Improvements to related party guidance for variable interest entities
The Accounting Standards Update 2018-17 (the “ASU”) that the FASB issued in 2018 is effective for fiscal years beginning after Dec. 15, 2020, for private entities (which excludes public business entities, not-for-profit entities, and employee benefit plans). It allows for an accounting alternative to not apply the variable interest entity (VIE) guidance to common control arrangements if certain criteria are met. It expands the accounting alternative codified by ASU 2014-07 to include all private company common control arrangements if the common control parent and the legal entity being evaluated for consolidation are not public business entities. In addition, this ASU amends guidance for determining whether a decision-making fee is a variable interest by requiring reporting entities to consider indirect interests held through related parties under common control on a proportional basis.
A private reporting entity does not need to evaluate a legal entity as a VIE if all of the following criteria, as noted in ASC 810-10-15-17AD, are met:
- The reporting entity (the company preparing financial statements) and the legal entity (the potential VIE) are under common control.
- The reporting entity 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.
- The reporting entity does not directly or indirectly have a controlling financial interest in the legal entity.
To apply this ASU, the private reporting entity would use the voting model to determine whether the reporting entity and the legal entity are under common control of a parent. That is, the private reporting entity would assess the parent’s direct and indirect voting interest in the private company and the legal entity would determine whether there is a controlling financial interest. The accounting alternative allowed under this ASU is an accounting policy election. Once the private reporting entity elects to use this accounting alternative, it must apply this to all legal entities that meet the criteria for application noted above. This across-the-board application is because the FASB “concluded that an inconsistent consolidation policy within the same reporting entity diminishes user relevance” (See ASU 2018-17).
However, keep in mind that private reporting entities will need to carefully assess whether common control exists, as described by the ASU. Particular care should be taken when the reporting entity holds a partnership or other direct interest in the legal entity.
In addition to accounting alternative, this ASU also changes how private reporting entities determine how decision-making fees impact the reporting entities’ accounting and reporting under the VIE guidance. Prior to the issuance of this ASU, the private reporting entity would determine whether its fee is variable interest by considering both direct and indirect interests in its entirety. This could result in a reporting entity concluding that its fee from another entity is variable interest because its other interests held through related parties in that VIE absorb more than an insignificant amount of the VIE’s variability even though the reporting entity may have little or no direct economic interest in the VIE. With the issuance of this ASU, the reporting entity (that is, the decision maker or service provider) should include its direct economic variable interests in the entity (i.e., the fee), and its indirect economic variable interests (i.e., interests held in the entity through related parties) considered on a proportionate basis, with some exceptions. ASC 810-10-55-37D provides the following illustrative example to calculate what the equivalent direct interest of an indirect interest through a related party would be:
“If a decision maker or service provider owns a 20 percent interest in a related party and that related party owns a 40 percent interest in the entity being evaluated, the decision maker’s or service provider’s interest would be considered equivalent to an 8 percent direct interest in the entity for the purposes of evaluating whether the fees paid to the decision maker(s) or the service provider(s) are not variable interests (assuming that they have no other relationships with the entity).”
The amendments in this ASU regarding the variability of a decision-making fee, and other indirect interests held by the reporting entity, provides for better alignment of the application of the variable interest model. The ASU notes, “alignment between determining whether a decision-making fee is a variable interest and determining whether a reporting entity within a related party group is the primary beneficiary of a variable interest entity.”
As a result of the adoption of this ASU, we believe be less decision makers reporting a variable interest through their decision-making arrangements. It will also help bring consistency in the application of the variable interest guidance for common control arrangements while allowing the private reporting entities to provide useful and relevant financial information, with the added benefit of mitigating the costs and complexities associated with applying VIE guidance.