What is a Variable Interest?

A variable interest is an investment or other interest that will absorb portions of a VIE's expected losses or receive portions of the entity's expected residual returns. Variable interests in a VIE change with changes in the fair value of the VIE's net assets, exclusive of variable interest.

The definition of variable interest dictates that the financial statement preparer must determine whether a particular item either absorbs expected losses or receives expected residual returns (collectively referred to as expected variability) or both. Only those interests that absorb changes in the fair value of an entity's net assets are considered variable interests. Changes in cash flows drive the success or failure of the entity. Thus, the cash flows create the variability in the entity. For example, ABC Equity Investment absorbs some or all of the fair value changes of VIE's assets—its variability. ABC will receive a lower return on investment if VIE generates poor cash flows. The cash flows absorb some of the entity's negative variability.

A variable interest is commonly found in:

• Equity or debt investments in a VIE,
• Financing provided to a VIE through such vehicles as guarantees or derivatives,
• A monetary arrangement with a VIE, perhaps through management or service contracts or leases, or
• Implicit relationships, particularly if a related party is involved.

ASC 810-10-55-16 through 55-41, Identifying Variable Interests, provides examples of potential variable interests. Each of the items below is potentially an explicit or implicit variable interest in an entity or in specified assets of an entity.

All of these examples potentially qualify as variable interests. However, they may vary widely in the extent of their variability, and that has a direct effect on the determination of the primary beneficiary. (Note that an interest can qualify as a variable interest but the entity in which the interest is held may not qualify as a VIE.) The identification of a variable interest can be challenging. The financial statement preparer identifies variable interests by thoroughly analyzing the assets, liabilities, and contractual arrangements of an entity.

Analyzing an Entity's Design

To address diversity in practice and provide consistency, in 2006 the FASB added a requirement to analyze an entity's design to determine the variability the entity was designed to create and distribute to the holders of the interest. This determination affects:

• Which interests are variable interests
• Whether the entity is a VIE
• Which party, if any, is the primary beneficiary. (ASC 810-10-25-21)

This “by design” assessment is applied in two steps:

1. Analyze the nature of the risks in the legal entity, including credit, interest rate, foreign currency exchange, commodity price, equity price, and operations risk. (ASC 810-10-25-24)
2. Determine the purpose for which the legal entity was created and the variabilities the legal entity is designed to create and pass along to interest holders. The role—to absorb or receive the legal entity's variability—of the contract or arrangement in the design of the legal entity determines whether the interest creates variability or absorbs variability. Generally, the assets and operations of the entity create variability and, therefore, are not variable interests. On the other hand, liabilities and equities absorb the variability and, therefore, are variable interests. (ASC 810-10-25-26)

The analyst should review:

• the activities of the legal entity,
• contract terms,
• the nature of the legal entity's interests issued,
• how those interests were negotiated or marketed to investors, and
• which parties had significant participation in the design or redesign of the legal entity.

Using the guidance, a qualitative analysis of the legal entity's design will often be sufficient to determine the variability to consider. (ASC 810-10-25-29)

Quantitative Analysis of Expected Losses, Expected Residual Returns, and Expected Variability. The current VIE model can be seen as a “power and “economics” model. However, there are some provisions in the current guidance that reference the earlier expected losses and expected residual returns model, and so it is useful to understand those concepts. Expected losses and expected returns are derived from expected cash flows as explained in CON 7, Using Cash Flow Information and Present Value in Accounting Measurement. It is important to note that expected losses and expected residual returns are not GAAP losses and income. They are statistical measures of the variability (or risk) inherent in the fair value of the entity.

