This is a great question because it is so important! Important because where an investment is identified as a subsidiary then this triggers the preparation of consolidated financial statements (group accounts). This is where the financial statements of a parent and its subsidiaries are presented as if they were a single economic entity. This means that the subsidiary’s income, expenses, assets, and liabilities are fully aggregated into the group accounts.
Principles not numbers are key
A principles-based approach is taken to defining a subsidiary. In simple terms a subsidiary is an entity that is controlled. It must be noted that the definition of a subsidiary is not a number, rather it is based on the principle of control.
Control is though normally, but not exclusively, evidenced by the investor holding a majority (50% +) of the voting rights. But there are exceptions where control can be achieved by holding less than a majority of the shares.
Principles prevent creative accounting
The principles-based approach is important as creative accountants, trying to adopt a legalistic approach, may wish to try and argue that an investment is not a subsidiary, on the basis that the investor’s shareholding is less than 50% (when it is actually controlled). This (false) argument can be trotted out where the investment is highly geared. In which case, what the creative accountant is trying to do, is to take the investment’s liabilities off the group balance sheet, as if the investment is defined as a subsidiary, then their liabilities are aggregated in full in the consolidated accounts.
Consider all the circumstances
In determining whether an investment is controlled, and therefore a subsidiary, it is important to consider the substance of the relationship and not just the size of the shareholding.
Let us learn by considering a question.
Q Whitstable & Oyster
Whitstable has recently acquired 40% of the equity capital and voting rights of Oyster. The other 60% of Oyster’s shares are held by a wide variety of investors, none of whom owns more than 1% individually. None of the other shareholders have any arrangements to consult any of the others or make collective decisions. Since Whitstable purchased the investment in Oyster it has actively participated in establishing the operating and financial policies of Oyster.
Discuss whether Whitstable’s purchase of the shareholding in Oyster should be accounted for in the consolidated financial statements as a subsidiary.
A Whitstable & Oyster
Oyster will be a subsidiary in the Whitstable group if it is established that Whitstable controls Oyster.
On a first review, Whitstable does not have the power to control Oyster on account of its the absolute size of its shareholding. After all it does not hold a majority. A holding of 40% gives a rebuttable assumption of significant influence (associate status) rather than control.
Whitstable will be able to control Oyster if, and only if, it has all of the following elements:
- power over the Oyster, i.e. Whitstable has existing rights that give it the ability to direct the relevant activities (the activities that significantly affect Oyster’s returns)
- exposure, or rights, to variable returns from its involvement with Oyster
- the ability to use its power over Oyster to affect the amount of Whitstable’s returns.
Whitstable will have to consider all relevant facts and circumstances when assessing whether it controls Oyster.
It is noted that the other shareholdings in Oyster are all small and widely disbursed. Further it is noted that none of the other shareholders have any arrangements to consult any of the others or make collective decisions.
This means that at a shareholder meeting of Oyster, Whitstable should be able to appoint the directors it wants. Many of those small investors may abstain or support the appointment. This assumption is validated by the assertion that since Whitstable purchased its investment it has actively participated in establishing the operating and financial policies of Oyster.
Whitstable therefore has power over Oyster, and there are no stated restrictions on its ability to use that power. Further with a 40% holding in Oyster, then Whitstable also has exposure to variable returns.
To conclude, despite owning less than a majority of the shares in Oyster, Whitstable does actually control Oyster and is therefore a subsidiary of Whitstable, albeit with a non-controlling interest of 60%!