Consolidation and the Variable Interest Model

Transcription

1 Financial reporting developments A comprehensive guide Consolidation and the Variable Interest Model Determination of a controlling financial interest Revised June 2013

2 To our clients and other friends Several years after the Financial Accounting Standards Board (FASB) revised the Variable Interest Model in its consolidation guidance, we continue to see some common misconceptions. The Variable Interest Model is complex, and knowing when and how to apply it can be challenging. Consolidation evaluations always begin with the Variable Interest Model, which applies to all legal entities, with certain limited exceptions. The Variable Interest Model has continued to evolve over the years in response to the needs of users of financial statements. While quantitative analyses are still present in the model, it has become increasingly more qualitative. The existing model, which was established in 2009, focuses on identifying the enterprise with power to make the decisions that most significantly impact an entity s economic performance. That power may be exercisable through equity interests or other means. In addition, with the FASB s current Exposure Draft, Consolidation (Topic 810): Principal versus Agent Analysis, we can expect consolidation guidance to continue to evolve. The FASB issued its consolidation exposure draft in November 2011, and comments were due in February This exposure draft would rescind the current FAS 167 deferral (ASU ) for certain investment funds, which remain subject to FIN 46(R) and would more closely align consolidation guidance in US GAAP with IFRS. The exposure draft would apply to all enterprises, including asset managers (and similar entities). The exposure draft would require a decision maker (e.g., an asset manager, a general partner) of a variable interest entity or voting partnership to evaluate three factors to determine whether it is using its power as a principal or as an agent. A decision maker that acts as a principal is deemed to have a controlling financial interest, and would therefore consolidate the entities it controls. A decision maker that acts as an agent on behalf of and for the benefit of another party or parties generally does not have a controlling financial interest in the entity. The consolidation exposure draft also would more closely align the Voting Model s consideration of kick-out and participating rights with the Variable Interest Model. Readers should continue to monitor developments in this area closely as the FASB continues to redeliberate its exposure draft. We have updated this Financial reporting developments publication to help you navigate through the Variable Interest Model. We added an overview that highlights the basics of the model and some common misconceptions. In an effort to provide a more comprehensive publication on consolidation guidance, we also added an appendix on applying the Voting Model. We have also provided updates on recent standard-setting activities and further clarifications and enhancements to our interpretative guidance. This publication includes excerpts from and references to the FASB s Accounting Standards Codification, interpretive guidance and examples. We hope this publication will help you understand and apply the consolidation models in ASC 810. We are also available to discuss any particular questions that you may have. June 2013 Financial reporting developments Consolidation and the Variable Interest Model

3 Contents 1 Overview The models Variable Interest Model Voting Model Navigating the Variable Interest Model Does a scope exception to consolidation guidance (ASC 810) apply? Does a scope exception to the Variable Interest Model apply? Does the enterprise have a variable interest in a legal entity? Is the legal entity a VIE? If the legal entity is a VIE, is the enterprise the primary beneficiary? Summary IFRS convergence Definitions of terms Legal entity Controlling financial interest Expected losses, expected residual returns and expected variability Kick-out rights Participating rights Protective rights Primary beneficiary Related parties and de facto agents Subordinated financial support Variable interest entity Variable interests Voting interest entity Consideration of substantive terms, transactions and arrangements Scope Introduction Legal entities Common arrangements/entities subject to the Variable Interest Model Portions of entities Collaborative arrangements not conducted through a separate entity Majority-owned entities Application of Variable Interest Model to tiered structures Fiduciary accounts, assets held in trust Scope exceptions to consolidation guidance Employee benefit plans Employee benefit plans not subject to ASC 712 or Employee stock ownership plans Deferred compensation trusts (e.g., a rabbi trust) Financial reporting developments Consolidation and the Variable Interest Model i

4 Contents Applicability of the Variable Interest Model to the financial statements of employee benefit plans Service providers to employee benefit plans Investment companies Variable interests in investment companies FASB standard-setting update Exposure Draft, Consolidation (Topic 810): Principal versus Agent Analysis ASU , Financial Services Investment Companies (Topic 946): Amendments to the Scope, Measurement and Disclosure Requirements SOP 07-1 considerations if adopted before its deferral Governmental entities Governmental financing vehicles Scope exceptions to the Variable Interest Model Not-for-profit organizations Not-for-profit organizations used to circumvent consolidation Not-for-profit organizations as related parties Separate accounts of life insurance enterprises Information availability Business scope exception Definition of a business Significant participation in the design or redesign of an entity Determining whether an enterprise holds a variable interest in an operating joint venture Determining whether an enterprise holds a variable interest in a franchisee Substantially all of the activities of an entity either involve or are conducted on behalf of an enterprise An enterprise and its related parties have provided more than half of an entity s subordinated financial support Evaluation of variability and identifying variable interests Introduction Step-by-step approach to identifying variable interests Step 1: Determine the variability an entity was designed to create and distribute Consideration 1: What is the nature of the risks in the entity? Certain interest rate risk Terms of interests issued Subordination Consideration 2: What is the purpose for which the entity was created? Step 2: Identify variable interests Consideration 1: Which variable interests absorb the variability designated in Step 1? Consideration 2: Is the variable interest in a specified asset of a VIE, a silo or a VIE as a whole? Financial reporting developments Consolidation and the Variable Interest Model ii

