Standards and the Determination of Control for Consolidation
Leslie Kivi, Pamela Smith, and Colette Wagner
number of stakeholders have endorsed replacing the current
rules-based approach to setting accounting standards with
principles-based standards. During his time as SEC chief accountant,
Robert K. Herdman captured concerns with recent standard setting
before a congressional subcommittee: “[E]xtremely detailed
rules that attempt to contemplate virtually every application
of the standard … encourage a check-the-box mentality
to financial reporting that eliminates judgments.” The
Sarbanes-Oxley Act [section 108(d)] required the SEC to conduct
a study and report to Congress on the feasibility of principles-based
standards. The SEC recommended a transition to a form of principles-based
standards. The SEC, in turn, requested that FASB solicit input
from its constituencies on the merits of a principles-based
system. The comment letters to FASB were mixed but show a
substantial amount of support for some form of a principles-based
system. Shifting from a rules- to a principles-based system
will have wide-ranging consequences for public accounting
firms, industry, education, and enforcement.
area ready for the shift to a principles-based standard
is that of the basis for consolidation. The majority of
Fortune 500 companies present consolidated financial
statements; therefore, any change in accounting for consolidations
will have a wide impact.
FASB proposed a change in the determination of control for
the purposes of consolidation in 1999. The proposed definition
focuses on economic substance and requires consolidation
whenever there is “effective” control rather
than legal control. Although this definition has gained
little support to date, it is a good example of a principles-based
standard. Comparing the rules-based definition of control
to the proposed principles-based definition provides insight
into the issues that may arise when adopting a principles-based
Approach to Accounting Standards
statement preparers, management, and auditors want precise
“rules” that unambiguously specify the accounting
for a transaction. Exhibit
1 summarizes the benefits and criticisms of a rules-based
approach. The major criticism—that, no matter how
technically detailed, there is a way around every rule—underscores
the extent of the problem faced by accountant or auditor
challenged with, “Show me the rule that says I cannot
do this.” Consequently, even if a transaction circumvents
the spirit of the standard, it is difficult for the accountant
or auditor to argue that the standard itself is violated.
Perhaps equally troubling is the situation where the auditor
applies individual accounting rules and does not step back
and consider whether the reported results actually reflect
the big picture.
standards that are developed under a rules-based approach
must be continuously updated. Whenever a new transaction
is engineered, or a variation of an existing transaction
occurs, guidance or a new amendment must be added. Therefore,
a rules-based approach is always at least one step behind.
The detailed level of interpretative guidance, amendments
to existing guidance, and rulings issued by various bodies
add to the complexity and have caused a rules explosion.
As business processes have become more complex, accounting
rules have rapidly changed and expanded. Many standards
are so complex that their application, implementation, and
implications require explanation. Rules-based GAAP has become
more complicated because of the numerous exceptions woven
into the standards. These exceptions make applying a standard
to a given transaction even more difficult.
standards use broad guidelines that focus on the spirit
of an underlying principle. The standards are based on underlying
principles with the application and implementation in the
hands of the preparers. Exhibit
2 presents the benefits and risks of adopting a principles-based
most compelling argument for a principles-based system is
that of presenting substance over form. Application of a
principles-based approach would focus on the intent of the
principle rather than the bright-line rule, thereby reducing
the gamesmanship of circumventing the rules. Another benefit
of a principles-based system is reduced complexity. Principles-based
standards would not require detailed guidance to deal with
increasingly complex transactions. Accordingly, a principles-based
system requires professional judgment. Many argue that the
application of professional judgment is what determines
fair presentation in a particular case, not rules for all
business practices and technology evolve in a principles-based
system, preparers can focus on applying the core principles
rather than searching for or demanding specific guidance.
More important, a principles-based approach focuses financial
statement preparers and auditors on the fairness of the
overall financial presentation rather than on satisfying
the past several years, FASB has worked with the International
Accounting Standards Board (IASB) on converging U.S. GAAP
with International Accounting Standards (IAS), which are
generally less detailed than many SFASs. If the European
Union adopts IAS on its scheduled 2005 deadline, the IAS
principles-based standards will have increasing international
acceptance. A shift of U.S. GAAP toward principles-based
standards could simplify the international convergence process.
that a principles-based system creates even greater potential
for fraud is a powerful counterargument. Some fear that
if financial statement preparers and auditors feel unconstrained
by clearly defined rules, they are unlikely to follow even
broader principles. Both rules-based and principles-based
standards, however, are effective only when rigorously applied.
