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JURIDICA INTERNATIONAL. LAW REVIEW.
UNIVERSITY OF TARTU (1632)

Consolidated Accounting Policies1

Risto Vahimets
pp. 90-99

Introduction

This paper discusses consolidation policies for consolidated accounting for investor-creditor information purposes. The goal is to establish some guidelines for the Estonian legislature. Obviously, it is in Estonia's best interests to use the experience and knowledge that other countries have acquired while developing and enforcing their consolidation policies. Estonia’s geographical, political and economic situation will be taken into account. Estonia's primary political goal is to join the European Union (“EU”), and therefore the rules of the EU are of special value to its legislative development. However, as consolidated accounting is by its origin an American concept, the rules of the United States (“US”) will be used for comparison. The International Accounting Standards (“IAS”), drafted by the International Accounting Standards Committee, will not be discussed in order to limit the scope of this paper.

Today, Estonia has no rules for preparing consolidated accounts.2 Many Estonian corporate groups do prepare consolidated accounts however. The ensuing information is conveyed to investors and the public. As will be seen, the lack of uniform requirements for consolidated accounting causes serious differences in the presentation of financial affairs of different groups. For example, it is possible to “hide” debts in a finance subsidiary that is exempted from consolidation because its activities are different from the rest of the group. This deceives investors and causes numerous incorrect investment decisions.

Consolidated accounting has two major components. These are consolidation policies and consolidation procedures. Consolidation policies deal with such issues as when should consolidated accounts be prepared and which entities should a consolidation encompass. These issues are the part of consolidated accounting which belongs within the sphere of company law.3 Consolidation procedures are a set of rules which form the accounting part of consolidated accounting. These rules provide the methods for presenting the financial affairs of a corporate group as if it were a single entity.4 For example, the elimination of intragroup sales, the goodwill of subsidiaries and minority interests in subsidiaries are issues that are covered by consolidation procedures. Only consolidation policies are analyzed in this paper.

One of the most important issues in this paper is the choice which Estonia and other countries have while drafting their consolidated accounting rules. This is a choice between consolidation policies that are based on the legal means of control and consolidation policies that are based on the effective means of control. Legal control means that the parent company has a legally enforceable right to direct the actions of a subsidiary. Effective control in turn, means that in addition to the legally enforceable means of control, economic means of control are considered while making decisions whether to consolidate or not consolidate a potential subsidiary.

This paper first discusses basic accounting principles and then discusses consolidation policies, which are discussed in two parts: firstly, general consolidation policies; and secondly, exemption rules.

Basic accounting principles

There are three basic accounting principles which are important for the purposes of this paper. These are comparability, relevance and representational faithfulness.

The basic principles of accounting for investor-creditor information purposes in the US are codified by the Financial Accounting Standards Board (“FASB”) in the Concepts Statements No. 1-6.5

Representational faithfulness is the correspondence or agreement between a measure or description and the phenomenon it purports to represent. In accounting, the phenomena to be represented are economic resources and obligations and the transactions and events that change those resources and obligations.6

Relevance of financial statements means that such financial statements present information in a way that is most relevant to users. The Statement of Financial Accounting Standards (“SFAS”) No. 94 states: “Information that is most relevant to investors, creditors and other users thus includes consolidated financial statements that present, primarily for the benefit of the shareholders and creditors of the parent company, the results of operations and the financial position of a parent company and its subsidiaries essentially as if the group were a single company with one or more branches or divisions.”7 While this paper deals with consolidated accounting for investor-creditor information purposes, the information the consolidated accounts present must be most relevant to the shareholders and creditors of the corporate groups.

A significant aspect of both relevance and representational faithfulness is completeness. The inclusion in reported information of everything material is necessary for faithful representation of the relevant phenomena.8

Comparability means that the financial results of different enterprises are comparable.9

The basic principles of accounting in the EU developed initially in the individual member states separately. The codification of these principles into EU law took place with the Fourth Council Directive (“Fourth Directive”).

The preamble of the Fourth Directive includes the principle of disclosing comparable and equivalent information (with regard to the valuation of assets and liabilities).10 The principle of representational faithfulness is formulated as the requirement for accounts to give a true and fair view11 of the companies’ assets and liabilities, financial position, and profit or loss. Provisions that allow omissions of irrelevant data and require the addition of relevant information, the disclosure of which is not required by the Fourth Directive itself, imply the principle of relevance. However to some extent, the principles of giving a true and fair view, and of comparability and equivalence of information cover relevance.12 Some European authors see relevance as a more basic principle, one that exists without specific enumeration in the Fourth or Seventh Council Directive (“Seventh Directive”).13

In Estonia, the basic accounting principles are in section 5 of the Accounting Act. The principle of representational faithfulness is in subsection 5 (3) of the Accounting Act, which states that the basis of accounting is the objective recording of economic transactions. The principle of relevance is fixed as an obligation to record all relevant business risks and opportunities. Relevant is the information that can affect decisions of the users of the accounts. The principle of completeness is separate from the principles of relevance and representational faithfulness. The law provides that accounts must present all information in a way that enables the presentation of a true and faithful picture of the assets, obligations etc. of the company. The principle of comparability is fixed in subsection 5 (11) of the Accounting Act.14

In conclusion, the basic principles of accounting in the US and the EU are very much the same. In Estonia, the wording of the principles is somewhat awkward, but the principles still exist. This gives a perfect basis for comparing the consolidation policies of the EU and the US. Through this comparison, solutions for Estonia can be found as well.

