A new rule on consolidating entities into a parent company’s financial statements might have been targeted at fixing a problem with an earlier rule, but its implications reach well beyond the narrow problem it aimed to fix. Financial reporting executives, take note.
First, a review of the somewhat convoluted history of accounting for consolidations. The Financial Accounting Standards Board recently published Accounting Standards Update No. 2015-02 to revise the rules around when a company should consolidate another entity to its own financial statements. It’s a correction to a 2010 accounting rule that grew out of a Sarbanes-Oxley-required study by the Securities and Exchange Commission to take a new look at how companies were reporting (or not reporting) activity in off-balance-sheet holdings.
In 2010, companies began implementing FASB’s Financial Accounting Standard No. 167, which was an attempt to correct yet earlier rules on how entities were to report their involvement with “variable interest entities.” VIEs are special-purpose vehicles used extensively by financial institutions to manage financial activity and risk. Rules long allowed entities to place a great deal of risky financial activity in their off-balance-sheet vehicles, until the Sarbanes-Oxley Act brought greater attention to the obscurity left to investors.
As companies began implementing FAS 167 (later codified in the Accounting Standards Codification under Topic 810), the guidance led to more off-balance-sheet entities brought onto corporate balance sheets, which was the point. FASB, however, began hearing that even investment companies found they had to bring onto their balance sheet entities that they were managing based on their fee arrangements—not something the rule was intended to address.
“The broad impact is that companies need to go back through their entire process and redo their analysis.”
Mark Winiarski, Shareholder, Mayer Hoffman McCann
“From the perspective of the user, they didn’t find this very helpful at all,” says Mark Scoles, partner-in-charge of the accounting principles group at Grant Thornton. “It would bulk up the balance sheet with assets and liabilities in non-controlling interests that obscure other things on the balance sheet.”
Below FASB explains how the new consolidation standard will improve accounting practice.
This [standard] amends ARB 51 to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a non-controlling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial [standard]s. Before this [standard] was issued, limited guidance existed for reporting non-controlling interests. As a result, considerable diversity in practice existed. So-called minority interests were reported in the consolidated [standard] of financial position as liabilities or in the mezzanine section between liabilities and equity. This [standard] improves comparability by eliminating that diversity.
This [standard] changes the way the consolidated income [standard] is presented. It requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the non-controlling interest. It also requires disclosure, on the face of the consolidated [standard] of income, of the amounts of consolidated net income attributable to the parent and to the non-controlling interest. Previously, net income attributable to the non-controlling interest generally was reported as an expense or other deduction in arriving at consolidated net income. It also was often presented in combination with other financial [standard] amounts. Thus, this [standard] results in more transparent reporting of the net income attributable to the non-controlling interest.
This [standard] establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation. For example, a parent’s ownership interest in its subsidiary changes if the parent purchases additional ownership interests in its subsidiary or the parent sells some of its ownership interests in its subsidiary. It also changes if the subsidiary reacquires some of its ownership interests or the subsidiary issues additional ownership interests. This [standard] clarifies that all of those transactions are equity transactions if the parent retains its controlling financial interest in the subsidiary. Before this [standard] was issued, decreases in a parent’s ownership interest in a subsidiary could be accounted for in one of two ways: as equity transactions or as transactions with gain or loss recognition in the income [standard]. A parent’s acquisition of non-controlling ownership interests in a subsidiary was previously accounted for by the purchase method. This [standard] simplifies accounting standards by establishing a single method of accounting for those economically similar transactions. Eliminating the requirement to apply purchase accounting to a parent’s acquisition of non-controlling ownership interests in a subsidiary also reduces the parent’s costs because it eliminates the need to value the assets and liabilities of the subsidiary on the date that each additional interest is acquired.
This [standard] requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. A parent deconsolidates a subsidiary as of the date the parent ceases to have a controlling financial interest in the subsidiary. If a parent retains a non-controlling equity investment in the former subsidiary, that investment is measured at its fair value. The gain or loss on the deconsolidation of the subsidiary is measured using the fair value of the non-controlling equity investment. Previously, the carrying amount of any retained investment was not remeasured and was used in determining any gain or loss on the deconsolidation of the subsidiary. Recognizing a retained investment in a former subsidiary at fair value provides more relevant information about the value of that investment on the date that the subsidiary is deconsolidated. Remeasuring any retained investment to fair value also is consistent with the requirements in FASB [standard] No. 141 (revised 2007), Business Combinations, for remeasuring any previously held equity interest in an entity if the acquirer obtains control of that entity in a business combination achieved in stages (a step acquisition).
