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HISTORICAL DEVELOPMENT OF THE CONCEPT OF CONTROL IN FINANCIAL REPORTING by NICOLA MANNING MINOR DISSERTATION submitted in fulfillment of the requirements for the degree MAGISTER COMMERCII in INTERNATIONAL ACCOUNTING in the FACULTY OF ECONOMIC AND FINANCIAL SCIENCES at the UNIVERSITY OF JOHANNESBURG SUPERVISOR: Professor N Stegmann October 2014
ABSTRACT The definition of control and the non-consolidation of special purpose entities in group annual financial statements became a topic of concern and focus to investors, securities exchange regulators and accounting professionals after the global financial crisis. The global financial crisis began in 2007 and was caused in part, by investors not being able to access reliable information about the risk levels of entities in which they had invested. Organisations from around the world began to focus on financial reporting and auditing standards in order to determine how the crisis had occurred and how it could be prevented in the future. The focus has highlighted the definition of control, which would determine whether an entity would be consolidated into a group of companies or not, and the disclosure of the decisions, judgements and assumptions made by management when determining whether to consolidate an entity. Stakeholders have pushed for a framework for consolidation to ensure that entities would not be able to hide poorly performing investments and be able to easily determine the risks that the group is exposed to as a result of management s investment policies. The International Accounting Standards Board (IASB) has responded to the requirements of stakeholders and the critiques of the previous definitions of control by releasing International Financial Reporting Standard 10: Consolidated Financial Statements (IFRS 10) in 2011, which prescribes the latest definition thereof. The research study will establish the historical international development of the definition of control in various accounting contexts as prescribed by the IASB and its predecessors. The definition of control as prescribed by other financial reporting standards will be analysed, but as IFRS 10 is the first financial reporting standard to be released with a significantly different definition, it will form the main focus of the study. Definitions and opinions as stated by the Financial Accounting Standards Board (FASB) will be assessed for comparability and context. The study will assess whether the latest definition of control is considered to be complete and sufficient to apply to all situations where the question of control has to be evaluated. A qualitative research design in a critical framework has been adopted for this research. The research traces the origins of the definition of control and makes a critical assessment of each definition prescribed by the IASB and its predecessors. The research is structured in chapters dedicated to specific decades, which detail the definition prescribed at the time, the reasons for any changes to definitions prescribed in previous periods and an assessment thereof. This research has found that the IASB s definition of control has changed significantly over the past 60 years, the most significant change being the way in which control relating to investments in other entities has been defined. The IASB has moved away from the concept of control being based on majority share ownership, to a definition based on risk and reward exposure and the decision making capabilities of the investor. IFRS 10 is effective for companies with a financial year beginning on or after 01 January 2013 and the effects of the new definition of control have yet to be analysed. The definition of an asset has followed suit, and is no longer based on the property rights to an asset, but is rather based on flows of economic benefits to an entity with the latest working definition being i
based on control. The new definition of an asset is in line with the objective of the IASB to create a principles-based financial reporting framework, rather than a rules-based framework which prescribes the required accounting methods for assets and investments. The new definition of an asset is currently a working definition contained in an exposure draft, the purpose being to allow users of IFRS to comment until the cut off date in 2014. Once formal feedback has been considered, the IASB will determine whether the new definition of assets should be adopted or not. The Conceptual Framework within which the new definition is to be contained forms the base on which all other financial reporting standards are structured and other exposure drafts have been released. All the new definitions of control that have been released in new financial reporting standards, exposure drafts and discussion papers are more in line with a decision making framework for control rather than a rules-based or risks and rewards framework. These are however limited to the financial reporting standard in which they have been released, and are not interchangeable or applicable to other types of transactions. The IASB has not released any statements which indicate that the development of a universally applicable definition of control is a priority or an objective at this time. Key words: control, financial reporting, consolidation, conceptual framework, asset, IASB ACKNOWLEDGEMENTS Firstly, I would like to offer my sincere gratitude to my supervisor Prof. Nerine Stegmann for her time, patience and generous contributions to this dissertation. I am also very grateful to my parents, Michael and Dianne Manning for their suggestions and reviews of the early drafts of this dissertation. Finally, I owe a large thank you to my husband, Michael Ross, for his patience and support. LIST OF FIGURES Figure 1: Timeline of development of US GAAP, page 22 Figure 2: Timeline of development of International standards, page 26 Figure 3: Development of the definition of control, page 119 ii