General consolidation requirement

A general consolidation requirement provides for circumstances where a corporate group must include a subsidiary in its consolidated accounts. In the case of a simple parent- subsidiary relationship, a general consolidation requirement sets forth circumstances where the parent company must prepare consolidated accounts.

In this part of the paper, the EU rules will first be compared with the Generally Accepted Accounting Principles (“GAAP”)15 of the US (together with the Securities and Exchange Commission Regulation S-X (“Regulation S-X”)) and then with the US Financial Accounting Standards Board Exposure Draft on Consolidated Accounts from 16 October 1995 (“Exposure Draft”).

Under GAAP, the line between members of a corporate group for the purposes of consolidated accounting is over 50% ownership of the outstanding voting stock of the subsidiary held directly or indirectly.16 While the same applies for Regulation S-X, the latter also requires the consolidation of subsidiaries where the parent-subsidiary relationship is established by a means other than the ownership of voting stock.

The GAAP rule is much simpler than the EU Seventh Directive rule. Article 1 (1) of the Seventh Directive makes it compulsory for all member states17 to require the preparation of consolidated accounts for certain corporate groups. Article 1 (2) permits, but does not make it compulsory, for member states to require corporate groups to prepare consolidated accounts.

The first section of Article 1 of the Seventh Directive includes five alternative grounds, upon which member states must require corporate groups to prepare consolidated accounts. According to Article 1 (1) of the Seventh Directive, a member state must require18 any undertaking19 governed by its national law to prepare consolidated accounts and a consolidated annual report if that undertaking (parent undertaking):

1. has a majority of the shareholders' or members' voting rights in the subsidiary; or

2. has the right to appoint or remove a majority of the members of the administrative, management or supervisory body of the subsidiary and is at the same time a shareholder in or member of that subsidiary; or

3. has the right to exercise a dominant influence over the subsidiary of which it is a shareholder or member pursuant to a contract entered into with that subsidiary or to a provision in its memorandum or articles of association, where the law governing that subsidiary permits it to be subject to such contracts or provisions. (A member state may require consolidated accounts even if the parent is not a shareholder in or member of its subsidiary. Those member states the laws of which do not provide for such control contracts or provisions are not required to apply this provision.); or

4. is a shareholder in or member of the subsidiary and a majority of the members of the administrative, management or supervisory bodies of that subsidiary who have held office during the financial year, during the preceding financial year and up to the time when the consolidated accounts are prepared have been appointed solely as a result of the exercise of the parent’s voting rights. (Member states are allowed to make the application of this consolidation requirement dependent upon the parent holding at least 20% of the shareholders' or members' voting rights. Also, member states do not have to prescribe this consolidation requirement, if they prescribe the consolidation requirement of alternative 5 below.); or

5. is a shareholder in or member of an undertaking and controls alone, pursuant to an agreement with other shareholders in or members of that subsidiary, a majority of the shareholders' or members' voting rights in that subsidiary.

The second section of Article 1 of the Seventh Directive allows member states to require undertakings governed by their national law to prepare consolidated accounts, if an undertaking holds a participating interest in another undertaking and either exercises dominant influence over the subsidiary or is managed together with the subsidiary on a unified basis by a common parent. A participating interest is more than a 20% shareholding.20 The purpose of this section is to accommodate German law. However, some other member states have adopted this section in order to avoid the use of certain subsidiaries for “off-balance sheet accounting”, that is, the keeping of certain assets and liabilities of a subsidiary off the balance sheet.21 In other words, Article 1 (2) defines a corporate group through economic criteria. Whether a company has the power to impose its domination over another entity is the ultimate criterion here. Although economic control is perhaps more meaningful than legal control, a certain ambiguity is unavoidable when one tries to formulate and enforce a definition of economic control.22 The ambiguity of assessing effective control is greater in the field of accounting than in fields where such an assessment is made by a single regulatory agency. Every accountant will make his or her own decision and there does not exist any compulsory information exchange between them.

Article 12 of the Seventh Directive provides that member states may also require undertakings which are managed on a unified basis pursuant to a contract or memorandum or articles of association to prepare consolidated accounts. Finally, undertakings the administrative, management or supervisory bodies of which consist for the most part of the same persons, can also be required to prepare consolidated accounts.23

Article 4 of the Seventh Directive provides a list of limited company forms24 in the different member states. Membership in a corporate group of at least one company, which belongs to the listed forms of companies, makes the Seventh Directive based rules applicable to the corporate group. As an exception to the rule, Article 4 allows member states to restrict the requirement to prepare consolidated accounts to those groups where the parents are limited companies.

As seen above, there are five alternative grounds when member states must require corporate groups to prepare consolidated accounts. All these tests are alternatives. If a company under a national law that has implemented the Seventh Directive does not fall under the first test, it can still fall under one of the other four tests and be obliged to prepare consolidated accounts. Some authors consider that Article 1 (1) of the Seventh Directive defines the legal standards of control and is based on the heritage of the United Kingdom (“UK”).25 However, tests 2-5 include some elements of effective control.

The many definitions of parent and subsidiary companies illustrate the compromising character of the Seventh Directive. As will be seen, these compromises considerably affect the comparability of the consolidated financial statements prepared on the basis of the Directive.26

Comparing the Seventh Directive with GAAP, the first test of the Seventh Directive which member states must include in their legislation is the over 50% of voting rights test. This test is basically the entire GAAP general rule for consolidation.27

The second test of Article 1 (1) of the Seventh Directive is the appointment power test. This test, as well as the third test of contractual or articles of association based control, the fourth test that evaluates actual appointments of directors28 and the fifth test which is again based on possible contractual control over voting rights, have no comparable provisions in GAAP.

