ASU 2016-17

In October 2016, the FASB issued narrow-scope amendments to consolidation guidance: ASU 2016-17, Consolidation (Topic 810) Interests Held Through Related Parties That Are Under Common Control.

Applying the Scope Guidance

If a reporting entity is within the scope of the VIE Subsections, that entity should apply the VIE guidance first. If not, then the reporting entity should determine whether it has a direct or indirect controlling financial interest. (ASC 810-10-15-3) For legal entities other than limited partnerships, this is defined as more than 50%. There are circumstances where an entity may hold a majority voting interest, but may not have a controlling interest, that is, the power to control the operations or assets of the investee. This is called a noncontrolling majority interest and may happen through a contract, lease, agreement with other stockholders, or court decrees. For limited partnerships, the usual condition for a controlling financial interest is ownership by one limited partner of more than 50% of the limited partnership's kick-out rights through voting interests. Control may exist by contract, lease, agreement with partners, or by court decrees. (ASC 810-10-15-8) Also see information on VIEs within scope according to ASC 810-10-15-14.

If the reporting entity has a contractual management relationship that is not a VIE, the reporting entity should use the guidance in the 810-10 Subsections, Consolidations of Entities Controlled by Contract, to determine if the arrangement is a controlling financial interest. (ASC 810-10-15(e))

Exhibit—Determining Scope and Scope Exceptions (ASC 810-10-15-3)

General Scope Exceptions

For entities that are not in the scope of the VIE subsection, a reporting entity should consolidate all entities in which the parent has a controlling financial interest, except:

• If the subsidiary:
  • Is in a legal reorganization
  • Is in bankruptcy
  • Operates under “foreign exchange restrictions, controls, or other governmentally imposed uncertainties, so severe that they cast significant doubt on the parent's ability to control the subsidiary”
  • Is a broker dealer within the scope of ASC 940 and control is likely to be temporary.
• If the power of the majority voting interest shareholder or limited partner with majority of kick-out rights through voting interest is restricted by rights given to the noncontrolling shareholder or limited partners (noncontrolling rights) and are so restrictive that it is questionable whether control exists with majority owners.
• If control exists other than through ownership of a majority voting interest or a majority of kick-out rights through voting interests.

  (ASC 810-10-15-10)

The guidance in ASC 810 does not apply to:

• An employee benefit plan subject to ASC 712, Nonretirement Postemployment Benefits, or to ASC 715, Retirement Benefits.
• An investment company within the scope of Topic 946 that is not an investment company.
• A governmental organization.
• A financing entity established by a governmental organization, unless the financing entity meets both of the following conditions:
  • It is not a governmental organization, and
  • It is used by a business entity in a manner similar to a VIE to attempt to circumvent VIE accounting rules.
• Money market funds registered with the SEC pursuant to Rule 2a-7 of the Investment Company Act of 1940, that is, registered money market funds and those legal entities that are similar in purpose and design.
• Similar unregistered money market funds.

  (ASC 810-10-15-12)

Variable Interest Entities Within Scope

VIEs follow the same scope and scope exceptions as in the general subsection, except as specified below. (ASC 810-10-15-13) The VIE model applies when the reporting entity has a variable interest in a legal entity. Any legal entity that, by design,¹ possesses one of the following characteristics is subject to consolidation under the VIE guidance:

1. The entity is thinly capitalized. The total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from either the existing equity holders or other parties. Normally, the equity provided by shareholders is sufficient to support operations. For this purpose, the total equity investment at risk:
   1. Includes only equity investments in the entity that participate significantly in profits and losses even if those investments do not carry voting rights.
   2. Does not include equity interests that the entity issued in exchange for subordinated interests in other variable interest entities.
   3. Does not include amounts provided to the equity investor directly or indirectly by the entity or by other parties involved with the entity (for example, by fees, charitable contributions, or other payments), unless the provider is a parent, subsidiary, or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor.
   4. Does not include amounts financed for the equity investor (for example, by loans or guarantees of loans) directly by the entity or by other parties involved with the entity, unless that party is a parent, subsidiary, or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor.
2. Equity holders lack the ability to direct the activities. For other than limited partnerships, that significantly affect the entity's economic performance, the investors do not have that ability through voting rights or similar rights if no owners hold voting rights or similar rights (such as those of a common stockholder in a corporation or a general partner in a partnership). Limited partners lack power if a simple majority is not able to exercise substantive kick-out rights or participating rights over the general partner.
3. Reporting entity lacks the obligation to absorb the expected losses of the entity. Conventionally, the investors are exposed to the risks of ownership. The investor or investors do not have that obligation if they are directly or indirectly protected from absorbing the expected losses or are guaranteed a return by the entity itself or by other parties with whom the entity is involved.
4. Reporting entity lacks the right to receive expected residual returns of the entity. Conventionally, the investors enjoy the benefit of ownership. The investors do not have that right if their benefits are limited to a specified maximum amount by the entity's governing documents or arrangements with other variable interest holders or with the entity.

