The guidance on consolidations experienced a revolutionary change in response to accounting scandals in the early 2000s related to off-balance sheet transactions. The resulting changes created the concept of a variable interest entity (VIE) and added complexity to accounting for public and private companies. For private companies, application of the VIE model is challenging because the arrangements among related or commonly controlled entities may not be clearly defined or may not reflect the economic interests of those involved. The VIE model also includes a significant amount of judgment and the application of technical terminology. Adding to the challenges and costs for private companies, the VIE guidance is applied before the more easily understood voting model because the VIE model is predicated on the idea that sometimes a controlling financial interest is obtained through interests other than voting or kick-out rights.
Various concerns over the VIE model have existed, ranging from the cost and complexity of the guidance to whether it was written with private company issues in mind. One group of concerns includes whether the consolidation guidance properly concludes on consolidation in certain situations where a reporting entity does not have contractual or voting rights in a legal entity to act on its own behalf or is not exposed to the majority of the risks and rewards of a legal entity. This concern led to a deferral of application of part of the current VIE model for situations where a reporting entity may appear to have a controlling financial interest but is acting as an agent on behalf of another party. Recent changes that address this concern impact the VIE and voting models and require re-evaluating consolidation conclusions. The changes are effective for private companies for their calendar year end financial statements ending December 31, 2017.
Changes resulting from ASU 2015-02 Consolidation (Topic 810): Amendments to the Consolidation Analysis impact each step in evaluating whether a relationship with another entity should be consolidated. Private companies will be significantly affected by the changes, which will affect the scope, decision-maker and service provider arrangements, determining if a legal entity is a VIE, determining the primary beneficiary, indirect interests and related parties and the voting model.
Scope: In current U.S. generally accepted accounting principles (U.S. GAAP), a reporting entity that has an interest in a VIE determines if it should consolidate the VIE based on whether it is the VIE's primary beneficiary. The reporting entity is the primary beneficiary when it has the power to direct the activities that are most significantly impact the VIE's economic performance (power) and it has the obligation to absorb losses or right to receive benefits that could be significant to the VIE (risk or reward). Interests held by a reporting entity in investment companies and similar entities received a deferral to applying this definition of a primary beneficiary. Instead, a reporting entity with interests in a VIE that is an investment company evaluates consolidation based on whether it receives a majority of the expected losses or residual returns of the VIE.
The revised guidance eliminates the deferral, but completely scopes out money market funds from the VIE model. As a result of the change, investment managers will go through significant changes in how they evaluate relationships with VIEs as they adopt the power and risk or reward definition for a primary beneficiary.
Decision makers and service provider arrangements: Private companies often have arrangements with related parties or others where they provide services to other legal entities. These arrangements are evaluated against six criteria under current U.S. GAAP to determine whether they represent a variable interest. Three of these criteria are eliminated. Under the new guidance a decision maker or service provider arrangement is a variable interest if any of the following are not true:
- The fee for the service is commensurate with the effort
- The reporting entity does not hold other interests that absorb more than an insignificant amount of expected losses or expected residual returns of the legal entity
- Terms, conditions and amounts are customary for a transaction negotiated at arm's length
For private companies with arrangements to provide services to related parties, these evaluations may still be challenging because it may be difficult to determine whether the transactions are consistent with those given to an unrelated entity. However, the elimination of some of the criteria, coupled with changes to how interests held by related parties of the reporting entity are considered, means that fewer of these arrangements will qualify as a variable interest.
Determining if a legal entity is a VIE: Determining whether a legal entity is a VIE requires the evaluation of multiple criteria. The power criteria says that if the holders of the equity at risk lack the power to direct the activities most significant to the economic performance of a legal entity, then the entity is a VIE. This guidance was modified such that entities that are limited partnerships, or similar in nature, are more likely to be VIEs.
A limited partnership typically has three characteristics that distinguish it from a corporation:
- Authority to manage the entity is given to a general partner
- Partners have separate capital accounts
- Partners are responsible for their share of taxes on income
When evaluating whether a reporting entity should consolidate another legal entity, part of the determination will include considering whether the legal entity is like a limited partnership. In many instances a limited liability company may be structured in the same way as a limited partnership thus requiring evaluation for these sorts of entities.