The rules of Article 12 and the “less important” rules of Article 1 of the Seventh Directive, that is, the rules of Article 1 (2), also do not have any points for comparison with the GAAP rules. The effective control provisions of the Seventh Directive are however, comparable with the “parent-subsidiary relationship is established by means other than ownership of voting stock” test of Regulation S-X. Regulation S-X however, does not give any guidelines for the application of its effective control provision.

Another important provision of the Seventh Directive is Article 4. This provision basically provides the forms of companies that make the Seventh Directive based rules applicable to corporate groups. Under Article 4, either the parent or one subsidiary must be a form of company listed in Article 4 which includes different “limited liability companies” in the member states. However, in Article 4 (2), the member states are also allowed to restrict the requirement to prepare consolidated accounts to those corporate groups the parents of which are organized as one of the forms of listed “limited liability companies”.29

The standards under the SFAS No. 94 are limited to consolidation of business organizations formed as stock companies.30 The Accounting Research Bulletin No. 51 and SFAS No. 94 both focused on companies issuing voting shares.31

Even though the exception provided in Article 4 (2) of the Seventh Directive is often considered to be a major shortcoming of the Seventh Directive because it releases a number of corporate groups from registration requirements, the SFAS No. 94 is even more limited.

In addition to the rules in Article 4, the Seventh Directive provides for several other situations when a corporate group need not prepare consolidated accounts. The first exemption from the requirement to prepare consolidated accounts is the situation where a parent undertaking is a financial holding company as defined in the Fourth Directive. Financial holding companies, which are subsidiaries of other companies, do not receive any special treatment under the Seventh Directive. There are several additional requirements that a member state must apply to financial holding companies when granting an exemption from the requirement to prepare consolidated accounts. Generally, such financial holding companies must not intervene during the financial year in the management of a subsidiary nor use its voting rights to appoint directors of the subsidiary. Under this rule, permission to exempt a corporate group from the requirement to prepare consolidated accounts must be granted by an administrative authority after the fulfillment of all necessary conditions.32

Accordingly, each member state must authorize certain administrative authorities to give the permissions under Article 5 of the Seventh Directive. Corporate groups seeking the exemption must apply to such authority and present proof that they have complied with all requirements presented in the Seventh Directive for the respective exemption. Exemption of financial holding companies from the obligation to prepare consolidated accounts was of special concern to Luxembourg which was afraid of losing its status as a financial centre.

The exemption for financial holding companies has two justifications. Firstly, it is argued, that generally, financial holding companies do not appoint directors of their subsidiaries or are otherwise involved in their management. This justification is questionable because this may not be the case in all financial holding companies and may only apply to some investment parents, the financial results of which are important for comparable, relevant and reliable consolidated accounts. Secondly, certain special interest groups have alleged that financial holding companies would leave the EU and incorporate in “more sunnier climates” if required to prepare consolidated accounts.33

A second exemption concerns small groups. Member states may provide an exemption from the requirement to prepare consolidated accounts, if at the balance sheet date of the parent undertaking, the undertakings to be consolidated do not together exceed at least two of the following three criteria:

(a) a balance sheet total of 6 200 000 ECU;

(b) a net turnover of 12 800 000 ECU; or

(c) an average number of employees during the financial year of 250.34

It may be questioned whether these requirements actually indicate that a certain group is too small and unimportant for the legislatures of all member states of the EU to deal with. Certainly in Estonia, a company that does not exceed two out of the three criteria may still be a giant.

If a group otherwise meets the above requirements, the exemption still will not apply, if the securities of one of the undertakings to be consolidated are listed on a stock exchange established in a member state.35 This is a very important requirement because usually the trading of securities on a stock exchange means that the shareholders are members of diverse groups of society and consequently, their ability to get information about the financial results of the group, at least without the consolidation of accounts, is more limited. The small group exemption relieves certain groups from the undue burden of preparing consolidated accounts. It is possible that there are few shareholders and creditors in such groups and that they have good access to the financial information of the group. On the other hand, if that is the reasoning behind the “small group” exemption, why is a minimum number of shareholders not a condition for the exemption?

Articles 7-11 of the Seventh Directive provide for the situation where a parent undertaking (together with its subsidiaries) which is itself a subsidiary of another undertaking, must or need not prepare separate consolidated accounts from its parent undertaking’s consolidated accounts (also for the situation where the ultimate parent is not obliged to prepare consolidated accounts). Articles 7-11 are worded as if these provisions are exemptions from the consolidation requirements. However, their actual purpose is to avoid the preparation of two or multiple sets of consolidated accounts because the intermediate parent will be exempt from the requirement to prepare consolidated accounts if the ultimate parent prepares consolidated accounts. It is compulsory for a member state to exempt 90-100% owned intermediate parents under certain conditions, but member states may also exempt less than 90% owned intermediate parents, which causes some special problems. The Directive has tried to solve these problems by giving minority shareholders a right to request the preparation of consolidated accounts.36

GAAP rules have no such exemptions. GAAP requires consolidation if there is ownership by a parent company of over 50% of the outstanding voting shares of another company. Prior to 1987, GAAP provided that the aim of consolidation should be to make the financial statements the most meaningful in the circumstances. As a result, it was up to the accountant who prepared the consolidated accounts to decide whether the circumstances were such that consolidation does or does not serve the purposes of “most meaningful” financial statements. Without more specific rules, it was very difficult to defend any decision to not prepare consolidated accounts if the over 50% ownership rule was met. This is no longer the case under the SFAS No. 94. All majority owned subsidiaries must be consolidated except in the case of temporary control and control not resting with the majority owner.

