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Problems with companies exerting "strong significant influence"

May 16, 2011

Every Tuesday I teach MBA & Masters of Professional Accounting students at the University of Technology, Sydney a third year subject called Corporate Accounting. 

Had a very interesting question come up in last weeks lecture on equity accounting about companies exerting strong significant influence but not having control of another company.  Strong significant influence could occur when say Company A owns 49.9% but obviously dont have control of the voting power of Company B.

But it got me thinking.

What if the best friend of the CEO of the acquiring company owned 2% of the other company and he or she just voted the same way that Company A did?  Could it then be argued that Company A really did control Company B?  And if so, then does Company A need to include Company Bs financials in consolidated financials rather than simply apply the equity method of accounting for investments with significant influence?

What impact would Company Bs financials have on debt to equity ratios that banks (and other users of financial information) heavily rely on?  What if Company B is heavily exposed to significant losses or it has commercially sensitive information that Company A doesnt want to get out into the mainstream just yet?

But how could auditors ever detect this true control of Company B?  And would they be liable if the structure one day blew up and smashed Company A shareholders in the face?  Who would want to be a registered company auditor these days with these issues, with huge ramifications about their own liability, to worry about lying in bed each night?

Lots of questions for food of thought.  So I read an email with interest from the Institute of Chartered Accountants this week which gives me an update of accounting and assurance standards.  The International Accounting Standards Board has issued a few new standards which will be affecting Australian companies going forward.  It includes an update to the definition of control where companies have strong significant influence.

Here are the new accounting standards:

  • IFRS 10 Consolidated Financial Statements:  contains a revised definition of control that will apply to all entities and will require significantly more judgement to determine whether control exists, particularly when the ownership percentage is less than 50%.
  • IFRS 11 Joint Arrangements: redefines which entities qualify as joint ventures and removes the option to account for joint ventures using proportional consolidation.
  • IFRS 12 Disclosure of Interests with Other Entities: now contains all the disclosure requirements associated with other entities (subsidiaries, associates and joint ventures) that were previously located in IAS 27, 28 and 31, and SIC 12. The disclosures have been enhanced to ensure that a reporting entity discloses all the information that helps users of financial statements understand the composition of the group and its inter-relationships.
  • IFRS 13 Fair value measurement: this standard aims to ensure that the varied requirements that do exist in IFRS are applied consistently, have clear measurement objectives and use a robust measurement framework. No new requirements to use fair value have been introduced.

Exciting times ahead in the financial accounting and auditing world no doubt. 

So back to the subject.  It is famous for being a tough subject purely because it introduces these would-be CFOs to consolidation accounting for the very first time. 

The mid-semester pass rate was 58% (but my classes had a 68.18% pass rate!).  What was really interesting in my class was that 77% of those that did a particular homework question in week 4 of the course passed the mid-semester but only 61% of the slackos that didnt do that question passed.  If ever there was an incentive to do your homework then this is the stat.  Hopefully the Gen-Yers have taken note.

If only I could get them to stop sniffling in class and use a tissue ... perhaps that is a topic best left for next semester!

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