Prior to FIN 46R, now incorporated into ASC 810, consolidation was a largely mechanical process. This was because the decision of whether to consolidate or not was based on ownership percentage and was relatively simple. FIN 46 changed consolidation profoundly by introducing a new concept: control exercised through economic power. Under this concept, the ability to influence decision making and financial results through contractual rights and obligations, and exposure to risk, is considered the primary factor for consolidation (the variable interest consolidation model) and ownership percentage is secondary. I should clarify. Economic influence is the primary factor if and only if the the entity being considered for consolidation is a “variable interest entity” or VIE. If the entity is not a VIE, then ownership percentage, the so-called voting interest consolidation model, rules the day.
The bummer about the variable interest consolidation model is that a company is forced by ASC 810 to evaluate virtually every relationship it has with both third parties and related, including subsidiaries. Remember, this model is an economic influence model and economic influence can come in many forms and flavors. Remember, too, that the variable interest model comes ahead of the voting interest model and, in certain circumstances, can force deconsolidation of an entity that would otherwise be consolidated under the voting interest model…even a wholly owned subsidiary(!).
Here is an overview of the consolidation evaluation process under ASC 810:
Step 1 – Evaluate the variable interest model scope exceptions.
There are several scope exceptions that could nullify applicability of the variable interest model to an entity, so start here. Here’s the list, but please keep in mind that there are criteria within each exception that must be met:
|Is the entity a “legal entity”?||The term ‘legal entity’ should be construed broadly. Some of the characteristics of a legal entity to consider include: Does the entity file a tax return? Did the entity file organization documents with a governmental agency? Does the entity have a governing board (e.g., something similar to a board of directors)? Is the entity required to file reports of any kind with a governmental agency? Can the entity enter into contracts in its own name? Does the entity have a bank account?|
|Does the entity meet the definition of a business?||The accounting definition of a business can be found in ASC 805. ASC 805-10-20 defines as business as, “An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members or participants.” In addition to this definition, ASC 805-10-55-4 through 9 provide implementation guidance that is helpful in determining what constitutes a business. The evaluation of whether an entity is a business or not can get messy.The definition of a business in ASC 805 is principles based and therefore open to interpretation and judgment. ASC 805-10-55-4 provides further guidance by declaring that, “A business consists of inputs and processes applied to those inputs that have the ability to create outputs. Although businesses usually have outputs, outputs are not required for an integrated set to qualify as a business.” This last element is important when evaluating a development stage entity which will likely have no outputs for an extended period of time. In the case of a development stage entity, ASC 805-10-55-7 provides other factors that should be considered. The “business” scope exception is frequently misunderstood so be very careful.|
|Is the entity a not-for-profit organization?||A not-for-profit organization is exempt from the VIE consolidation guidance as both consolidator and consolidatee.|
|Is the entity a benefit plan?||A benefit plan need not be consolidated nor must it consolidate a VIE.|
|Is the entity an investment company accounted for at fair value under ASC 946?||Investment companies accounted for at fair value under ASC 946 are exempt from the VIE consolidation guidance.|
|Is the entity a “separate accounts” of a life insurance entity as described in in Topic 944?||This one’s a bit narrow and probably does not apply to most companies.|
|The “information out” exception||This is a transitional scope exception that was primarily applicable during the transition phase to FIN 46R and would still presumably apply to an entity that qualified for this exception back then. It is not, as a practical matter, available to relationships entered into since FIN 46R was issued.|
|Is the entity a government organization?||You don’t have to consolidate consider a government organization, including government agencies, for consolidation as a VIE unless the government organization was formed specifically to circumvent the ASC 810-10.|
|Does the entity meet any of the criteria for deferral set forth in ASU 2010-10?||Certain investment companies in the asset management industry are subject to required deferral of ASC 810-10. There are specific condition that must be met and, if met, make deferral compulsory. Please see ASU 2010-10 for details.|
In addition to the above, there is the always-present matter of materiality.
If any one of the scope exceptions applies, you can immediately jump out of the variable interest model analysis for that entity and evaluate the entity under the voting interest model (Step 6).
Step 2 – Does the company hold a variable interest?
You have to evaluate an entity for possible consolidation under the variable interest model only if you hold a variable interest in that entity. A variable interest is an interest, or a combination of interests, that absorbs the variability of the entity. Not very helpful I admit. This concept is difficult to put in plain English. I like to think of a variable interest as any relationship that benefits when the entity does well and/or takes the hit when the entity does poorly. Under the voting interest model, the shareholders reap the benefits, and suffer the losses, of the entity’s financial performance. Under the variable interest model, you have to also look at non-shareholders and therefore have to look at the non-ownership relationships you have. A simple example is a collateralized, non-recourse loan. If you hold such a loan in an entity, you are subject to the general credit of the entity (its ability and willingness to pay) and the financial performance of the collateral (the fair value of the assets that you can claim should the company default). This loan is a variable interest since it absorbs the variability of the fair value of the collateral.