This [standard] requires expanded disclosures in the consolidated financial [standard]s that clearly identify and distinguish between the interests of the parent’s owners and the interests of the non-controlling owners of a subsidiary. Those expanded disclosures include a reconciliation of the beginning and ending balances of the equity attributable to the parent and the non-controlling owners and a schedule showing the effects of changes in a parent’s ownership interest in a subsidiary on the equity attributable to the parent. This [standard] therefore improves the completeness, relevance, and transparency of the information provided in the consolidated financial [standard]s.
This [standard] does not change ARB 51’s provisions related to consolidation purpose or consolidation policy or the requirement that a parent consolidate all entities in which it has a controlling financial interest. This [standard] does, however, amend certain of ARB 51’s consolidation procedures to make them consistent with the requirements of [standard] 141(R). It also amends ARB 51 to provide definitions for certain terms and to clarify some terminology. This [standard] does not change the requirements in FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities.
In addition to the amendments to ARB 51, this [standard] amends FASB [standard] No. 128, Earnings per Share, so that earnings-per-share data will continue to be calculated the same way those data were calculated before this [standard] was issued. That is, the calculation of earnings-per-share amounts in consolidated financial [standard]s will continue to be based on amounts attributable to the parent.
FASB quickly carved such entities out of the standard with a deferral of the requirements while the board worked on a solution. That led to FASB’s issuance of its latest rule, ASU 2015-02, which revises FAS 167 in a way intended to correct the unintended consequences. “This was intended to fix the problems with 167,” Scoles says. “And it has fixed it. This will change the requirements when looking at limited partnerships or any similar entity. Anyone with an interest in those will have to do a new evaluation.”
All of which, finally, brings us to the changes to consolidation accounting announced this year. According to FASB, ASU 2015-02 reduces the number of consolidation models from four to two, places more emphasis on the risk of loss when determining if an entity has a controlling financial interest, and reduces the use of related-party guidance so that it will be applied to fewer parties in a VIE. FASB says the new guidance changes consolidation conclusions for both public and private entities in many industries that typically make use of limited partnerships or VIEs.
“This is meant to eliminate consolidating things that don’t make a lot of sense to consolidate,” says Pete Bible, a partner with audit firm EisnerAmper. “We will have the ability to isolate one related party who will be the primary beneficiary. It’s common sense. I hope they keep the common sense standards coming.”
Where to Take the Standard From Here
The extent to which companies might be affected by the new guidance will vary, depending on how extensively they have involvement with VIEs, says Mark Winiarski, a shareholder with audit firm Mayer Hoffman McCann. “The broad impact is that companies need to go back through their entire process and redo their analysis,” he says.
For entities subject to the deferral, they now have plenty of work to do applying a new model and determining what should be consolidated, Winiarski says. For those that were applying the old guidance and now must apply a new approach, it’s not clear whether it will lead to an increase or decrease in the number of entities they will have to consolidate.
“Some may pick up consolidations, and others may reduce,” he says. “On average, it will probably be similar to what we had before. The important thing to understand is that you need to go back and re-evaluate your consolidation decisions. It’s going to cause some work initially to do the evaluation.”
John Bishop, a partner with PwC, says one of the changes to the model—how to evaluate limited partnerships—is most significant for investment companies that will have to apply it. The traditional corporate entity, however, might be more affected by other changes to the VIE evaluation, he says.
“There are three other areas where we do believe the evaluation will creep into the traditional corporate world,” he says. “How much depends on how active a company is in using these kinds of special-purpose entities.” Those changes include, according to Bishop, a new way to evaluate the economics held by an investor in an entity, a new evaluation of whether corporate shareholders should be considered to have control over a particular entity, and how related parties in a particular entity are to be considered.
Companies should begin applying the new guidance by taking an inventory of all their VIE interests, whether historically consolidated or not, Bishop says. “Then they need to begin the process of evaluating whether the changes in this ASU will impact their inventory of these kinds of entities.” To the extent companies determine they must consolidate entities they have not in the past under the new guidance, then they will need to consider whatever process and systems changes they will need to put in place to capture the information necessary to consolidate.
Mojgan Vakili, a partner with Deloitte, says companies need to be careful not to overlook the operational aspects of changing consolidation conclusions. “What does it mean to remove assets and liabilities from the books and start recognizing revenue from fees?” she says. “Am I set up to report that way? And if I’m consolidating entities, are the financial results of those entities available to me? Can I rely on that information? Companies should not underestimate the change management aspect of this new standard.”