5 Contents 5.3 Compute expected losses and expected residual returns Illustrative examples of variable interests Equity investments Beneficial interests and debt instruments Trust preferred securities Derivative instruments Common derivative contracts Forward contracts Total return swaps Embedded derivatives Financial guarantees, written puts and similar obligations Purchase and supply contracts Operating leases Lease prepayments Local marketing agreements and joint service agreements in the broadcasting industry Local marketing agreements Joint service agreements Purchase and sale contracts for real estate Netting or offsetting contracts Implicit variable interests Fees paid to decision makers or service providers FASB standard-setting update Condition (a): Fees are commensurate with the level of effort required Condition (b): Substantially all of the fees are at or above the same level of seniority as other operating liabilities of the VIE Condition (c): Other interests held by a decision maker or service provider in a VIE Condition (d): Service arrangement includes only customary terms and conditions Condition (e) and (f): Total anticipated fees and their variability are insignificant relative to the anticipated economic performance and variability of the VIE Related parties in evaluating fees paid to a decision maker or service provider Reconsideration of a decision maker s or service provider s fees as variable interests Consideration of quantitative analysis in evaluating fees paid to a decision maker or service provider as variable interests Considerations when a decision maker concludes its fee does not represent a variable interest Variable interests in specified assets Silos Introduction Determining whether the host entity is a VIE when silos exist Effect of silos on determining variable interests in specified assets Relationship between specified assets and silos Financial reporting developments Consolidation and the Variable Interest Model iii

6 Contents 7 Determining whether an entity is a VIE Introduction The entity does not have enough equity to finance its activities without additional subordinated financial support Forms of investments that qualify as equity investments Determining whether an equity investment is at risk Equity investment participates significantly in both profits and losses Equity interests that were issued by the legal entity in exchange for subordinated interests in other VIEs Amounts provided to the equity investor directly or indirectly by the legal entity or by other parties involved with the legal entity Amounts financed for the equity holder directly by the legal entity or by other parties involved with the legal entity Other examples of determining equity investments at risk Methods for determining whether an equity investment at risk is sufficient % test a misnomer The legal entity can finance its activities without additional subordinated financial support The legal entity has at least as much equity invested as other entities that hold only similar assets of similar quality in similar amounts and operate with no additional subordinated financial support The amount of equity invested in the legal entity exceeds the estimate of the legal entity s expected losses based on reasonable quantitative evidence Illustrative examples Development stage entities Assessment of a development stage entity as a potential VIE The equity holders, as a group, lack the characteristics of a controlling financial interest FASB standard-setting update Ability to make decisions and consideration of kick-out rights, participating rights and protective rights Step 1: Consider purpose and design Step 2: Identify the activities that most significantly impact the entity s economic performance Steps 3 and 4: Identify how decisions about significant activities are made and the party or parties that make them Determining whether a general partner s at-risk equity investment is substantive Consider kick-out rights, participating rights and protective rights Effect of decision makers or service providers when evaluating ASC (b)(1) Franchise arrangements when evaluating ASC (b)(1) Illustrative examples Financial reporting developments Consolidation and the Variable Interest Model iv

7 Contents Obligation to absorb an entity s expected losses Common arrangements that may protect equity investments at risk from absorbing losses Disproportionate sharing of losses Variable interests in specified assets or silos Illustrative examples Right to receive an entity s expected residual returns Disproportionate sharing of profits Variable interests in specified assets or silos Illustrative examples Legal entity established with non-substantive voting rights Condition 1: Disproportionate votes to economics Condition 2: Substantially all of a legal entity s activities either involve or are conducted on behalf of an investor that has disproportionately few voting rights Related party and de facto agent considerations Illustrative examples Initial determination of VIE status Primary beneficiary determination Introduction Power Step 1: Consider purpose and design Involvement with the design of the VIE Step 2: Identify the activities that most significantly impact the VIE s economic performance Steps 3 and 4: Identify how decisions about significant activities are made and the party or parties that make them Related party considerations Situations in which no party has the power over a VIE Shared power Power conveyed through a board of directors and no one party controls the board Multiple unrelated parties direct the same activities that most significantly impact the VIE s economic performance Multiple unrelated parties direct different activities that most significantly impact the VIE s economic performance Different parties with power over the entity s life cycle Evaluating rights held by the board of directors and an operations manager in an operating entity Kick-out rights, participating rights and protective rights FASB standard-setting update Kick-out rights Participating rights Protective rights Potential voting rights (e.g., call options, convertible instruments) Benefits Evaluating disproportionate power and benefits Other frequently asked questions Financial reporting developments Consolidation and the Variable Interest Model v

