially hinder the exercise of the rights of the parent over the assets or management of the subsidiary; or
(b) the interest in the subsidiary is held exclusively with a view to subsequent resale; and the subsidiary has not previously been consolidated in the consolidated financial statements prepared in accordance with this FRS.
9.9A A subsidiary excluded from consolidation on the grounds set out in paragraph 9.9(a) shall be measured using an accounting policy selected by the parent in accordance with paragraph 9.26, except where the parent still exercises a significant influence over the subsidiary. If this is the case, the parent should treat the subsidiary as an associate using the equity method set out in paragraph 14.8.
9.9B A subsidiary excluded from consolidation on the grounds set out in paragraph 9.9(b) which is:
(a) held as part of an investment portfolio shall be measured at fair value with changes in fair value recognised in profit or loss; or
(b) not held as part of an investment portfolio shall be measured using an accounting policy selected by the parent in accordance with paragraph 9.26
OmniPro Comment
(a) Long term restrictions
A Subsidiary must be excluded due to long term restrictions being applied which hinder the rights of the parent over the management and assets of the subsidiary. Examples where restrictions apply would include:
- where the company is placed into insolvency or administration
- veto powers held by a third party e.g. a lender due to covenant breaches
- severe restriction on future distributions/remittances
Where such a subsidiary is excluded it should be included in the consolidated financial statements assuming significant influence is not held and carried at either:
- cost less impairment
- fair value through the profit and loss account
- fair value through other comprehensive income
NOTE where the fair value through the profit and loss is applied the consolidated financial statements should disclosure the fact that a true and fair view override was required.
Where significant influence is held it should be accounted for under the equity method i.e. treated as an associate, the carrying amount under the equity method on the date control is lost is the value of the net assets and goodwill attributable to the investment on the date the restriction is applied.
(b) Subsidiary held with a view to a subsequent sale
A subsidiary held with a view to a subsequent sale is defined in Appendix I of FRS 102 as an interest:
- ‘for which a purchaser has been identified or is being sought, which is reasonably expected to be disposed of within approximately one year of its date of acquisition; or
- that was acquired as a result of the enforcement of a security, unless the interest has become part of the continuing activities of the group or the holder acts as it intends the interest to become so; or
- which is held as part of an investment portfolio’.
The subsidiary which is classified as held exclusively for future sale is that it must not have been consolidated in the past.
Special purpose entities
Extract from FRS102: Section 9.10-9.12
9.10 An entity may be created to accomplish a narrow objective (e.g. to effect a lease, undertake research and development activities, securitise financial assets or facilitate employee shareholdings under remuneration schemes, such as Employee Share Ownership Plans (ESOPs)). Such a special purpose entity (SPE) may take the form of a corporation, trust, partnership or unincorporated entity. Often, SPEs are created with legal arrangements that impose strict requirements over the operations of the SPE.
9.11 Except as permitted or required by paragraph 9.3, a parent entity shall prepare consolidated financial statements that include the entity and any SPEs that are controlled by that entity. In addition to the circumstances described in paragraph 9.5, the following circumstances may indicate that an entity controls a SPE (this is not an exhaustive list):
(a) the activities of the SPE are being conducted on behalf of the entity according to its specific business needs;
(b) the entity has the ultimate decision-making powers over the activities of the SPE even if the day-to-day decisions have been delegated;
(c) the entity has rights to obtain the majority of the benefits of the SPE and therefore may be exposed to risks incidental to the activities of the SPE; and
(d) the entity retains the majority of the residual or ownership risks related to the SPE or its assets.
9.12 Paragraphs 9.10 and 9.11 do not apply to post-employment benefit plans or other long-term employee benefit plans to which Section 28 Employee Benefits applies. A special purpose entity that is an intermediate payment arrangement shall be accounted for in accordance with paragraphs 9.33 to 9.38.
OmniPro comment
A Special Purpose Entity is not defined however examples of where an entity holds a Special Purpose Entity would include:
- the entity has the ultimate decision making powers of the Special Purpose Entity even in relation to day to day operations
- absence of a profit motive of the Special Purpose Entity instead all profits are paid out in interest or fees such that there is a nil profit.
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