Definition
“Control” is defined by FRS 110 by the following:
- “Power” over the investee
- Entitled to “Returns” from involvement with investee
- Ability to influence “Returns” from investee through its “Power”
As a supplement to above, it maybe helpful to consider the design and nature of the investee as well as its relevant activities and how decisions about these activities are made.
Power
The glossary of “Power” as provided by FRS 110 is as follow:
- Existing rights: Voting rights from equity instruments or rights from contractual arrangements
- Current ability: Ability to direct relevant activities even if rights are yet to be exercised
- Relevant activities: Activities that generate return for the company. In a company with 2 or more different relevant activities, each with a different influencer or director, the activity with that generate the most return is the most relevant.
As Varys from “Game of Thones” put it:
Power resides where men believe it resides.
It’s a trick. A shadow on the wall.
And a very small man can cast a very large shadow.
Following are a few forms of “large shadow”:
- Voting rights or potential voting rights
- Ability to influence investee’s key management personnel
- Rights to adjust or approve any changes in the relevant activities
It is also noteworthy that in cases where power is solely determined by voting rights, it is not necessary to have >50% to have power. You only need to be the majority shareholder, even if its only 40%. Voting rights sometimes can also be indirect which can be illustrated easily using the example of Ultimate Holding Company – Parent – Child.
There are many instances in which “Power” can be subjective. For example, if it takes only 2 other minority shareholder to overrule 1 majority shareholder, the power of the majority shareholder here is very fragile and not always straightforward. Most of such cases usually involves majority shareholder with <50% share and all facts and circumstances must be considered. Considerations such as past voting patterns and size and dispersion of minority shareholders are crucial.
Potential convertible voting rights that are substantive must also be part of the consideration for “Power”. Key word here is “substantive”, meaning the option to convert is probable. The exercise price must not be too expensive compared to current market price and the owner of option must have enough capital to exercise.
Contractual obligations are another form of power. Although rare, these are contracts that requires consent of shareholders to rescind, which may enable control over sales or purchase of the company. An important distinction here however, is that “protective rights” included in contract is NOT a form of power. A typical example of a “protective right” is bank seizure of assets in event of loan default.
There are also a lot of other unique scenarios where voting rights does not translate to power. For example, shareholders does not have any voting rights for a company under judiciary management.
Returns
The key to understanding “Control” is that its NOT sufficient to be just be a beneficiary to investee’s returns. Providing a loan and receiving interest for example, is not sufficient to have control. Power is when you are the beneficiary of investee’s return AND is able to use its power to influence investor’s return.
Principal vs Agent
Then there comes the good ol’ accounting issue of principal vs agent. Guidance from FRS 110 is such that all decision makers, delegated on not, must consider the following to determine whether it is acting as agent or principal:
- Scope of decision making ability authority
- Rights held by other parties
- It’s remuneration
- Exposure to variability of returns through other interest
In my opinion, the key criteria here is remuneration. So long as the decision maker is receiving remuneration to act on someone’s behalf at a fixed rate independent of performance of investee, it is very likely he/she is only an agent. Even if the rate is base on a percentage on the performance of investee, the amount of returns must be significant enough in order for it be a principal. 1% or 2% of overall returns doesn’t cut it.
Another consideration is probably how likely he/she can be removed or replaced without cause. A decision maker who can be removed or replaced easily is unlikely to have control.
All materials produced on this website, including this article, is based on author’s best interpretation of accepted accounting standards and his own experience. Any information bias, inaccuracies, misstatements, obsolesce are unintentional and should strictly not be held liable against the author. The author is not responsible for any losses, monetary or non-monetary, as a result of using these materials.
Derrick How 