With yet another change in the guidance on when a company needs to consolidate a particular entity onto its balance sheet, all public companies need to walk through a new evaluation process in the first quarter, even if it doesn’t change the outcome.
Accounting Standards Update 2015-02 takes effect with the beginning of the 2016 reporting year to change the analysis necessary to determine who consolidates variable-interest entities onto the corporate balance sheet. A VIE is a stand-alone legal entity that has multiple investors, none of which have a clear majority ownership or clear control. The analysis helps determine which investor is the primary beneficiary of the entity and therefore should consolidate the entity to the corporate balance sheet.
Accounting abuses in the early 2000s demonstrated the weaknesses in the rules in place at that time, enabling companies to carry risky investments completely off the balance sheet, hidden from shareholders. The Securities and Exchange Commission tasked the Financial Accounting Standards Board in its 2005 report on off-balance-sheet problems to continue to work on the consolidation rules to assure they leave no loopholes through which risky activity can escape reporting to investors.
“It is a thicket,” says Adam Brown, a partner with audit firm BDO USA. “The standards have changed quite a bit over the last 10 years or more.” FASB’s latest iteration taking effect in 2016 is meant to address the unintended consequences of an earlier accounting pronouncement that left the investment management community concluding they faced some consolidation requirements that didn’t make sense.
“Conclusions may not change, but you’re going to have to go through the whole VIE analysis where before you did not have to go through that process. The most challenging aspect of all this remains all the judgment that is required in the VIE analysis.”
Mark Winiarski, Shareholder, Mayer Hoffman McCann
“With the reassessment, there will likely be fewer consolidations than more consolidations,” says Dee Mirando-Gould, executive director at MorganFranklin Consulting. “For companies that did consolidate a particular entity before, this new model could make a change. But you really have to go through that evaluation under the new guidance now because it is effective in the first quarter.”
The original goal, says Mark Winiarski, a shareholder with audit firm Mayer Hoffman McCann, was to align the analysis in U.S. Generally Accepted Accounting Principles with that in International Financial Reporting Standards. “Ultimately, they didn’t really achieve that, but what they did decide was to modify the guidance in a few different ways that are fairly important,” he says. “They took a relatively straightforward flow chart and made it much more complex.”
Companies that are most affected by the new analysis fall into three primary groups, says Mark Scoles, partner-in-charge of accounting principles at Grant Thornton. That includes any company that has investments in limited partnerships or limited liability companies, any entity that has an investment in or is an asset manager in certain securitization structures, and any entity that has had to apply the “related-party tiebreaker test” to determine consolidation under historic rules, he says.
“Anyone who has had to evaluate entities for consolidation in the past is going to need to understand and go through this guidance,” says Scoles. “It may not change the answers, but it may change how you came to the conclusions or what type of disclosures you might have to make. There are a lot of things in here to think about.”
One of the key changes in the new standard, says Winiarski, focuses on how companies should consider fees paid to decision makers who manage variable-interest entities. That’s one of the changes to the standard meant to address the unintended consequences for investment companies, adding criteria to the model that all companies need to factor into their evaluations.
SEMESKY ON CONSOLIDATION
Below is an excerpt from SEC Professional Accounting Fellow Christopher Semesky’s speech on consolidation.
The next topic I would like to address is the evaluation of whether a decision-maker’s fee constitutes a variable interest under the FASB’s updated consolidation guidance. After considering a number of questions posed by registrants, I would like to share with you several observations regarding implementation of the new guidance.
For purposes of illustration consider an entity that has four unrelated investors with equal ownership interests, and a manager that is under common control with one of the investors. The manager has no direct or indirect interests in the entity other than through its management fee, and has the power to direct the activities of the entity that most significantly impact its economic performance.