ACRONYMS The acronyms below are listed in alphabetical order AAA AAPA AC 132 AIA AICPA AISG APB APB 16 APB South Africa ARB ARB 43 ARB 51 ASAF ASBSA ASOBAT ASSC CAP DP 2013/1 ED 10 ED 2011/6 ED 2013/6 ED 1999 EFRAG EU FASB FIN 46 FSB American Accounting Association American Association of Public Accountants AC 132: Consolidated Financial Statements and Accounting for Investments in Subsidiaries American Institute of Accountants American Institute of Certified Public Accountants Accountants International Study Group Accounting Principles Board Accounting Principles Board 16: Business Combinations Accounting Practises Board of South Africa Accounting Research Bulletin Accounting Research Bulletin 43: Restatement and Revision of Accounting Research Bulletins Accounting Research Bulletin 51: Consolidated Financial Statements Accounting Standards Advisory Forum Accounting Standards Board of South Africa A Statement of Basic Accounting Theory Accounting Standards Steering Committee Committee on Accounting Procedure Discussion Paper 2013/1. A Review of the Conceptual Framework for Financial Reporting Exposure Draft 10: Consolidated Financial Statements Exposure Draft 2011/6: Revenue from Contracts with Customers Exposure Draft 2013/6: Leases Exposure Draft 1082-194R: Consolidated Financial Statements: Purposes and Policy European Financial Reporting Advisory Group European Union Financial Accounting Standards Board Interpretation No. 46: Consolidation of Variable Interest Entities Financial Stability Board iii
G20 GAAP IAS Group of Twenty Generally Accepted Accounting Principles International Accounting Standard(s) IAS 1(1975) International Accounting Standard 1: Disclosure of Accounting policies (1975) IAS 1(1997) International Accounting Standard 1: Presentation of Financial Statements (1997) IAS 1(2001) International Accounting Standard 1: Presentation of Financial Statements (2001) IAS 3 IAS 8 IAS 12 IAS 14 IAS 17(1982) IAS 17(2003) IAS 22 (1998) IAS 22 (1983) IAS 25 IAS 27(1989) IAS 27(2003) International Accounting Standard 3: Consolidated Financial Statements International Accounting Standard 8: Accounting Policies, Changes in Accounting Estimates and Errors International Accounting Standard 12: Income Taxes International Accounting Standard 14: Reporting Financial Information by Segment International Accounting Standard 17: Accounting for leases International Accounting Standard 17: Leases International Accounting Standard 22: Business combinations International Accounting Standard 22: Accounting for business combinations International Accounting Standard 25: Accounting for Investments International Accounting Standard 27: Consolidated Financial Statements and Accounting for Investments in Subsidiaries (1989) International Accounting Standard 27: Consolidated and Separate Financial Statements (2003) IAS 27(2011) International Accounting Standard 27: Separate Financial Statements (2011) IAS 28(1998) International Accounting Standard 28: Accounting for Investments in Associates (1998) IAS 28(2011) International Accounting Standard 28: Investments in Associates (2011) IAS 32 IAS 36 IAS 38 IAS 39 IASB IASC ICAEW ICAS International Accounting Standard 32: Financial Instruments: Disclosure and Presentation International Accounting Standard 36: Impairment of Assets International Accounting Standard 38: Intangible Assets International Accounting Standard 39: Financial Instruments: Recognition and Measurement International Accounting Standards Board International Accounting Standards Committee Institute of Chartered Accountants in England and Wales Institute of Chartered Accountants of Scotland iv
IFAC IFRS IFRS 3 IFRS 7 IFRS 9 IFRS 10 IFRS 11 IFRS 12 IFRS 14 IFRS 15 IOSCO JSE NYSE SA GAAP SAICA SATTA SEC SFAC 1 SFAC 3 SFAC 6 SFAS 94 SSAP SIC SIC 12 SPE UK US GAAP USA International Federation of Accountants International Financial Reporting Standards International Financial Reporting Standard 3: Business Combinations International Financial Reporting Standard 7: Financial Instruments: Disclosure International Financial Standard 9: Financial Instruments International Financial Reporting Standard 10: Consolidated Financial Statements International Financial Reporting Standard 11: Joint Arrangements International Financial Reporting Standard 12: Disclosure of Interests in Other Entities International Financial Standard 14: Regulatory Deferral Accounts International Financial Standard 15: Revenue from Contracts with Customers International Organisation of Securities Commissions Johannesburg Securities Exchange New York Securities Exchange South African Generally Accepted Accounting Practice South African Institute of Chartered Accountants Statement of Accounting Theory and Theory Acceptance Securities and Exchange Commission Statement of Financial Accounting Concepts 1: Objectives of Financial Reporting by Business Enterprises Statement of Financial Accounting Concepts No. 3: Elements of Financial Statements of Business Enterprises Statement of Financial Accounting Concepts No. 6: Elements of Financial Statements Statement of Financial Accounting Standards No. 94: Consolidation of all Majority- Owned Subsidiaries Statements of Standard Accounting Practice Standards Interpretation Committee Standard Interpretation Committee 12: Consolidation Special Purpose Entities Special Purpose Entity United Kingdom United States Generally Accepted Accounting Principles United States of America v
DEFINED TERMS The definitions below are listed in alphabetical order: Term Consolidated financial statements Group Parent Separate financial statements Subsidiary Definition Financial statements of a group in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity (IASB, 2011c: Appendix A). A parent and its subsidiaries (IASB, 2011c: Appendix A). An entity that controls one or more entities (IASB, 2011c: Appendix A). Financial statements presented by a parent (i.e. an investor with control of a subsidiary) or an investor with joint control of, or significant influence over, an investee, in which the investments are accounted for at cost or in accordance with International Financial Standard 9: Financial Instruments (IASB, 2011b: Appendix A). An entity that is controlled by another entity (IASB, 2011c: Appendix A). vi