Variable interests from the holder’s perspective, as opposed to the entity’s perspective, are usually assets such as receivables, leases (as lessor), rights to economic benefits (a beneficial interest in residual value of assets of the entity, for example), obligations to perform (a loan guarantee, for example), options (an exercisable right to purchase an asset for a fixed price, for example), among many others. There is no specific list.
If you hold a variable interest, proceed to Step 3. If not, jump to Step 6 (the voting interest model).
Step 3 – Is the entity a variable interest entity?
This is where things get interesting. You are only required to consolidate (or deconsolidate) an entity under the variable interest model if it is a variable interest entity (VIE). The definition of a VIE in ASC 810-10-20 is not helpful at all, “A legal entity subject to consolidation according to the provisions of the Variable Interest Entities Subsection of Subtopic 810-10.”
It is better to look at the variable interest entity criteria to find a definition. Essentially, VIE is a legal entity (an important scope criteria) a) that has insufficient at-risk equity to fund its activities without additional subordinated financial support from any other party or parties, b) whose at-risk equity holders as a group do not have the power through voting or similar rights to direct the entity’s activities that most significantly affect its economic performance or c) whose at-risk equity holders do not absorb the entity’s losses or receive the entity’s residual returns.
Ok, so this isn’t all that helpful either, but it’s at least longer. The simple truth is that can’t look at an entity on a superficial basis and determine whether or not it is a VIE. You have have to perform significant analysis and you will often need to crunch some numbers as well. Here are the basic steps to determining whether an entity is a VIE:
|Identify and segregate any “specified assets” of the entity||The expected losses associated with so-called specified assets of the legal entity should be excluded from the expected losses of the overall legal entity. However, if the expected losses of the specified assets are in any way limited (for example by a limited guarantee), then any excess expected losses should be associated with the legal entity as a whole and therefore added back to the overall legal entity’s expected losses.|
|Identify and segregate any “silos” of the entity||The equity investment at risk and expected losses of a silo that is separately consolidatable as a VIE should be excluded from the equity at risk and expected losses of the legal entity as a whole. In this situation, none of the expected losses or benefits of the silo inure to any other variable interest holders of the legal entity, and none of the specified liabilities are payable from the residual assets attributable to the other variable interests of the entity.|
|After excluding the expected losses of any separately consolidated silos and/or specified assets, if applicable (and very rarely done), is the equity investment at risk sufficient to finance the legal entity’s activities?||Determining whether the equity investment at risk is sufficient can be a qualitative analysis, a quantitative analysis, or both. There is a rebuttable presumption in the ASC 810 guidance that equity investment at risk of less than 10% of total assets, both measured at fair value, constitutes insufficient equity investment at risk to finance expected losses. Sufficiency of equity investment at risk should be, if possible, demonstrated qualitatively. This can be very difficult to do for a legal entity with a complex capital structure. A simple capital structure may appear easier to handle from a qualitative perspective, but this may not always be true. The most convincing qualitative evidence is to compare the legal entity’s equity at risk to that of another entity with similar assets and comparable investment equity at risk. If that entity operates with no additional subordinated support, that is strong evidence that the legal entity can do so also. If the answer to this question is “NO”, the entity is a VIE.|
|Do the holders of equity investment at risk lack the power to direct the activities that most significantly impact the entity’s economic performance?||The power to direct the activities of the entity is vested in the voting rights of the holders of equity investment at risk, unless those voting rights are insufficient due to rights and powers granted to other variable interests through the entity’s governing documents and/or contracts. This condition focuses on the voting rights and other powers granted to holders of equity investment at risk as a group. If those rights are nonexistent, are not substantive, or are not centered around the decisions that most significantly affect the legal entity’s economic performance, then the equity investors at risk as a group do not have decision making rights. If this is the case, then decision making rights rest outside this equity group. Therefore, review of the the decision-making authority granted to other interest holders through the entity’s governing documents and/or contracts is necessary. Even if the entity’s governing documents provide broad, strong powers to equity investors, those powers can be transferred by contract or agreement to other parties. Governing documents and contracts will sometimes provide for kick-out rights and participation rights to equity investors and other parties. The ASC 810 guidance clearly states that these rights have no bearing on the analysis unless they can be exercised by a single party (including its de facto agents and related parties). Limited partnerships present a special challenge when evaluating decision making rights. As a general rule, the general partner controls a limited partnership. This general rule, however, does not always hold up. If the answer to this question is “YES”, the entity is a VIE.|