In Estonia, it might be suitable to follow the Seventh Directive and release intermediate parents from the requirement to prepare consolidated accounts, but also to give minority shareholders the respective right to require the preparation of consolidated accounts.

The EU rule exempting financial holding companies from preparing consolidated accounts has no similar rule in the US GAAP. The rule itself has no justification. It was drafted in order to appease a powerful special interest group and does not serve any other significant purpose.

In conclusion, the Seventh Directive general consolidation policy is much more complicated than the GAAP rules for its general consolidation policy. It is clear however, that simple drafting does not necessarily result in simple application even if simplicity of application is not the goal of consolidation policies. The real goals are comparability, relevance and representational faithfulness of the consolidated financial statements.

The Exposure Draft on consolidated financial statements issued by the FASB on 16 October 1995 proposes much more complicated rules for consolidation than previous GAAP documents. The FASB proposes a consolidation policy based on control rather than on the majority ownership of voting stock. Control is defined as the power over an entity’s assets, that is, the power to use or direct the use of individual assets of another entity in essentially the same way as the controlling entity uses its own assets. At first sight, this seems different from the EU Seventh Directive, which emphasizes a majority voting rights requirement as the principal test for establishing the basis for consolidation.

The Exposure Draft abandons reliance solely on legal control and also includes effective control. For example, the establishment of a subsidiary’s policies, as well as its capital and operating budgets, may indicate a parent's control. A parent's control may also exist if it effectively appoints or elects the subsidiary’s personnel responsible for implementing its policies and decisions. The Exposure Draft lists these and other circumstances (all together 6) where effective control is presumed. These requirements in turn seem somewhat similar to the functional elements of the control requirements of the Seventh Directive. Article 1 (1) of the Seventh Directive uses the appointment power test, the test of contractual or articles of association based control and the mixed test of voting rights and contractual control as bases for the requirement to consolidate accounts. The Exposure Draft's distinction between two different types of control which require consolidated financial statements (legal control and effective control) was considered by the drafters of the Seventh Directive. Legal control is the basis for consolidation in Article 1 (1) (a) and effective control is the basis for consolidation in Article 1 (2). While the list of six circumstances where effective control is presumed has no equivalent in the Seventh Directive, the list may be utilized when drafting, enforcing and applying Article 1 (2) based national laws, including Estonian laws.

Thus, the Exposure Draft's proposal to alter the objective over 50% ownership test to a more complex subjective analysis of the control relationship brings the US GAAP standards and the EU Seventh Directive standards closer to each other through reliance on effective control. At the present time, the Seventh Directive is, though perhaps not very integrally drafted, closer to achieving one of the goals of consolidation policy, that is, the determination of standards which would always reveal if one entity actually controls the other. The EU Seventh Directive touched on the subject of effective control (de facto control),37 but did not decisively provide standards. The Exposure Draft does so and should be regarded as progressive.38

One of the differences between the EU Seventh Directive and the FASB Exposure Draft is that the latter applies not only to business organizations with limited liability but also to non-profit organizations, trusts and partnerships.39

Neither GAAP nor the Exposure Draft deal with the issue of sub-holding groups as does the Seventh Directive. Recall that Articles 7-11 provide for the situation where a parent undertaking (together with its subsidiaries) which is itself a subsidiary of another undertaking, must or need not prepare separate consolidated accounts from its parent undertaking’s consolidated accounts. The intermediate parent is exempt from the requirement of preparing consolidated accounts, only if the ultimate parent prepares consolidated accounts. It is compulsory for a member state to exempt 90-100% owned intermediate parents under certain conditions, but member states may also exempt less than 90% owned intermediate parents. As mentioned, this latter exemption has caused some special problems which the Directive has tried to solve by giving minority shareholders the right to request the preparation of consolidated accounts. The fact that GAAP and the Exposure Draft oblige the corporate group, rather than a parent company of one or several other companies to prepare consolidated accounts, does not solve this problem. The issue is how to guarantee high quality information for minority shareholders of intermediate parents. Such shareholders are definitely not interested in the consolidated accounts prepared by the ultimate parent of the group since these statements may include many other subsidiaries of the ultimate parent which have no relevance to these minority shareholders. The Estonian law should deal with this issue by requiring intermediate parents to prepare consolidated accounts, if so required by a certain number of minority shareholders.

In conclusion, the primary difference in systems and the search for the best solution for a general consolidation policy can be viewed as a question of whether effective control should be the basis for general consolidation policies instead of or in addition to legal control. The same question will be crucial when Estonia begins to develop its consolidation policies.

In order to answer this question, the goals of comparability, relevance and representational faithfulness will be addressed again. To simplify this discussion, some specific features of effective control or legal control based consolidation policies in the EU and the US will not be considered. Rather, legal control and effective control will be considered in general terms: not exactly as they were proposed by the Exposure Draft, Regulation S-X or the Seventh Directive, but as synthesized from both systems.