In this simple example, if the manager’s fee would otherwise not meet the criteria to be considered a variable interest, the fact that an investor under common control with the manager has a variable interest that would absorb more than an insignificant amount of variability would not by itself cause the manager’s fee to be considered a variable interest. The guidance to consider interests held by related parties when evaluating whether a fee is a variable interest specifically refers to instances where a decision-maker has an indirect economic interest in the entity being evaluated for consolidation. However, in the instance where a controlling party in a common control group designs an entity in a way to separate power from economics for the purpose of avoiding consolidation in the separate company financial statements of a decision-maker, OCA has viewed such separation to be non-substantive.
In my example, if the manager determines that its fee is not a variable interest the amendments in ASU 2015-2 are not intended to subject the manager to potential consolidation of the entity. In other words, a decision-maker would not be required to consolidate through application of the related party tiebreakers once it determines that it does not have a variable interest in the entity.
I would also like to address the evaluation of whether a decision-maker’s fee arrangement is customary and commensurate. This evaluation is done at inception of a service arrangement or upon a reconsideration event, such as the modification of any germane terms, conditions or amounts in the arrangement.
The determination of whether fees are commensurate with the level of service provided often may be determined through a qualitative evaluation of whether an arrangement was negotiated on an arm’s length basis when there are no obligations beyond the services provided to direct the activities of the entity being evaluated for consolidation. This analysis requires a careful consideration of the services to be provided by the decision-maker in relation to the fees.
The evaluation of whether terms, conditions and amounts included in an arrangement are customarily present in arrangements for similar services may be accomplished in ways such as benchmarking the key characteristics of the subject arrangement against other market participants’ arrangements negotiated on an arm’s length basis, or in some instances against other arm’s length arrangements entered into by the decision-maker. There are no bright lines in evaluating whether an arrangement is customary, and reasonable judgment is required in such an evaluation. A decision-maker should carefully consider whether any terms, conditions, or amounts would substantively affect the decision-maker’s role as an agent or service provider to the other variable interest holders in an entity.
Staff members at the Securities and Exchange Commission have been hearing discussion and questions about how that particular aspect of the standard should be applied and decided to address it in a speech at a year-end accounting conference. Christopher Semesky, a professional accounting fellow in the Office of the Chief Accountant at the SEC, said managers with no direct or indirect interest in a variable interest entity, other than being paid a fee to manage it, do not hold a variable interest in the entity.
If that same manager is under common control with one of multiple equal investors in the variable-interest entity, that still wouldn’t by itself cause the management fee to considered a variable interest in the entity, Semesky said. “Where a controlling party in a common control group designs an entity in a way to separate power from economics for the purpose of avoiding consolidation in the separate company financial statements of a decision maker, OCA has viewed such separation to be non-substantive,” he said.
Semesky also addressed questions around whether a manager’s fee is customary and commensurate, another criterion in the consolidation analysis. There are no bright lines to observe, he said, so judgment is necessary. “A decision maker should carefully consider whether any terms, conditions, or amounts would substantively affect the decision maker’s role as an agent or service provider to the other variable-interest holders in an entity,” he said.
The SEC remarks provided “welcome clarification,” says Brown. “The related party guidance is very dense and the wording is difficult to interpret in some places.” The example Semesky provided helps clarify a critical point in the consolidation analysis about whether a particular entity must consolidate or not, he says.
Another key change, says Winiarksi, is new guidance that might cause some limited partnerships to be regarded as variable-interest entities under the new standard. Application of the new standard might cause some limited partnerships that were considered voting-interest entities to be classified as variable-interest entities instead.
“Conclusions may not change, but you’re going to have to go through the whole VIE analysis where before you did not have to go through that process,” says Winiarski. “The most challenging aspect of this remains all the judgment that is required in the VIE analysis.”
It will be important for companies to assure they have a process in place to perform the new evaluation, says Mirando-Gould, along with sound internal controls around that process, when auditors start asking questions. “Hopefully auditors are also reminding their public company clients that they have to think about this new guidance,” she says.