The Financial Accounting Standards Board has revisited the issue of which entities to include in consolidated financial statements and formed certain tentative conclusions. In August 1994, it issued a discussion document to seek comments on its preliminary views and tentative conclusions. The authors discuss those views and describe the proposed consolidation requirement.

Decisions about which entities to include in consolidated financial statements may be of special interest to those companies forming partnerships and other nonstock entities to respond to new, complex, and changing market forces. For example, pharmaceutical companies, HMOs, health insurers, and hospitals are joining together through new corporate or noncorporate "partnerships" to respond to pressures to slow the pace of increasing health-care costs. The unique nature of partnerships and other nonstock entities raises questions about whether one entity should include the other entity in its consolidated financial statements.

The Board's preliminary view about consolidation policy is that a parent company should consolidate all those entities it controls (its "subsidiaries"), unless control is temporary at the time an entity becomes a subsidiary. Control is deemed as power over an entity's assets - the power to use or direct the use of the individual assets of the subsidiary to achieve the objectives of the parent. The requirement would apply to business enterprises and not-for-profit organizations that control other entities, whether organized as corporations or in other legal forms.

The Board believes it can achieve a significant improvement in practice by developing a consolidation policy that would apply to all entities and would focus on the economic relationship among organizations, rather than their legal form. Present standards issued by the FASB and its predecessors are primarily directed at business enterprises formed as stock corporations. Thus, they have limitations in their application, particularly when entities form alliances through means other than stock corporations. The Preliminary Views, Consolidation Policy, sought comments on the Board's proposed policy. Those comments will assist its efforts in developing an exposure draft of a proposed standard that would cover both consolidation policy and procedures.

Concept of Control

The Preliminary Views establishes a fundamental and unifying concept of control that can be applied to all entities. That is, if one entity has the power to direct the use of individual assets of another entity to achieve its own objectives, it should include those assets in its consolidated financial statements, as well as the liabilities, and the transactions and events that result in changes in those assets and liabilities. Implicit in that concept is an ability to derive benefits from the probable economic or service potential inherent in an asset. An entity can have less than a majority equity interest and still receive significant benefits through its power over individual assets. Stewardship responsibility and exposure to losses are also inherent aspects of control of assets. However, the level of benefits, stewardship responsibility, or exposure to losses inherent in the control of assets are not viewed as separable conditions or necessary criteria for purposes of establishing a consolidation policy.

In practice, differences in the objectives of business enterprises and not-for-profit organizations may affect the application of the concept of control. The proposed definition of control includes the restrictive phrase to achieve the objectives of the controlling entity. For purposes of consolidation policy, the objective of a business enterprise is to provide net cash inflows to its owners, while the objective of a not- for-profit organization is to provide needed goods and services to its beneficiaries or other constituents. The assets of a charitable foundation, for example, might be usable to achieve the objective of a controlling not-for-profit organization by providing goods or services to the controlling organization's constituents, but those of a company- sponsored foundation might not be usable to provide future net cash inflows to owners of the sponsoring company. Thus, although a unifying concept of control is proposed, there may be some instances in which results may differ based on differences in the objectives of business enterprises and not-for-profit organizations.

Differences in the organizational characteristics of entities also may affect the application of the proposed concept of control. Business corporations usually are organized as stock corporations, and ownership of voting shares usually is the most important factor in identifying a controlling entity. Not-for-profit corporations usually are organized as nonstock corporations and voting interests do not exist. Consequently, other factors such as the power to appoint members of the governing board or provisions in the corporation's charter or bylaws become important in identifying a controlling entity.

U.S. companies that operate and raise capital in global markets and users of their financial statements are likely to benefit to the extent that common concepts of financial accounting and reporting can be established on a worldwide basis. During its deliberations, the Board considered the consolidation policies of international accounting standards setters, particularly those issued by the Australian Accounting Research Foundation (AARF) and by the Canadian Institute of Chartered Accountants. The Board noted that several international standards setters have recently adopted consolidation policies based on a broad notion of control, rather than a narrow notion of majority voting interest. It also noted the AARF was able to apply its notion of control to not-for-profit organizations as well as business enterprises. Although harmonization with international standards is not the reason for addressing consolidation policy, this Preliminary Views provides an opportunity to move in that direction while improving on U.S. standards.

Temporary Control

The Board's concept of control is similar to that used in Australia; the Board, however, derided to allow an exception for temporary control. The proposed requirement would not require the inclusion of a subsidiary in consolidated financial statements if control is temporary at the time a subsidiary is obtained. That exception differs from and is narrower than present standards that allow an exception for "control that is likely to be temporary."

