Private companies face new guidelines for determining which entities are included in their consolidated financial statements. Guidance issued in Accounting Standards Update 2015-02, Consolidation (Topic 810) Amendments to Consolidation Analysis (ASU 2015-02) is effective for the 2017 calendar year end for non-public business entities.
Consistent with existing practice, the update requires a reporting entity that has an interest in another legal entity to first consider the variable interest entity (VIE) consolidation model, before applying the voting interest entity (voting) model. However, the update makes significant changes to both the VIE model and the voting model, which means that previous conclusions to consolidate or not consolidate entities under the VIE and voting model must be re-evaluated. The update does not change the consolidation model used by not-for-profit reporting entities.
Although the changes are broad enough to warrant a review of all past consolidation conclusions, several situations stand out as being most significantly impacted. These are:
- Determining whether relationships with investment companies are in scope of the VIE model,
- Evaluating whether decision-maker or service provider fees are variable interests,
- Deciding if a limited partnership or similar entity is a VIE,
- Determining whether a decision-maker or service provider is the primary beneficiary of a VIE,
- Application of the related party tie-breaker test to determine the primary beneficiary, and
- Applying the voting model to limited partnerships and similar entities.
Making matters more complicated, the FASB is working on two projects that will likely modify the consolidation guidance. One, a recent FASB proposal, would create a common control scope exception for private companies; modify the analysis for whether a decision-maker or service provider fee qualifies as a variable interest; and further modifying the related party tie-breaker rules. The second project seeks to re-write the guidance to reduce the use of technical terminology and reorganize the consolidation guidance to make it easier to understand.
Reporting entities consider whether they should consolidate another entity when they have an interest in another legal entity. Interests may include equity ownership, subordinated loans, arrangements to provide services, or any other form of interest that exposes the reporting entity to expected losses or residual returns of another legal entity. How reporting entities determine whether they consolidate depends on which consolidation model applies. Multiple consolidation models exist, including industry specific ones and general consolidation models. For-profit entities primarily apply the VIE and voting models. The VIE model is the primary model; it is considered prior to applying the voting model or other models that may exist.
Several differences may result from consolidations under the VIE model compared to the voting model. The VIE model requires significantly more disclosure in almost all situations and often requires assets and liabilities of a VIE to be presented separately on the face of the balance sheet of the consolidated financial statements. Also, the VIE model requires that when a noncontrolling interest in a subsidiary exists, the intercompany eliminations of income and expense items between a parent entity and a subsidiary be attributed to the parent. Under the voting model, eliminations may be allocated between the parent and the noncontrolling interest.
Although the VIE model does not require a specific order of operations, it can be useful to think of the VIE model as a four step process:
- Consider whether a scope exception applies.
- Determine if the reporting entity holds a variable interest exists in the legal entity.
- Determine whether the legal entity is a variable interest entity.
- Determine if the reporting entity is the primary beneficiary of the VIE.
If a scope exception applies (Step 1), the reporting entity does not hold a variable interest in the legal entity (step 2), or the legal entity is not a VIE (step 3) then the reporting entity applies the voting model before considering other accounting guidance. If however, the reporting entity determines the legal entity is a VIE, a conclusion whether to consolidate the legal entity will be reached under the VIE model. The voting model will not be considered. If the reporting entity is the primary beneficiary of the legal entity, then it will consolidate, if not, additional disclosure specific to the VIE model is required.
Variable Interest Entity Model
Step 1: Do I Qualify for the VIE Model?
Reporting entities will need to determine whether the relationship with another legal entity qualifies for a scope exception from the entire consolidation guidance or specifically the VIE model. Employee benefit plans sponsored by the reporting entity, governmental agencies, money market funds that operate under Rule 2a-7 of the Investment Company Act of 1940 or similar rules, and investments of investment companies accounted for at fair value under ASC Topic 946, Financial Services—Investment Companies are scoped out of the entire consolidation guidance (VIE and voting model). Not-for-profit organizations, separate accounts of life insurance entities, entities that qualify under the business scope exception, and legal entities created before 2003 for which information is not available are scoped out of the VIE model. In addition, a private company may elect to not apply the VIE model to certain qualifying leasing arrangements under a Private Company Council (PCC) accounting alternative.
ASU 2015-02 makes ann important update to the scope of the consolidation guidance. Previously, a deferral existed so that a reporting entity that provided services to an investment company was required to apply an older version of the VIE model where the primary beneficiary was determined based solely on the risk of loss. Adoption of ASU 2015-02 eliminates the deferral and creates a scope exception for money market funds. This change will cause investment managers to reassess their arrangements with investment companies for potential consolidation.
Step 2: Identify Variable Interests
Variable interests absorb portions of expected losses or receive portions of expected residual returns of a legal entity. Expected losses and residual returns are essentially the probability weighted amount that the returns (based on cash flows or fair value) of the legal entity will be below or above the pinpoint estimated amount of expected returns.