|Was the investment equity at risk of the entity established without substantive voting rights?||The holders of equity investment at risk are deemed to not have the power to direct the entity’s activities if their voting rights are determined to be non-substantive. Under the ASC 810 guidance, equity investors at risk do not have substantive voting rights if: 1) The voting rights of some investors are not proportional to their economic interests (based on obligations to absorb expected losses and rights to receive expected residual returns), and 2) substantially all if the legal entity’s activities are conducted for or involve the investors with disproportionately few voting rights. If the answer to this question is “YES”, the entity is a VIE.|
|Do parties other than the holders of equity investment at risk have the obligation to absorb expected losses?||Determining which parties have the obligation to absorb expected losses may be a qualitative analysis, a quantitative analysis, or both. To start, you need to identify all of the variable interests and variable interest holder of the entity. Traditionally, equity investors is exposed to the expected losses of their investment. Complex capital structures, contracts and transactions may shift this exposure to parties other than the equity investors. If equity investors at risk do not have ‘first dollar’ exposure to expected losses through arrangements made outside of the equity investment at risk instrument, then their exposure to expected losses has been diverted. A prime example of this would be an asset value guarantee in a lease that absorbs the expected losses of the asset that would otherwise be incurred by the equity investors. Alternatively, a traditional debt guarantee would probably not protect the equity investors from first dollar loss since the guarantee would normally be exercised only after equity has been exhausted. This concept applies to both direct relationships (i.e., explicit variable interests) with the legal entity and indirect relationships (i.e., implied variable interests). If the answer to this question is “YES”, the entity is a VIE.|
|Do parties other than the holders of equity investment at risk have the right to receive the residual returns?||Determining which parties have the right to receive residual returns may be a qualitative analysis, a quantitative analysis, or both. This condition addresses situations in which the equity interests’ right to receive the expected residual returns of the legal entity are capped or diverted to other parties. Participating debt, percentage leases, management fees and other arrangements shift expected residual returns away from the equity interests. and, if the shift is significant, would cause the legal entity to be a VIE. If the answer to this question is “YES”, the entity is a VIE.|
If the entity is a VIE, proceed to Step 4; otherwise, jump to Step 6 (the voting interest model).
Step 4 – Does the company, on its own or together with related parties and de facto agents as a group, have the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance?
This is a two-step evaluation. First, identify the activities of the VIE that most significantly impact the VIE’s economic performance. In most cases this is not difficult. In practice, a VIE is typically a carefully designed entity with only one or a very few activities.
Second, determine if your company has the power to direct those activities, either alone or together with related parties and de facto agents. This one is much more difficult to sort out. You need to look at the entity’s organizational and governing documents, as well as contractual rights of all interest holders, including at-risk equity holders, to determine which parties have exercisable decision-making rights and under what circumstances those rights may be exercised. The decision-making rights that matter in this analysis are those that affect the significant activities of the entity as described above. A well-designed and structured VIE will make this determination much easier. An entity with a poorly crafted structure leaves much to interpretation that will sometimes require opinion from legal counsel to sort out.
If the company, alone or together with your related parties and de facto agents, have the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance, proceed to Step 5; otherwise, jump to Step 6 (the voting interest model).
Step 5 – Does the company, alone or together with related parties and de facto agents as a group, have the obligation to absorb losses of the VIE that could potentially be significant, or the right to receive benefits from the VIE that could potentially be significant?
There is no bright line means of determining whether the losses that may be absorbed or the benefits that may be received are potentially significant. “Significant” is a subjective, qualitative evaluation. In practice, it is most often the case that a variable interest in a VIE is by definition potentially significant.
If the company alone has the obligation to absorb losses of the VIE that could potentially be significant, or the right to receive benefits from the VIE that could potentially be significant, then the company must consolidate the VIE.
If the company together with related parties and de facto agents as a group, but not the company on its own, has the obligation to absorb losses of the VIE that could potentially be significant, or the right to receive benefits from the VIE that could potentially be significant, then the company must consolidate the VIE if it is the party in the group most closely associated with the VIE.
If the company does not meet this criterion, then the proceed to Step 6 (the voting interest model).
Step 6 – Ah, familiar territory. Apply the voting interest model which basically requires that an entity consolidate another entity if it owns a majority (greater than 50%) of that other entity.
There is no longer anything easy about consolidation. The VIE analysis summarized above is compulsory for any relationship a company has with a third party. It can be onerous and time-consuming. Further, the company must monitor its relationships to determine if any reconsideration events occur subsequently that change the nature of the entity (into a VIE or the reverse), change the power structure or otherwise alter the above analysis. The GAAP Logic Variable Interest Entity Analysis tool is an excellent way to walk through the analysis requirements and produce auditable documentation. This tools does everything but the number crunching…though we even provide guidance on how to do that. Use it. It’s free!