The proposal specifies that an assessment of whether control is temporary should be based on circumstances that exist when an entity becomes a subsidiary. Once consolidated, a subsidiary should continue to be consolidated until the parent ceases to control it. For example, control is considered temporary if a parent is required by antitrust laws or regulatory authorities to relinquish control of a newly acquired subsidiary. A controlling entity's intent to dispose of a subsidiary would not lead to a conclusion that control is temporary; however, the Board's preliminary view is to consider control temporary if the parent relinquishes control before the balance sheet date for financial statements that are for the period control was obtained.

Types of Control

The Preliminary Views discusses two differing types of control of corporations that would call for consolidated financial statements: legal control and effective control. Control of a corporation is vested in the governing board by law and corporate charter. Control that results from a legal right, such as rights from majority ownership in a corporation that issues only a single class of stock, is called legal control.

Legal control of a corporation that does not issue stock is conferred by the legal right to appoint a majority of the members of that corporation's governing board. That right usually comes from provisions in the controlled corporation's charter or bylaws. Legal control also may be indirect, that is, through legal control of a subsidiary that has legal control of another corporation.

Although the surest means of control is the legal right to elect or appoint a majority of a corporation's governing board, control can be achieved in other ways. Control without that legal right is referred to as effective control. Most often effective control results from owning a large minority interest coupled with certain favorable circumstances. Although the means of achieving effective control differ from the means of achieving legal control, the result of being in control is the same.

The Board knows that determining the existence or absence of effective control often is difficult and may present some problems in applying the proposed definition of control. Although our present standard - consolidate all majority-owned subsidiaries - can be applied in practice with relative ease, it does not address our changing environment and those circumstances where control exists through means other than majority ownership of a corporate entity. The Board believes that when control exists, consolidated financial statements more fairly present the financial position and results of operations of the controlled group. Moving from an easy-to-apply rule to a broader-based concept of control is a necessary step to keep financial reporting relevant.

Implementation Guidance

The Preliminary Views includes implementation guidance to assist an entity's management and its auditors in determining the existence of control. The guidance is not intended to replace professional judgment; rather, it is intended to aid in applying judgment that would help reduce the cost of applying the standard and reduce instances of inconsistent application in practice. The guidance includes a list of presumptions of control and other factors that may indicate control of a corporation.

Unlike corporations, partnerships do not necessarily have governing boards and, as the term implies, a partnership usually involves the sharing of decision-making authority rather than control by a single entity. However, a partnership can include almost any division of decision-making authority to which the partners agree. Careful consideration of the partnership agreement and related law is necessary to determine if control exists. The Preliminary Views also includes factors to consider in assessing limited partnerships and determining whether a general partner may be in control.

Certain circumstances make the presence of effective control highly probable, and if any of those circumstances exists, one entity is presumed to have effective control of another. Of course, the existence of significant evidence to the contrary can overcome a presumption of control. For example, control is presumed if one entity owns a large minority voting interest in a corporation (approximately 40% or more) and there is no other party or organized group of parties with a significant interest (approximately 20% or more). However, defeat of the holder's nominees in an election of board members would provide convincing evidence that control does not exist. Exhibits 1, 2, and 3 provide lists of the presumptions and indicators of control and one of the six illustrative examples in the Preliminary Views.

Who Might Be Affected?

Consolidation practices are reasonably consistent where legal control exists, but effective control may exist for subsidiaries that remain unconsolidated.

The FASB staff performed a study of the 10,850 companies with securities publicly traded in the U.S. that are tracked in Disclosure Incorporated's database, Compact d SEC. It shows about 450 companies (four percent) that have a single investor with a voting interest greater than 25% but less than a majority that are not being consolidated by that investor. This small group, that represents potential unconsolidated but controlled entities, suggests few publicly traded companies will be affected.

The proposed requirement will affect those business enterprises and not- for-profit organizations that have controlled but unconsolidated subsidiaries. It is difficult, however, to identify unconsolidated private companies, limited partnerships, or other entities that may be controlled but unconsolidated entities.

While the impact on private companies and not-for-profit organizations is unclear because of inconsistencies in the existing guidance for not- for-profit organizations, it is reasonable to presume that the proposal will affect many of those organizations. The Board and staff expect that respondents to the Preliminary Views will provide a better understanding of the magnitude and impact of the proposed changes on practice.