8 Contents 9 Determining the primary beneficiary in a related party group Introduction Factors to consider Principal-agency relationship Relationship and significance of a VIE s activities to members of a related party group Exposure to variability associated with the anticipated economic performance of the VIE Purpose and design One member of a related party group not clearly identified Related parties and de facto agents Related parties De facto agents A party that has an agreement that it cannot sell, transfer or encumber its interests in the VIE without the prior approval of the reporting enterprise One-sided versus two-sided restrictions Common contractual terms Right of first refusal Right of first offer Approval cannot be unreasonably withheld A party that has a close business relationship Separate accounts of insurance enterprises as potential related parties Reconsideration events Reconsideration of whether an entity is a VIE Common VIE reconsideration events Conversions of accounts receivables into notes Transfer of an entity s debt between lenders Asset acquisitions and dispositions Distributions to equity holders Replacement of temporary financing with permanent financing Adoption of accounting standards Incurrence of losses that reduce the equity investment at risk Acquisition of a business that has a variable interest in an entity Bankruptcy Loss of power or similar rights Reconsideration of whether an enterprise is the primary beneficiary Initial measurement and consolidation Introduction Primary beneficiary and VIE are under common control Primary beneficiary of a VIE that is a business Primary beneficiary of a VIE that is not a business Contingent consideration in an asset acquisition when the entity is a VIE that does not constitute a business Other considerations Form 8-K and pro forma reporting requirements Financial reporting developments Consolidation and the Variable Interest Model vi

9 Contents Form 8-K and SEC Regulation S-X Rules 3-05 and 3-14 reporting requirements Pre-existing hedge relationships under ASC Continuation of leveraged lease accounting by an equity investor in a deconsolidated lessor trust Accounting after initial measurement Introduction Intercompany eliminations and attribution of net income or loss Attribution to noncontrolling interests held by preferred shareholders Attribution of net income or loss in an asset-backed financing entity Primary beneficiary s acquisition of noncontrolling interest Accounting for liabilities after initial consolidation Deconsolidation Presentation and disclosures Presentation Disclosures Disclosure objectives Primary beneficiaries of VIEs Holders of variable interests in VIEs that are not primary beneficiaries Primary beneficiaries or other holders of interests in VIEs Scope-related disclosures Aggregation of certain disclosures Public company MD&A disclosure requirements Effective date and transition Effective date FAS 167 deferral for certain investment funds FASB standard-setting update Asset management funds Attributes of an investment company Obligation to fund losses Entities not subject to the deferral Continuous evaluation of the deferral A money market fund (MMF) Disclosures Transition Recognition Initial measurement when an enterprise consolidates an entity Reconsideration events Fair value option Practicability exceptions Initial measurement when an enterprise deconsolidates an entity No practicability exception available when deconsolidating an entity Retrospective application SEC registration requirements following the adoption of FAS Table of selected financial data in Form 10-K Financial reporting developments Consolidation and the Variable Interest Model vii

10 Contents A Expected losses and expected residual returns... A-1 A.1 Introduction... A-1 A.2 Expected losses, expected residual returns and expected variability... A-1 A.3 Calculating expected losses and expected residual returns... A-2 A.3.1 Effect of variable interests in specified assets or silos... A-5 A.4 Allocation of expected losses and expected residual returns... A-5 A.5 Reasonableness checks... A-10 A.6 Approaches to calculate expected losses and expected returns... A-11 A.6.1 Fair value, cash flow and cash flow prime methods... A-12 A Fair value method... A-12 A Cash flow method... A-13 A Cash flow prime method... A-13 A.7 Inability to obtain the information... A-17 A.8 Example analysis of sufficiency of equity... A-17 B Affordable housing projects... B-1 B.1 Summary of the tax credit... B-1 B.2 Summary of the investment... B-1 B.3 Primary beneficiary considerations... B-3 C Voting Model and consolidation of entities controlled by contract... C-1 C.1 Introduction... C-1 C.2 Voting Model: Consolidation of corporations... C-4 C.2.1 Exceptions to consolidation by a majority owner... C-4 C Circumstances when more than a simple majority is required for control... C-6 C.2.2 Evaluating indirect control... C-7 C.2.3 Evaluating call options, convertible instruments and other potential voting rights... C-9 C.2.4 Control when owning less than a majority of voting shares... C-10 C Evaluating size of minority investment relative to other minority investors... C-10 C.2.5 Evaluating the effect of noncontrolling rights... C-10 C Participating rights... C-12 C Evaluating the substance of noncontrolling rights... C-14 C Protective rights... C-16 C.3 Voting Model: Control of limited partnerships and similar entities... C-17 C.3.1 Scope of ASC s consolidation guidance... C-18 C Limited liability companies (LLCs)... C-20 C Application when there are multiple general partners in a limited partnership... C-21 C Application to brokers and dealers in securities... C-21 C.3.2 Evaluating the substance of kick-out rights including liquidation rights... C-21 C What constitutes without cause?... C-22 C Ability of any single limited partner to remove the general partner... C-23 C Evaluating limited partners that are related parties or are under common control... C-24 Financial reporting developments Consolidation and the Variable Interest Model viii