This quantitative approach to analyzing the expected losses, expected residual returns, and expected variability is not required and should not be the only factor considered when determining whether the entity has the obligation to absorb significant losses or the right to receive significant benefits:

Expected losses + Expected residual returns = Expected variability

Estimating expected future cash flows. The absorbing/receiving of variability of the entity's cash flows is the sole determinant of whether an interest is a variable interest. In analyzing specific situations, the degree of variability can differ widely for each item. It is the role of the item to absorb or receive variability that distinguishes it as a variable interest. The role, in turn, often depends on the design of the legal entity. Therefore, it is critical for the financial statement preparer to understand the purpose and design of the entity being evaluated.

When estimating an entity's expected future cash flows in accordance with CON 7 a range of probability-weighted expected outcomes is used. Mathematically, this is simply a weighted-average calculation. The following example illustrates the mathematical concept of expected variability:

Initial Determination of VIE Status

Whether or not an entity qualifies as a VIE is initially determined on the date the reporting entity becomes involved with the legal entity. Involvement includes:

• Ownership,
• Contractual interest, or
• Other pecuniary interests.

This determination is based on the circumstances existing at that date, taking into account future changes that are required in existing governing documents and contractual arrangements.

Is the Reporting Entity the Primary Beneficiary?

Once the reporting entity has determined that:

1. A VIE scope exception does not apply, and
2. The reporting entity has a variable interest in the legal entity (ASC 810-10-55-16),

then, the reporting entity applies the VIE model to determine if it is the primary beneficiary and, therefore, most consolidate the variable entity.

Exhibit—Overview of the VIE Model

How to Determine If an Interest Holder is the Primary Beneficiary

Once it is determined that the reporting entity has a variable interest in a VIE, the reporting entity must determine whether it has a controlling financial interest. This assessment includes:

• The characteristics of the reporting entity's variable interests
• Other involvement, including related parties or de facto agents
• The involvement of other interest holders
• The VIE's purpose and design.

The reporting entity is a primary beneficiary and must consolidate when it has:

• The power to direct the activities that most significantly affect the economic performance of the entity, and
• The obligation to absorb losses or the right to receive benefits of the entity that could be potentially significant to the entity. (ASC 810-10-25-38A)

The primary beneficiary must consolidate the VIE regardless of the extent of ownership (or lack of it) by that entity. More than one entity may have the obligation to absorb losses or the right to receive benefits, but only one reporting entity will have the power to direct those activities of the VIE that most significantly affect the VIE's performance and, therefore, be the primary beneficiary. (ASC 810-10-25-38A) Only one enterprise should be identified as the primary beneficiary, with the determining factor being the power to direct those activities of the VIE most significantly impacting its economic performance. It is possible that no primary beneficiary can be identified.

Shared power. ASC 810 includes the concept of shared power when evaluating a primary beneficiary: Power is shared

• if two or more unrelated parties together have the power to direct the activities of a VIE that most significantly impart the VIE's economic performance, and
• if decisions about those activities require the consent of each of the parties.

If power is shared with other unrelated parties and no one party has the power to direct activities that most significantly impact the VIE's economic performance, then the reporting entity is not the primary beneficiary. (ASC810-10-25-38D)

Fees paid to decision maker. In some arrangements, a legal entity may outsource all or some decision-making over the entity's activities through a contractual arrangement. The fees received by those decision makers or service providers may represent variable interests. Decision makers or service providers may include oil and gas operators, real estate property managers, asset managers, and so forth. The decision maker or service provider must assess the fee arrangement to determine if it qualifies as a variable interest.

Currently, if a decision maker meets all six of the criteria below, it is not a variable interest. ASU 2015-02 eliminates three of the criteria as illustrated in the exhibit below.

Exhibit—Criteria to Determine Whether a Fee Paid to a Decision Maker or Service Provider Is a Variable Interest

ASU 2015-02 Changes. As can be seen in the Exhibit above, ASU 2015-02 retains the criterion to consider the level of other economic interests held by the decision maker. (ASC 810-10-25-37C above) Certain related-party interests need to be considered in assessing that criterion. A decision maker or service provider limits the extent to which related-party interests are included in Criterion C above and should consider only its direct interest plus its proportional share of the related party's or de facto agent's interests, unless the decision maker and related party are under common control. In that case, the decision maker should consider the related party's entire interest.

