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1.3 The consolidation models
Publication date: 31 Jul 2022
us PwC Consolidation guide 1.3
There are two primary consolidation models in US GAAP – the variable interest entity (VIE) and voting interest entity (VOE) models.
A reporting entity that has a variable interest in a legal entity not subject to a scope exception would need to first determine whether the VIE model applies. Only if the entity is determined to not be a VIE would the VOE model be applied.
Figure CG 1-2 illustrates the general framework to be applied once a variable interest in a legal entity has been identified.
Figure CG 1-2
Consolidation framework decision tree
Consolidation framework decision tree
1.3.1 The variable interest entity model
Prior to applying the VIE model for consolidation of a legal entity, the reporting entity must first assess whether the legal entity qualifies for a scope exception (see CG 1.3.1.1) and whether it meets any of the five characteristics of a variable interest entity (see CG 1.3.1.2). If the legal entity does not qualify for a VIE scope exception and meets one of the five characteristics of a variable interest entity, the reporting entity should evaluate whether it is the primary beneficiary of the variable interest entity (see CG 1.3.1.3).
1.3.1.1 Exceptions to the variable interest entity model
Some legal entities may be subject to evaluation under the consolidation guidance, but are exempt from being evaluated for consolidation under the VIE model (e.g., not-for-profit entities as discussed in NP 5.2). In these circumstances, the entity would need to be evaluated for consolidation under the voting interest model. See CG 2.3 for these scope exceptions.
1.3.1.2 The five characteristics of a variable interest entity
There are five principle reasons that an entity would be deemed to be a VIE. These are commonly referred to as the characteristics of a VIE. If any one of these is present, then the entity needs to be evaluated for consolidation under the VIE model.
The characteristics aim to capture those situations where it would be inappropriate to look to only voting rights for determining whether a reporting entity has a controlling financial interest. The first characteristic acknowledges that when an entity is insufficiently capitalized, it may be the debt holders or other variable interest holders who have control. The second characteristic identifies those situations where the equity holders do not have power over the activities of the entity that matter (nonsubstantive voting). The third characteristic identifies situations where the voting rights of the equity holders are not proportionate to their economic interests. The final two characteristics capture those situations where the equity holders are not exposed to the residual losses or benefits that one would normally associate with equity investors.
The VIE model typically applies to entities that are formed for a predefined limited purpose, such as securitizations and asset-backed financing entities because these entities normally meet the definition of a VIE. However, the VIE model may also apply to operating companies and joint ventures. For example, contractual arrangements may be used to convey control over an operating entity when equity ownership is precluded for legal or regulatory reasons. Or, equity holders may not be fully exposed to the entity’s benefits or losses due to a cost plus or guarantee arrangement.
See CG 4 for a detailed discussion of each of the characteristics.
1.3.1.3 Primary beneficiary of a variable interest entity
Within the VIE model, the party that is determined to have a controlling financial interest is referred to as the primary beneficiary. The primary beneficiary is defined as being the party that meets both of the following criteria:
- Power to direct the activities of the entity that most significantly impact the entity’s economic performance (the power criterion)
- The obligation to absorb losses of the entity, or the right to receive benefits of the entity, that could be potentially significant to the entity (the economics criterion)
The primary beneficiary analysis requires the exercise of judgment. Depending on the entity being assessed, one of the criteria may require more analysis than the other. For example, in a joint venture, it is often clear that the venturers all have significant economic interests in the entity and therefore determining the primary beneficiary hinges on which party has power. In contrast, in an entity that holds only financial assets, such as a securitization vehicle, it may be clear that a servicer has decision making power and therefore determining the primary beneficiary will hinge on whether the servicer has a potentially significant economic exposure to the entity.
The level of economic exposure needed to be a primary beneficiary is well below that of a majority. This is in sharp contrast to the voting interest entity model where, since voting rights and economic interests are usually aligned, consolidation typically is not required when a reporting entity is not exposed to a majority of the economics of an entity. The assessment of what is a potentially significant economic exposure is not solely a quantitative assessment. See CG 5 for detailed discussion on the primary beneficiary assessment under the VIE model.
