The consolidation and reporting of related entities can be a complicated accounting topic, particularly for private companies that use separate legal entities to manage a diverse network of businesses and business interests. Often, these companies manage and fund a network of legal entities via a single parent company or through a small group of related entities, which this article refers to as “entities under common control” or “common control entities.”
In determining consolidation requirements, private companies that are members of a common control group must apply the complex guidance of Accounting Standards Codification (ASC) Topic 810, Consolidation, and its related amendments. This article discusses ASC 810’s consolidation guidance with a specific focus on the application of that guidance for common control entities. It summarizes the history of FASB’s consolidation guidance (for list of relevant standards, see Exhibit 1), provides a brief discussion of the relevant amendments, and concludes with a discussion of a recent proposed Accounting Standards Update (ASU), Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities.
Relevant Accounting Standards on Consolidation for Common Control Entities
Overview of Consolidation Guidance
The challenges associated with consolidating controlled companies have existed for a long time. Formal accounting guidance was first issued in 1959 with the release of Accounting Research Bulletin (ARB) 51, Consolidated Financial Statements. ARB 51 requires a company to consolidate any affiliate for which the company retains a direct or indirect controlling financial interest. A controlling financial interest is defined as an investment of 50% or more of the voting equity of another entity (or related group of entities). Therefore, in accordance with ARB 51, a company that holds 50% or more of the voting equity of an affiliate is viewed as the controlling parent company and should include the affiliate (or affiliated group) in its consolidated financial statements.
In accounting jargon, ARB 51 codified the “voting interest model” (VOE). Under a VOE model, the entity with the majority ownership interest retains significant influence over the way in which the affiliate manages its operations, and the controlled affiliate should therefore be included in the financial statements of its majority interest investor. ARB 51’s guidance presumes that the controlling parent would exercise its voting power to prevent the affiliate from entering transactions that the parent’s management views as being contrary to its own best interest or contrary to the best interest of the controlled group.
As one might assume, companies have developed very complex approaches for financing and administering the activities of their affiliated legal entities. Many of these approaches render the guidance contained in ARB 51 ineffective for ensuring that the controlling investor is properly consolidating affiliates for which it retains significant controlling influence. ARB 51’s guidance is particularly ineffective when a parent entity maintains control over its affiliate in an ownership structure different from the VOE approach, such as without retaining a direct majority ownership interest in its affiliate. Therefore, FASB’s guidance regarding consolidation of affiliated entities has evolved beyond the ARB 51 VOE model.
In consideration of these types of arrangements, FASB, in 2003, issued FASB Interpretation 46 (revised December 2003), Consolidation of Variable Interest Entities [FIN 46(R)]. FIN 46(R) provides criteria for classifying an investee/affiliate as a variable interest entity (VIE), rather than as a VOE, a distinction that must be determined at the inception of the arrangement. In designating an investee/affiliate as either a VIE or a VOE, the key considerations are the funding structure arranged for the legal entity and the related rights, risks, and rewards of the equity investors relative to one another and relative to other subordinated financing received by the legal entity.
In addition to developing criteria for classifying the investee/affiliate, FIN 46(R) established guidance for identifying the equity investor responsible for consolidating a VIE. In general, under FIN 46(R), an equity investor consolidates the VIE when that investor retains a majority interest in the VIE’s expected losses or a majority interest in the VIE’s residual returns. If the equity interest investor retaining a majority interest in VIE’s residual returns differs from the equity interest investor retaining a majority interest in its expected losses, FIN 46(R) requires the latter to consolidate the VIE.
Under FIN 46(R), the consolidating entity is designated as the “primary beneficiary,” a term that is still used to identify the consolidating entity. In determining the primary beneficiary, FIN 46(R) requires equity investors in a VIE to include the equity investments of any related parties as its own direct investment: “For purposes of determining it is the primary beneficiary of a VIE, a reporting entity with a variable interest shall treat the variable interest in the same VIE held by its related parties as its own interests.” (par. 16)
In 2009, FASB issued Statement of Financial Accounting Standards (SFAS) 167, Amendments to FIN 46(R). SFAS 167 retains the primary beneficiary notion but moves away from FIN 46(R)’s “risks and rewards”–based consolidation model. Instead, SFAS 167 establishes consolidation requirements for VIEs based on both a qualitative, rather than quantitative, assessment of an equity investor’s control over significant activities of the VIE and the equity investor’s retention of certain rights and obligations that are disproportionate to that investor’s investment.
