EXCEPTION TO CONSOLIDATION: GUIDE TO THE MEANING OF SEVERE AND LONG-TERM RESTRICTIONS

By Beni Agarwal (beni@vinodkothari.com)

Introduction

For the group enterprises, as the Companies Act provides, there is a requirement to prepare and present Consolidated Financial Statements. However there are a certain number of conditions which if satisfied may exclude a subsidiary from consolidation for preparation of consolidated financial statements. This article talks about one such restriction which deals with severe and long term restrictions. The purpose of the article is to throw more light and provide clarity to the meaning of “severe” and “long term” restrictions.

Background

Companies Act 2013, section 129(3) states that where a company has one or more subsidiaries, it shall, in addition to financial statements provided under sub-section (2), prepare a consolidated financial statement of the company and of all the subsidiaries in the same form and manner as that of its own which shall also be laid before the annual general meeting of the company along with the laying of its financial statement under sub-section (2). Schedule III of Companies Act 2013, provides that the financials should be prepared in accordance with the applicable Standards.

Hence, it is the requirement of companies act to prepare consolidated financial statements where there is a parent company and the economic activities of the group is presented in the financial statements. For the preparation of Consolidated Financial Statements, presentation is as per Schedule III and as per the rules stated in Accounting Standard 21( AS 21). The disclosure and presentation requirements as per schedule III are in addition to and not in substitution of the Accounting Standards.

The Standard lays down the rules for the preparation and presentation of Consolidated Financial Statements of the group enterprise under the control of the parent. These are in addition to the Standalone Financial Statements. Now the question arises as to what is the meaning of “control” that builds the subsidiary and holding relationship?

What is a Subsidiary and Holding relationship?

AS 21 states that “A subsidiary is an enterprise that is controlled by another enterprise (known as the parent)” and “A parent is an enterprise that has one or more subsidiaries.”

The definition is a non-cumulative one where control shall be established if either there is a direct or indirect ownership of the voting rights of the enterprise or if there is a control of the composition of the board of directors or other corresponding governing body with the intent to obtain economic benefits.

Once the control is established, subsidiary holding relationship is established and the financials should be prepared in accordance with AS 21 along with standalone Financials by the parent undertaking to consolidate all its subsidiaries whether foreign or domestic. Consolidated Financial Statements include consolidated balance sheet, consolidated statement of profit and loss, and notes, other statements and explanatory material that form an integral part Consolidated cash flow statement is presented in case a parent presents its own cash flow statement. The consolidated financial statements are presented, to the extent possible, in the same format as that adopted by the parent for its separate financial statements.

Subsidiary Excluded from Consolidation

The standard makes it clear that consolidation cannot be avoided on the grounds that the subsidiary is involved in dissimilar business activities from those of the enterprise within the group. However, the standard does provide a clause wherein the subsidiary is excluded from consolidation on satisfaction of either of the two points.

AS 21- Consolidated Financial Statements Para 11 states that:-

“A subsidiary should be excluded from consolidation when:

• control is intended to be temporary because the subsidiary is acquired and held exclusively with a view to its subsequent disposal in the near future; or
• It operates under severe long-term restrictions which significantly impair its ability to transfer funds to the parent.”

Para 5.1 defines control as :

“(a) the ownership, directly or indirectly through subsidiary(ies), of more than one-half of the voting power of an enterprise; or

 (b) control of the composition of the board of directors in the case of a company or of the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities.”

Thus, the control is temporary when all of the shares in the subsidiary company are acquired and held exclusively as stock in trade with the intent to dispose them all off ordinarily within a period of 12 months from the date of acquisition. In case of temporary control, subsidiary is not required to be consolidated. If the control is not found to be temporary then if there is a long term and severe restriction on the subsidiary undertaking that significantly impairs its ability to transfer funds to the parent company, then consolidation shall not be required.

Severe and Long Term restrictions

There is no clarification or explanatory note on the meaning of “severe” and “long term” restrictions in Indian Act or Standards. Hence, reference has been drawn from UK Laws.

As per UK Companies Act 2006 section 405 para 3(a),

“(3) A subsidiary undertaking may be excluded from consolidation where—

(a) severe long-term restrictions substantially hinder the exercise of the rights of the parent company over the assets or management of that undertaking, or (b) the information necessary for the preparation of group accounts cannot be obtained without disproportionate expense or undue delay, or (c) the interest of the parent company is held exclusively with a view to subsequent resale.”

