FASB issues revisions to consolidation guidance
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In February 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2015-02, Consolidation (Topic 810)—Amendments to the Consolidation Analysis. The ASU is intended to make targeted improvements to the consolidation guidance in U.S. generally accepted accounting principles (GAAP), and was issued in response to certain concerns expressed about that guidance. Stakeholders were concerned about situations in which the legacy consolidation guidance provided information that was not useful and that sometimes resulted in users requesting supplemental deconsolidating financial statements so as to provide a basis on which to analyze the reporting entity’s economic and operational results.
Under the consolidation guidance in U.S. GAAP, there are primarily two consolidation models, both of which are focused on determining whether a reporting entity has a controlling financial interest in another entity. The first model applied by a reporting entity is the variable interest entity (VIE) consolidation model. If the VIE consolidation model is not applicable, then a reporting entity applies the voting interest consolidation model. Under the VIE consolidation model, a reporting entity has a controlling financial interest in a VIE if it has: (a) the power to direct the activities of the VIE that most significantly affect the VIE’s economic performance (the “power criterion”) and (b) the obligation to absorb losses or the rights to receive benefits that could be significant to the VIE (the “economics criterion”). Under the voting interest consolidation model, a controlling financial interest generally exists if a reporting entity has a majority voting interest in another entity. In certain circumstances, the power to control may exist when one entity holds less than a majority voting interest (e.g., because of contractual provisions or agreements with other shareholders).
While the overall approach to consolidation under U.S. GAAP is not affected by the ASU, certain aspects of applying that approach were changed by the ASU, including the following:
VIE consolidation model
- Evaluation of fees paid to a decision maker or a service provider as a variable interest
- Determination of the primary beneficiary of a VIE when fee arrangements exist
- Treatment of related parties in the VIE consolidation model
- Consolidation of certain investment funds
Both the VIE and voting interest consolidation models
- Consolidation of limited partnerships and similar legal entities
RSM’s middle market insights
Middle market companies should benefit from the changes introduced by the ASU easing application of the VIE consolidation model. Those changes should alleviate some stakeholders’ concerns over the legacy consolidation guidance providing information that was not useful and the need to provide supplemental deconsolidating financial statements.
The ASU is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. For all other entities, the ASU is effective for fiscal years beginning after December 15, 2016, and for interim periods within fiscal years beginning after December 15, 2017. Early adoption is permitted.
Additional information about the impact of the ASU on the legacy consolidation guidance as well as transitioning to the guidance in the ASU is provided in the remainder of this summary.
Evaluation of fees paid to a decision maker or a service provider as a variable interest
Under the legacy VIE consolidation model, if a fee paid to an entity’s decision maker(s) or service provider(s) meets all of the following conditions from paragraph 810-10-55-37 of the FASB’s Accounting Standards Codification (ASC), that fee is not a variable interest:
a. The fees are compensation for services provided and are commensurate with the level of effort required to provide those services.
b. Substantially all of the fees are at or above the same level of seniority as other operating liabilities of the VIE that arise in the normal course of the VIE’s activities, such as trade payables.
c. The decision maker or service provider does not hold other interests in the VIE that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE’s expected losses or receive more than an insignificant amount of the VIE’s expected residual returns.
d. The service arrangement includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arm’s length.
e. The total amount of anticipated fees are insignificant relative to the total amount of the VIE’s anticipated economic performance.
f. The anticipated fees are expected to absorb an insignificant amount of the variability associated with the VIE’s anticipated economic performance.
The ASU eliminates conditions (b), (e) and (f). Additionally, the ASU clarifies how condition (c) should be applied such that when a decision maker or service provider evaluates whether its fee is a variable interest, it is only required to consider its direct interests plus its proportionate share of interests held by de facto agents or related parties (rather than the entire interests held by these other parties). However, when the decision maker and the related party are under common control, the decision maker is required to consider the related party’s entire interest, rather than the proportionate share.
The expectation is that the changes to ASC 810-10-55-37 will result in fewer fee arrangements being considered variable interests. In addition, the changes may impact consolidation decisions that were based on interests held by related parties.
Determination of the primary beneficiary of a VIE when fee arrangements exist
Under the VIE consolidation model (both before and after the ASU), a decision maker is the primary beneficiary of a VIE if it meets both the power criterion and the economics criterion discussed earlier. The VIE consolidation model requires that a decision maker include a fee arrangement in its determination of the primary beneficiary if it is a variable interest.
The ASU excludes from the evaluation of the economics criterion most fees paid to a decision maker that are both customary and commensurate with the level of effort required for the services provided. In contrast, these fees were included in the evaluation of the economics criterion under the legacy VIE consolidation model. As a result, it is possible that a reporting entity that previously had consolidated a VIE might be required to deconsolidate it. Such an effect might arise if the conclusion under the legacy VIE consolidation model had been based on the significance of the fee. Under the ASU, even if that fee is significant, it would not be considered in the determination of whether the decision maker meets the economics criterion when the fee is commensurate with the services provided, and the arrangement includes only terms, conditions or amounts that are customarily present in arrangements for similar services.