11 Contents C Ability of a simple majority of limited partners to remove the general partner... C-24 C Evaluating the significance of barriers to exercise kick-out rights... C-27 C Difference between withdrawal rights and liquidation rights... C-28 C Withdrawal right may qualify as a substantive kick-out right... C-29 C.3.3 Substantive participating rights vs. protective rights... C-29 C Participating rights... C-29 C Determining whether participating rights are substantive... C-31 C Evaluating participating rights individually or in the aggregate... C-33 C.3.4 Evaluating protective rights... C-34 C.3.5 Initial assessment and reassessment of limited partners rights... C-35 C.4 Control by contract... C-36 D Abbreviations used in this publication... D-1 E Index of ASC references in this publication... E-1 F Other publications... F-1 G Summary of important changes... G-1 Financial reporting developments Consolidation and the Variable Interest Model ix

12 Contents Notice to readers: This publication includes excerpts from and references to the FASB Accounting Standards Codification (the Codification or ASC). The Codification uses a hierarchy that includes Topics, Subtopics, Sections and Paragraphs. Each Topic includes an Overall Subtopic that generally includes pervasive guidance for the topic and additional Subtopics, as needed, with incremental or unique guidance. Each Subtopic includes Sections that include numbered Paragraphs. Thus, a Codification reference includes the Topic (XXX), Subtopic (YY), Section (ZZ) and Paragraph (PP). Throughout this publication, references to guidance in the Codification are shown using these reference numbers. References are also made to certain pre-codification standards (and specific sections or paragraphs of pre-codification standards) in situations in which the content being discussed is excluded from the Codification or to distinguish the Variable Interest Model under FAS 167 from FIN 46(R). This publication has been carefully prepared, but it necessarily contains information in summary form and is therefore intended for general guidance only; it is not intended to be a substitute for detailed research or the exercise of professional judgment. The information presented in this publication should not be construed as legal, tax, accounting or any other professional advice or service. Ernst & Young LLP can accept no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. You should consult with Ernst & Young LLP or other professional advisors familiar with your particular factual situation for advice concerning specific audit, tax or other matters before making any decisions. Portions of FASB publications reprinted with permission. Copyright Financial Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk, CT , U.S.A. Copies of complete documents are available from the FASB. Financial reporting developments Consolidation and the Variable Interest Model x

13 1 Overview 1.1 The models Under the traditional Voting Model, ownership of a majority voting interest is the determining factor for a controlling financial interest. This model is not effective in identifying controlling financial interests in entities that are controlled through other means. Under the Variable Interest Model, enterprises may be required to consolidate entities in which the power to make decisions comes from a variety of equity, contractual or other interests, collectively known as variable interests. By describing the model and highlighting some common misconceptions in this overview, we hope to help you navigate through the complexity of the Variable Interest Model. Throughout this publication, we refer to the entity evaluating another entity for consolidation as the enterprise and the entity subject to consolidation as the legal entity or entity. Comprehensive guidance on applying the model is included in the chapters that follow. There are two primary consolidation models under US GAAP: (1) the Variable Interest Model and (2) the Voting Model. The Variable Interest Model applies to an entity in which the equity does not have characteristics of a controlling financial interest. An entity that is not a variable interest entity (VIE) is often referred to as a voting interest entity Variable Interest Model Consolidation evaluations always begin with the Variable Interest Model, which was designed to enable an enterprise to determine whether an entity should be evaluated for consolidation based on variable interests or voting interests. Regardless of what type of entity an enterprise is evaluating for consolidation, it should first consider the provisions of the Variable Interest Model. The Variable Interest Model applies to all legal entities, including corporations, partnerships, limited liability companies and trusts. Even a majority-owned entity may be a VIE that is subject to consolidation in accordance with the Variable Interest Model. Misconception: Operating entity The Variable Interest Model does not apply to the entity I am evaluating because the entity is an operating entity. A common misconception is that the Variable Interest Model does not apply because the entity being evaluated for consolidation is a traditional operating entity (e.g., a business). Many tend to associate the evaluation of an operating entity with the Voting Model. The Variable Interest Model, however, applies to all legal entities. The Codification defines a legal entity as any legal structure used to conduct activities or to hold assets and is intentionally broad. Therefore, a traditional operating entity must first be evaluated using the Variable Interest Model and may be a VIE. Entities subject to the Variable Interest Model include the following: Corporations Partnerships Limited liability companies Other unincorporated legal entities Financial reporting developments Consolidation and the Variable Interest Model 1