The proposed concept of control and its underlying rationale also are likely to impact pending Board deliberations on consolidation procedures, combined financial statements, accounting for unconsolidated entities, new basis of accounting, and disaggregated disclosures.

Time for a Change?

Consolidation standards require revisions to reflect changes in methods of doing business and in the economic environment. The accelerating pace of mergers, acquisitions, and other corporate restructuring and formation of new and often global partnerships and other nonstock entities make keeping standards current a difficult task. Our consolidation standards of the past and present are rules that may have worked reasonably well in their limited set of circumstances; however, more often than not the diverse ways of conducting business today require broader and more general standards that can be applied to those diverse and changing sets of circumstances. This Preliminary Views is a step toward moving away from a nile that requires consolidation of majority-owned subsidiaries to a policy that requires consolidation of controlled entities.

RELATED ARTICLE: EXHIBIT 1

PRESUMPTIONS OF CONTROL FOR CORPORATIONS

One entity is presumed to have effective control of another if that entity has -

* ownership of a large minority voting interest (approximately 40% or more) in the absence of another party or organized group of parties with a significant interest (approximately 20% or more);

* an ability demonstrated by a recent election to dominate the process of nominating candidates for an entity's governing board and to cast a majority of the votes cast in an election of board members;

* a unilateral ability to obtain a majority voting interest without significant additional cash outlay, for example, through ownership of securities that may be converted into a majority voting interest at the option of the holder; or

* provisions in its corporate charter or bylaws that cannot be changed by entities other than its creator (or through legal due process) and that limit the corporation to activities that can be initiated or were scheduled by the creating entity and are designed primarily to provide future net cash inflows or other future economic benefits to its creator.

RELATED ARTICLE: EXHIBIT 2

INDICATORS OF CONTROL FOR CORPORATIONS

Indicators of control identify circumstances that often accompany control but do not lead to a presumption of control. However, multiple indicators suggest an increased likelihood of the existence of control. Some indicators of possible effective control are as follows:

* An ability to cast a majority of the votes in an election of directors;

* An ability to use the resources of a corporation to control the process of nominating members of an entity's governing board and to solicit proxies from other shareholders;

* An ability to appoint members of a corporation's governing board to fill vacancies until the next election;

* A right to a majority of the net assets of a corporation in the event of liquidation or a distribution other than a liquidation;

* A business or charitable purpose of one corporation that is integrated with the business or charitable purpose of another entity, for example, an organization formed for the primary purpose of 1) holding and investing assets to generate income for another entity, 2) holding assets to pay the debts of another entity, or 3) raising contributions for a specific charitable organization. (The lack of integrated businesses or charitable purposes does not necessarily indicate lack of control.);

* Retention of a minority voting interest in an entity after previously holding a majority voting interest (If the level of voting interest is approximately 40% or more, a presumption of control may apply.);

* Beneficial contractual relationships with an entity that continue after previously holding a majority voting interest;

* A continuing ability to appoint some members of the governing board of a corporation for which majority appointment or election powers previously existed; or

* Ownership of an option to acquire a majority or large minority voting interest that requires the outlay of a significant amount of additional cash.

RELATED ARTICLE: EXHIBIT 3

ILLUSTRATION

During its deliberations, the Board used several cases to test the definition of control and decided to include six of its illustrative cases in its Preliminary Views. The following is one illustration.

Company F establishes Company G to develop a new product to be manufactured and marketed by Company F. Company F engages Mr. Smith, an experienced product development executive, to lead the team responsible for developing the product. Mr. Smith invests $10,000 in the project and receives all of Company G's initial issue of 10 shares of voting common stock. Company F transfers $500,000 to Company G in exchange for seven percent, 10-year debentures convertible at any time into 500 shares of Company G voting common stock. Mr. Smith is named president of Company G at an annual salary of $60,000, of which $10,000 is advanced to Mr. Smith by Company G at the time Company G is established.

Company F is presumed to hove effective control of Company G because of its unilateral ability to obtain a majority voting interest by converting its debentures without a significant additional cash outlay. There are no economic or legal impediments to converting; in fact, Company F has a strong incentive to convert. The only way that Company G can repay the debentures is to develop a successful product, and if a successful product is developed, Company F will be in a better position as the majority shareholder rather than as a bondholder. Mr. Smith does not control Company G because Company F can revoke his power at any time.

Ronald J. Bossio is a project manager and Gisele Dion a technical associate at the FASB. The views expressed in this article are those of Bossio and Dion. Official positions of the FASB are determined only after extensive due process and deliberation.