Taking the long view, the most important accounting development of the 20th century may have been the rise of consolidated financial reporting. In the early 1900s, the possibility of reporting financial information on a group basis was only starting to be discussed. By the end of the century, the use of consolidated financial statements had been universally accepted as essential to feed the financial markets with information about the complex multi-entity organisations of the modern global economy.

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Which entities should be included as part of the group? This question lies at the heart of consolidation policy. For international consistency a single answer is required. But the issue is difficult; the US Financial Accounting Standards Board has yet to reach a conclusion after 19 years of debate!

Two main concepts are available to determine which entities are part of a group—control and ownership. Control is the ability to direct the controlled entity and ownership is a legal concept that gives rise to rights, including those to votes and benefits. Control and ownership are linked—rights to votes usually provide the basis for controlling another entity and rights to benefits usually provide the motive for wanting to control another entity. The search for a robust consistent criterion for consolidation is not a straight choice between control and ownership but is a question about how they can be combined into a practical universal test.

When consolidation was introduced, the criterion for being part of a group was generally ownership of 50 per cent of the shares. However, it became clear that ownership was not the essential relationship; carried to its logical conclusion, basing accounting on ownership interests leads to proportional rather than full consolidation. The essential issue underlying consolidation was whether the parent had, directly or indirectly, control over other entities in its group. That control was what formed the single economic unit.

In the UK and the Republic of Ireland and in IASs, the criterion for consolidation is control, interpreted as both the ability to direct and the ability to benefit. Those supporting the use of control as the basis for consolidation argue that this is consistent with the definition of an asset (eg the IASC Framework defines an asset as a resource controlled by the entity). In financial statements prepared on a control-based consolidation policy, therefore, the group's assets and liabilities are those controlled directly by the group parent plus those controlled indirectly through the parent's control of other entities.

However, 'control' is a complex and multi-faceted concept. There are different interpretations in principle about what it means for one entity to control another before one even starts to consider whether a control-based criterion can be implemented consistently and effectively policed. A controlling party needs to be distinguished from a manager or a trustee—this distinction is often made on the basis of whether the party receives a fee or a share in the residual profit, but can become blurred by the use of performance-based management fees. The UK approach is to look at where the benefits and risks fall—the residual risks and benefits are the equity ones and will lie with the controlling party.

One entity's control of another entity may depend on another party's failing to exercise its rights—for example, a holding of 40 per cent of voting rights can give control, if other shareholders either fail to vote or vote with the 40 per cent holder. The relationship between one entity and another can also be affected by conditional rights (options, warrants, convertibles etc), formal or informal agreements and vetoes, such as on policies or appointments.

At the margin, implementing a control-based consolidation criterion requires distinctions to be made either between control and joint control or between control and lesser (but significant) influence. The development of swaps, especially 'total return swaps', whereby an entity exchanges part or all of its return from a set of assets or its obligations under a set of liabilities, has made identifying what should be included in consolidated financial statements still more complicated. The effects of consolidation policy need to be consistent with principles for asset derecognition.

There are also circumstances where a control-based model for consolidation has limited relevance, for example where the freedom of a special purpose entity (SPE) to choose its operating and financial policies is severely constrained. SPEs are widely used for securitisations and group borrowing but they may also be used for other purposes. For example, in the UK SPEs are often used to hold shares for issue to employees; in the USA they are used for research and development projects. Because SPEs are set up with some special, limited purpose in mind, their policies can be predetermined when they are set up.

The possible different interpretations of control and the difficulty of developing universal implementation guidelines have led some to despair of control itself as the basis for consolidation because they believe it will never provide sufficient certainty about which entities should be included. Some even argue for a return to ownership as the basis for consolidation because of the certainty of its application. However, consolidations prepared for groups identified on the basis of ownership are fundamentally flawed because ownership without control does not lead to the economic unity that consolidation needs to reflect. Furthermore, on a practical level, if it is possible to manipulate definitions of control, which in essence concerns how things actually are (ie a substance issue), it is even easier to manipulate ownership, which is almost wholly determined by legal form. The challenge is to make the control model work acceptably in practice by developing a common understanding of the essential features of control and a consistent view of what provides evidence for control. The integrity of group accounting can be satisfied with nothing less.

The ASB is conducting research, on behalf of the international standard-setting partnership, into the nature and effect of the consolidation requirements of different jurisdictions. If you would like to contribute please contact Janie Crichton (j.crichton@asb.org.uk).