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Consolidated Reporting Amendments May Be Linked to Related-Party Guidance

March 17, 2014

As the FASB continues to work on its proposed guidance for fund managers and others to decide whether they have enough interest in a fund or investment to require them to report the holdings on their balance sheets, the board has determined that it needs to weigh how related-party interests will affect the decision. The determination for the “principal versus agent” analysis was laid out in a November 2011 proposal.

The FASB on March 12, 2014, continued to fine-tune its proposal to help fund managers or boards of directors determine whether the stake they hold in funds or investments is significant enough to be reported on their balance sheets.

The determination hinges on a “principal versus agent” analysis, which lays out steps to assess whether a fund manager or board of directors is acting as a principal with control of a fund or whether it has less exposure and should be considered an agent with no obligation to report the holding.

The March 12 discussion focused on one of the several pieces of the analysis—the interests held in an entity by the related parties of the fund managers or boards of directors. The FASB calls fund managers, boards of directors, or general partners in a trust “decision makers.”

The board decided that a decision maker should consider its indirect interests held through its related parties on a proportionate basis when evaluating whether to consolidate the holding. The decision maker needs to evaluate “the nature and substance of the related party relationship,” to make the call.

“What it does is, it basically says all related-party arrangements are not the same, so you have to judge the [substance] of the related party and how the related-party activities work to determine whether or not to include it in a related-party group,” FASB Chairman Russell Golden said of the FASB’s decision. He added that he recognized that requiring decision makers to evaluate the nature and substance of their related-party relationships would require judgment, but “I think it will give better reporting to investors.”

The decision was part of the FASB’s effort to finalize Proposed Accounting Standards Update (ASU) No. 2011-220, Consolidation (Topic 810): Principal versus Agent Analysis, which was released in November 2011 as part of a package of proposals to update the accounting standards for investment companies and increase the transparency and consistency of financial reporting about consolidations.

In U.S. GAAP, Topic 810, Consolidation, provides guidance on how an interest held by a company’s related parties should affect the consolidation analysis. First, the decision maker must consider whether it is the primary beneficiary in what is called a variable interest entity. If the manager has the power to direct activities that significantly affect the entity’s economic performance, and it also must absorb the losses or reap the economic benefits of the entity, it is considered the primary beneficiary.

If it doesn’t meet the primary beneficiary criteria, it must consider whether the voting interests held by its related parties collectively could meet the requirements.

“The related-party guidance serves as an anti-abuse provision to prevent reporting entities from allocating variable interests to others in an effort to avoid consolidation,” FASB fellow Andrew Winters said.

If the manager concludes that, as a group, it meets both the power criterion and the significant economics criterion, then the party within the related-party group that is most closely associated with the variable interest entity is the primary beneficiary. The party may use the “tie-breaker test” described in Subtopic 810-10 to make the call.

The FASB on March 12 also discussed what happens when a decision maker is considered an agent—not a principal. The board decided that neither the decision maker nor any member of its related-party group would be required to consolidate a variable interest entity under the related-party tie-breaker test. However, “if the related parties are being used to circumvent the consolidation guidance, the related-party tie-breaker test must be performed,” and the decision maker or another member of the related-party group would be required to consolidate the entity.

FASB members had difficulty reaching a decision. Board members want a standard that reduces a business’s ability to move assets it controls off its balance sheet, but they don’t want a standard that forces assets onto a balance sheet if they don’t belong there.

“It seems like we want a decision maker to consider the related-party nature and all facts and circumstances to determine whether or not the decision maker is or is not a principal,” Golden said. “If it concludes it’s not a principal, then consider other related parties to determine whether or not the other related parties should consolidate.”

The FASB’s decision was tentative, and the board wants to gather feedback about how its related-party guidance will interact with the consolidated reporting requirements. The FASB also wants feedback on whether there might be circumstances where other related parties should report the off-balance-sheet entity on their balance sheets.

The FASB said it won’t provide explicit guidance on how a decision maker’s related-party interests should be considered for limited partnerships or similar entities that are evaluated for consolidation under the voting interest entity requirements.

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