Related-Party Considerations in Determining the Primary Beneficiary

For the purpose of a variable interest holder determining whether it is the primary beneficiary of a VIE, the definition of related parties is expanded from the definition set forth in ASC 850, Related-Party Disclosures, to include additional parties that act as “de facto agents” or “de facto principals” of the variable interest holder. Under the VIE model, the identification of related parties and de facto agents is an important step in evaluating which party should consolidate the entity. The following table sets forth the related parties as prescribed by ASC 850 as well as additional related parties designated for this purpose in ASC 810-10-25-42 and 43:

The related-party attribution rules require consolidation of many of the currently popular SPE structures, unless the VIE is well capitalized and such subordinated support vehicles as loan guarantees are dispensed with.

Related-Party Tie Breaker

The related-party tiebreaker test helps identify which related party in a group is the primary beneficiary. If two or more related parties (including the de facto principals/agents specified above) hold variable interests in the same VIE, and the aggregate variable interests held by those parties would, if held by a single party, identify that party as the primary beneficiary, then the member of the related-party group that is most closely associated with the VIE is the primary beneficiary and is required to consolidate the VIE as a subsidiary in its financial statements. In determining which party is most closely associated with the VIE, all relevant facts and circumstances are considered, including:

1. Whether there is a principal/agent relationship between parties within the related-party group
2. The relationship of the activities of the VIE to each of the parties in the related-party group
3. The significance of the VIE's activities to each of the parties in the related-party group
4. The extent of a party's exposure to the expected losses of the VIE
5. The structure of the VIE.

Variable Interests in “Silos”

A party may hold a variable interest in specific assets of a VIE (e.g., a guarantee or a subordinated residual interest). In computing expected losses and expected residual returns, a holder of a variable interest in specified assets of a VIE must determine if the interest it holds qualifies as an interest in the VIE itself. The variable interest is considered an interest in the VIE itself if either (1) the fair value of the specific assets is more than half of the total fair value of the VIE's assets, or (2) the interest holder has another significant variable interest in the entity as a whole.

If the interests are deemed to be interests in the VIE itself, the expected losses and expected residual returns associated with the variable interest in the specified assets are treated as being associated with the VIE. (ASC 810-10-25-55)

Initial Measurement with Common Control

If the primary beneficiary of a VIE and the VIE itself are under common control, the primary beneficiary (parent) initially measures the assets, liabilities, and noncontrolling interests of the newly consolidated reporting entity at their carrying amounts in the accounting records of the entity that controls the VIE. (ASC 810-10-30-1)

Initial Measurement Absent Common Control

The rules governing the initial measurement of the assets and liabilities of a newly consolidated VIE conform closely to the rules governing other business combinations. The following table summarizes the rules.

Accounting by a Primary Beneficiary (Parent) for Initial Consolidation of a Variable Interest Entity

After initial measurement, the assets, liabilities, and noncontrolling interests of a consolidated variable interest entity are accounted for as if the entity were consolidated based on majority voting interests.

Noncontrolling Interests

If there are other (noncontrolling) interests, these are shown in the consolidated balance sheet as minority interests, and likewise a share of the operating results of the VIE are allocated to the noncontrolling interests in the consolidated statements of income (operations). A noncontrolling interest represents the portion of equity (or net assets) in a subsidiary (VIE) that is not directly or indirectly attributable to a parent (primary beneficiary). Thus parent companies of subsidiaries that are VIEs are required to fully record the noncontrolling interest's share of VIE losses even if recording these losses results in a deficit in noncontrolling interest. ASC 810-10-45 requires that the noncontrolling interest be reported within the equity section of the consolidated statement of financial position, separately from the equity of the parent company, and clearly identified with a caption such as “noncontrolling interest in subsidiaries.” Should there be noncontrolling interests attributable to more than one consolidated subsidiary, the amounts may be aggregated in the consolidated statement of financial position.