The effective control based consolidation policies of Article 1 (2) of the Seventh Directive and of the Exposure Draft do not result in more comparable consolidated accounts than legal control based consolidated accounts. Effective control is a characteristic that can be determined only by subjective decision making and line drawing. Such subjective decisions by accountants of different corporate groups inevitably result in different interpretations of the consolidation policies. However, the Exposure Draft does a better job for the purposes of comparability than Article 1 (2) of the Seventh Directive. The Exposure Draft lists specific situations and describes when effective control exists. Therefore, its application is much easier and gives less discretion to the groups. The Seventh Directive describes effective control rather briefly and gives more discretion to the member states and possibly individual groups, unless a member state describes effective control more successfully than the Seventh Directive. Once again, it must be stated that the assessment of control by a regulatory agency differs substantially from the assessment of control by accountants of different corporate groups due to differences in the exchange of information.

In contrast, the legal control based general consolidation policy does not give much discretion to corporate groups while making consolidation decisions. When ownership of a majority of voting stock exists, the subsidiary must generally be consolidated. Article 1 (1) of the Seventh Directive however, while providing legal control as a basis for a general consolidation policy, is not as straightforward. The appointment power test and the test of contractual or articles of association based control over a subsidiary possess both quasi-legal control and quasi-effective control elements. These elements affect the goal of comparability by allowing a number of interpretational differences.

The goals of relevance and representational faithfulness justify the causation of non-comparability by the effective control standard. The comparability achieved by legal control consolidation policies results in non-relevance and non-reliability of consolidated financial statements. The effective control standard for general consolidation policies considers all possible means by which a parent can control its subsidiary and direct its assets and liabilities. The legal control standard enables corporate groups to avoid the consolidation of inconvenient subsidiaries by using other means than the ownership of a majority of voting stock to control their subsidiaries. The consolidation of information concerning these subsidiaries is potentially very relevant for investors and creditors. Furthermore, the omission of financial data pertaining to these subsidiaries, through the omission of significant assets and liabilities from the consolidated financial statements, would impair the representational faithfulness of the consolidated accounts.

Exclusion of certain members of corporate group from concolidated accounts

As in the previous part, the EU rules will first be compared with GAAP (together with Regulation S-X) and then with the Exposure Draft.

Under GAAP, consolidated financial statements are not to be prepared in circumstances where the parent's control of a subsidiary is temporary or control does not rest with the majority owner.40

Regulation S-X adds, subject to its “most meaningful presentation” test, the rule which provides that subsidiaries that have substantially different (93 days) fiscal periods from the parent company are not to be consolidated. This rule is unjustified by comparability, relevance and representational faithfulness.

Under the Seventh Directive, such rules are much more complex. The EU Seventh Directive distinguishes between undertakings that need not be included in the consolidated accounts and undertakings that must be excluded from consolidated accounts.

First, according to the EU exclusion rule, non-material undertakings may be excluded from consolidated accounts, if the corporate group so desires.41 The reasoning behind this rule seems to be that certain undertakings are so irrelevant for the purposes of the consolidated accounts that they can be excluded. The term “non-material” is subject to a case by case interpretation. As a result, drawing the line between material and non-material undertakings may be very difficult to administer. GAAP does not include such rules. Thus, US companies are relieved from determining which subsidiaries are non-material. GAAP also avoids a manipulation of materiality, by requiring all subsidiaries, regardless of their size, to be consolidated. The Seventh Directive though, limits manipulation under the materiality rule by providing that if there are two or more undertakings which separately would not be material for the above purposes but are material when taken together, they must be included in the consolidated accounts.

Second, the EU allows the exclusion of subsidiaries in the case of severe long term restrictions which substantially hinder the parent's exercise of its rights in the subsidiary.42 This rule has a comparable counterpart in the US. GAAP provides that majority owned subsidiaries are not to be consolidated if control does not rest with the majority owner. The SFAS No. 94 includes bankruptcy, legal reorganization, severe foreign exchange restrictions, controls or other governmentally imposed uncertainties as indicators that control does not rest with the majority owner. Basically, the substance of the rules is very similar, but the extent of the compulsion is different. Under GAAP, these subsidiaries “shall not be consolidated”, while under the Seventh Directive, they “need not be included in consolidated accounts”. Therefore, the Seventh Directive again has disregarded the principle of comparability.

Third, the EU Seventh Directive allows exclusion of subsidiaries from consolidated accounts, if the information necessary for the preparation of consolidated accounts cannot be obtained without disproportionate expense or undue delay.43 This is very questionable. If a parent undertaking is not able to receive the accounts of its subsidiary, then who should be able to do that? Parent undertakings are in the position of making it difficult, impossible or expensive to obtain the accounts of their subsidiaries. GAAP, which does not allow such an exclusion, is by far preferable over Article 13 (3) (b) of the Seventh Directive.

Fourth, the EU allows an exclusion from consolidation of subsidiaries if the shares of these subsidiaries are held exclusively with a view to their subsequent resale.44 The GAAP respective rule provides that a majority owned subsidiary is not to be consolidated if the control is temporary. While the rules are similar, the GAAP rule is superior because it avoids a considerable loss of comparability by giving corporate groups less discretion over consolidation decisions. The Seventh Directive enables corporate groups to decide not only whether a subsidiary's shares are held with a view to resale, but also whether to consolidate or not to consolidate such subsidiaries. GAAP requires groups to decide which subsidiaries are controlled temporarily and requires that subsidiaries which are controlled temporarily not be consolidated.

Finally, EU member states may choose to allow corporate groups to exclude certain holding companies from consolidated accounts.45 GAAP in turn has no such provisions. On one hand, holding companies do not conduct any business of their own. Therefore, their exclusion from consolidation does not result in any great loss of comparability, relevance or representational faithfulness. On the other hand, holding companies are necessary devices for creating a corporate group, and therefore, their exclusion has no justification other than the relatively minor negative effect on comparability, relevance and representational faithfulness.