5. The entity was established with nonsubstantive voting interest. The guidance contains what can be thought of as an anti-abuse clause. This is designed to prevent an entity from structuring in a way that allows the sponsor to avoid consolidation under the VIE mode. This provision includes a two conditions, both of which must be met:

   • The distribution of economic benefits generated by the entity is proportional to equity ownership and voting rights.
   • Substantially all of the entity's activities either involve or are conducted on behalf of a party that has disproportionally low voting rights relative to economic interest.

   (ASC 810-10-15-14)

Variable Interest Entities Scope Exceptions

As is clear from the above, a VIE differs from a voting interest entity because the VIE is structured in a way that voting rights are ineffective in determining which party has a controlling interest. In a VIE, control of an entity is achieved through arrangements that do not involve voting equity. The following are excluded from the scope of the subtopics and sections of ASC 810-10 governing variable interest entities (VIEs):

• Not-for-profit entities unless the entity was organized to avoid VIE status. It is important to note, however, that a not-for-profit organization can be a related party for the purpose of determining the primary beneficiary (parent) of a VIE by applying ASC paragraphs 810-10-25-42 through 44.
• Separate accounts of life insurance entities.
• An entity created prior to December 31, 2003, for which, after expending “exhaustive efforts,” management of the variable interest holder is unable to obtain information needed to determine whether the entity is a VIE, determine whether the holder is the primary beneficiary, or make the required accounting entries required to consolidate the VIE.
• Entities that meet the definition of a business do not have to be evaluated by a variable interest holder to determine whether they are VIEs unless one or more of the following conditions exists:
  • The variable interest holder and/or its related parties/de facto agents² (de facto agents are discussed later in this chapter) participated significantly in the design or redesign of the entity. This factor is not considered when the entity is an operating joint venture jointly controlled by the variable interest holder, and either one or more independent parties, or a franchisee.
  • The design of the entity results in substantially all of its activities either involving or being conducted on behalf of the reporting entity and its related parties.
  • Based on the relative fair values of interests in the entity, the variable interest holder and its related parties provide more than half of its total equity, subordinated debt, and other forms of subordinated financial support.
  • The entity's activities relate primarily to one or both of the following:
    • Single-lessee leases
    • Securitizations or other forms of asset-backed financings.

    (ASC 810-10-15-17)

The above requirements for scope exceptions for businesses can be difficult to meet.

Alternative Approach for Measuring the Financial Assets and the Financial Liabilities of a Consolidated Collateralized Financing Entity

An entity may measure the financial assets and financial liabilities of a qualifying collateralized financial entity (CFE) using either the fair value of the financial assets or the financial liabilities, whichever is more observable. (ASC 810-10-30-11)

Entities that elect this option are relieved from independently measuring the fair value of the financial assets and financial liabilities. Entities that do not elect the alternative must attribute any differences in the fair value to the controlling interest holder in the consolidated income statement.

An entity may use the alternative if it meets both of the following conditions:

1. All of the financial assets and the financial liabilities of the collateralized financing entity are measured at fair value in the consolidated financial statements under other applicable Topics, other than financial assets and financial liabilities that are incidental to the operations of the collateralized financing entity and have carrying values that approximate fair value (for example, cash, broker receivables, or broker payables).
2. The changes in the fair values of those financial assets and financial liabilities are reflected in earnings.

   (ASC 810-10-15-17D)

This guidance is applied using:

• A modified retrospective approach by recording a cumulative-effect adjustment to equity as of the beginning of the annual period of adoption or
• A retrospective approach by applying the changes retrospectively to all relevant prior periods beginning with the annual period of initial adoption.

ASC 810-30, Research and Development Arrangements

ASC 810-30 is limited to those research and development arrangements in which all of the funds for the research and development activities are provided by the sponsor of the research and development arrangement. It does not apply to either:

• Transactions in which the funds are provided by third parties, which would generally be within the scope of Subtopic 730-20.
• Legal entities required to be consolidated under the guidance on variable interest entities.