Only equity-classified instruments issued by the subsidiary may be classified as equity in this manner. If, for example, the subsidiary had issued a financial instrument that, under applicable GAAP, was classified as a liability in the subsidiary's financial statements, that instrument would not be classified as a noncontrolling interest since it does not represent an ownership interest.

Sufficiency of Equity Investment at Risk

ASC 810-10-25-45 et seq. provides a 10% equity threshold test, which in practice is confusing and unworkable. The guidance indicates that an at-risk equity investment of less than 10% of the entity's total assets is presumptively not considered sufficient to permit the entity to finance its activities without obtaining additional subordinated financial support but then goes on to provide that the presumption of insufficiency can be overcome by either quantitative analysis, qualitative analysis, or both. Consequently, financial statement preparers could mistakenly rely on the 10% presumption to conclude that an entity with less than 10% at-risk equity is a VIE, when in fact, further analysis would contradict that conclusion. Conversely, the interpretation indicates that it is also possible that an entity can require at-risk equity of more than 10% in order to sufficiently finance its activities. Consequently, the financial statement preparer also cannot rely on meeting or exceeding the 10% threshold as conclusive proof that the entity is sufficiently capitalized to avoid being characterized as a VIE.

ASC 810-10-25 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among the parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed.

Implicit variable interests. One of the most misunderstood aspects of this area of the literature is referred to as an implicit variable interest. The FASB staff attempts to clarify this matter in ASC 810-10-25-49 through 54 and ASC 810-10-55-88 through 89.

A party that did not explicitly issue a direct guarantee of another party's obligation may, nevertheless, be held to be an implicit guarantor of that obligation and thus, hold a variable interest in the party whose debt is implicitly guaranteed.

Other Lease Terms and Provisions

The following discussion examines the effect that certain changes to the above facts would have on the foregoing conclusions:

Existence or absence of guarantees. Even if the stockholder/member's guarantee of the mortgage is not required by the lender and only the lessee guaranteed the debt, the analysis above would be identical. Due to the fact that the lessee/variable interest holder is exposed to the expected losses of the lessor under the terms of the guarantee, the lessor/LLC's sole member (and at-risk equity holder) is not the only party that potentially would absorb expected losses of the lessor.

Conversely, when ASC 810 was originally issued, many observers initially believed if the lessee was not required by the lender to guarantee the mortgage, and the only guarantee was that of the stockholder/member, that the absence of an explicit variable interest held by the lessee would preclude the conclusion that the lessor was a VIE.

This situation illustrates one of the most misunderstood provisions of ASC 810—referred to as an implicit variable interest—which the FASB staff attempts to clarify in ASC 810-10-25-49 et seq.

Even though the lessee did not directly guarantee the debt of the lessor, consideration must be given to the likely scenarios if the lessor/LLC should be close to a default on the mortgage payments. Realistically, what is the likelihood that the sole stockholder/sole member would perform under his or her personal guarantee obligation rather than directing the lessee to pay additional rent sufficient to enable the LLC to keep its mortgage payments current?

Clearly, it would not make economic sense for the sole stockholder/member to perform personally under the guarantee, as this would, in substance, result in the stockholder/member making a loan or capital contribution to an otherwise insolvent LLC. Instead, it would logically follow that the best course of action would be for the lessee to pay rent in amounts adequate to fund the LLC's mortgage payments so that the lessee would continue to have use of the leased premises without concern over whether the bank will foreclose on and sell the property to a third party. If the lessee were having difficulty funding the rent payments, its owner would probably authorize it to borrow money or sell assets in order to enable it to do so before its owner used personal funds to perform under the guarantee.

After analyzing this situation, with appropriate attention to the substance rather than simply its form, it can be seen that the lessee is the holder of an implicit variable interest in the lessor in the form of an implicit guarantee of the lessor's mortgage debt.