Although the VIE model includes example computations of expected losses and residual returns, such computations are rarely necessary. In place of computations, qualitative analysis is encouraged. A qualitative analysis generally considers the risks that an entity is designed to pass on to interest holders (i.e. the design of the entity). Risks (or returns) are typically generated from assets, and include operational risks and investment risks (credit risk, interest rate risk, market risk). The holders of variable interests are those that are expected to receive losses or returns generated by these risks.
Variable interests may be explicit (contractual) or implicit (non-contractual). Common forms of variable interests include equity ownership, subordinated loans, junk bonds (or debt with similar interest rates), and explicit or implicit guarantees.
Decision-maker or service provider arrangements—for example, agreements where the reporting entity directs the operations of another legal entity—may be variable interests. They are evaluated to determine if they are based on several criteria that have been narrowed as a result of ASU 2015-02. These arrangements are a variable interest held by the service provider in the legal entity receiving services under ASU 2015-02 unless all of the following conditions are met:
- Amount of the fee is commensurate with the service provided
- Terms, conditions, and amounts of the fee are customary (arm's length)
- The service provider does not hold other significant interests in the legal entity
When evaluating whether the service provider holds other significant interest in the legal entity, the service provider considers its direct and indirect interests. Direct interests include other forms of variable interest, such as owning equity, while indirect interests are those held downstream, such as an equity interest in the legal entity receiving services held by an equity method investee of the service provider.
Indirect interests are evaluated to determine if they are significant on a proportionate basis. For example, if the service provider has a 25 percent interest in an equity method investee that owns 40 percent of the equity of the legal entity receiving services, the service provider would have a 10 percent (.25 X .4) interest in the legal entity.
As the VIE model is currently written under ASU 2015-02, the service provider also includes interests held by its related parties under common control as if it were the service provider interests directly. Under this provision, if the equity method investee of the service provider discussed above was under the control of the parent of the service provider, the service provider would be deemed to have a 40 percent interest in the legal entity receiving services. The FASB has proposed eliminating this common control guidance from the analysis.
Step 3: Is the Legal Entity a VIE?
The VIE model requires evaluation of whether a legal entity is a VIE at the date of initial involvement or a later reconsideration event. When adopting the update, the analysis of whether a legal entity is a VIE or not is performed as of the date of the most recent reconsideration event, or the date of initial involvement if no reconsideration events have occurred. The evaluation is not performed as of the date of adoption of the Update. The VIE model defines several conditions that cause a legal entity to be a VIE:
- Legal entity has insufficient equity at risk,
- Equity holders at risk as a group lack, through voting interests, any of the following:
- Obligation to absorb expected losses,
- Right to receive residual benefits, or
- Power to direct the activities that most significantly impact the legal entity's economic performance ("power")
In addition, the equity holders at risk are considered to lack the power when nonsubstantive voting rights exist. Nonsubstantive voting rights exist when:
- The voting rights of some investors are disproportionate from the obligation to absorb losses or the right to receive expected residual returns, and
- Substantially all the legal entities activities either involve or are conducted on behalf of an investor (and its related parties) with disproportionately few voting rights.
The conditions above require understanding the amount of equity at risk of the legal entity being evaluated. Determining the amount of equity at risk begins by taking all amounts classified as equity under U.S. Generally Accepted Accounting Principles (GAAP) and subtracting equity that does not participate significantly in profits and losses, equity issued in exchange for subordinated interests in other VIEs, and equity directly or indirectly received from the legal entity or others involved with the legal entity (for example, sweat equity). Once the amounts to be included in equity at risk are determined, the reporting entity can begin evaluating the conditions that cause the legal entity to be a VIE.
The evaluation of the sufficiency of equity at risk and whether equity at risk absorbs expected losses and receives residual benefits has not been impacted by the update. The evaluation of whether the equity holders at risk have the power has been significantly modified for limited partnerships and similar entities. Determining whether an entity, such as a limited liability company (LLC), is similar to a limited partnership requires significant judgement. Limited partnerships generally have three core characteristics:
- Managed by one or small group of partners
- Maintain individual partnership accounts
- Pass income taxes through to the partners
Prior to considering the power criteria, a reporting entity will first consider whether the legal entity being evaluated is similar to a limited partnership based on the above characteristics and any other characteristics of the legal entity that may be relevant. Oftentimes an LLC will be judged to be similar to a limited partnership if it has a single member or subset of members that are designated as managers over the day-to-day operations of the legal entity instead of having a corporation-like board of managers with proportionate representation of each member's ownership interest.
In a limited partnership or similar entity, the holders of equity at risk lack the power when the limited partners do not have the power through voting rights to direct the ordinary activities of the limited partnership. The limited members are considered to have the power to direct the ordinary activities when a vote of the simple majority (or fewer) of the limited partners can remove the general partner or can exercise substantive participation rights. Substantive participation rights are those rights that permit the limited partners to overrule the decision making of the general partner in the ordinary course of business.