TABLE OF CONTENTS Chapter One: Introduction. 5 1.1 Research problem 8 1.2 Objective of the research..10 1.3 Rationale..11 1.4 Research method...14 1.4.1 Chapter two: The development of modern accounting.12 1.4.2 Chapter three: The development of business combinations and group accounting..12 1.4.3 Chapter four: Early financial reporting standards..12 1.4.4 Chapter five: Convergence begins..12 1.4.5 Chapter six: The refinement of the standards 13 1.4.6 Chapter seven: Harmonisation and financial reporting standard development in the 1990s.13 1.4.7 Chapter eight: Changes to the definition of control from 2003 to 2013.13 1.4.8 Chapter nine: Conclusion and future research..14 Chapter Two: The development of modern accounting...15 2.1 The origins of modern accounting...15 2.1.1 Development in the United Kingdom 15 2.1.2 Development in South Africa.16 2.1.3 Development in the United States of America 17 2.2 Changes to financial reporting after 1929..18 2.2.1 Effect of the 1929 stock market crash on USA accounting regulation...18 2.2.2 Development of accounting principles.20 2.3 Formation of the Financial Accounting Standards Board (FASB).21 2.3.1 United States Generally Accepted Accounting Principles (US GAAP)..21 2.4 Formation of the International Accounting Standards Body (IASB)...23 2.4.1 Committee on International Relations..23 2.4.2 International Accounting Standards Committee.24 2.4.3 International Financial Reporting Standards (IFRS)..26 2.4.4 South African Generally Accepted Accounting Practice (SA GAAP)..27 2.5 Convergence in financial reporting.29 2.6 Conclusion...31 Chapter Three: The development of business combinations and group accounting..32 3.1 The development of asset recognition 32 3.2 The development of group accounting 34 3.2.1 Legislation and accounting practise development.35 3.2.2 Accounting for business combinations 37 3.3 Conclusion...39 1
Chapter Four: Early financial reporting standards...40 4.1 A Statement of Basic Accounting Theory (ASOBAT)...41 4.1.1 ASOBAT and control..43 4.2 A Statement of Accounting Theory and Theory Acceptance (SATTA)..44 4.2.1 Control under SATTA.44 4.3 American Institute of Certified Public Accountants (AICPA) 45 4.3.1 Control theories based on consolidation.46 4.3.2 Control theories relating to asset recognition.48 4.4 Institute of Chartered Accountants in England and Wales (ICAEW).50 4.4.1 Control per ICAEW.50 4.5 Accounting Standards Steering Committee (ASSC). 51 4.6 The first international accounting textbook. 51 4.7 Conclusion...52 Chapter Five: Convergence begins 53 5.1 South African Generally Accepted Accounting Practise (SA GAAP).53 5.1.1 AC 132: Consolidated and Separate Financial Statements (AC 132) 54 5.2 Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises (Basic Concepts)...54 5.2.1 Control concepts relating to assets..55 5.2.2 Control concepts relating to business combinations.57 5.2.2.1 Business combinations..57 5.3 Objectives of Financial Statements (The Objectives)...58 5.3.1 Concept of control in The Objectives...59 5.4 Statement of Financial Accounting Concepts 1: The Objectives of Financial Reporting by Business Enterprises (SFAC 1) 60 5.4.1 Control concepts within SFAC 1...61 5.5 International Accounting Standard 1: Disclosure of Accounting Policies (IAS 1(1975)).62 5.5.1 Fundamental accounting assumptions 62 5.5.2 Accounting policies.63 5.6 International Accounting Standard 3: Consolidation of Financial Statements (IAS 3) 64 5.6.1 The use of consolidated financial statements.65 5.6.2 The concept of control 66 5.6.2.1 Difference in voting power.67 5.6.2.2 Control by statute or contract 67 5.6.2.3 Temporary control...68 5.6.2.4 Funds transfer..68 5.6.2.5 Dissimilar activities..68 5.6.3 Significant influence 70 5.6.4 Disclosure.71 5.7 Conclusion...72 2
Chapter Six: The refinement of the standards.73 6.1 International Accounting Standard 22: Accounting for Business Combinations (IAS 22(1983))...73 6.1.1 Control per IAS 22(1983)...73 6.2 International Accounting Standard 25: Accounting for Investments (IAS 25)...75 6.2.1 Recognition..75 6.3 Statement of Financial Accounting Standards No. 94: Consolidation of all Majority-Owned Subsidiaries (SFAS 94).76 6.3.1 Control in terms of SFAS 94..77 6.4 International Accounting Standard 27: Consolidated Financial Statements and Accounting for Investments in Subsidiaries (IAS 27(1989))...77 6.4.1 Consolidation based on control.78 6.4.1.1 Power...79 6.4.1.2 Temporary control..79 6.4.1.3 Funds transfer.80 6.4.1.4 Dissimilar activities.81 6.4.1.5 Accounting in the parent s separate financial statements 81 6.4.2 Disclosure.81 6.5 Framework for the Preparation and Presentation of Financial Statements (the Framework) 82 6.5.1 IASB definition of an asset.83 6.5.2 FASB definition of an asset...85 6.6 Accounting for finance leases..86 6.6.1 International Accounting Standard 17: Accounting for Leases (IAS 17(1982))...86 6.7 Conclusion...87 Chapter 7: Harmonisation and financial reporting standard development in the 1990s..88 7.1 Reformatting International Accounting Standards.89 7.2 Exposure Draft 1082-194R: Consolidated Financial Statements: Purpose and Policy (ED 1999).90 7.2.1 Definition of control per ED 1999..90 7.3 Definition of assets.91 7.4 Standard Interpretations Committee 12: Consolidation of Special Purpose Entities (SIC 12)..92 7.4.1 Control of SPEs...92 7.5 Intangible assets.94 7.5.1 Control over intangible assets...94 7.6 Financial instruments.96 7.6.1 Transfer of control...96 7.6.2 Disclosure of control...97 7.7 Conclusion...97 3