  (ASC 810-30-15-3)

Analyzing an Entity's Design

The Codification requires an analysis of 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 810-10-25-22 and 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 810-10-25-22 and 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.(ASC 810-10-25-25)

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:

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. (ASC 810-10-25-37)

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.

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. A de facto agency relationship does not exist if both the reporting entity and the party have the right of prior approval and those rights are agreed to by willing, independent parties who mutually agree on the terms. The following table lists the related parties as described in 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 design of the VIE.

   (ASC 810-10-25-44)

Sufficiency of Equity Investment at Risk

ASC 810-10-25-45 through 25-47. 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. The guidance then goes on to say that the presumption of insufficiency can be overcome by either quantitative analysis, qualitative analysis, or both. Financial statement preparers must be careful not to 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, it is also possible that an entity can require at-risk equity of more than 10% in order to sufficiently finance its activities. 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 Codification attempts to clarify this matter in ASC 810-10-25-49 through 54.

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.

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.

Protective Rights

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). The presence of protective rights does not serve to overcome the presumption of control by the general partner(s).

Among the actions illustrating protective (not participating) rights are:

1. Amendments to the articles of incorporation or partnership agreements
2. Pricing on transactions between the owner of a majority interest or limited partner with a majority kick-out right through voting interests and the investee and related self-dealing transactions
3. Liquidation of the investee or a decision to cause the investee 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 noncontrolling rights relating to acquisitions and dispositions expected to be made in the ordinary course of business are participating rights)
5. Issuance or repurchase of equity interests.

   (ASC 810-10-25-10)

Substantive Participating Rights

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.

The two types of noncontrolling rights listed below are considered substantive participating rights and overcome the majority interest presumption of control:

1. Selecting, terminating, and settling the compensation of management responsible for implementing the investee's policies and procedures.
2. Establishing operating, and capital decision of the investee in the ordinary course of business.

Changes not Affecting Control

The treatment of changes not affecting control are detailed in the Disclosure and Presentation Checklist for Commercial Businesses at www.wiley.com/go/GAAP2018; references to ASC 810-10-45-22 through 45-24.

Changes Resulting in Loss of Control

This guidance does not apply to sales of real estate or the conveyance of oil and gas mineral rights. Refer to ASC 360-20 and 976-605⁴ for the appropriate guidance for real estate, and to ASC 932-360 for oil and gas mineral rights. (ASC 810-10-40-3A)

If a parent company ceases to have a controlling financial interest in a subsidiary, the parent is required to deconsolidate the subsidiary as of the date on which its control ceased. Examples of situations that can result in a parent being required to deconsolidate a subsidiary include:

1. Sale by the parent of all or a portion of its ownership interest in the subsidiary resulting in the parent no longer holding a controlling financial interest,
2. Expiration of a contract that granted control of the subsidiary to the parent,
3. Issuance by the subsidiary of stock that reduces the ownership interest of the parent to a level not representing a controlling financial interest,
4. Loss of control of the subsidiary by the parent because the subsidiary becomes subject to control by a governmental body, court, administrator, or regulator.

If a parent effects a deconsolidation of a subsidiary through a nonreciprocal transfer to owners, such as through a spin-off transaction, the transaction is accounted for under ASC 845-10. Otherwise, the parent is to account for the deconsolidation by recognizing, in net income, a gain or loss attributable to the parent. (ASC 810-10-40-5) The gain or loss is measured as follows:

Should the parent's loss of controlling financial interest occur through two or more transactions, management of the former parent should consider whether the transactions should be accounted for as a single transaction. In evaluating whether to combine the transactions, management of the former parent should consider all of the terms and conditions of the transactions as well as their economic impact. The presence of one or more of the following indicators may lead to management concluding that it should account for multiple transactions as a single transaction:

1. The transactions are entered into simultaneously or in contemplation of one another,
2. The transactions, when considered in tandem, are in substance a single transaction designed to achieve an overall commercial objective,
3. The occurrence of one transaction depends on the occurrence of at least one other transaction,
4. One transaction, when considered on its own merits, does not make economic sense, but when considered together with the other transaction or transactions would be considered economically justifiable.

   (ASC 810-10-40-6)

Obviously, this determination requires the exercise of sound judgment and attention to economic substance over legal form.

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.