Determining whether a simple majority of limited partners have a right that can be exercised by a simple majority can be complicated. For example, assume an LLC has a managing member responsible for day-to-day operations that owns 20 percent of the equity. The managing member can be removed by a vote of 51 percent of the ownership interest. If the same LLC has three members that are not involved in day-to-day operations (limited members) with one owning 40 percent and two owning 20 percent of the equity, the LLC would be determined to be a VIE. The LLC is a VIE, because in the scenario where only the two 20 percent limited members vote for removal of the managing member the removal would not pass. The entity therefore does not permit a simple majority of the limited members to remove the managing member even though in other fact patterns two out of three limited members could vote to remove the managing member.
The evaluation of whether the holders of equity at risk have the power to direct the activities most significant to the legal entities' economic performance for entities that are not limited partnerships or similar to limited partnerships remains unchanged under the update, except that the FASB clarified that the evaluation should first consider whether the equity holders have voting rights that have the power, such as the ability to elect a board of directors that is actively involved in decision making over the activities that most significantly impact the entity's economic performance. If they do not, then consider whether there is a decision-maker that holds the power and for which kick-out rights or participation rights exist that can be exercised unilaterally by a single holder of equity at risk. When such a unilateral holder of equity at risk exists, the entity is not a VIE.
Step 4: Determining the Primary Beneficiary
The Update introduced the term "single decision-maker" into the guidance but did not otherwise change the principle that the primary beneficiary of a VIE is the entity that has the power to direct the activities that are most significant to the economic performance of the VIE ("power criterion"), and has the obligation to absorb losses or right to receive benefits that could be significant to the VIE ("risk or reward criterion").
The concept of a single decision-maker primarily identifies the entity that meets the power criterion. As a result of ASU 2015-02, situations are more likely to occur when the single decision-maker does not also directly meet the risk or reward criterion, especially in instances where the single decision-makers only variable interest in the VIE is a service provider arrangement. In a departure from prior guidance, a service provider arrangement is not considered to meet the risk or reward criterion if
- The arrangement fee is commensurate with the service provide, and
- The terms, conditions, and amounts of the fee are customary (arm's length).
If a single decision-maker does not directly meet the risk or reward criterion, it then considers whether it has an indirect interest in the VIE that would meet the risk or reward criterion. An indirect interest is the proportionate amount of a downstream interest, such as the interest held by an equity method investee described in Step 2. Unlike Step 2, the single decision-maker does not attribute interests held by entities under common control as its own when evaluating Step 4.
ASU 2015-02 also changes the analysis when related parties groups meet both the power and risk or reward criteria. If the reporting entity determines that the single decision-maker does not meet the risk or reward criterion, it then decides if the related party group of the single decision maker or a group under common control with the single decision-maker meets the risk or reward criterion. If a related party group meets the risk or reward criterion, then the member of the related party, if any, for which substantially all the activities of the VIE are conducted, consolidates. If a common control group meets the risk or reward criterion, then the related party most closely associated with the VIE consolidates. Likewise, if shared power exists and the reporting entity and its related parties together would meet both the power and risk or reward criteria, then the related party most closely associated with the VIE would consolidate.
Voting Interest Model
If the VIE model does not apply because of a scope exception to the VIE model identified in Step 1, there was no variable interest in the legal entity in Step 2, or the legal entity is not a VIE in Step 3 of the VIE model, then the voting model applies.
The voting model has several scope exceptions. These exceptions include entities in legal reorganization or bankruptcy, situations where the subsidiary operates under foreign restrictions that make it difficult to be controlled by the reporting entity, the control exists through means other than voting, and situations involving broker-dealer parents where the control of the subsidiary is likely temporary. In addition to the explicit scope exceptions to the voting model, the voting model would also not be applied to rabbi trusts and research and development arrangements that are not VIEs because these arrangements have separate specific consolidation guidance.
ASU 2015-02 modifies the voting model for all entities except not-for-profit entities. Under the revised voting model, as in previous guidance, there is a presumption that a party with more than 50 percent of the voting rights consolidates an entity. However, for limited partnerships and similar entities, a voting right is now defined as the right to remove the general partner(s) (or equivalent). Updated guidance in ASU 2015-02 therefore eliminates the previous presumption that the general partner consolidates a limited partnership or similar entity.
Noncontrolling rights can still result in an entity with more than 50 percent of the voting rights overcoming the presumption that it should consolidate when those noncontrolling rights can prevent the holder of more than 50 percent of the voting rights from taking action in the ordinary course of business.
Transition to the new consolidation standard can follow either a retrospective or modified retrospective approach. Under either method, entities will evaluate if they have a VIE at the initial involvement or the most recent reconsideration event. All other analysis is conducted based on initial involvement and all changes in facts and circumstances are considered as they occur.
For More Information
If you have specific comments, questions or concerns about the consolidation guidance, you can contact Mark Winiarski of MHM's Professional Standards Group. Mark can be reached at firstname.lastname@example.org or 816.945.5614.
Published on August 29, 2017