14 1 Overview Majority-owned subsidiaries Grantor trusts Arrangements that, while established by contract, are not conducted through a separate legal entity are not subject to the Variable Interest Model. Illustration 1-1: No legal entity Assume two companies enter into a joint marketing arrangement. They agree to collaboratively produce marketing materials and to use their existing sales channels to market each other s products and services. Each company contractually agrees to share a specified percentage of the revenues received from the sale of products and services made under the joint marketing arrangement to customers of the other company. However, no separate entity is established to conduct the joint marketing activities, and each company retains its own assets and continues to conduct its activities separate from the other. Analysis Although the companies have contractually agreed to the joint arrangement, the provisions of the Variable Interest Model do not apply to the arrangement because no separate entity has been established to conduct the joint marketing activities Voting Model The Variable Interest Entities subsections of ASC provide guidance on applying the Variable Interest Model. The Voting Model generally can be subdivided into two categories: (1) consolidation of corporations and (2) consolidation of limited partnerships and similar entities. Consolidation of corporations is based upon whether an enterprise owns more than 50% of the outstanding voting shares of an entity. This, of course, is a general rule. There are exceptions, such as when the legal entity is in bankruptcy or when minority shareholders have certain approval or veto rights. Consolidation based on a majority voting interest may apply to legal entities other than corporations. However, we use the term corporation to distinguish from the approach applied to limited partnerships and similar entities. For limited partnerships and similar entities (e.g., limited liability companies) that are not VIEs, there is a presumption that the general partner (or its equivalent) controls the entity, regardless of ownership percentage, unless the presumption can be overcome. The general partner does not control a limited partnership if the limited partners have either (1) the substantive ability to dissolve (liquidate) the limited partnership or otherwise remove or kick out the general partner without cause or (2) substantive participating rights. The General subsections of ASC provide guidance on applying the Voting Model to corporations or similar entities. ASC provides guidance on applying the Voting Model to limited partnerships or similar entities. In addition to the Variable Interest and Voting Models, ASC also includes a subsection, Consolidation of Entities Controlled by Contract. This subsection provides guidance on the consolidation of entities controlled by contract that are determined not to be VIEs. However, we believe application of this guidance is limited because entities controlled by contract generally are VIEs. See Appendix C for further guidance on the Voting Model and entities controlled by contract. The following chart illustrates how to generally apply consolidation accounting guidance. Financial reporting developments Consolidation and the Variable Interest Model 2

15 1 Overview Variable Interest Model Is the entity being evaluated for consolidation a legal entity? No Yes Does a scope exception to consolidation guidance (ASC 810) apply? Employee benefit plans Governmental organizations Certain investment companies Yes Apply other GAAP, which may include the Voting Model No Consider whether fees paid to a decision maker or a service provider represent a variable interest Does a scope exception to the Variable Interest Model apply? Not-for-profit organizations Separate accounts of life insurance companies Lack of information Certain businesses No Yes Does the enterprise have a variable interest in a legal entity? No Apply other GAAP Consider whether silos exist or whether the interests or other contractual arrangements of the entity (excluding interests in silos) qualify as variable interests in the entity as a whole 1 Yes Is the legal entity a variable interest entity? Does the entity lack sufficient equity to finance its activities? Do the equity holders, as a group, lack the characteristics of a controlling financial interest? Is the legal entity structured with non-substantive voting rights (i.e., anti-abuse clause)? Yes No Variable Interest Model (cont.) Voting Model Is the enterprise the primary beneficiary (i.e., does the enterprise individually have both power and benefits)? Consolidation of partnerships and similar entities Consolidation of corporations and other legal entities No No No Does the enterprise, including its related parties and de facto agents, collectively have power and benefits? Do not consolidate Does a related party or de facto agent individually have power and benefits? Yes Party most closely associated with VIE consolidates Yes Related party or de facto agent consolidates entity Yes Consolidate entity The general partner (GP) is presumed to have control unless that presumption can be overcome by one the following conditions: Can a simple majority vote of limited partners remove a general partner without cause and are there no barriers to the exercise of that removal right? Do limited partners have substantive participating rights? No GP consolidates entity Yes No GP does not consolidate the entity. In limited circumstances a limited partner may consolidate (e.g., a single limited partner that has the ability to liquidate the limited partnership or kick out the general partner without cause). Does a majority shareholder, directly or indirectly, have greater than 50% of the outstanding voting shares? Do not consolidate No Consolidate entity Yes Do the minority shareholders hold substantive participating rights or do certain other conditions exist (e.g., legal subsidiary is in bankruptcy)? Yes Do not consolidate 1 See Chapters 5 and 6 of this publication for guidance on specified assets and silos, respectively. Financial reporting developments Consolidation and the Variable Interest Model 3