If the legal entity being evaluated is a limited partnership, it is considered to be a VIE based on the power criteria of the new guidance so long as the limited partners can remove the general partner based on a simple majority (or fewer) vote or the limited partners have substantive participating rights in the ordinary course of business of the legal entity.
Determining the primary beneficiary: Several changes were made to how a primary beneficiary is determined. The most significant impact is in how related parties are evaluated. Under current U.S. GAAP, if no single entity is determined to be the primary beneficiary of a VIE, then an entity considers whether the related party rules apply. The related party rules state that if the reporting entity plus the powers and interests of its related party meet the criteria to be a primary beneficiary, then the most closely associated member in the related party group consolidates the VIE. The revised guidance applies different related party rules for situations where the reporting entity has the power and where the reporting entity shares power. In situations where the reporting entity has the power but does not have the risk or rewards, it considers whether its interests combined with its related parties meets the risk or rewards criteria. If they do, and they are under common control, the reporting entity applies the most closely associated test. If the reporting entity plus its related parties that are not under common control meet the risk or rewards criteria, then the related party for which substantially all of the activities of the VIE are on the behalf of (if any) would be the primary beneficiary of the VIE.
Indirect interests and related parties: A new concept in the revision to the VIE model is the concept of an indirect interest. An indirect interest is an interest held by a related party of the reporting entity in another legal entity or VIE. In general, an indirect interest is a proportionate interest. For example, if a reporting entity has a 25 percent ownership in an equity method investment and that equity method investment has a 40 percent ownership interest in a legal entity that is being evaluated under the VIE model, the reporting entity has a 10 percent interest in the legal entity. That proportionate interest is factored into the analysis in two different areas of the guidance:
- When evaluating whether a decision-maker or service provider arrangement is a variable interest, the reporting entity considers the indirect (proportionate) interest when determining whether it has other interests that absorb more than an insignificant amount of expected losses or expected residual returns of the legal entity. In this situation, the reporting entity generally does not include in its related parties its employees or employee benefit plans, but it is required to consider interests held by entities under common control with it as if those interests were 100 percent held by the reporting entity.
- When evaluating whether the reporting entity has the risk or rewards in a VIE, it considers its indirect interest to determine if its exposure to the VIE's risk or rewards could be significant to the VIE. In this analysis, it includes those interests held by employees on a proportionate basis. For instance, if it funded the employees' ownership in a legal entity through debt, the reporting entity would include the amount of the interest that it paid for through the debt, but it only treats those interests held under common control on a proportionate basis.
Voting model: The voting interest model was also changed by the new guidance so that the determination of whether a limited partnership or similar entity is a VIE would be aligned with how these entities are evaluated for consolidation under the voting model. Under existing U.S. GAAP, a general partner is presumed to consolidate a limited partnership. Under the revision, if the limited partnership is not a VIE, then it is presumed that a limited partner with more than 50 percent of the voting rights consolidates. A voting right is considered to be equivalent to a substantive kick-out right to remove the general partner or equivalent. As always, in the voting model the presumption of consolidation can be overcome based on existence of substantive noncontrolling rights that prevent the entity with voting control from taking actions in the ordinary course of business.
Transition and Beyond
The standard took effect for public business entities in the 2016 calendar year and will affect private entities for annual periods beginning after December 15, 2016 (calendar year 2017). Due to the scope of the changes, all entities should reconsider their existing consolidation conclusions.
Applying the changes to determining whether a legal entity is a VIE under the updated guidance will require companies to go back to the most recent reconsideration event or the date of initial involvement with the legal entity to determine whether that entity is a VIE. However, any consolidations or deconsolidations that result from adoption may be applied either retrospectively or under a modified retrospective approach whereby the changes are reflected as changes to equity as of the beginning of the period of adoption.
The FASB recently added projects to its agenda to consider additional revisions to the consolidation guidance. These include reorganizing the guidance to make it easier to apply.
For more information about applying the new VIE guidance to private companies, contact Hal Hunt or Mark Winiarski of MHM's Professional Standards Group. Hal can be reached at email@example.com or 816.945.5610. Mark can be reached at firstname.lastname@example.org or 816.945.5614.
Published on November 08, 2016