The Seventh Directive requires an undertaking to be excluded from consolidation, if the activities of the undertaking are so different from the undertakings to be consolidated that its inclusion in the consolidated accounts would not enhance the presentation of a true and fair view of the assets, liabilities, financial position and profit or loss of the undertakings included in the consolidated accounts of the corporate group taken as a whole. This requirement is further explained as not applicable solely because some undertakings are industrial, while others are commercial or provide services, or because they produce different products or provide different services.46 Basically, the rule has been taken from the US-UK rules that were in force at the time of drafting the Seventh Directive. Therefore, the justifications for it are also the same, that is, the different debt-equity and other ratios of finance subsidiaries from manufacturing subsidiaries.

GAAP previously included similar rules. The pre-1987 rule stated that consolidated financial statements need not include subsidiaries with non-homogeneous operations. Most subsidiaries with non-homogeneous operations were in the finance, insurance or real estate industries Today, all such subsidiaries must be included in the consolidated accounts, even if their operations are unrelated to the rest of the corporate group.47 This change came about due to groups using these non-homogeneous subsidiaries for “off-balance sheet financing”. Such non-consolidation also affected the comparability of financial statements.

The non-homogeneous rule was included in the EU Seventh Directive because it was a well-established rule in Anglo-American accounting practice in the 1970’s. However, as can be seen, the rule was reconsidered in the US in 1987. The EU has not followed the US changes and operates still under the outmoded rules of Article 14.48 Even the UK had to amend its laws to comply with the Seventh Directive.

Under the Exposure Draft, all entities that a parent controls must be consolidated, unless control is temporary at the time the entity becomes a subsidiary.49 Temporary control is defined generally as control which will cease within one year. In some exceptional circumstances, the one year rule does not apply.50 The one year rule in turn sets specific limits for the determination of temporary control. Control over a subsidiary that lasts longer than one year is temporary only under very exceptional circumstances.

The only common ground between the Exposure Draft and the Seventh Directive for exclusion of subsidiaries from consolidated accounts is the “temporary control” provision and the “shares held with a view to their subsequent resale” provision, respectively.

The Exposure Draft, apart from GAAP and the Seventh Directive, provides specific rules for determining when control is temporary. The Exposure Draft's one year limit will make it easier to understand and to apply the temporary control provision.

Another change proposed by the Exposure Draft would eliminate the second common exclusion of the Seventh Directive and of GAAP, that is, the exclusion concerning subsidiaries the control of which does not rest with the majority owner. If the Exposure Draft is approved, then regardless of whether there is a significant doubt concerning a parent’s ability to control a subsidiary, the subsidiaries which meet another consolidation requirement must be consolidated. However, as shown above, the general consolidation requirements would also change and if control does rest with the majority owner, the subsidiary need not be consolidated because the general consolidation requirement of “effective control” will not have been met.

Therefore, the difference between the Exposure Draft and the Seventh Directive is similar to the difference between GAAP and the Seventh Directive. Only the structuring of the rules that avoid not-in-control parents from consolidating the respective companies in which they are members or shareholders is different.

In conclusion, the differences between the Seventh Directive and both GAAP and the Exposure Draft can be divided into two groups. Firstly, there are the differences deriving from the compromising nature of the Seventh Directive which provides that some rules are optional for EU member states. Secondly, there are the substantive differences. The most negative substantive differences in the exclusion rules are the options that the Seventh Directive gives to corporate groups with regard to exclusions or inclusions of particular subsidiaries. These impair the comparability of consolidated accounts dramatically. These provisions should not be followed in Estonia so that corporate groups will not be able to manipulate their consolidated accounts by choosing whether to consolidate or not to consolidate particular subsidiaries. Both, the US GAAP and the Exposure Draft have the advantage, that at least in terms of exclusions and inclusions of subsidiaries, the consolidated accounts of different groups are comparable. As mentioned previously, the exclusion rule of Regulation S-X concerning different fiscal years does not promote comparability.

The number of allowed or required exclusions in Estonian law should be as small as possible for several reasons. First, all exclusion rules give a certain discretion to their interpreters, even if they are uniformly compulsory. Second, most of the exclusions from consolidation allowed by the EU are not very well founded and do not result in a more correct view of a corporate group than if the excluded subsidiaries were included. In fact, most of the EU exclusion rules are in conflict with the goals of relevance and representational faithfulness. Only two of these are justified because they benefit relevance and representational faithfulness substantially more than they impair the comparability of financial statements.

As well, the consolidation of subsidiaries, the shares of which are held temporarily, would undoubtedly make the results of consolidation defective. However, this rule is the same in all three systems.

Finally, the exclusion from consolidation of subsidiaries where there are severe long term restrictions and the parent is not in control of the subsidiary, is justified. Under certain circumstances, subsidiaries in another country, which are under the risk of expropriation, need not be consolidated.

Conclusion

A country like Estonia which is beginning to draft its consolidated accounting rules including consolidation policies, should ask itself, what are the consolidation policies that would result in the most relevant, comparable and representationally faithful consolidated financial statements. This paper tries to give guidelines for drafting such consolidation policies for shareholder-creditor information purposes.

From the point of view of a general consolidation policy, the effective (functional) control standard of consolidation results in the most reliable and relevant financial statements for shareholders and creditors. The comparability of the consolidated accounts which are prepared in accordance with the effective control standard may sometimes be not as good as consolidated statements prepared in accordance with the majority ownership of voting stock or legal control based consolidation policy. However, the achievements in relevance and representational faithfulness outweigh the risk of loss in comparability. From that standpoint, the US GAAP ranks last behind the EU Seventh Directive and the US Exposure Draft. The effective control standard general consolidation policy would be a good start for drafting the Estonian consolidated accounting consolidation policies.