The VIE model specifies how to consider related parties. Related parties can have a significant impact on the ultimate consolidation conclusion. The related party guidance in the VIE model is applied differently when there is a single party with decision making power versus when power is shared between two or more parties. Even when a reporting entity is not the primary beneficiary on a standalone basis, it may still need to consolidate the entity if its related party group has control and it is deemed to be the party that is most closely associated with the entity. This concept is referred to as the related party tiebreaker. See CG 5.6 to CG 5.8 for a detailed discussion on the related party and related party tiebreaker considerations under the VIE model.
1.3.2 The voting interest entity model
A reporting entity that has a variable interest in a legal entity may need to assess that legal entity for consolidation under the voting interest entity model. The VOE model would apply either because (1) the legal entity does not have one of the five characteristics of a VIE (see CG 1.3.1.2), or (2) the entity or reporting entity is subject to a scope exception from the VIE model (see CG 2.3). A consolidation evaluation is only required under one of the models. The voting interest model should not be applied in instances where the investor determines it has a variable interest in a VIE but is not required to consolidate the VIE.
Under the VOE model, for legal entities other than partnerships, the usual condition for control is ownership, directly or indirectly, of more than 50% of the outstanding voting shares over an entity. For limited partnerships and similar entities, the usual condition for control is ownership, directly or indirectly, of more than 50% of a limited partnership’s kick-out rights. However, substantive participating rights held by the noncontrolling interest holders would preclude the holder of the majority voting or kick-out rights from having a controlling financial interest. Substantive participating rights are those rights that enable the holder to block or participate in certain significant financial and operating decisions of the entity that are made in the ordinary course of business.
There are also other situations where a holder of the majority voting rights may not have a controlling financial interest. For example, this could occur when an entity files for bankruptcy or otherwise becomes subject to the control of a government, court, administrator, or regulator. See BLG 3.17 for a discussion of consolidation considerations when an entity files for bankruptcy.
See CG 7 for a detailed discussion on the voting interest entity model.
1.3.2.1 Control by contract (consolidation)
Within the VOE model, there is guidance to accommodate entities that may be controlled through a contractual arrangement. This “control by contract” was initially developed specifically for physician practice management structures at a time when the VIE model did not exist, but the model is not limited in scope to physician practice management structures. Today, most physician practice management structures and other entities controlled through a contractual arrangement fall within the VIE model. Consequently, few structures seen today fall within the control by contract guidance under the VOE model. See CG 7.4 for a detailed discussion on the control by contract voting model.
1.3.3 Comparison of the variable and voting interest entity models
Figure CG 1-3 summarizes some of the more notable differences between the two consolidation models.
Figure CG 1-3
Key differences between the variable interest entity and voting interest entity models
Key differences between the variable interest entity and voting interest entity models
Area |
Voting interest entity model |
Variable interest entity model |
Definition of control (controlling financial interest)
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For legal entities other than partnerships, the usual condition for control is ownership, directly or indirectly, of more than 50% of the outstanding voting shares over an entity
For limited partnerships and similar entities, the usual condition for control is ownership, directly or indirectly, of more than 50% of a limited partnership’s kick-out rights (i.e., having the ability to replace the general partner or to liquidate the entity)
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A party has control if it has both:
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Related party considerations
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No specific guidance
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Interests held by related parties have the potential to impact a number of areas, including whether:
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Participating rights
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Defined as rights to block or participate in certain significant financial and operating decisions of the entity that are made in the ordinary course of business
Substantive participating rights over a significant activity (e.g., budgets) held by a noncontrolling investor preclude the majority shareholder from consolidating
The voting interest definition of participating rights is applied for determining if a limited partnership is a VIE
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Defined as rights to block or participate in actions through which power to direct the activities that most significantly impact the entity’s performance are exercised
To be substantive and preclude the party with decision making power from consolidating, the participating rights must enable the holder to participate in all significant activities, and must be unilaterally exercisable by a single party
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Disclosures
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Limited required disclosures for consolidated subsidiaries that are voting entities; however, consideration is given to disclosures on key judgments (see FSP 18.5)
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Incremental disclosures are required for reporting entities that are the primary beneficiary and also for other reporting entities that hold variable interests in a VIE. In addition, incremental disclosures about support arrangements and financial support provided to money market funds are required (see FSP 18.4 for further discussion on the disclosures)
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