Under Criterion 1, each equity investor should be evaluated individually to determine whether its obligation to absorb the entity’s expected losses and/or receive the entity’s expected residual returns are in proportion to that investor’s voting rights. Characteristic 3 is different from the other five characteristics of a VIE in that all variable interests held by the holders of equity at risk must be considered, and not just the voting rights and economics related to each investor’s equity investment.
Related parties should not be considered in the evaluation of Criterion 1, but should be considered in an evaluation of Criterion 2 (discussed below).
When evaluating whether Criterion 1 has been met, we believe an investor’s voting rights and economics are not required to be identical, but should generally be approximately the same, to be considered proportionate. Judgment should be applied based on the facts and circumstances.
Question CG 4-5
If a reporting entity’s economic interest in an entity is greater than its relative voting interest, is Criterion 1 met?
PwC response
The disproportionate voting and economic interest criterion was included to identify entities designed with nonsubstantive voting rights. It is the intent of GAAP to subject those entities to the “power” and “economics” model established in
ASC 810-10. In situations where the interests are disproportionate, it should not be automatically assumed that the criterion is met. Additional analysis should be performed to determine whether the entity’s voting rights would be substantively different if its relative voting rights mirrored its economic interest.
For example, if an investor held a 25% economic interest in an entity but was limited to exercising 15% of its relative voting rights, a reporting entity should consider whether that investor’s ability to influence or participate in the entity’s operating or financial decisions would be substantively different if the investor held 25% of the entity’s relative voting rights. If the investor’s ability to influence or participate in the entity’s operating or financial decisions would not be substantively different if it held 25% of the entity’s relative voting interests, then it should not be assumed that the investor’s voting and economic interests are disproportionate (i.e., that Criterion 1 is met).
When an investor’s economic and voting interests straddle 50% (i.e., 48% voting rights and 52% economics), its voting and economic interests should not ordinarily be considered proportional. Generally, an investor’s ability to exercise voting rights over an entity would be substantively different when its voting interest crosses the 50% threshold.
In practice, joint ventures and partnerships frequently meet this criterion as the equity investors typically have other variable interests in the entity that create economics that are disproportionate to their voting rights.
Based on a literal read of the guidance, evaluation of Criterion 1 would require a comparison of each participant’s variable interests to their voting interest, which would necessitate the determination of all expected losses and expected residual returns for the entity and for each investor. However, in some circumstances, detailed analyses may not be necessary. For example, if one party clearly has an economic participation of 60% or greater, but only has a noncontrolling 50% voting interest, Criterion 1 would be met (i.e., the voting interests and economic interests would be disproportionate). Criterion 2 would then need to be evaluated to determine if the entity should be considered a VIE.
Conversely, if one party has 50% of the vote and 40% of the equity, but also has a variable interest via a long-term purchase contract, a detailed calculation may be required to determine if the equity investor’s incremental economic exposure through the purchase contract causes the equity investor to be exposed to greater than 50% of the entity’s expected losses and residual returns.
The determination of the level of voting rights may require judgment, since, in many cases, voting percentages are not defined by the underlying agreements.
Question CG 4-6
If a partnership with three investors operates in a manner that requires all three investors to agree to all significant operating decisions, what level of voting rights should the partners be considered to hold if their relative ownership interests are not equal?
PwC response
Even though the partners’ legal ownership percentages may vary, we believe the entity is under joint control and each partner would have 33.3% of the partnership’s voting interests.
In this scenario, when assessing whether Criterion 1 of Characteristic 3 has been met, the analysis should focus on whether the governance of the entity would be substantively different if voting rights were exactly equal to the investor’s economic interest. If the governance of the entity would be substantively different, then Criterion 1 of Characteristic 3 would be met.
To further understand the application of Criterion 1, consider Example CG 4-19, Example CG 4-20, and Example CG 4-21.
EXAMPLE CG 4-19
Determining whether a majority investor’s interest is disproportionate
Company A holds a 65% equity interest in Entity 1 and Company B holds the remaining 35% equity interest. Company A and Company B share in Entity 1’s profits and losses in proportion to their relative equity investment. Entity 1’s governing documents include specific provisions providing Company B with approval rights over the substantive operating decisions of Entity 1 (i.e., joint control).
Is Criterion 1 met?
Analysis
Yes. Entity 1’s governing documents provide Company A with a 50% vote over key operating decisions. If Company A’s voting rights equaled its 65% economic interest, its right to govern Entity 1 would be substantively different. Consequently, Criterion 1 would be met. If Criterion 2 is also met (i.e., substantially all of the entity’s activities either involve or are conducted on behalf of Company A and its related parties), Characteristic 3 would be present and Entity 1 would be considered a VIE.
EXAMPLE CG 4-20
Determining whether a majority investor’s interest is disproportionate
Company A is an equity investor in Corporation X, holding 55% of Corporation X’s voting interests. Through its 55% voting interest, Company A is able to control Corporation X. Company A is exposed to 60% of Corporation X’s profits and losses.
Is Criterion 1 met?
Analysis
No. Although Company A’s voting rights (55%) and exposure to Corporation X’s economics (60%) are not exactly equal, Company A’s voting and economic interests would be considered proportional since control resides with Company A at either the 55% or 60% level.
EXAMPLE CG 4-21
Determining whether other interests held by a 50% equity investor cause disproportionality
Company A and Company B each contributed $20 million in cash for 50% of Corporation X’s common stock. In addition, Company A loaned $50 million to Corporation X in return for a note receivable. Company A therefore has two variable interests in Corporation X: (1) an equity investment and (2) a note receivable from Corporation X.
Is Criterion 1 met?
Analysis
Most likely. While it is likely that the note receivable absorbs little variability in the change in Corporation X’s net assets given its seniority in Corporation X’s capital structure (i.e., it exposes Company A to little credit risk), it would be required to absorb very little variability to increase Company A’s total economic exposure above 50%.