SFAS 167 is codified in ASC 810-10. Therefore, the remainder of this article refers to ASC 810-10.
ASC 810-10 and Consolidation of a Variable Interest Entity
ASC 810-10 retains the ARB 51 notion that the investor with the controlling financial interest should consolidate the investee/affiliate. It also retains the FIN 46(R) notion that, for some investor/investee relationships, the traditional voting interest approach may not be sufficient for identifying “the party with a controlling financial interest.”
According to ASC 810-10, an investee is identified as a VIE when “its equity investors do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support or, as a group, the holders of the entity’s equity investment at risk lack any one of the following three characteristics:
- a. The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance
- b. The obligation to absorb the expected losses of the entity
- c. The right to receive the expected residual returns of the entity.”
If, after considering the VIE criteria, an equity interest investor determines that the investee/affiliate is not a VIE, the investor should consider using the VOE model.
ASC 810-10 also establishes consolidation requirements related to investments in a VIE. It says that an equity interest investor consolidates a VIE when it retains an investment in the entity, is considered a variable interest investor in the entity, and is the primary beneficiary of the entity. An investor in a VIE is a “variable interest beneficiary” when, per an arrangement’s governing documents, the investor will absorb a portion of the VIE’s expected losses or will receive a portion of the entity’s “residual returns.” The variable interest beneficiary retaining a controlling financial interest in the VIE is designated as its “primary beneficiary” and must consolidate the VIE.
ASC 810-10 explains that a variable interest beneficiary retains a “controlling financial interest” in a VIE when that beneficiary retains the power to direct the activities of the VIE that have the greatest influence over the VIE’s economic performance and retains an obligation to absorb the VIE’s significant losses or the right to receive benefits from the VIE that could potentially be significant to the VIE. Investees in a VIE must determine their status as a variable interest beneficiary when they enter into their investor relationship.
ASC 810-10 states that only one reporting entity is expected to be identified as the primary beneficiary. Accordingly, it establishes a detailed list of criteria for identifying and designating the primary beneficiary. Exhibit 2 lists those criteria. In addition, ASC 810-10 says that when evaluating whether a reporting entity is the primary beneficiary, consideration must be given not only to that entity’s interest in the VIE but also to the variable interests held by its related parties “in the same VIE … as its own interests.” This guidance was retained from FIN 46(R).
ASC 810-10 Criteria for Identifying the Primary Beneficiary among a Group of Variable Interest Beneficiaries
Obviously, for common control entities, ASC 810-10’s consolidation model has significant implications for identifying the entity within a common control group that might be required to consolidate an interest identified as a VIE.
Common Control Entities and Consolidating a VIE
In determining whether an entity meets its VIE consolidation guidance, ASC 810-10-25 extends the definition of related parties to include those entities or others acting as “agents or de facto principals” of an equity investor, including a party that—
- requires subordinated financial support to finance its operations, such as another VIE in which the reporting entity is a primary beneficiary;
- receives its interest via a loan or a contribution from the reporting entity;
- is an officer, employee, or member of the governing board of the reporting entity; or
- maintains either an agreement that it cannot sell, transfer, or otherwise encumber its interest in the VIE without prior approval from the reporting entity, or maintains a close business relationship, such as a relationship between a professional service firm or one of its significant clients. ASC 810-10-25-43d states that the “the right of prior approval creates a de facto agency relationship only if that right constrains the other party’s ability to manage the economic risks or realize the economic rewards from its investment in a VIE through the sale, transfer, or encumbrance of those interests.”
Thus, where a VIE is a component of a related party group, even if no single reporting entity meets the definition of its primary beneficiary, one of the related party entities might be required to consolidate the VIE (i.e., the one with cumulative power, within the group, to direct the activities of the VIE that most significantly impact its economic performance).
In addition, if the reporting entity and its related parties, as a group, meet the definition of a primary beneficiary, then the entity within the group that is “most closely associated with the VIE” will be classified as the primary beneficiary and will be required to consolidate the VIE (ASC 810-10-25-44). Determining the entity within the related party group that is most closely associated with the VIE is subjective and should be based on an analysis of all relevant fact and circumstances, including the following:
- The existence of a principal-agency relationship between parties within the related party group
- The relationship and significance of the VIE’s activities to various members within the related party group
- A party’s exposure to variability of the VIE’s economic performance
- The VIE’s design.