16 1 Overview 1.2 Navigating the Variable Interest Model As shown in the flowchart above, it helps to evaluate the Variable Interest Model in an orderly manner by asking the following questions: 1. Does a scope exception to consolidation guidance (ASC 810) apply? 2. Does a scope exception to the Variable Interest Model apply? 3. If a scope exception does not apply, does the enterprise have a variable interest in a legal entity? 4. If the enterprise has a variable interest in a legal entity, is the legal entity a VIE? 5. If the legal entity is a VIE, is the enterprise the primary beneficiary of that entity? Does a scope exception to consolidation guidance (ASC 810) apply? There are three scope exceptions to the consolidation guidance in ASC 810: Employee benefit plans An employer should not consolidate its sponsored employee benefit plans that are subject to the provisions of ASC 712 or 715. Governmental organization An enterprise should not consolidate a governmental organization. An enterprise also should not consolidate a financing entity established by a governmental organization, unless the financing entity is not a governmental organization and the enterprise is using it in a manner similar to a VIE to circumvent the Variable Interest Model s provisions. Certain investment companies Enterprises that are investment companies are not required to consolidate their investments under ASC 810. That is, investments made by an investment company are accounted for at fair value in accordance with the specialized accounting guidance in ASC 946 and are not subject to consolidation. It is important to note that investment companies themselves are subject to consolidation under the Variable Interest Model. In other words, enterprises investing in or providing services to an investment company entity (e.g., an asset manager) are required to evaluate the investment company for consolidation. 1 However, entities subject to the Securities and Exchange Commission (SEC) Regulation S- X Rule 6-03(c)(1) 2 are not required to consolidate an entity that is subject to that same rule Does a scope exception to the Variable Interest Model apply? There are four other scope exceptions specific to the Variable Interest Model: Not-for-profit (NFP) organizations NFP organizations should not evaluate an entity for consolidation under the Variable Interest Model. Likewise, a for-profit enterprise should not evaluate an NFP organization for consolidation under the Variable Interest Model. 3 1 On 26 February 2010, the FASB issued Accounting Standards Update (ASU) , Amendments for Certain Investment Funds. ASU deferred the effective date of the consolidation guidance under FAS 167 for enterprises that have an interest in certain investment companies. However, these enterprises are still subject to consolidating investment companies under FIN 46(R). (See Chapter 4 for further information). 2 Entities subject to Regulation S-X Rule 6-03(c)(1) include, but are not limited to, Regulated Investment Companies, Unit Investment Trusts, Small Business Investment Companies and Business Development Companies. Generally, an investment company is required to register with the SEC under the Investment Company Act of 1940 if either (1) its outstanding shares, other than short-term paper, are beneficially owned by more than 100 persons or (2) it is offering or proposing to offer its securities to the public. 3 However, if an enterprise is using an NFP organization to circumvent the provisions of the Variable Interest Model, that NFP organization would be subject to evaluation for consolidation under the Variable Interest Model. Financial reporting developments Consolidation and the Variable Interest Model 4

