Consolidation refers to the preparation and presentation of consolidated financial statements by an entity. When a parent consolidates a subsidiary, the parent presents its results of operations and financial position as if the parent and its subsidiary were a single entity. Any company controlling another entity is subject to the consolidation guidance in the Codification.
The purpose of consolidation is to provide meaningful financial information to stakeholders. There is a presumption that presenting the financial information for a consolidated group is a fairer and more relevant representation of a parent entity to its shareholders and creditors than a series of stand-alone financial statements (transactions with subsidiaries, for instance, are eliminated).
Consolidation is a complex Topic in the FASB Codification. The consolidation guidance is complicated and includes specific terminology and intricate rules. Nuances are important. Over time, the consolidation guidance has evolved to prevent abuses and it is still evolving. Accounting Standards Update (ASU) No. 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis, is becoming effective now and is making a number of significant changes to Topic 810, Consolidation.
The decision to consolidate can be particularly complex, especially when potential variable interest entities are involved. A good understanding of the rules and recent changes is paramount.
In general, an entity is required to consolidate if it has a controlling financial interest in another entity. An entity might have a controlling financial interest if either:
- It holds the majority of the voting shares of another entity. This is referred to as the voting interest entity model;
- It serves as management of the other entity as a result of a contractual relationship. This is referred to as the model for entities controlled by contract; or
- It is the primary beneficiary of a variable interest entity. This is referred to as the variable interest entity (VIE) model.
In the past, many stakeholders criticized the FASB’s consolidation rules because they did not always lead to the most accurate depiction of the economics of certain relationships and so did not yield the most useful financial information. To address these criticisms, in February 2015 the FASB issued ASU No. 2015-02.
ASU No. 2015-02 becomes effective for public business entities for annual reporting periods beginning after December 15, 2015, and interim periods within those annual periods, which means it is effective now for public business entities with a calendar year-end. ASU No. 2015-02 is effective for all other entities for annual reporting periods beginning after December 15, 2016, and interim periods included within annual reporting periods beginning after December 15, 2017. Early adoption is allowed.
Some of the more significant changes required by this ASU to the analysis to determine if an entity must be consolidated include:
- Revisions to the analysis for interests in limited partnerships and similar entities;
- Changes to how fees and related party relationships affect the analysis of interests in variable interest entities; and
- A new scope exception for interests in legal entities subject to Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds.
ASU No. 2015-02 has more significant effects in certain industries than in others, but all entities that own a variable interest in another entity will have to reassess their consolidation decisions. While the whole VIE model does not change, the ASU introduces a few changes that can have significant consequences for entities involved with VIEs. The ASU also modifies certain rules that apply to voting interest entities.
Revisions to the analysis for interests in limited partnerships and similar entities
After the adoption of ASU No. 2015-02, partners in limited partnerships and similar legal entities must have substantive kick-out or participating rights for the entity to meet the definition of a voting interest entity. A limited partner may have a controlling financial interest in a partnership if it holds an interest that provides substantive kick-out rights.
The ASU also eliminates the prior presumption that the general partner in a partnership or similar entity is the party who must consolidate the entity.
Changes to how fees and related party relationships affect the analysis of interests in VIEs
The ASU does not amend the definition of a variable interest. It does, however, change the analysis of whether a fee arrangement is a variable interest. The ASU removes three of the six criteria that a decision-maker fee must meet for the fee to be a variable interest.
The criteria to consider when assessing whether a decision-maker fee is a variable interest are:
|Criteria remaining after the ASU||Criteria removed by the ASU|
|Fees are compensating services and commensurate with the level of service required (in other words, the fees are at a market rate).||The fees receivable by the decision maker or service provider must be ranked at the same seniority level or higher than general operating liabilities.|
|Fees and other terms in the service agreement are consistent with those of an arm’s length transaction.||The total fees are not significant when compared to the VIE’s expected economic performance.|
|The service provider does not hold other interests in the VIE that, individually or in the aggregate, would absorb a more than insignificant part of the VIE’s losses or receive more than an insignificant part of the expected residual returns.||The fees are not expected to absorb a significant amount of the VIE’s variability.|
If all three remaining criteria are present, then the fee is not considered a variable interest.
ASU No. 2015-02 provides relief for asset managers. Prior to ASU No. 2015-02, asset managers were required to consolidate some of the funds that they managed, in part because:
- The asset managers had a variable interest in the funds (they received variable fees dependent on the fair value of the assets under management); and
- The funds were considered variable interest entities because the asset managers had the power to direct the activities with the most significant effect on the funds’ economic performance. Essentially, an asset manager decided on a daily basis which investments to buy or sell within the limits of the fund’s investment policy.
The asset managers, however, objected to the consolidation of these funds, because they often had no other involvement with the funds.
As a result of ASU No. 2015-02, fewer fee arrangements will qualify as variable interests. There is an expectation that many asset managers will no longer have to consolidate the funds that they manage.
The amendments made by ASU No. 2015-02 are primarily the result of stakeholder concerns regarding consolidation of limited partnerships by asset managers; these amendments, however, also apply to reporting entities across all industries. If a reporting entity holds a variable interest in a legal entity, the reporting entity must consider possible changes to its consolidation analysis. Some reporting entities may be required to consolidate a legal entity for the first time. Conversely, other reporting entities may be required to deconsolidate a legal entity that was consolidated in reporting periods prior to the issuance of ASU No. 2015-02.
If no single party owns a controlling financial interest in a VIE, a reporting entity must consider all interests held by its related party group (all related parties of the entities that hold an interest in the VIE) to determine if, as a group, the reporting entity and its related parties have the characteristics of a primary beneficiary, thus requiring consolidation of the VIE. ASU No. 2015-02 reduces the number of situations in which the most closely associated test (also known as the related-party tie-breaker) must be applied.
A new scope exception for certain investment funds
Accounting Standards Update No. 2010-10, Consolidation (Topic 810): Amendments for Certain Investment Funds, indefinitely deferred the adoption of Accounting Standards Update No. 2009-17, Consolidations (Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities, (also known as FAS 167, Amendments to FASB Interpretation No. 46(R)) for certain investment funds. ASU No. 2015-02 rescinds this deferral, but provides a new scope exception for interests in legal entities subject to Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds.
The guidance in ASU No. 2009-17 would have resulted in many investment managers consolidating the investment companies they managed. Stakeholders raised concerns that the consolidation of investment companies by investment managers would decrease the usefulness of the investment manager’s financial statements. The FASB deferred the implementation of ASU No. 2009-17 for certain investment funds to allow time for the FASB to work on changes to evaluating whether a manager is acting as a principal or an agent. The deferral was eliminated by ASU No. 2015-02 because changes made to the consolidation analysis in ASU No. 2015-02 are expected to address the issues raised by stakeholders and eliminate the requirement for some investment managers to consolidate the investment companies that they manage.
ASU No. 2015-02 should not be overlooked. It will require parent companies to rethink some of their past consolidation decisions and may have to consolidate new entities and deconsolidate some starting this year.
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