Treatment of related parties in the VIE consolidation model
Under the legacy VIE consolidation model, a reporting entity determines whether it meets the power and economics criteria by giving consideration only to its own variable interests in the VIE. The ASU changes that. The ASU refers to a single reporting entity that meets the power criterion as a single decision maker. When a single decision maker is determining whether it is the primary beneficiary of a VIE, that single decision maker should include its own direct economic interests in the VIE, as well as any indirect economic interests held by related parties. The indirect economic interests held by related parties should be considered proportionally under the ASU, rather than entirely. For example, if Reporting Entity A (a single decision maker) owns a 40 percent equity interest in Entity B, and Entity B owns a 25 percent interest in the VIE, Reporting Entity A should include its effective interest of 10 percent (40 percent multiplied by 25 percent) in the VIE when evaluating whether it meets the economics criterion.
The ASU introduces another change to the way related parties affect the application of the legacy VIE consolidation model. The consequence of this change is that the so-called “related party tiebreaker” test will be performed in fewer situations.
Under the legacy VIE consolidation model, if a reporting entity reaches a conclusion that neither it nor one of its related parties individually meets the power and economics criteria, but they meet those criteria as a group, the related party tie breaker test is performed to identify the party that is most closely associated with the VIE. The party that is identified as most closely associated with the VIE is the primary beneficiary of the VIE.
Under the ASU, the related party tiebreaker test is only applied in the following situations:
- A single decision maker does not exist
- A single decision maker exists because the power criterion is met, but it does not individually meet the economics criterion; however, a group of related parties that is under common control with the single decision maker meets the power and economics criteria
In addition to the changes to the related party tiebreaker test, the ASU also requires that if the power criterion is met by a single decision maker, but substantially all of the VIE’s activities involve, or are conducted on behalf of, a single variable interest holder, that single variable interest holder is the primary beneficiary and should consolidate the VIE.
Consolidation of certain investment funds
The ASU rescinds the indefinite deferral of FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R), which was included in ASU 2010-10, Consolidation (Topic 810): Amendments for Certain Investment Funds, for a reporting entity’s interest in money market funds. It replaces the deferral with a scope exception for a reporting entity’s interest in an entity that is required to comply with or operate in accordance with requirements similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. Reporting entities that have interests in funds that qualify for this exception are not required to evaluate those interests under the VIE consolidation model, but are required to disclose: (a) any financial support that they provided to the funds during the periods presented and (b) any arrangements to provide support to the funds.
Entities that previously qualified for the deferral, but do not qualify for the scope exception in the ASU, will have to be evaluated under the VIE consolidation model to determine if they are VIEs that should be consolidated.
Consolidation of limited partnerships and similar legal entities
With respect to consolidating limited partnerships and similar legal entities, the ASU:
- Introduces an additional requirement that limited partnerships and similar legal entities must meet to qualify as voting interest entities (rather than VIEs). To be considered a voting interest entity, a limited partnership must provide limited partners with either: (a) substantive kick-out rights or (b) substantive participating rights over the general partner. If the limited partners in a limited partnership have neither of those rights, then the limited partnership is classified as a VIE. Kick-out rights or participating rights are substantive if they can be exercised by a simple majority vote (or a lower threshold) of the unrelated limited partners.
- Eliminates the specialized consolidation model and guidance for limited partnerships and similar entities. The ASU eliminates the limited partnership model that was introduced by Emerging Issues Task Force Issue 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights. As a result, it eliminates the presumption that a general partner should consolidate a limited partnership.
- Indicates that when a limited partnership or similar entity qualifies as a voting interest entity, the limited partner with a controlling financial interest should consolidate the limited partnership.
For entities that are not VIEs, it is expected that these changes will result in: (a) more limited partnerships being considered VIEs and (b) fewer general partners being required to consolidate as primary beneficiaries.
Effective date and transition
The amendments in the ASU are effective for public business entities for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2015. For all other entities, the amendments in the ASU are effective for fiscal years beginning after December 15, 2016, and for interim periods within fiscal years beginning after December 15, 2017.
Early adoption is permitted, including adoption in an interim period. If a reporting entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period.
A reporting entity may apply the amendments in the ASU using a modified retrospective approach by recording a cumulative-effect adjustment to equity as of the beginning of the fiscal year of adoption. A reporting entity also may apply the amendments retrospectively.
A reporting entity that is required to consolidate a VIE as a result of the initial application of the ASU should initially measure the assets, liabilities and noncontrolling interests of the VIE at the amounts at which those items would have been carried in the consolidated financial statements if the requirements of the ASU had been in effect when the reporting entity first became the primary beneficiary, provided that determination of those amounts is practicable. If determination of those amounts is not practicable, the reporting entity should measure those items at their fair values at the date that the ASU first applies.
The ASU also allows a reporting entity to apply the fair value option included in ASC 825, Financial Instruments. However, if the reporting entity elects the fair value option, it must apply the option to all financial assets and financial liabilities of the VIE that are eligible for the option.
A reporting entity that is required to deconsolidate a legal entity as a result of the initial application of the ASU should measure the retained interest in the deconsolidated entity at the retained interest that would have been carried if the ASU had been in effect when the reporting entity became involved with the legal entity or no longer met the conditions to consolidate the legal entity, provided that determination of those amounts is practicable. If determination of those amounts is not practicable, the retained interest should be measured at its fair value at the date the ASU first applies.