The remainder of the analysis would be identical to what was presented earlier. Due to the fact that the lessee/variable interest holder is exposed to the expected losses of the lessor under the terms of the implicit guarantee, the lessor/LLC's sole member (and at-risk equity holder) is not the only party that potentially would absorb expected losses of the lessor.

Finally, consider the situation where neither the lessee nor the owner is required to guarantee the debt. A prudent lender would probably not waive both guarantees unless the lessor was sufficiently capitalized by the owner's at-risk equity. That is, there is a presumption that the lessor in such an instance is not a VIE. Under this scenario, the lessee would perform the quantitative analysis required to estimate expected losses and estimated residual returns to determine whether the lessor is a VIE and, if it is, whether it is the primary beneficiary.

Above- or below-market rentals. Rentals due under related-party leases sometimes exceed arm's-length market rentals because the owner is using the lessor as a conduit for the lessee to indirectly provide additional salary or dividends to the owner (characterized as the excess rent).

Under ASC 810, an operating lease is generally not considered to be a variable interest unless:

1. The lease terms include a lessee residual guarantee of the fair value of the leased asset, since this results in the lessee potentially absorbing estimated negative variability that would otherwise be absorbed by the equity holder of the lessor.
2. The lease terms include an option for the lessee to purchase the property at the end of the lease term at a specified price, since this means that the lessee potentially may receive estimated positive variability that would otherwise be received by the equity holder of the lessor.
3. The lease terms are not indicative of market terms for a similar property in the same geographic location, since this would result in the lessee either receiving estimated positive variability of the lessor (if the lease terms were below market) or absorbing negative variability of the lessor (if the lease terms were above market).

Under each of the foregoing scenarios, the lease is considered a variable interest in determining the primary beneficiary, because the expected losses of the lessor that would be borne by the lessee (the excess of the rentals required over the fair value of the right to use the leased property) exceed the amounts that would have been expected had the rentals been at fair value. Thus, the stockholder/member would not be considered to have a controlling financial interest, since s/he was not the only party exposed to the lessor's expected losses.

If the situation reversed, and the rentals were below market amounts, it could be logically concluded that the lessor was absorbing negative variability of the lessee and that, therefore, the lease was a variable interest in the lessee held by the lessor that could potentially result in the lessor being considered the primary beneficiary of the lessee that would necessitate the lessor consolidating the lessee in its financial statements.

Other contractual arrangements. Leases are often accompanied by other contractual arrangements between the lessee and lessor. Such contractual arrangements can include management, marketing, brokerage, and other types of service agreements. These agreements must be carefully analyzed, as ASC 810 provides restrictive rules that often result in such agreements being characterized as variable interests.

All parties affected by these transactions should seek expert professional advice prior to either structuring a new transaction or modifying an existing transaction. For example, adverse income tax consequences could result from the transfer of property from one form of ownership to another.

Parent-Only Financial Information

Parent company-only financial statements are unacceptable. However, there are circumstances where parent-only financial information is needed. An acceptable way to present the parent information is with columns or parent and subsidiaries with a consolidated column. Where individual investors or unconsolidated subsidiaries have control, the financial statements may be combined. Combined financial statements are the same as consolidated financial statements, except no one entity has control.

Differences in Fiscal Year-End

If the difference between parent and subsidiary fiscal year ends is less than three months, it is feasible to consolidate. If the difference is greater than three months, it is usually acceptable to use the subsidiary's financial statements and disclose in notes interim events that materially affect the results of operations or financial position. (ASC 810-10-45-12)

ASC 810-10-45 and ASC 810-10-50 state that the following scenarios constitute voluntary changes in accounting principle that are subject to the accounting and disclosure rules in ASC 250:

1. A consolidated entity changes its fiscal year-end to alter or eliminate a difference between its year-end and the fiscal year-end of the entity that consolidates it in its financial statements (the parent or ASC 810 primary beneficiary).
2. An investee that is accounted for by an investor using the equity method changes its fiscal year-end to alter or eliminate a difference between its year-end and the fiscal year-end of the equity method investor.

