Q1.12 Determining the power to control (Section 1.7)
Notes to instructors: The purpose of this question is to demonstrate how to build an argument for or against control. The usual steps involved in this process are:
Application of definition of control Consideration of control without majority ownership
Implications of convertible instruments Conclusion with supporting reason
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Technical reference(s)
AASB 10.5–10.7 AASB 10.B38
AASB 10.B47–B50
Application of the above technical references to the circumstances of each scenario
(a) Target Ltd holds a non-controlling interest shareholding in ABC Pty Ltd but it has five of the seven seats on the board of directors and is responsible for operating and financial policies on a day-to-day basis. This scenario has resulted from an agreement with the majority shareholder (75%) of ABC Ltd, Mr and Mrs M. All of the facts would need to be assessed very carefully here.
Prima facie, Target Ltd is in a position of control because of its ability to control the casting of a majority of votes at a meeting of the board of directors. However, AASB 10.12 indicates that an investor with the current ability to direct the relevant activities of the investee can still have power over the investee even if that power is not being exercised. In this case, Mr and Mrs M are closely monitoring the business and have the existing voting power to override any decision made by Target Ltd. Consequently, Target Ltd does not have power over ABC Ltd and so does not satisfy the control requirement of AASB 10. As the first criterion of the control concept in AASB 10.7 is not satisfied, it is not necessary to address the remaining criteria. Target Ltd does not need to consolidate ABC Ltd. (It is possible that Target Ltd has ‘significant influence’ over ABC Ltd and may, therefore, equity account for its investment in ABC Ltd; see Section 1.4.3 of the chapter.)
(b) Default under a loan agreement has given Target Ltd power over the financing decisions and cash payments of HHQ Pty Ltd. To exercise power over HHQ Pty Ltd, Target Ltd must have substantive rights over the relevant activities of HHQ Pty Ltd. In this case, it seems likely that although Target Ltd exercises power over the financing and cash payments, it does not have the ability to direct the other relevant activities of HHQ Pty Ltd. More importantly, given that Target Ltd’s rights have arisen from default on a loan and that its powers are restricted only to financing and cash payments, it is likely that these powers are ‘protective’ rather than substantive (see AASB 10.B26–B28). The powers that Target Ltd is currently exercising have only arisen because of an exceptional circumstance (AASB 10.B26) and are designed to protect the capital sum lent by Target Ltd rather than giving it power over all the relevant activities of HHQ Pty Ltd. AASB 10.B28 gives a lender’s right to restrict a borrower from certain activities as an example of a protective right. Consequently, Target Ltd does not control HHQ Pty Ltd and does not consolidate that entity.
(c) As a joint shareholder with Y Pty Ltd, Target Ltd is unlikely to be in a position of unilateral control. Prima facie the position may be one of X Pty Ltd being subject to ‘joint control’ by Target Ltd and X Pty Ltd, although it would be necessary that there is a contractual agreement that all decisions about the relevant activities would need the unanimous consent of Target and Y Pty Ltd (see Section 1.4.2 of this chapter). In this particular case, it would seem that Target Ltd has power over one set of relevant activities of X Pty Ltd (i.e., financing) but Y Pty Ltd has power over the other relevant activities of X Pty Ltd (i.e., management of operations). AASB 10.B13 suggests that
when two or more investors have power over different relevant activities, it may become necessary to decide which of the relevant activities most significantly affects the returns of the investee; it might be suggested that as X Pty Ltd is an operating concern, it is likely that the operations are the relevant activity most likely to significantly impact on returns and this would result in Y Pty Ltd having power, not Target Ltd. Based on this analysis, Target Ltd would not consolidate X Pty Ltd.
(d) In this situation, it is necessary to determine whether Target Ltd is operating the trust as a principal or as an agent on behalf of the beneficiaries (AASB 10.B58). AASB 10.B60 identifies four factors that are indicative of the decision-maker (i.e., Target Ltd) being an agent rather than a principal. These indicators are: the scope of Target Ltd’s decision-making authority; the rights held by others (e.g., their ability to dismiss Target Ltd as trustee); the remuneration to which Target Ltd is entitled (e.g., is the remuneration comparable to ordinary market conditions); and the extent to which Target Ltd is exposed to variability in returns from other interests it might have in the trust. The facts of the question are silent on some of these factors (which are only indicators anyway) but given that Target Ltd must act in accordance with the instructions of Mr F, it seems likely that it actually has very limited decision- making authority (if any at all). It is also common for a trust deed to allow beneficiaries to remove a trustee that is not acting in their best interests which gives them some so-called ‘kick-out’ rights. Based on the information available, it is concluded that Target Ltd is acting as an agent rather than a principal with regard to its decision making for the trust. As such, Target Ltd does not control the trust and would not consolidate it.
(e) Target Ltd is a passive investor as evidenced by it having no seats on the board of directors of BIJ Pty Ltd. Nonetheless, Target Ltd’s 75% shareholding is likely to convey the power to govern decision making as envisaged in the definition of control (AASB 10.B35). Hence, in these circumstances Target Ltd controls BIJ Ltd and therefore it should consolidate the financial statements of BIJ Pty Ltd. It does not matter that Target Ltd is a passive investor given the other facts (AASB 10.12).
(f) The independent directors of HTE Ltd have a fiduciary duty to all the shareholders of HTE Ltd equally (which, of course, does include Target Ltd as a shareholder). As such, Target Ltd has the power only to control the casting of the votes of the four executive directors it has appointed to HTE Ltd through its 40% shareholding.
Prima facie, Target Ltd’s 40% shareholding does not give it the power to dominate the composition of the board of directors and Target Ltd does not have the power to control the casting of a majority of director votes at a board meeting. Furthermore, a shareholding of 40% does not, of itself, give Target Ltd the power to control the casting of a majority of votes at a general meeting of shareholders and under these circumstances Target Ltd would not be required to prepare consolidated financial statements as a business combination has not occurred. AASB 10.B38 gives examples of situations in which de facto power might exist where less than a majority of voting power is held but these situations are not evident in the facts provided.
Alternatively, if the remaining 70% of shareholders of HTE Ltd regularly fail to exercise their voting rights at general meetings, it could be argued that Target Ltd does control HTE Ltd. If, for example, only 50% of the shareholders of HTE Ltd are actively involved in voting at meetings, then Arrows’ 40% shareholding would effectively constitute 57.15% (40/70) of votes that are normally exercised at a shareholder meeting. The fact that Target Ltd has nominated ‘four executive directors’ to HTE Ltd (i.e., the directors involved in the day-to-day operations) also suggests that its 40% shareholding is sufficient for control. If this alternative view is
accepted then Target Ltd would be required to consolidate.
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