Amendments to ASC 810
After establishing the VOE/VIE consolidation model in ASC 810, FASB and the Private Company Council, a FASB advisory group focusing on application of FASB guidance to nonpublic companies, issued several amendments. ASU 2014-07, Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements, allows the reporting entity/lessee to elect not to apply VIE guidance to a lessor entity under common control. Under ASC 2014-07, a private company can elect to apply the exception to VIE guidance when—
- the lessee and lessor are private companies and are common control entities,
- the lessee has a lease arrangement with the lessor,
- substantially all the activities between the lessee and the lessor are leasing activities, and
- the lessee explicitly guarantees or provides collateral for any obligation of the lessor related to the leased asset, and the principal amount of the obligation at inception of such guarantee or collateral arrangement does not exceed the value of that leased asset.
If the private company/lessee elects this exemption, it is also exempted from the related VIE disclosures regarding its relationship with the lessor entity. In that instance, ASU 2014-07 includes separate disclosure requirements related to the leasing arrangements with its common control affiliate.
Those lessees electing the ASU 2014-07 VIE exemption must apply that election to all current and future lessor entities under common control that meet its criteria. If the exemption is elected, it should be applied retrospectively to all periods presented.
Issued in February 2015, ASU 2015-02, Consolidation (Topic 810): Amendments to Consolidation Analysis, modified the evaluation of whether legal entities like limited partnerships are VIEs or VOEs, eliminated the presumption that a general partner should consolidate a limited partnership, clarified the implications of fee arrangements and related party relationships when considering the consolidation implications of reporting entities that are involved with VIEs, and provided a scope exception from consolidation guidance for reporting entities with interests in legal entities that are subject to requirements like those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds.
Prior to the issuance of this amendment, ASC 810-10 required a reporting entity to consider the interests in a VIE held by its related parties as though those interests belonged to the reporting entity when determining the VIE’s primary beneficiary. ASU 2015-02 revised that guidance to permit a single decision maker to consider the interest held by its related parties indirectly on a proportionate basis, rather than considering those investments as its own interests.
For the single decision maker, completing this “indirect evaluation” fulfills the primary beneficiary assessment. After considering the interest held by related parties indirectly and on a proportionate basis, if the common control group has characteristics of a primary beneficiary, it must consider the related party relationship in its entirety—that is, determine collectively whether the common control group retains a controlling financial interest in the VIE. Then, after considering the collective financial interests of the common control group, if the group is not classified as the primary beneficiary, it must evaluate whether a single variable interest holder in that group represents the primary beneficiary. And of course, if it determines that substantially all of the VIE’s activities are conducted on behalf of a member of the controlled group, that single variable interest holder consolidates the VIE.
Common Control Entities and Consolidation of VIEs
After issuing ASU 2015-02, FASB, working with the Private Company Council (PCC), identified some additional difficulties associated with applying the amended guidance of ASC 810-10, particularly for entities under common control. At public hearings and its periodic meetings, the PCC discussed a common control situation for which applying the VIE accounting can be challenging. The example involves a three-party related party group:
- Company A and its affiliates/subsidiaries Unit B and Unit C.
- Company A holds a 100% equity investment in Unit B and in Unit C.
- Unit C was established to vertically integrate its production activities with Unit B. It is an operating company that has a bank loan with Local Bank Company.
- Unit B is an operating company that has a bank loan with a different bank, Regional Bank, Inc. In addition, Unit B purchases 90% of Unit C’s products.
- Periodically, Unit B has “bailed out” Unit C when it was under financial stress.
In presenting this example, FASB staff asked accountants to answer the following questions: 1) Is Unit C a VIE? 2) Assuming Unit C is a VIE, based on guidance in ASC 810, who is the primary beneficiary—Company A or Unit B?
According to a FASB staff memo, in general, respondents classified Unit C as a VIE, mainly because of its insufficient funding and Unit B’s periodic bailout of Unit C. Although many respondents agreed that Unit C meets the VIE definition, several other respondents indicated that the information provided was not sufficient to answer the question.