Retrospective application is not required if it is impracticable to do so. (See chapter in this volume on ASC 250.)

Combined Financial Statements

While the presentation of consolidated financial statements is required under GAAP, there is no parallel requirement to present combined financial statements for entities under common control (brother/sister entities). However, in certain cases, it is desirable that combined financial statements be prepared for such entities. This process is very similar to an accounting consolidation using pooling accounting, except that the equity accounts for the combining entities are carried forward intact.

The financial statements of a combined group of commonly controlled entities or commonly managed entities are presented as those of a single economic entity. The combined group does not include the parent. (ASC 810-10-20)

Limited partnership is a VIE

If the investee entity is a variable interest entity (VIE) under the provisions of ASC 810, the holders of interests in the entity must use the guidance applicable to those interests. If the investor has a controlling financial interest in the VIE, the investor is deemed to be the entity's primary beneficiary (analogous to a parent company) and is required to consolidate the investee in its financial statements.

Noncontrolling interest holders in an LP that is a VIE are to account for their interests using the equity method or the cost method. Limited partner interests that are so minor that the limited partner has virtually no influence over operating and financial policies of the partnership are accounted for using the cost method. (ASC 970-323) To be considered to be this minor, the SEC staff has indicated that an interest would not be permitted to exceed 3–5%. (ASC 323-30-S99) In practice, this benchmark is also generally accepted for non-SEC registrants, since it represents the most authoritative guidance currently available with respect to making this determination.

Limited Partnership is not a VIE

If the LP is not a VIE and the partners are not subject to specialized industry fair value accounting rules, a determination is made as to whether a single general partner or multiple general partners control the LP. If a single general partner controls the LP, that partner is consolidates the LP. All other general partners apply the equity method of accounting to their investments, and the limited partners use either the cost method (for minor investments) or the equity method, as previously discussed.

If more than one general partner controls the partnership, ASC 810-20 provides the framework for analyzing the respective legal and contractual rights and privileges associated with each owner/investor's interests to determine control. For the purpose of applying ASC 810-20, entities under common control are considered to be a single general partner. No guidance is offered, however, in ASC 810-20 as to how to determine which of several general partners should consolidate the partnership.

Kick-Out Rights

ASC 810 includes the concept of “kick-out rights” which, when held by limited partners, gives them the right to eject the general partner(s) of the partnership, thereby (often) preventing the general partner(s) from exercising control. ASC 810-20 holds that there is a refutable presumption that general partners in a partnership have control, regardless of their actual ownership percentage. This presumption can be overcome if the limited partners have certain defined abilities.

If the limited partners have the substantive ability to dissolve (liquidate) the limited partnership or otherwise remove the general partners without cause—which is referred to as “kick-out rights”—then the general partners are deemed to lack control over the partnership. In such cases, consolidated financial reporting would not be appropriate, but equity method accounting would almost inevitably be warranted. To qualify, the kick-out rights must be exercisable by a single limited partner or a simple majority (or fewer) of limited partners. Thus, if a super-majority of limited partner votes is required to remove the general partner(s), this would not constitute a substantive ability to dissolve the partnership and would not thwart control by the general partner(s).

There is a range of possible qualifying requirements to exercise kick-out rights that could lead to the conclusion that nominal kick-out rights are ineffective in precluding the general partner(s) from exercising control. ASC 810-20 offers a series of illustrative examples to help the preparer interpret this guidance and should be consulted to benchmark any real-world set of circumstances. Examples of barriers to the exercise of kick-out rights include:

1. Conditions that make it unlikely the rights will be exercisable (e.g., conditions that narrowly limit the timing of the exercise)
2. Financial penalties or operational barriers associated with dissolving (liquidating) the limited partnership or replacing the general partners that would act as a significant disincentive for dissolution (liquidation) or removal
3. The absence of an adequate number of qualified replacements for the general partners or the lack of adequate compensation to attract a qualified replacement
4. The absence of an explicit, reasonable mechanism in the limited partnership agreement or in the applicable laws or regulations, by which the limited partners holding the rights can call for and conduct a vote to exercise those rights
5. The inability of the limited partners holding the rights to obtain the information necessary to exercise them.