Chapter 8: Changes to the definition of control from 2003 to 2013...98 8.1 International Accounting Standard 27: Consolidated and Separate Financial Statements (IAS 27(2003)).99 8.1.1 Exclusions from consolidations..100 8.2 International Accounting Standard 27: Separate Financial Statements and International (IAS 27(2011)) Financial Reporting Standard 10: Consolidated Financial Statements (IFRS 10)..101 8.2.1 The global financial crisis.101 8.2.2 New definition of control..102 8.2.2.1 Power over the investee.103 8.2.2.2 Returns..104 8.2.2.3 Use of power to affect returns 105 8.2.3 Manipulation of the new definition of control 105 8.2.4 Disclosure..107 8.3 The new Conceptual Framework...108 8.3.1 World standard setters discussion.109 8.3.2 Discussion Paper 2013/1: A Review of the Conceptual Framework for Financial Reporting (DP 2013/1) 111 8.3.2.1 Clarity on control..112 8.4 Leases 112 8.4.1 The right to control 113 8.4.2 Disclosure..114 8.5 Revenue.115 8.5.1 Considerations relating to control...115 8.6 Conclusion.116 Chapter 9: Conclusion and future research 117 9.1 Findings.117 9.2 Conclusion.123 9.3 Recommendations for future research.124 4
Chapter one Introduction The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) are presently the two most influential financial standard setting bodies in the world (Gillis et al., 2014: 904). Both bodies have issued many financial reporting standards since their inceptions in 2003 and 1973 respectively. These financial reporting standards built on those issued by their predecessors, namely the International Accounting Standards Committee (IASC), formed in 1973, and the American Institute of Certified Public Accountants (AICPA), formed in 1957. Both the IASB and the FASB have issued financial reporting standards relating to control, however, until recently neither accounting body released a definition of control that could be applied to all economic transactions (Nobes, 2014: 996). The focus of the definition was either on controlling an entity or an asset. The first definition of control issued by an IASB or FASB predecessor was that of the AICPA in 1959 and it related to the control of an entity through majority share ownership. During the development of business combinations and investment transactions, situations were identified where it was found that a party with a minority shareholding in an entity had more influence over that entity than the majority shareholder. There have been cases where shareholders have been misled as to the financial position of companies (Beyer et al., 2010: 296) due to the inclusion or exclusion of information that misrepresented the financial position of those companies (Kennedy, 2012: 6). The consolidation of all the operations in which a company is involved is meant to provide a true picture of the risks and rewards to which the consolidated group of companies is exposed and by misleading users of those financial statements, a true picture is not presented. An example of the effect of manipulation of company results by management is the global financial crisis that began in the year 2007. This was caused in part by the non-disclosure of the risks to which companies were exposed due to the widespread use of special purpose entities not consolidated by the entities who in truth controlled them (Damien, 2013: 94). Companies and investors across the globe were affected by the financial crisis as many companies were listed on securities exchanges in multiple countries, resulting in diversification of investments across the world, known as globalisation. Globalisation had encouraged companies to develop in a manner that would enable them to compete at an international level, which often resulted in them listing on several securities exchanges and thus requiring them to comply with different financial reporting rules and regulations. Groups would often find that the simplest way of dealing with multiple regulations would be to adopt the financial reporting rules that the parent company itself was subjected to (Gerbhardt, 2000: 342). The global adoption of reporting rules meant that when certain companies manipulated results and caused financial instability, the effects were felt globally, a factor that contributed to the financial instability experienced during the global financial crisis in 2007 (Damien, 2013: 95). 5
After the global financial crisis, the IASB received requests from the Group of Twenty (G20) (a forum for international economic cooperation and decision-making (IASB, 2013f)) and the Financial Stability Board (FSB) (an organisation established to coordinate international financial reporting bodies (FSB, 2014)) to improve the disclosure and consolidation requirements prescribed in IFRS in order to prevent entities, amongst others, to hold off-balance sheet investments in the future. The disclosure requirements envisioned by the G20 and Financial Stability Board would enable users to determine the relationships that entities were involved in and the value of the investments held. The IASB issued an exposure draft in December 2008 called Exposure Draft 10: Consolidated Financial Statements (ED 10) in order to address the perceived shortcomings of International Accounting Standard 27: Consolidated and Separate Financial Statements (2003) (hereafter referred to as IAS 27(2003)) in terms of the disclosure and consolidation problems referred to above which were highlighted by the global financial crisis. The IASB had been working on a revised definition of control, aimed at guiding management to determine whether an investment could be regarded as a subsidiary or not. The IASB decided to issue the new definition prior to their intended release date due to pressure from a variety of organisations and bodies, such as the G20, the FASB and the Security Exchange Commission (SEC), thus resulting in the replacement of IAS 27(2003) and SIC-12 Consolidation of Special Purposes Entities (SIC-12) with International Financial Reporting Standard 10 Consolidated Financial Statements (IFRS 10). IAS 27(2003) had focused mainly on the ability to govern an entity and SIC- 12 focused on exposures to risks and rewards (IASB, 2011c: A373), but neither publication included guidance on how to weight different types of power or to determine if control exists, a limitation that led to inconsistent applications and misuse of the financial reporting standards in order to avoid the consolidation of poorly performing investments (IASB, 2011a: 1). The release of IFRS 10 addressed the differences in the accounting for an investment in another entity where the investor did not have majority voting power, but controlled the entity (IASB, 2011a: 6). The IFRS 10 definition of control is a principles-based concept that will allow management to apply their own judgement to the situation under consideration. The IFRS 10 definition of control is in line with the IASB s objective to move away from a rules-based approach, a change that is reflected in the degree to which the new definition differs from prior reporting standards. The previous definition of control had been prescribed by International Accounting Standard 27: Consolidated Financial Statements and Accounting for Investments in Subsidiaries (IAS 27(1989)) that had originally been released in April 1989 by the International Accounting Standards Committee with the goal of enhancing the information contained in separate and consolidated annual financial statements. IAS 27(1989) required consolidation where there was control and defined control as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities (IASC, 1989b: 4). The IAS 27(1989) definition worked well for consolidation until companies began to make use of the concept of Special Purpose Entities (SPE). These were entities whose shares were owned by an investor, but management advice, resources and skill development were provided by another company. The latter company would effectively receive all of the benefits from the SPE that would usually be associated with ownership, but the SPE was not consolidated into the 6
company s consolidated financial statements as it was not owned by it (Hartgraves et al., 2002: 246). Off-balance sheet investments left stakeholders unaware of the company s involvement in the SPE. In order to address this, the IASC released Standard Interpretation Committee 12: Consolidation Special Purpose Entities (referred to hereafter as SIC 12) in 1998 which would address the requirements of IAS 27(1989) when dealing with special purpose entities. The release meant that entities would only consolidate those investments in which they held the majority share ownership, regardless of their involvement in those entities. The shortcoming of this approach would be the exclusion of relevant information to users in the financial statements of the group. IAS27(1989) and SIC 12 had been released by the IASC, the predecessor to the IASB. Subsequent to its formation in 2001 and the dismantling of the IASC, the IASB adopted all financial reporting standards previously released by the IASC, including IAS 27(1989). The IASB then began to revise all financial reporting standards as part of their mission to revise and further develop IFRS, a process which led to the re-release of International Accounting Standard 27: Consolidated and Separate Financial Statements (hereafter referred to as IAS 27(2003)). During the review of IAS 27(2003) and its application it was noted that there was inconsistency resulting from the guidance contained in IAS 27(2003) and SIC-12. IAS 27(2003) had used control as the basis for consolidation of another entity, while SIC-12 focused on risks and rewards (IASB: 2012, 4). The application of SIC-12 was intended for the consolidation of special purpose entities, however, there were inconsistencies between companies when deciding whether an investment was considered to be an SPE or not, resulting in the inconsistent application of IAS 27(2003) and SIC-12. In 2003, as a response to the problem of inconsistent application of these financial reporting standards, the IASB added to their agenda the goal of producing a single definition of control together with the necessary guidance as to how the definition should be applied. The approach was intended to eliminate the complexities and inconsistencies associated with the choice between IAS27(2003) and SIC-12. The most recent definition of control, as issued by the IASB in IFRS 10 in May 2011, is effective for all companies with a financial reporting period beginning on or after 01 January 2013. In terms of this research, the date on which IFRS 10 became effective represents the end point of the historical development analysis and the research performed will trace the key events leading up to this final definition prescribed by the IASB. It is to be noted that in 2013 another working definition of control was released by the IASB in Discussion Paper 2013/1: A Review of the Conceptual Framework for Financial Reporting (referred to hereafter as DP 2013/1), but given that the paper is still open for comment by professionals and users, it has not yet been prescribed by the body. The fact that DP 2013/1 has not yet been prescribed by the IASB will not however preclude the working definition from consideration within this research. The IASB s definition of control is the end point of the historical development of the definition of control as discussed above, the organisation itself will be historically analysed in order to provide context for the development of the financial reporting standards in which definitions of control are prescribed. The financial reporting standards released by the IASB are prescribed in South Africa by the South African Institute of Chartered Accountants (SAICA), the body responsible for standard 7
setting in South Africa. South Africa is a member country of the IASB. The financial reporting needs of the country therefore by association could influence the decisions made by the IASB. The IASB releases standards (IFRSs) in line with their objective of developing a single set of high quality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles (IASB, 2013c: 1). IFRS is permitted or used by almost 127 countries (IASB, 2013c: 6), which makes the IASB the leader of the financial reporting standard setting boards. The global adoption of IFRS emphasises both the relevance and importance of the IASB s objective. In order to meet this objective the IASB is governed by a board of trustees who oversee the development of financial reporting standards. Input from industry leaders and academics is encouraged by the board. Single stakeholders are by implication unable to push IFRS in a direction that would be beneficial to their interests alone (IASB, 2013c: 1). The result