With regard to exceptions to a general consolidation policy, the less the better. In that sense, GAAP and the Exposure Draft are far ahead of the EU Seventh Directive. The exclusion rules of GAAP and the Exposure Draft meet the requirements of representational faithfulness and relevance. The loss of comparability exists, but is limited and most of all, justified. In the EU Seventh Directive, the loss of comparability is enormous. The options for exclusion of subsidiaries given to both member states and corporate groups result in numerous different consolidation policies at the corporate group level. This loss of comparability is not justified by greater relevance or representational faithfulness. Estonia should allow only one exclusion to the effective control based general consolidation policy: the exclusion concerning the temporary control of a parent over a subsidiary.

In general, the US Exposure Draft consolidation polices meet the goals of relevance, comparability and representational faithfulness better than GAAP and the EU Seventh Directive. However in the case of Estonia, the political goal of joining the EU may dictate acceptance of the outdated and old-fashioned EU rules for consolidated accounting.

Although European accounting rules were considered very important in the 1970's and 1980's, today many European multinationals view these as obstacles to the free movement of capital in terms of access to US capital markets. Uniform European accounting rules might be good for the free movement of capital within Europe, but Europe is too small of a capital market for some large European multinationals. In this situation, many companies prepare GAAP (or IAS) based consolidated financial statements in addition to the statements prepared on the basis of their national law. This of course, is an expensive practice.51

Recognizing this reality, there are plans for changes to European consolidated accounting. Even some governments consider the Seventh Directive as outdated and are willing to turn a “blind eye” to companies producing US GAAP (or IAS) accounts instead of accounts based on the requirements of their national law. While some critics believe that it is possible to create new directives which would actually achieve the goals of harmonization of European Accounting Standards and comparability between accounts by different corporations, others think that reforming the directives would destroy them and propose to leave the Seventh and Fourth Directives totally aside.52

As a result, the author would view very unfavourably any attempt to copy and translate the EU Seventh Directive into an Estonian law on consolidated accounting. Estonia has adopted many laws that are basically just intermediate level translations of laws of some other jurisdiction. This must change soon. Otherwise, Estonia will pay a high price in terms of development and stability of its society and economy.

Notes:

1 This paper is based on the LL.M. thesis written by the author for the University of Connecticut School of Law LL.M. program. The thesis compares the consolidation policies of the Generally Accepted Accounting Principles of the United States, the Securities Exchange Commission Regulation S-X, the Financial Accounting Standards Board Exposure Draft on Consolidated Accounting from 16 October 1995 and the European Union Seventh Council Directive on Consolidated Accounting.
2 Accounting Act (RT I 1994, 48, 790, subsection 3 (13)). The Estonian Accounting Act refers to EU accounting directives and IAS documents. The consolidation policies of these two are very different. In addition, the Seventh Council Directive contains so many options for member states, that it can not be used by corporate groups without implementing legislation.
3 Michael Petite, “The Conditions for Consolidation under the 7th Company Law Directive”, (1984) C.M.L. Rev. 83.
4 Paul Grady, “Inventory of Generally Accepted Accounting Principles for Business Enterprises” in Accounting Research Bulletin No. 51, Consolidated Financial Statements § 1 (American Institute of Public Accountants ed., 1965) 318.
5 Statement of Financial Accounting Standards No. 94 Consolidation of All Majority Owned Subsidiaries, 051 Financial Accounting Series 15 §§ 33-34 (1987).
6 FASB Concepts Statement No. 2 Qualitative Characteristics of Accounting Information, § 63 (May, 1980).
7 Statement of Financial Accounting Standards No. 94 Consolidation of All Majority Owned Subsidiaries, supra note 5 at § 35.
8 Statement of Financial Accounting Standards No. 94 Consolidation of All Majority Owned Subsidiaries, supra note 5 at § 37; FASB Concepts Statement No. 2 Qualitative Characteristics of Accounting Information, §§ 79-80; “Glossary” (May 1980).
9 FASB Concepts Statement No. 2 Qualitative Characteristics of Accounting Information, § 111 (May 1980).
10 Frank Woolridge, “The EEC Council Seventh Directive on Consolidated Accounts”, (1988) 37 I.C.L.Q. 714; Herman Niessen, “The Seventh Directive on Consolidated Accounts and Company Law Harmonization in the European Community” in International Group Accounting, Issues in European Harmonization (1988) 4.
11 David Flint, “A True and Fair View in Consolidated Accounts” in International Group Accounting, Issues in European Harmonization (1988) 11-32.
12 Fourth Council Directive 78/660 of 25 July 1978 based on Article 54 (3) (g) of the Treaty on the Annual Accounts of Certain Types of Companies 1978 O.J. (L222) 11, Preamble and Article 2.
13 Flint, supra note 11 at 21.
14 RT I 1994, 48, 790, subsections 5 (3), (10), (11), (13).
15 For a different comparative analysis see Konrad Kubin, “Group Accounting in the United States of America” in International Group Accounting, Issues in European Harmonization (1988) 269-294.
16 Grady, supra note 4 at 318; Statement of Financial Accounting Standards No. 94 Consolidation of All Majority Owned Subsidiaries, supra note 5; Walter B. Meigs, A.N. Mosich, John E. Larsen, Modern Advanced Accounting (1975) at 165-166.
17 Under EU Directives, the enforcement of rules is possible only if they are adopted by member states.
18 Treaty on European Union of 1 August 1992, O.J. (C 224) (1992) 1, Article 189; George A. Berman et al., Cases and Materials on European Community Law, (1993) 182-192; Eric Werlauff, EC Company Law, The Commom Denominator For Business Undertakings in 12 States, (1993) 41-43. European Council Directives are generally not law over private persons in member states. Directives are obligatory for member states only, and the substance of a directive becomes enforceable against private persons only if the respective member state has by legislative enactment incorporated the requirements of the directive into its national law. There are exceptions however to that principle.
19 Undertaking is the word that the Seventh Directive uses for business entities.
20 Seventh Council Directive of 13 June 1983, based on Article 54 (3) (g) of the Treaty on Consolidated Accounts (83/349/EEC) (O.J. L. 26/18 No. 193/1 (July 1983)).
21 Woolridge, supra note 10 at 720.
22 Petite, supra note 3 at 85-86.
23 Seventh Council Directive, supra note 20 at Article 12.
24 Seventh Council Directive, supra note 20 at Article 4. Limited companies under Article 4 of the Seventh Directive include for example: -die Aktiengesellschaft, die Kommanditgesllschaft auf Aktien and die Gesellschaft mit beschrankten Haftung in Germany; and
- public companies limited by shares or by guarantee and private companies limited by shares or guarantee in the United Kingdom; and
- la societe anonyme, la societe en commandite par actions and la societe a responsabilite limitee in France.
25 Petite, supra note 3 at 86.
26 Woolridge, supra note 10 at 715.
27 Statement of Financial Accounting Standards No. 94 Consolidation of All Majority Owned Subsidiaries, supra note 5 at § 2; Grady, supra note 4 at 318. Under the Accounting Research Bulletin No. 51 and the SFAS No. 94, direct or indirect ownership of over 50% of the outstanding voting shares of another company is a condition indicating consolidation.
28 Robert Pennington, “Consolidated Accounts: The Seventh Directive”, (1984) 5 The Company Lawyer 68. A curious feature of alternative 4 is that an undertaking may become or cease to be a subsidiary as the result of preparing consolidated accounts. As soon as this is done, the relevant period for which the count of directors must be made moves forward by 12 months because the earlier of the two financial years on which the count was previously based ceases to be relevant. Therefore, an undertaking might find itself to be a parent undertaking in some years and not in other years, and the obligation to prepare consolidated accounts depends on that.
29 Lewis D. Solomon et al., Corporations Law and Policy (3d ed.) (1994) 162-163. EU limited companies have similarities with US companies as follows: a German aktiengesellschaft and a French la societe anonyme are similar to US stock corporations. A German kommanditgesellschaft auf aktien and a French la societe en commandite par actions are similar to US limited partnerships. Finally, a German die gesellschaft mit beschrankten haftung and a French la societe a responsabilite limitee are similar to US limited liability companies.
30 Gregory J. Bushong, “FASB Proposes Significant Changes in Consolidation Policies and Procedures”, (1996) 55 Ohio CPA Journal.
31 Exposure Draft, Proposed Statements of Financial Accounting Standards, Consolidated Financial Statements: Policy and Procedures, § 1, Financial Accounting Series No. 154-D (October 16, 1995).
32 Seventh Council Directive, supra note 20 at Article 5.
33 Petite, supra note 3 at 102.
34 Seventh Council Directive, supra note 20 at Article 6; Fourth Council Directive, supra note 12 at Article 27.
35 Seventh Council Directive, supra note 20 at Article 6.
36 Seventh Council Directive, supra note 20 at Articles 7-11.
37 Federation des Experts Comptables Europeans, Seventh Directive Options and Their Implementation, (1993) at 6. The 1976 and 1978 drafts of the Seventh Directive contained more de facto control oriented provisions than the final directive. De facto control was abandoned as a result of Anglo-American influence.
38 The Exposure Draft goes further. It develops concepts of effective control in addition to traditional legal control as a basis for consolidation requirements.
39 Bushong, supra note 30.
40 Statement of Financial Accounting Standards No. 94 Consolidation of All Majority Owned Subsidiaries, supra note 5 at § 13; Martin A. Miller, Comprehensive GAAP Guide 1992, (1991) at 5.02.
41 Seventh Council Directive, supra note 20 at Artilces 13 (1), 13 (2) and 16 (3).
42 Seventh Council Directive, supra note 20 at Articles 13 (3) (a) and 12 (1).
43 Seventh Council Directive, supra note 20 at Article 13 (3) (b).
44 Seventh Council Directive, supra note 20 at Article 13 (3) (c).
45 Seventh Council Directive, supra note 20 at Artilce 15.
46 Seventh Council Directive, supra note 20 at Article 14.
47 Miller, supra note 40 at 5.03.
48 Seventh Directive Options and Their Implementation, supra note 37 at 11.
49 “Consolidated Financial Statements Exposure Draft Issued”, (1995) 28 Practical Accountant.
50 Exposure Draft, Proposed Statements of Financial Accounting Standards, Consolidated Financial Statements: Policy and Procedures, supra note 31 at § 16.
51 Paul Rogerson, “Europe Enters the Fray”, (1995) 11 Euroacct; Paul Rogerson, “Brussels Abandons Low-Key Approach”, (1995) 8 Euroacct.
52 Liz Fisher, “Tackling the Nationalist Front”, (1995) Acct 26.






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