17 1 Overview Separate accounts of life insurance enterprises Separate accounts of life insurance enterprises as described in ASC 944 are not subject to the provisions of the Variable Interest Model. Lack of information An enterprise is not required to apply the provisions of the Variable Interest Model to entities created before 31 December 2003 if the enterprise is unable to obtain information necessary to (1) determine whether the entity is a VIE, (2) determine whether the enterprise is the primary beneficiary or (3) perform the accounting required to consolidate the entity. However, to qualify for this scope exception, the enterprise must have made and must continue to make exhaustive efforts to obtain the information. Certain legal entities deemed to be a business See the business scope exception below. Business scope exception An enterprise is not required to apply the provisions of the Variable Interest Model to a legal entity that is deemed to be a business (as defined by ASC 805) unless any of the following conditions exist: The enterprise, its related parties or both, participated significantly in the design or redesign of the legal entity, suggesting that the enterprise may have had the opportunity and the incentive to establish arrangements that result in it being the variable interest holder with power. Joint ventures and franchisees are exempt from this condition. That is, assuming the other conditions below do not exist, an enterprise that participated significantly in the design or redesign of a joint venture or franchisee is not required to apply the provisions of the Variable Interest Model. The legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the enterprise and its related parties. The enterprise and its related parties provide more than half of the total equity, subordinated debt and other forms of subordinated financial support to the legal entity based on an analysis of fair values of the interests in the legal entity. The activities of the legal entity are primarily related to securitizations or other forms of assetbacked financing or single-lessee leasing arrangements. If an enterprise qualifies for one of the scope exceptions above, it should consider the voting interest entity provisions of ASC 810 to determine whether consolidation is required. If an enterprise does not qualify for one of the scope exceptions above, it is within the scope of the Variable Interest Model and must further evaluate the entity for possible consolidation under that model. Misconception: Business scope exception An entity qualifies for the business scope exception because the entity being evaluated for consolidation is a business. Some assume that an entity qualifies for the business scope exception because the legal entity being evaluated for consolidation meets the definition of a business but fail to consider the other conditions described above. Others recognize that all four conditions must be evaluated but spend too much time evaluating each of the conditions. The criteria for the business scope exception were intended to limit the circumstances in which the exception would apply. See Chapter 4 of this publication for further guidance on the business scope exception. Financial reporting developments Consolidation and the Variable Interest Model 5

18 1 Overview Misconception: Joint ventures An entity qualifies for the business scope exception, even though the enterprise participated in the design of the entity, because the entity is a joint venture. A party to a transaction may believe an entity is a joint venture when, in fact, it is not. Some enterprises use the term joint venture loosely to describe involvement with another entity. The actual term has a narrow definition for accounting purposes in ASC The fundamental criteria for an entity to be a joint venture are (1) joint control over all key decisions, with (2) such control through the owners equity interest. For example, if three parties form a venture and make decisions about the venture based on a majority vote, the entity is not a joint venture for accounting purposes because decisions are not made jointly (with consent among all parties). See our Financial reporting developments publication, Joint ventures, for further guidance. Also, keep in mind that if a legal entity meets the definition of a joint venture, it is still subject to the remaining three criteria of the business scope exception. See Chapter 4 of this publication for further guidance on the business scope exception Does the enterprise have a variable interest in a legal entity? An enterprise must determine whether it has a variable interest in the legal entity being evaluated for consolidation. Identifying variable interests generally requires a qualitative assessment that focuses on the purpose and design of a legal entity. To identify variable interests, it helps to take a step back and ask, Why was this entity created? What is the entity s purpose? and What risks was the entity designed to create and distribute? To answer these questions, an enterprise should analyze the legal entity s activities, including which parties participated significantly in the design or redesign of the entity, the terms of the contracts the entity entered into, the nature of interests issued and how the entity s interests were marketed to potential investors. The entity s governing documents, formation documents, marketing materials and all other contractual arrangements should be closely reviewed and combined with the analysis of the activities of the entity to determine the risks the entity was designed to create and distribute. Risks that cause variability include, but are not limited to, the following: Credit risk Interest rate risk (including prepayment risk) Foreign currency exchange risk Commodity price risk Equity price risk Operations risk An enterprise may be exposed to a number of risks through the interests it holds in a legal entity, but the Variable Interest Model considers only interests that absorb variability the entity was designed to create and distribute. Keep in mind that when the Variable Interest Model refers to variability, it is referring to returns that are positive, negative or both. After determining the variability to consider, an enterprise can then identify which interests absorb that variability. The Variable Interest Model defines variable interests as contractual, ownership (equity) or other financial interests in an entity that change with changes in the fair value of the legal entity s net Financial reporting developments Consolidation and the Variable Interest Model 6