is that the IASB is not independent from the users of IFRS, allowing for clear communication with industry leaders and the elimination of political pressure. The IASB is free from governmental pressure from a single country and therefore has international relevance. In contrast, the USA does not adopt financial reporting standards prescribed by the IASB and instead adopts those prescribed by the American accounting body, the FASB. The FASB is a similar organisation to the IASB and its objective is the development of standards of financial accounting that govern the preparation of financial reports by non-governmental entities, however the organisation is not independent from USA legislation (FASB, 2014). The lack of independence is due to the appointment of the FASB by the SEC, the body in the USA that regulates companies listed on the NYSE and in turn the financial statements released by those companies (FASB, 2014). The IASB is influenced by the FASB as the bodies work together on specific convergence projects. Despite their focus on companies registered in the USA, the FASB is involved with the IASB as part of a convergence project, which is discussed in 2.5 below. The goal of the convergence project is the development of a single set of financial reporting standards that can be used internationally by companies for both domestic and international financial reporting. The convergence project began in 1999 (FASB, 2014) and has had an influence on the development of financial reporting standards issued by the IASB and on the definition of control. 1.1 Research problem The development of the definition of control has influenced the information contained in financial statements presented to stakeholders since the early 1900s. Financial statements are the medium through which companies communicate with their stakeholders. Stakeholders are therefore not only dependent on management to truthfully disclose the information to them, but also rely on financial reporting standard setters to regulate the information that management is preparing. Whenever the definition of control changes, the information presented changes, thus altering the information available to stakeholders. 8
IFRS 10 was issued in line with the IASB s objective of producing a single definition of control together with the necessary guidance as to how the definition should be applied. IFRS 10 (2011c: 6) determines through this definition of control that an investor has control over an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. The analysis undertaken by the IASB (2011c: 3) has indicated that the new definition of control prescribed by IFRS 10 would lead to more appropriate consolidations of complex group structures and that basic group structures would probably not be affected as it is easier to determine control in structures containing only two companies and simple contractual arrangements with other entities. This implies that there are groups who have previously not included subsidiaries in their consolidated financial statements when they have in effect been in control of the operations in question. Adoption of IFRS 10 by these types of companies would result in the consolidation of certain companies, now considered to be subsidiaries for the first time. The preparers of financial statements would have to apply IFRS 10 retrospectively in terms of International Accounting Standard 8: Accounting Policies, Changes in Accounting Estimates and Errors (hereafter referred to as IAS 8) (IASB, 2003c). The only exception to this retrospective application of IFRS 10 would occur if all investments considered to be controlled under IFRS 10 had previously been consolidated under IAS 27(2003) and SIC-12. For companies that have previously not considered an investment to be a subsidiary, but now have to consolidate such investee in terms of IFRS 10, such application could have a major impact on the consolidated financial statements. The Conceptual Framework for Financial Reporting, International Accounting Standard 17: Leases, International Accounting Standard 38: Intangible Assets and International Accounting Standard 39: Financial Instruments: Recognition and Measurement all refer to the concept of control, but do not as yet adopt the new definition per IFRS 10. Each of these financial reporting standards have their own definition of control which is applied within the scope of the particular financial reporting standard. The result of this is the existence of different definitions of control. Convergence of these definitions within existing IFRS is not a current objective of the IASB. New financial reporting standards that had been released since 2011 however utilise the latest definition of control as prescribed in Discussion Paper 2013/1: A Review of the Conceptual Framework for Financial Reporting (DP 2013/1). Referencing of the definition between financial reporting standards has not taken place, nor have previously released financial reporting standards been updated for the new definition. Inconsistencies in application of different definitions of control could lead to issues further on in the development of financial reporting standards and lead to additional issues if the IASB converges IFRS with United States Generally Accepted Accounting Principles (US GAAP). With reference to the concept of globalisation and the existence of complex cross-border companies, convergence of IFRS and United States Generally Accepted Accounting Practise (US GAAP), the accounting standards used in the United States of America (USA) is a long term goal of both the IASB and the Financial Accounting Standards Board (FASB). The financial reporting standard setters responsible for US GAAP and IFRS developed the new definitions of control with convergence in 9
