Private companies may want to revisit their accounting for consolidation before yearend to make sure they have captured the necessary updates from recent changes to the variable interest entity model.
The changes to consolidation accounting date back to 2018 when the Financial Accounting Standards Board (FASB) made the most recent update to the variable interest entity model for determining whether a reporting entity should consolidate another entity. That update, issued as Accounting Standards Update (ASU) 2018-17 Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities (ASU 2018-17), focuses on how related party relationships are evaluated.
The first change, which has been early adopted by many private companies, expands the private company accounting alternative for variable interest entities (VIEs) beyond common control leasing entities. The second change addresses how related party relationships impact the evaluation of whether a decision maker and service provider fee is a variable interest.
The accounting standard must be implemented for entities that are not public business entities (private companies) for fiscal years beginning after Dec. 15, 2020 (i.e. calendar year end Dec. 31, 2021). Private companies adopting ASU 2018-17 this year may benefit from updating their analysis before year end to ensure the scope of their financial statements and their audit, review, or other attest engagements is appropriate.
Key Considerations for the New Accounting Alternative
The first change expands the number of entities that can qualify for the scope exception, which may result in a reduction in the cost of applying GAAP for most private companies electing the scope exception. Considerations that may be relevant to private companies preparing to adopt the revised accounting alternative include:
- Private companies that had adopted the accounting alternative scope exception for common control leasing arrangements will need to either adopt the new accounting alternative or revert back to applying the full variable interest entity model
- Due to changes in how common control is evaluated for purposes of the accounting alternative, it is possible for a leasing entity that previously qualified as under common control with the private company for the accounting alternative scope exception for common control leasing arrangements to not qualify as under common control under the new accounting alternative.
- The new accounting alternative must be applied to all legal entities that meet the requirements. A private company is not permitted to apply the accounting alternative by cherry picking only certain entities.
- If adoption of the new accounting alternative results in deconsolidating or consolidating an entity, that conclusion is applied retrospectively to all periods presented.
- A private company can elect to combine all, or some, of the entities that are deconsolidated because they qualify for the new accounting alternative as long as the combined presentation is more meaningful.
The Basics of the Accounting Alternative
Prior to the adoption of ASU 2018-17, a private company could elect to scope out from the VIE model common control entities that were leasing to the private company. These arrangements qualified for the scope exception when the lessor and private company were under common control, the two legal entities had a lease arrangement, substantially all activity between entities was related to leasing, and, if the private company explicitly guaranteed or provided collateral to the lessor for obligations related to the asset being leased by the private company, the value of the asset leased was more than the principal amount of the obligations guaranteed or collateralized by the private company.
Under the new guidance, a private company may scope out from the VIE model all legal entities under common control. To qualify for the accounting alternative the entities must meet the following conditions:
- Private company and the legal entity are under common control as determined by the general subsection of the Topic 810 Consolidation (i.e. the voting model)
- The private company and the legal entity are not under common control of a public business entity.
- The legal entity under common control is not a public business entity, and
- The reporting entity does not directly or indirectly have a controlling financial interest in the legal entity under the voting model (i.e. it is not a majority owned or wholly owned subsidiary of the reporting entity).
These conditions can be broken down into assessing whether the entities are ‒ or are controlled by ‒ a public business entity, whether the private company owns a majority of the legal entity being considered, and, typically the most difficult assessment, whether the entities are under common control.
What is Common Control?
The FASB does not have a definition of common control, so private companies must develop an accounting policy for what they consider to be common control. In practice, the starting point for the definition is often the conclusion reached by the staff of the Securities and Exchange Commission (SEC) which said common control only exists when:
- An individual or enterprise holds more than 50% of the voting ownership of each entity.
- A group of shareholders holds more than 50% of the voting ownership of each entity and has contemporaneous written evidence of an agreement to vote a majority of the entities’ shares in concert.
- Immediate family members (married couple and their children, but not the married couples grandchildren or, in some situations, living siblings and their children) hold more than 50% of the voting ownership interest of each entity, and there is no evidence those family members will not vote their shares in concert.
The FASB and the Private Company Council (PCC) explained that they interpret common control broader than the narrow definition contained in the SEC guidance. In practice, many private companies will consider family groups that include family members beyond those defined as immediate family by the SEC staff as a control group. For example, a private company may conclude that a combination of three generations (grandparents, parents, and children) that are expected to vote in concert and hold more than 50% of the voting rights of each entity result in the entities being under common control via the “family group”.
The assessment of the family group will usually require considering the past history, does the family have a history of working together or do they dispute decisions? A family group that has a does not have a history of disputes and is expected to vote in concert can be assessed as a single entity for purposes of determining common control.
For purposes of a corporation, the general rule is that ownership of more than 50% of the outstanding voting shares would point to control. Therefore, it is usually the case that when assessing two private corporations owned more than 50% by an individual, or family group, will be considered under common control for purposes of the accounting alternative.
The assessment becomes more complex when considering limited partnerships and similar entities (i.e. a limited liability company (LLC) managed by a managing member that is the equivalent of a “general partner”). When applying the accounting alternative, the voting model is used for purposes of assessing control, and the voting model for limited partnership focuses on control over the right for a limited partner to kick-out the general partner. As a result when the majority owner of the private company is the general partner of a related limited partnership, the two entities may not be under common control for purposes of the accounting alternative.