A limited partner's unilateral right to withdraw is pointedly not equivalent to a kick-out right. However, if the partnership is contractually or statutorily bound to dissolve upon the withdrawal of one partner, that would equate to a kick-out right.

ASC 810-20 also addresses “participating rights” held by the limited partners, which it contrasts to “protective rights” as these are first defined in ASC 810. Limited partners' rights (whether granted by contract or by law) that would allow the limited partners to block selected limited partnership actions would be considered protective rights and would not overcome the presumption of control by the general partners(s).

Among the actions cited by ASC 810-20 as illustrating protective (not participating) rights are:

1. Amendments to the limited partnership agreement
2. Pricing on transactions between the general partners and the limited partnership and related self-dealing transactions
3. Liquidation of the limited partnership initiated by the general partners or a decision to cause the limited partnership to enter bankruptcy or other receivership
4. Acquisitions and dispositions of assets that are not expected to be undertaken in the ordinary course of business (note that limited partners' rights relating to acquisitions and dispositions expected to be made in the ordinary course of the limited partnership's business are participating rights)
5. Issuance or repurchase of limited partnership interests.

The presence of protective rights does not serve to overcome the presumption of control by the general partner(s). Substantive participating rights, on the other hand, do overcome the presumption of general partner control. Such rights could include:

1. Selecting, terminating, and setting the compensation of management responsible for implementing the limited partnership's policies and procedures
2. Establishing operating and capital decisions of the limited partnership, including budgets, in the ordinary course of business.

ASC 810-20 states that determination of whether the presumption of general partner control is overcome is a “facts and circumstances” assessment to be made in each unique situation. For example, depending on which decisions are required to be put to a full vote of the partnership (as opposed to being reserved for the general partner), the limited partners may be found to have substantive participating rights. Another important factor weighing on this determination: the relationships among limited and general partners (using ASC 850 related-party criteria).

The assessment of the extent of limited partners' rights and the impact those have on the presumption of general partner‘(s)’ control over the partnership (for consolidated financial reporting purposes) is to be made upon initial acquisition of the general partner's interest or formation of the partnership, and again at each financial reporting (i.e., statement of financial position) date.

Limited partnerships controlled by the general partners. As previously stated, the general partners are collectively presumed to be in control of the limited partnership and, if this is substantively the case, the accounting for the general partners depends on whether control of the entity rests with a single general partner. If a single general partner controls the limited partnership, that general partner consolidates the limited partnership in its financial statements. If no single general partner controls the limited partnership, each general partner applies the equity method to account for its interest. (ASC 810-20)

Noncontrolling limited partners account for their interests using the equity method or by the cost method. As previously discussed, limited partner interests that are so minor (not to exceed 3–5%) that the limited partner has virtually no influence over operating and financial policies of the partnership would be accounted for using the cost method. (ASC 970-323)

Limited partnerships controlled by the limited partners. If the presumption of control by the general partners is overcome by applying ASC 810-20 and the limited partners control the partnership, the general partners would use the equity method to account for their interests in the partnership.

If there is a controlling limited partner, that partner would consolidate the limited partnership in its financial statements. Noncontrolling limited partners would follow the same guidance provided above that applies when the general partners control the partnership (i.e., use the equity method unless the interest is minor—in which case the cost method would be used).

ASC 2015-02 Changes to ASC 810-20

ASU 2015-02 eliminates Subtopic 810-20, changes some guidance, and merges the guidance with Subtopic 810-10.