mind. The same control model for consolidations has been adopted in both IFRS 10 and US GAAP. The effect being a standard and global definition of control that will guide global financial reporting standards relating to consolidations. The definitions as mentioned in other financial reporting standards are not yet globally accepted and although the FASB has been involved with the IASB s development of those control definitions, they have not yet been formally adopted by the FASB as US GAAP. The research will explore the development of the definition of control from its inception from the AICPA s definition in 1959, through to its current form. The research will track and analyse the high points during the development of the definition with an emphasis on the post-world War II period. In this regard, the research question will focus on how the definition of control has developed and why. The research will highlight the problem that a definition of control applicable to all types of financial transactions without becoming rules-based is difficult to perfect, especially since the IASB has a principles-based focus. Per Fisher (1906: 103) a definition needs to allow for the determination of whether an item can belong to a specific class or not, and it needs to be consistent with a common sense understanding of the item. The research will conclude with a proposed definition that could be applicable to all types of transactions. 1.2 Objective of the research The objective of this research is to perform an analysis of the historical development of the definitions of control for financial reporting purposes that have been issued by the IASB and its predecessors. The results of the research will provide a comprehensive background of the development of the definition of control as it currently stands. Each definition will be compared to the previous one released in order to analyse the reasons for the release, the improvements or shortfalls of that new definition and the opinion of accounting academics and professionals on the release. The study will not attempt to analyse the effects of each definition of control on the financial statements released at the time. The starting point will be the first financial reporting standard to be issued by an IASB predecessor. A historical background of the IASB will be discussed in order to contextualize the standard setting body ultimately responsible for defining the concept under examination. The IASB was selected as they are responsible for setting IFRS, which is the financial reporting standards used by South African entities as required by South African Company Law that dictates in the case of financial reporting standards for public companies, [annual financial statements] must be in accordance with the International Financial Reporting Standards of the International Accounting Standards Board or its successor body (Companies Act No. 71 of 2008, p29(5)(b)). The research will focus on the historical background of how and why the IASB and its predecessors initiated changes to the definition of control and, key events that prompted decisions to issue new financial reporting standards. The research is designed to identify and analyse key events and key concepts from each decade beginning with the post World War II era. By identifying key events and 10
key considerations made by the IASB, the research study should be able to determine whether the new definition of control succeeds in eliminating inconsistent applications, and ensuring that management are prevented from hiding off-balance sheet investments from stakeholders. The release of IFRS 10 as one response to the global financial crisis and the inconsistencies of the application of previous financial reporting standards serves to highlight the historical development of the definition of control. In this regard, the research study will not focus on the definition of control in the context of IFRS 10 or consolidations alone, but rather on the manner in which the definition of control evolved from its earliest versions to the one reflected in IFRS 10 as prescribed by the IASB. Other financial reporting standards within IFRS, including the conceptual framework, for example the standard relating to leases, are reliant on the definition of control. For this reason, each financial reporting standard released by the IASB and its predecessor that prescribes a definition of control will be evaluated, in order to understand the manner in which the definition of control developed, and how it contributes to establishing an ideal concept and definition. 1.3 Rationale The new definition of control as per IFRS 10 is only effective for companies with a reporting period beginning on or after 01 January 2013. IFRS 10 is relatively new and the effects on group structures have not yet been fully studied. The purpose of the research is to determine how the definition of control has evolved over time and been transformed into its current form and the needs that the changes addressed. The research will contribute to both the understanding of the working definitions of control and the applications thereof. A historical study of the definition of control and its influences has not yet been performed in South Africa and so the study provides context to the new definition of control per IFRS 10. 1.4 Research method A qualitative research design was adopted for this historical analysis. The chronological development of the definition of control was reconstructed in order to analyse the changes and deduce the shortfalls, improvements and way in which each development contributed to the current definition per IFRS 10. Inferences were made as to the reasons for certain shortfalls and improvements based on changes to financial reporting at the time. Limitations of the study include the assumptions made based on interpretations of historical information. For this reason, the core of the research is the development of financial reporting standards published as these are free from bias and political opinion. Primary sources of data were financial reporting standards issued by the IASB, the FASB and their predecessors, including International Accounting Standards, International Financial Reporting Standards, Accounting Research Bulletins and exposure drafts released for comment. The selection of the financial reporting standards was based on their relevance to the concept of control and the era 11