19 1 Overview assets. For example, a traditional equity investment is a variable interest because its value changes with changes in the fair value of the company s net assets. Another example would be an enterprise that guarantees a legal entity s outstanding debt. Similar to an equity investment, the guarantee provides the enterprise with a variable interest in the legal entity because the value of the guarantee changes with changes in the fair value of the legal entity s net assets. The labeling of an item as an asset, liability, equity or contractual arrangement does not determine whether that item is a variable interest. Variable interests can be any of these. A key factor distinguishing a variable interest from other interests is its ability to absorb or receive the variability an entity was designed to create and pass along to its interest holders. Illustration 1-2: Variable interests leases Assume a lessor creates a legal entity to hold an asset that it leases to a third party (lessee) under an operating lease. The operating lease includes market terms and conditions and does not contain a residual value guarantee, purchase option or other similar features. Analysis When evaluating this transaction under the Variable Interest Model, the lessee must determine the purpose and design of the entity, including the risks the entity was designed to create and pass through to its variable interest holders. In this example, the entity is designed to be exposed to risks associated with a cumulative change in the fair value of the leased property at the end of the lease term as well as the risk that the lessee will default on its contractually required lease payments. Under this scenario, the lessee does not have a variable interest in the legal entity because the lessee does not absorb changes in the fair value of the asset through its operating lease. Rather, the lessee introduces risk to the legal entity through its potential failure to perform. However, if the lessee guarantees the residual value of the asset or has an option to purchase the asset at a fixed price, the lessee would have a variable interest in the legal entity. The lessee would absorb decreases in the fair value of the asset through a residual value guarantee or would receive increases in the fair value of the asset through a fixed price purchase option. Because the lessee has a variable interest in the legal entity, the lessee must evaluate the legal entity to determine whether the entity is a VIE and whether the lessee is the primary beneficiary of the entity. Guarantees, subordinated debt interests and written call options are variable interests because they absorb risk created and distributed by the legal entity. Items such as forward contracts, derivative contracts, purchase or supply arrangements and fees paid to decision makers or service providers may represent variable interests depending on the facts and circumstances. These items require further evaluation and are discussed in detail in Chapter 5 of this publication. Fees paid to decision makers or service providers The Variable Interest Model provides separate guidance on determining whether fees paid to a legal entity s decision makers or service providers represent variable interests in an entity. Asset managers, real estate property managers and research and development service providers are examples of decision makers or service providers that should evaluate their fee arrangements under this guidance to determine whether they have a variable interest in an entity. A decision maker or service provider must meet six criteria to conclude that its fees do not represent a variable interest and it is not subject to the Variable Interest Model. The criteria include evaluating whether the total anticipated fees are insignificant, are at market and represent compensation for services provided. A decision maker or service provider must use judgment when evaluating whether the Financial reporting developments Consolidation and the Variable Interest Model 7

20 1 Overview total anticipated fees are insignificant. A decision maker or service provider also should consider its other interests, including those held by certain related parties, when performing this evaluation. (The criteria are described in detail in Chapter 5 of this publication.) The guidance is intended to allow a decision maker or service provider to determine whether it is acting as a fiduciary or agent rather than as a principal. If a decision maker or service provider meets all six criteria, it is acting as an agent of the legal entity for which it makes decisions or provides services and therefore would not be subject to consolidation under the Variable Interest Model. If, however, a decision maker or service provider fails to meets any one of the six criteria, it is deemed to be acting as a principal and may need to consolidate the legal entity Is the legal entity a VIE? An enterprise that concludes it holds variable interests in a legal entity, either from fees or other interests, would then ask, Is the legal entity a VIE? The initial determination is made on the date on which an enterprise becomes involved with the entity, which is generally when an enterprise obtains a variable interest (e.g., an investment, loan, lease) in the entity. The distinction between a VIE and other entities is based on the nature and amount of the equity investment and the rights and obligations of the equity investors. For example, consolidation based on a majority voting interest is generally appropriate when the entity has sufficient equity to finance its operations, and the equity investor or investors make the decisions to direct the significant activities of the subsidiary through their equity interests. Entities that fall under the traditional Voting Model have equity investors that expose themselves to variability (i.e., expected residual returns and expected losses) in exchange for control through voting rights. The Voting Model is not appropriate when an entity does not have sufficient equity to finance its operations without additional subordinated financial support or when decisions to direct significant activities of the entity involve an interest other than the equity interests. If the total equity investment at risk is not sufficient to permit the legal entity to finance its activities, consolidation based on a majority shareholder vote may not result in the appropriate enterprise consolidating a legal entity. Misconception: Variable interest If an enterprise has a variable interest in an entity, the entity is a variable interest entity. A common misconception is that having a variable interest in an entity means the entity is a variable interest entity. It is easy to understand the confusion based on the words alone. However, an enterprise can have a variable interest (e.g., shares of stock, a fee, a guarantee) in an entity without the entity being a VIE if the entity does not have any of the characteristics of a VIE (e.g., lack of sufficient equity at risk). If an entity is not a VIE, the entity is a voting interest entity, and consolidation based on voting interests is appropriate. It is the nature and amount of equity interests and the rights and obligations of equity investors that distinguish a VIE from other entities. An entity is a VIE if it has any of the following characteristics: The entity does not have enough equity to finance its activities without additional subordinated financial support. The equity holders, as a group, lack the characteristics of a controlling financial interest. The legal entity is structured with non-substantive voting rights (i.e., an anti-abuse clause). Financial reporting developments Consolidation and the Variable Interest Model 8