Under the assumption that Unit C is a VIE, respondents agreed that Unit B was the primary beneficiary of Unit C. Despite that observation, some argued that, for the given fact pattern, a case could be made that the primary beneficiary is Company A, the 100% equity-holder for Unit B and Unit C. On this point, the staff memo states:
Each respondent stated that [Unit B] would likely be the primary beneficiary, but also acknowledged that some arguments exist for [Company A] being the primary beneficiary. Arguments on why [Unit B] would be the primary beneficiary differed between practitioners from the large accounting firms and practitioners from regional and midsize accounting firms (Staff Memo, Nov. 20, 2015, page 7).
In general, respondent viewpoints differed over how they reached their decision; those from large firms interpreted and applied the guidance in ASC 810, while their counterparts in regional and mid-sized firms advocated a “common sense” approach that focused on which entity retained the risks and rewards associated with the VIE and on their opinions concerning the value of issuing consolidated financial statements in situations involving entities under common control. In such situations, these respondents suggested that providing consolidated financial statements represents the default conclusion, irrespective of the technical nuances of the accounting guidance. (At a 2016 PCC public meeting, the author of this article, along with several other participants, made a similar argument.)
The FASB staff discussed other examples involving application of ASC 810 VIE guidance, after which they concluded that 1) when applied correctly, accountants agree with the reporting results provided by ASC 810; 2) diversity in practice exists in the application of ASC 810 for transactions involving VIEs, particularly among regional and midsize firms, and 3) in accounting for transactions involving VIEs, particularly for entities under common control, accountants prefer consolidation of subsidiaries with the majority equity owner, irrespective of the ASC 810 guidance.
After additional outreach, including several town hall style meetings, FASB issued proposed ASU, “Consolidation (Topic 810)—Interest Held Through Related Parties That Are under Common Control,” which amends guidance regarding the application of VIE rules for entities under common control. The proposal clarified the evaluation for determining the primary beneficiary of a VIE in situations involving a reporting entity and its related parties, which are entities held under common control. Under the proposal’s approach, one would conclude that Unit C is a VIE, Unit B is the primary beneficiary and in stand-alone financial statements would consolidate the VIE, and Company A would consolidate both Unit B and Unit C for consolidated reporting purposes.
FASB received 18 comment letters on the proposal. While offering additional suggestions for improving financial reporting for VIEs, most commenters agreed with the proposal. They noted that the clarification in the proposal would require a reporting entity (i.e., Company A in the example), in evaluating whether it is a primary beneficiary of a VIE, to include all its direct variable interests and, on a proportionate basis, the indirect variable interests held by its related parties of that VIE.
After reviewing comments received on the proposal, and after further deliberations between FASB and the PCC, FASB finalized its guidance in October 2016 in ASU 2016-17, Consolidation (Topic 810): Interests held through Related Parties that are under Common Control. ASU 2016-17 amends ASC 810-10 to specify that, in determining its financial interest in a VIE, an entity should consider its direct interest in the VIE and, “on a proportionate basis, its indirect variable interests in a VIE held through related parties, including related parties that are under common control with the reporting entity.”
If the reporting entity concludes that its direct and indirect interest establishes it as the primary beneficiary, the reporting entity consolidates the VIE. Otherwise, the reporting entity and its related party affiliates held under common control must evaluate their interest, and if it is determined that as a group they meet the characteristics of a primary beneficiary, they must determine the entity within the common control group that “most closely” retains the characteristics of a primary beneficiary.
In substance, by amending the ASU 2015-02 guidance, ASU 2016-17 makes it less likely that a reporting entity will be required to consolidate a VIE when it retains only a minor indirect economic interest in the VIE via a nonconsolidating interest held in a common control affiliate.
Clearly, for common control groups with investees that meet the VIE definition, applying the ASC 810-10 guidance is complex and subject to significant judgment. In considering these issues, FASB recently issued a proposed ASU, “Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities.” According to the proposed amendment, a private company would not have to apply the ASC 810-10 VIE guidance to affiliates under common control if both the parent and the investee/affiliate being evaluated for consolidation are not public business entities. Instead, the common control group could apply an accounting alternative allowing the private company to provide detailed disclosures about its involvement with and exposure to the investee/affiliate under common control. To apply the disclosure alternative, both the controlling entity and its investee/affiliate must not be public business entities. The comment deadline for the proposed ASU was September 5, 2017. Currently, FASB is redeliberating the issue and considering the comments received.