The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 8, March 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

The Financial Accounting Standards Board (FASB) has long grappled with the concept of effective control. Way back in 1995, the FASB issued an Exposure Draft (No. 154-D, October 16, 1995) in which it sought to alter the policy and procedures underlying the filing of consolidated financial statements. This Exposure Draft was widely criticized, so much so that the FASB nearly terminated the project. Fairly quickly, though, it was resurrected and a new Exposure Draft is expected to address only consolidation policy.

It's All In a Name

The principal alteration to the current rules is designed to center on the concept of effective control. When this elusive effective control exists, the holder will be required to consolidate the investee with respect to which this effective control exists. Currently, consolidation is required only in cases where legal control is present. Legal control is present in cases where the investor possesses a controlling financial interest with respect to an investee.

A controlling financial interest, in turn, is evidenced by a majority voting interest which, itself, refers to the power to elect to elect directors who hold a majority of the board votes. The FASB is attempting to adopt a more flexible definition of control that takes into account the complexities and sophistication of modern business relationships.

Indicia of Control

In the prior Exposure Draft on this topic, the FASB enumerated certain indicia of effective control that one might expect to see reiterated in the upcoming Draft. In the world of research and development (R&D) spinoffs, the indicator of effective control that is most relevant is the one that suggests that control is present where there exists a unilateral ability to obtain a majority voting interest through ownership of securities or other rights that may be converted into a majority voting interest, without assuming risks in excess of the expected benefits from conversion.

On the surface, it would appear that most sponsors, in light of the call option they possess with respect to the R&D entity's stock, would be seen as in effective control of that entity. Consequently, they would have to consolidate such entity. At issue, though, is how such a consolidation would be implemented, in light of the fact that a sponsor does not actually own stock in the investee. If consolidation is required but the deleterious results thereof are "backed out" through the minority interest line, then the effect of consolidation will be relatively benign.

Uncertain Future

Unfortunately, there is a disquieting and cryptic footnote in the prior Exposure Draft. It says that if effective control is obtained by acquiring securities with unexercised conversion rights, their conversion will be assumed as of the date control is achieved for purposes of applying the provisions of the FASB's Statement.

That may mean that all bets are off. FASB followers should keep an eye out.

FASB Rules and Consolidations, Vol. 7, No. 8, M&A Tax Report (March 1999), p. 8.