To illustrate, consider a private corporation that is controlled by a family group through 100% ownership. The private corporation has a related party that is an LLC that is determined to be similar to a limited partnership. Assume the LLC is owned 60% by the family group, which includes the managing member, and 40% by an unrelated party that is the equivalent of a limited partner. For purposes of assessing which party controls the LLC, the voting rights of only the limited partner equivalent are considered. So either the limited partner can remove the general partner (i.e. the limited partner controls the entity) or the limited partner cannot remove the general partner and no party has voting control. In either case, the private company and LLC are not under common control through the voting rights and the accounting alternative does not apply. Rather, the private company must consider the full VIE model when assessing whether the LLC is subject to consolidation.
Disclosures to Note
There are a few essential accounting disclosures required for entities applying the accounting alternative. These include:
- The nature and risks associated with a reporting entity’s involvement with the legal entity under common control;
- How a reporting entity’s involvement with the legal entity under common control affects the reporting entity’s financial position, performance, and cash flows;
- The carrying amounts and classification of assets and liabilities in the reporting entity’s state of financial position that result from involvement with the legal entity under common control;
- The reporting entity’s maximum exposure to loss resulting from its involvement with the legal entity under common control; and
- If the reporting entity’s maximum exposure to loss exceeds the carrying amount of the assets and liabilities, qualitative information to allow users of financial statements to understand the excess exposure.
Fees Paid to Decision Makers or Service Providers
The second change in ASU 2018-17 addresses the effect of related parties on the evaluation of fees paid to decision maker and service providers (“decision maker arrangements”). The change is intended to clarify when an entity acts as an agent of other parties or is a principal. Due to the change, entities that have previously concluded that a decision maker arrangement was a variable interest because of indirect interests held by parties under common control will need to reconsider their assessment of the whether the service arrangement is a variable interest. For some entities, the decision maker arrangement was their only variable interest. These entities will no longer have a variable interest. When an entity does not have a variable interest in a legal entity, it does not need to assess if the legal entity is a VIE and will not have any disclosure or consolidation requirements under the VIE guidance.
The Basics of the New Guidance for Decision Maker Arrangements
Under the revised guidance a decision maker arrangement is a variable interest when it meets any of the following criteria:
- The decision maker (i.e. reporting entity) has another interest in the legal entity that would absorb more than an insignificant amount of the expected losses or expected residual returns of the legal entity,
- The decision maker has direct interest in a related party that cause the decision maker to absorb a more than insignificant amount of the expected losses or expected residual returns of the legal entity.
- The fees that are compensation for the service provided are not commensurate with the level of effort required to provide the services, or
- The arrangement includes terms, conditions, or amounts that are not customarily present in arrangements for similar services that are negotiated at arm’s length
Prior to the adoption of ASU 2018-17, an entity also included the interests of entities under common control as if the interests were its own interests in its evaluation of whether the decision maker absorbs a more than insignificant amount of the expected losses or expected residual returns of the legal entity.
The Standard in Action
Consider this example that puts the new standard into action. Owner holds 100% of the equity voting rights for Reporting Entity, Inc., and 25% of the equity voting rights for Related Party, Inc. Reporting Entity, Inc. provides decision-making services to Legal Entity, Inc., for a fee. Assume that Reporting Entity, Inc. does not have any other interest that would absorb a more than insignificant amount of expected losses or expected residual returns, that the fees are commensurate with the level of effort required to provide the services and the arrangement includes terms, conditions and amounts that are all customary for similar services negotiated at an arm’s length.
Under the guidance prior to the adoption of ASU 2018-17, Reporting Entity, Inc. considers the interest of entities under common control as its own interests when evaluating whether the decision making services are a variable interest. Therefore, the owner’s 25% interest would result in Reporting Entity, Inc.’s decision making services to be a variable interest in Legal Entity, Inc., and Reporting Entity, Inc. would be required to assess whether Legal Entity, Inc. is a variable interest entity. If it was, if Reporting Entity, Inc. is the primary beneficiary (i.e. should it consolidate Legal Entity, Inc.).
Upon adoption of ASU 2018-17, Reporting Entity, Inc. does not consider owner’s 25% interest as its own, and it would conclude that the decision maker arrangement is not a variable interest. If Reporting Entity, Inc. does not have any other variable interests in Legal Entity, Inc., it would not be required to assess whether Legal Entity, Inc. is a VIE.
All entities are required to apply both of these amendments retrospectively with a cumulative-effect adjustment to retained earnings applied at the beginning of the earliest period presented. The update provides certain provisions that may provide transition relief for entities that are required to consolidate or deconsolidate entities upon initial adoption of this ASU.
Your Next Steps
Understanding and implementing these consolidation changes can be a confusing process. An accounting provider experienced with ASU 2018-17 can help you understand how the alternative will affect your business and provide clear recommendations on handling financial reporting with your commonly controlled entities.
For more information on how the consolidation accounting standard affects you, contact us.
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