When one business controls another, accounting standards treat them as a single economic entity. The controlling business, the parent, must prepare consolidated financial statements that include every asset, liability, revenue and expense of the businesses it controls, its subsidiaries. Control is therefore one of the most consequential judgements in financial reporting: it decides what appears in a group’s accounts and what does not.
Most of the time, control is obvious. A company that owns 80% of another company’s shares, appoints its board and directs its strategy clearly controls it. But not always. A company can control another with less than half the shares, or fail to control it despite owning more. Control can arise through contracts rather than shares. Entities can be designed so that voting rights tell you little about who really bears the risks and rewards.
This article explains what control means, how it is assessed under Australian standards and under the US standards described in the source course material, how direct and indirect ownership work, and why the answer matters for business owners and readers of financial statements. It is part of GoCore’s series on investments, groups and acquisitions.
Key terms
The course material sets out a handful of definitions that underpin the topic:
- A business combination is a transaction or event in which an acquirer obtains control of one or more businesses.
- Control, or a controlling financial interest, is the ability to direct the management and policies of another entity, whether through ownership, contracts or otherwise.
- A parent is an entity that controls one or more subsidiaries.
- A subsidiary is an entity controlled by a parent.
- Consolidated financial statements present a parent and all its subsidiaries as a single economic entity.
The last point deserves emphasis. A parent and its subsidiaries are separate legal entities, each with its own assets, debts and obligations. For financial reporting, however, they are presented as if the subsidiaries were divisions of the parent. The legal separateness does not disappear; it simply is not the focus of consolidated statements.
Control through voting rights
The usual source of control is owning a majority of the voting rights. Holding more than 50% of the votes typically allows the holder to appoint a majority of the board, and through the board to direct management and policies.
Under US standards, as the course describes, this is the voting interest model: ownership, directly or indirectly, of more than 50% of the outstanding voting shares generally points towards consolidation.
The Australian approach: a single definition of control
Australian standards (AASB 10 Consolidated Financial Statements, equivalent to IFRS 10) use a single definition of control for all types of entity. An investor controls an investee when it has all three of the following:
- Power over the investee: existing rights that give it the current ability to direct the relevant activities, the activities that significantly affect the investee’s returns.
- Exposure, or rights, to variable returns from its involvement with the investee: returns that can vary with the investee’s performance, such as dividends, changes in value, fees or access to synergies.
- The ability to use its power to affect those returns.
All three must be present. Power without exposure to returns, such as a manager acting purely as an agent for others, is not control. Exposure without power, such as a lender with no say over the investee’s activities, is not control either.
Control without a majority
Because the test focuses on power rather than percentages, control can exist with less than half the votes. Examples include:
- De facto control: an investor holds, say, 45% of the votes and the remaining shares are spread among many small holders who are unlikely to act together. In practice, the 45% holder can direct the investee.
- Contractual arrangements: an agreement gives an investor the right to direct the relevant activities.
- Potential voting rights: options or convertible instruments that could be exercised to obtain a majority, if they are substantive, meaning the holder has the practical ability to exercise them.
Majority without control
Conversely, a majority shareholder may lack control if, for example, another party has contractual rights to direct the relevant activities, or if the investee is under the control of a court-appointed administrator or liquidator.
Protective rights
Some rights protect an investor’s interests without giving power, such as a lender’s right to approve major asset sales, or a minority shareholder’s right to approve changes to the constitution. These protective rights do not, on their own, give control.
Special-purpose entities and variable interests
Some entities are designed so that voting rights are not the deciding factor in who directs them. They may have very little equity, be financed mainly by debt or other arrangements, and operate under predetermined rules. Examples include certain securitisation vehicles, financing structures and project entities.
The US variable interest model
The course material describes the US approach to such entities. Where voting interests do not identify who has a controlling financial interest, a variable interest model applies. The entity is called a variable interest entity, and the party that must consolidate it is its primary beneficiary.
Under US standards, the primary beneficiary is the party that has both:
- the power to direct the activities that most significantly affect the entity’s economic performance, and
- the obligation to absorb losses, or the right to receive benefits, that could potentially be significant to the entity.
The course gives an example of this kind: a company is formed with a tiny amount of share capital from one investor but financed with a large loan from another party. The share capital is a poor guide to who bears the entity’s risks and rewards. Under the variable interest model, the analysis looks beyond the shares to identify who has power over the key activities and significant exposure to the entity’s results.
The Australian approach to structured entities
Australian standards apply the same single control definition to these entities, which are often called structured entities. The analysis looks at the entity’s purpose and design, who has power over the activities that significantly affect its returns, and who is exposed to those returns. Extra disclosures are required about interests in unconsolidated structured entities, under AASB 12 Disclosure of Interests in Other Entities.
Direct and indirect ownership
Control can be held directly or through other entities.
Direct ownership: a company holds shares in another company itself. If Company A owns 80% of Company B, A controls B and consolidates it.