in which they were issued. Secondary sources of information included articles published in authoritative journals, online publications by the IASB and FASB as well as online IFRS advisory websites. The purpose of the secondary sources of information was to gain a broader insight into the key considerations, events and analytical processes that led to changes in the definition of control. The dissertation is structured in a chronological manner with each chapter representing a particular decade together with the key events that occurred within each decade. The cause and effects of each event, together with the response of the IASB and other industry specialists was analysed, together with the effect that these developments had on the definition and application of control. The exposition of the study is briefly as follows: 1.4.1 Chapter two: The development of modern accounting The chapter provides background to the development of the two most influential accounting bodies worldwide, the IASB and the FASB by providing a historical context to accounting, financial reporting in South Africa, the UK and the USA, and the eventual convergence project between the IASB and the FASB. 1.4.2 Chapter three: the development of business combinations and group accounting A review of the development of group financial reporting, including the rationale behind those developments. The chapter traces the reasons for the establishment of business combinations and the increase in their popularity and need for an accounting framework to regulate the financial reporting thereof. 1.4.3 Chapter four: Early financial reporting standards Chapters two and three provide a background to the development of the accounting bodies that prescribe general accounting practices relevant to the current South African context and the process of consolidation. The background provides a base to analyse the development of the definition of control from 1950 onwards. 1950 was selected as, in a chronological sense, it is the point of departure for the analysis of financial reporting standards relating to control. The reason behind that being that it was at this time that the formal development of financial reporting standards began worldwide. In tandem with formalisation of financial reporting standards, the period witnessed the recognition of the need for convergence of financial reporting practises and the development of international financial reporting frameworks. 1.4.4 Chapter five: Convergence begins The chapter provides an outline of how A Statement of Basic Accounting Theory (ASOBAT) evolved simultaneously with a new financial reporting guideline published by the AAA, called A Statement of Accounting Theory and Theory Acceptance. The release of other important financial reporting standards and the move towards the IASC framework and the associated financial reporting standards is covered. 12
An integral part of the chapter is the analysis of the evolution of the financial reporting standards and in tandem, a description of the variation in approach adopted by different regions despite the growing and acknowledged need for an international financial reporting framework. The changes that occurred during the period 1970 to 1979 will offer the first and objective opportunity to demonstrate the evolution of financial reporting standards and concepts both within and across countries. 1.4.5 Chapter six: The refinement of the standards The move towards an IASC prescribed financial reporting framework and the publication of the AAA s Statement of Accounting Practises during the course of the prior period laid the groundwork for the incremental development and refinement of financial reporting standards during the period that ended in 1989. The period lacked any meaningful convergence worldwide, a concept that forms the basis of the discussion in the chapter. 1.4.6 Chapter seven: Harmonisation and financial reporting standard development in the 1990s The continuing trend towards convergence receives attention in this chapter, with the focus being the harmonisation of financial reporting. The FASB, which had been formed in 1973 with the goal of setting financial reporting standards in the USA, began to cooperate with the IASC. The IASC and the FASB begun to focus on harmonising their financial reporting standards and the two organisations formed ways in which to assist with converged prescriptions without adopting financial reporting standards of either. The nature of control together with the shift away from a rules-based approach will be reviewed. The shift led to a more principles-based approach for both the IASC and the FASB in the 1990s. The IASC had previously held the objective of maintaining a principles-based approach to financial reporting standards and in this decade it became evident as to how they intended to achieve this goal. 1.4.7 Chapter eight: Changes to the definition of control from 2003 to 2013 The results of the global financial crisis and the effect it had on the way the IASB and the FASB were managing the development and application of the revised financial reporting standards are reviewed in this chapter. The releases of certain financial reporting standards that prescribed how to determine the existence of control were accelerated and those standards form the basis of this chapter. The intention of the financial reporting standards, together with the objectives of consistency and comparability, created the need to apply urgent attention to the prevention of off-balance sheet investments. 13
1.4.8 Chapter nine: Conclusion and future research This chapter summarises the evolution of the actions taken by the different financial reporting standard setters together with the significant events that contributed to the eventual standardisation of the definition of control per IFRS 10 in 2011. Further to the summarising of the evolution of the definition of control, an ideal definition of control is proposed, and a conclusion offers details of possible improvements and suggestions as to whether the changes should be incorporated into the IFRS framework as a whole. 14