Neither principles nor rules will prevent fraud. We have
no way of knowing if principles-based accounting would have
stopped the recent accounting debacles.
argue that a principles-based system will require the SEC
to spend considerably more time in enforcement and that
evaluating accounting decisions made in good faith will
be difficult. As a consequence, de facto rules may form
in the absence of adequate guidance, thereby defeating the
purpose of a principles-based system. The considerable judgment
that a principles-based system requires invokes another
significant concern: legal liability. Both auditors and
managers could be exposed to litigation despite good-faith
application of the principles. Many also argue that principles-based
standards will reduce comparability, because different outcomes
are bound to occur when different individuals apply professional
judgment to the same situation.
investors find it difficult to understand the financial
information presented in a corporation’s annual report.
Some argue that this is due not to the complexity of the
rules, but to the complexity of business models in the marketplace.
While using a principles-based system might improve reporting
the economic substance of a transaction, eliminating rules
may not make the financial information more understandable.
a Principles-Based Definition of Control
financial statements are critical to the evaluation of the
economic entity. Control is the criterion for consolidation,
and the debate is over how to define control. Since 1959,
control has meant either direct or indirect ownership of
more than half of the outstanding voting shares of another
company’s stock, unless the control is determined
to be temporary (ARB 51, 1959). The Enron debacle demonstrates
the need for a principles-based definition of control; Enron
did not consolidate hundreds of off-balance-sheet entities
and therefore failed to recognize the associated liabilities.
The irony is that even though Enron violated the core principles
of financial reporting, the financial engineering complied
with the rules.
1999, FASB issued an exposure draft that proposed a principles-based
definition of control. “Exposure Draft (Revised),
Proposed Statement of Financial Accounting Standards, Consolidated
Financial Statements: Purpose and Policy” (October
16, 1999) stated the following:
is the ability of an entity to direct the policies and
management that guide the ongoing activities of another
entity so as to increase its benefits and limit its losses
from that other entity’s activities. For purposes
of consolidated financial statements, control involves
decision making ability that is not shared with others.
a company has “exclusive power” over another
entity, it can “direct the use of and access to another
entity’s assets.” This would generally be true
when a company has the power to set policies that guide
how subsidiaries’ assets are used in ongoing activities.
definition would apply to the control of entities other
than corporations, such as partnerships and joint ventures.
It would also include control by a minority shareholder
as long as that person has nonshared decision-making ability
to guide the activities of the subsidiary. Applying the
principle underlying this definition of control requires
ascertaining which entity is the decision-maker. In many
instances this will require assumptions about the entity
in control and the entities not in control.
example, if a minority shareholder is determined to be the
one that has nonshared decision-making, and therefore control,
then it is necessary to assume that another holder (or the
majority holder) will not step in and overpower that controlling
holder. Possibly, however, the majority holder is happy
with the decisions made by the minority shareholder and
therefore is silent. If the majority shareholder were not
satisfied, it could usurp power and take over the decision
making. The principles-based definition essentially requires
the assumption that another holder will not exercise its
majority ownership rights. This scenario illustrates the
professional judgment required under a principles-based
use of convertible preferred stock, stock options, redeemable
instruments, and convertible bonds must also be addressed.
Some observers have pointed out that these instruments are
taken into consideration for purposes of determining control.
To do so would be consistent with how accounting principles
(presumably) treat convertible instruments when calculating
fully diluted earnings per share (EPS); however, currently,
convertible instruments are not taken into consideration
when determining ownership interest. If these instruments
are taken into consideration, assumptions must be made regarding
the probability that the nonactive but potential majority
owner will actually exercise the conversion rights and also
exercise control by making decisions.
assumptions would be needed if the conversion were mandatory.
The holder of a convertible instrument may not hold it until
the date of mandatory conversion. Is one to assume the convertible
instrument is always held to maturity? That assumption may
be complicated if a conversion has a benefit that would
be too great to forfeit. Clearly, a principles-based definition
of control requires evaluating the holder’s intentions.
questions remain unanswered regarding the implementation
of a principles-based system, and the above discussion describes
just a few as applied to the definition of control. Whether
principles-based standards will result in a system with
better transparency, understandability, and comparability
overall probably has no clear answer at present. Advocates
believe that, over time, the principles-based approach will
lead to better reporting of financial information. Opponents
believe the subjective nature of a principles-based system
will reduce comparability.
definition of control for purposes of consolidation is needed.
Although majority ownership may be an indicator of control,
Enron has demonstrated that there are other ways to garner
the risks and rewards of another entity without a majority
holding. In addition, control cannot always be objectively
measured. Perhaps a principles-based definition is a better
way to capture the essence of control. The question remains:
Is it possible to make the judgments and accept the uncertainty
needed to determine control in principle?
Smith, PhD, CPA, is the KPMG Professor of Accountancy
at Northern Illinois University, Dekalb, Ill. This article
is the result of a project completed in Advanced Financial
Accounting as part of the Masters of Accounting Program at
Northern Illinois University. Leslie Kivi and
Colette Wagner were students in that class.