Indirect ownership: a company controls another through one or more subsidiaries. If A controls B, and B owns 70% of Company C, then A controls C through B, and A’s consolidated statements include both B and C.
A worked illustration
This is an illustration based on the type of example in the course material.
Company A owns 40% of Company B and 45% of Company C. Company B owns 25% of Company C.
- A does not control B: it holds only 40%, and assume no other rights give it control.
- Does A control C? A holds 45% directly. B’s 25% is not under A’s control, because A does not control B. So A controls only 45% of C’s votes, and on these facts does not control C.
Now change one fact: A owns 60% of B.
- A now controls B, so B is a subsidiary.
- A controls B’s 25% stake in C, in addition to its own 45%. A therefore controls 70% of C’s votes and controls C.
Control is not the same as economic ownership
The second scenario illustrates an important distinction. A controls 70% of C’s votes, but its economic interest in C is lower. A owns 45% of C directly, plus 60% of B’s 25% stake, which is 15%. A’s effective economic interest in C is therefore 60%.
For consolidation, control determines whether C is included in A’s group accounts, and C is included in full. The economic interest determines how C’s results are divided between A’s shareholders and other owners, shown as a non-controlling interest. In this example, 40% of C’s results would be attributed to non-controlling interests: the 30% of C held by outside shareholders directly, plus the 40% of B’s 25% stake held by B’s other shareholders, which is 10%.
Why control matters
It decides what is in the group accounts. A controlled entity’s revenue, assets and debts are included in full. A non-controlled entity appears, at most, as a single line.
It affects how the group looks. Consolidating a heavily indebted subsidiary increases the group’s reported debt. Not consolidating it keeps the debt off the group balance sheet. This is why control assessments, and structures designed around them, attract scrutiny.
It affects reporting obligations. Whether a group must prepare consolidated financial statements depends on its size and type under the Corporations Act and accounting standards. Large proprietary companies, public companies and listed entities generally have such obligations; many small proprietary companies do not.
It is not the same as legal liability. A parent is not automatically liable for a subsidiary’s debts merely because it consolidates it, although guarantees, cross-guarantee arrangements and other legal factors can create liability.
Reassessing control
Control is not assessed once and forgotten. Under Australian standards, an investor reassesses whether it controls an investee whenever facts and circumstances indicate that one or more of the three elements of control has changed. Events that can trigger reassessment include buying or selling shares, changes in the holdings of other investors, the expiry or exercise of options, changes to agreements, and changes in the investee’s activities or governance. A group’s composition can change without any transaction by the parent itself, for example when other shareholders become more organised or a contractual right lapses.
Control in Australian private groups
Many Australian private businesses operate through groups combining companies and trusts: an operating company, a trust holding property or intellectual property, a corporate trustee and family members in various roles. For entities in such groups that prepare financial statements under Australian Accounting Standards, the same control principles apply.
Assessing control of a trust involves looking at who can direct its relevant activities, often the trustee, and who can appoint or remove the trustee, often a person called the appointor, as well as who is exposed to the trust’s returns through distributions. Discretionary trusts, where distributions are at the trustee’s discretion, can make the analysis particularly complex. These assessments often require specialised advice. It is also worth remembering that accounting control, tax consolidation and legal liability follow different rules, and a group’s structure can have different consequences under each.
Investment entities
Some entities that exist to invest for capital appreciation or investment income, such as certain investment funds, are classed as investment entities under Australian standards. Instead of consolidating the companies they control, they measure those investments at fair value through profit or loss, because fair value is the most relevant information for their investors. The criteria are specific, and most operating businesses do not qualify.
Common mistakes
Relying only on share percentages. Power, rights and exposure to returns decide control.
Ignoring potential voting rights. Substantive options and convertible instruments can matter.
Confusing protective rights with power. Rights that only protect an investor do not give control.
Mixing up control and economic interest. Control decides consolidation; ownership decides the split of results.
Assuming consolidation means legal liability. Liability depends on guarantees and legal arrangements.
Questions to ask
- Who has the current ability to direct the activities that most affect this entity’s returns?
- Who is exposed to the entity’s variable returns?
- Are there contracts, options or other rights that give power beyond shareholdings?
- Is control held directly, or indirectly through other entities?
- For your own business: which entities in your structure do you control, and what is your economic interest in each?
Bringing it together
Control decides whether one entity must consolidate another. Under US standards, as described in the course material, a majority of voting interests usually indicates control, with a variable interest model for entities where voting rights are not decisive. Under Australian standards, a single definition applies: power over the relevant activities, exposure to variable returns, and the ability to use that power to affect those returns.
Control can be held directly or indirectly, and it can differ from economic ownership, which determines how a subsidiary’s results are shared with non-controlling interests. Getting the control assessment right is the foundation of accurate group reporting.
Sources: course materials from an advanced financial reporting course (Module 1, based on US GAAP), together with Australian Accounting Standards, including AASB 10 and AASB 12. Figures are illustrations. This article is general information, not accounting, legal or financial advice; consult a qualified accountant about your circumstances.