Because of their unique design and purpose, ASU 2015-02 adds a requirement for limited partnerships and similar entities, like limited liability companies governed by a managing member. The evaluation of whether an entity should be treated as a limited partnership or as a corporation requires judgment.

To demonstrate that a limited partnership is a voting entity, the partners or members must have:

• Kick-out rights
• Participating rights.

These rights give the partners or members rights that are comparable to the voting rights of corporate shareholders. However, even if these rights are present, the limited partnership might still be a VIE under one of the other VIE characteristics.

If a limited partnership is determined to be a VIE and the general partner meets the power and economics tests to avoid consolidation, the general partner would need a single party kick-out or participating right over all the entity's most significant activities. The right must be unilaterally exercisable.

ASU 2015-02 removes the presumption that the general partner should consolidate a limited partnership. It also amends the definition of kick-out rights to include removal rights and liquidation rights. The liquidation rights are the ability to dissolve the entity.

In order to demonstrate that the limited partnership is not a VIE, those rights must be substantive. They are substantive only if exercisable by a simple majority vote of the entity's limited partners or as low as a single limited partner.

The substance of the kick-out rights might be questionable if there are economic or operational barriers to exercising them, such as:

• Conditions making it unlikely they will be exercised
• The rights are subject to financial penalties
• The rights are subject to operational barriers
• There is an inadequate number of qualified replacements
• The level of compensation paid to the decision maker is not enough to attract a replacement
• No explicit mechanism exists to allow the holder to exercise the right or obtain the information necessary to exercise the rights.

Substantive participating rights held by at least one limited partner demonstrate that the partnership is a voting entity. For this purpose, ASU 2015-02 defines participating rights as rights to block or participate in significant financial and operating decisions made in the ordinary course of business. This is consistent with the voting entity model. Current standards contain guidance for assessing whether the participating rights are substantive. Note that redemption rights held by the limited partners are not considered.

Sponsored Research and Development Activities

ASC 810-30-55 discusses the accounting for a transaction in which a sponsor creates a wholly owned subsidiary with cash and rights to certain technology originally developed by the sponsor, and receives from the newly created subsidiary two classes of stock. The sponsor then distributes one of the classes of stock (e.g., Class A) to its stockholders. This class of stock has voting rights. Under a purchase option, the sponsor has the right, for a specified period of time, to repurchase all the Class A stock distributed to the stockholders for an exercise price approximating the fair value of the Class A shares. The class retained by the sponsor (e.g., Class B) conveys essentially no financial interest to the sponsor and has no voting rights other than certain blocking rights. The certificate of incorporation prohibits the subsidiary from changing its capital structure, from selling any significant portion of its assets, and from liquidating or merging during the term when the purchase option is outstanding.

The sponsor and the subsidiary enter into a development contract that requires the subsidiary to spend all the cash contributed by the sponsor for research and development activities mutually agreed upon with the sponsor. The subsidiary has no employees other than its CEO. The subsidiary contracts with the sponsor to perform, on behalf of the sponsor, all of the research and development activities under the development contract.

The sponsor accounts for the research and development contract as follows:

• The sponsor reclassifies the cash contributed to the subsidiary as restricted cash when the Class A shares are distributed to its stockholders.
• The distribution of the Class A shares by the sponsor to its stockholders is accounted for as a dividend based on the fair value of the shares distributed.
• In the financial statements of the sponsor, the Class A shares are presented similar to a minority interest.
• The sponsor recognizes research and development expense as the research and development activities are conducted.
• The research and development expense recognized by the sponsor is not allocated to the Class A shares in determining net income or in calculating earnings per share.
• If the Class A purchase option is exercised, the sponsor accounts for the purchase as the acquisition of a minority interest.
• If the Class A purchase option is not exercised by its expiration date, the sponsor reclassifies the Class A stock to additional paid-in capital as an adjustment of the original dividend.

The effect of the above guidance is quite similar to what would be achieved by consolidating the subsidiary.