Para 78c of Amendments to FRS 2- Accounting to Subsidiary Undertakings issued by ASB gives a clarification to the meaning of “severe” and “long term” restrictions:-

“78(c) Restrictions are only relevant to justify the exclusion of a subsidiary undertaking from consolidation if the restrictions substantially hinder the exercise of the rights of the parent undertaking over the assets or management of the subsidiary undertaking. The rights affected must be those by reason of which the undertaking holding them is the parent undertaking and without which it would not be the parent undertaking. Severe long-term restrictions justify excluding a subsidiary undertaking from consolidation only where the effect of those restrictions is that the parent undertaking does not control its subsidiary undertaking. Severe long-term restrictions are identified by their effect in practice rather than by the way in which the restrictions are imposed. For example, a subsidiary undertaking should not be excluded because restrictions are threatened or because another party has the power to impose them, unless such threats or the existence of such a power has a severe and restricting effect in practice in the long-term on the rights of the parent undertaking. Generally, restrictions are dealt with better by disclosure than by non-consolidation. However, the loss of the parent undertaking’s control over its subsidiary undertaking resulting from severe long-term restrictions would make it misleading to include that subsidiary undertaking in the consolidation. Where a subsidiary undertaking is subject to an insolvency procedure in the United Kingdom, control over that undertaking may have passed to a designated official (for example, an administrator, administrative receiver or liquidator) with the effect that severe long term restrictions are in force. A company voluntary arrangement does not necessarily lead to loss of control. In some overseas jurisdictions even formal insolvency procedures may not amount to loss of control.”

Prior to the December 2003 revision of IAS 27, the standard provided for exclusion from consolidation of the subsidiary into the parent company if the subsidiary operated under long term severe restriction that significantly impairs the ability of the subsidiary company to transfer funds(dividend) to the parent company. However, post the December 2003 revision in IAS 27, IASB concluded that these restrictions in themselves do not preclude control and hence removed this point in revised IAS 27.

In the Indian Accounting Standard for Consolidation (Ind AS 110) there is no provision for severe long term restrictions whereby the need to consolidate subsidiary is excluded.

Analysis

AS 21 provides for exclusion of a subsidiary from consolidation. Para 11 provides two circumstances where exclusion of subsidiary is possible. Para 11(a) talks about temporary control. Para 11 (b) talks about the circumstance where a subsidiary may be excluded from consolidation when it is operating under severe long term restrictions due to which it cannot transfer funds to the parent company.  The same view was presented in IAS 27 prior to the December 2003 revision. Hence, AS 21 and IAS 27(prior to 2003 revision) accepted non-payment of dividend by the subsidiary undertaking to the parent company as long term severe restriction and excluded consolidation. Even though IAS 27 got revised and removed the above condition, AS 21 continued and still continues with the clause in para 11(b).

Now the question is what shall amount to “severe” and “long term” restrictions? There is no clear cut explanation available as to the meaning in the Indian laws and standards. Hence, we extend to the UK Laws and draw reference from there. Section 405 3(a) in the Companies Act 2006 of UK states that severe and long term restrictions should substantially hinder the rights of the parent undertaking over exercise on either the assets or the management of the subsidiary undertaking.

We also refer to the amendment to the FRS 2 dealing with Accounting to Subsidiary Undertakings as stated above.

Hence, we understand that a restriction to be severe and long term it should be such that effect of such restrictions is that the parent undertaking does not control the subsidiary undertaking. The hindrance should be on the rights of the parent company and the rights hindered should be such without which it will not remain the parent company anymore. This can be possible when there exists a hindrance to the rights of the parent company that it exercises over the assets or the management of the subsidiary undertaking. This means that there should be a restriction on the parent undertaking over the use of subsidiary’s assets or over the control on the management of the subsidiary. This is not a cumulative restriction over assets and management of the subsidiary. It is non- cumulative in nature.

Further, mere threat of restrictions or the fact that a third party has power to impose restrictions does not in itself become severe and long term restrictions. Also, under some Laws like UK, a company that has gone into liquidation and its assets have been handed over to the Liquidator means the company is under severe and long term restrictions. While for other countries, the case may not be the same.

Revised IAS 27(2003) and Ind AS 110 have lifted such a condition and does not talk about long term severe restrictions.

Thus, for the purpose of AS 21, the severe and long term restriction should be such that the very existence of control by the parent company over the subsidiary company is hindered which will challenge the parent subsidiary relationship itself. For this, we move to the definition of control in the standard as stated above. Thus, in order to hinder the control of the parent company over its subsidiary, either of the two should be affected:-

• The voting rights
• The power to control the Board of Directors composition or any such governing body from which economic benefits are available.

This can be brought about by granting rights of appointment of Directors (control of the composition of Board of Directors) to another shareholder other than the parent company. This is basically hindrance of the right of the parent company over the management of the subsidiary company. Hence, it challenges the control element of the parent undertaking over the subsidiary and is a severe and long term restriction.

Conclusion

For a restriction to be “severe” and “long term” the restriction should hinder the rights of the parent undertaking such the parent does not control the subsidiary. This restriction should impair the rights of the parent undertaking to utilize the resources of the subsidiary undertaking which is either the assets or the management of subsidiary.