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4.8 When to reconsider VIE status
Publication date: 31 Dec 2022
us Consolidation guide
If a reporting entity has a variable interest in a legal entity that does not qualify for a VIE scope exception, then it is required to determine whether that entity is a VIE at its formation date, or on the date the reporting entity first became involved with the entity.
Certain events may occur after the initial analysis that require the reporting entity to reassess whether or not an entity is, in fact, a VIE. In the VIE model, the occurrence of any of the following specific events would require the reconsideration of an entity’s VIE status:
A legal entity that previously was not subject to the Variable Interest Entities Subsections shall not become subject to them simply because of losses in excess of its expected losses that reduce the equity investment. The initial determination of whether a legal entity is a VIE shall be reconsidered if any of the following occur:
- The legal entity’s governing documents or contractual arrangements are changed in a manner that changes the characteristics or adequacy of the legal entity’s equity investment at risk.
- The equity investment or some part thereof is returned to the equity investors, and other interests become exposed to expected losses of the legal entity.
- The legal entity undertakes additional activities or acquires additional assets, beyond those that were anticipated at the later of the inception of the entity or the latest reconsideration event, that increase the entity’s expected losses.
- The legal entity receives an additional equity investment that is at risk, or the legal entity curtails or modifies its activities in a way that decreases its expected losses.
- Changes in facts and circumstances occur such that the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity’s economic performance.
A troubled debt restructuring should also trigger a reassessment of the entity’s status as a VIE. In most instances, if the entity becomes a VIE upon a troubled debt restructuring, banks/lenders may conclude that they are not the primary beneficiary, although they may become subject to the VIE disclosure requirements (see FSP 18.4 for a discussion about disclosure requirements).
We believe only substantive events should trigger reconsideration of the entity’s VIE status. The determination of whether an event is substantive requires judgment.
4.8.1 VIE reconsideration — reassessment of design
A reporting entity should consider the purpose and design of a potential VIE, including the risks it was designed to create and pass along to its interest holders, when determining whether the entity is a VIE. The entity’s purpose and design must also be considered upon the occurrence of any event triggering a reassessment of the entity’s status as a VIE. This could require the reporting entity to consider new or different risks (e.g., interest rate risk) that the entity has become exposed to since the prior analysis was performed.
The following sections discuss each of the reconsideration events described in the VIE model in further detail.
4.8.2 VIE reconsideration — losses that reduce the equity at risk
Excerpt from ASC 810-10-35-4
A legal entity that previously was not subject to the Variable Interest Entities Subsections shall not become subject to them simply because of losses in excess of its expected losses that reduce the equity investment.
The first concept discussed is the notion that operating losses in excess of an entity’s expected losses that reduce its equity at risk should not trigger a reconsideration of an entity’s VIE status. The rationale behind this concept focuses on the design of the entity. Incurring operating losses alone does not impact the characteristics of the equity investment at risk or the relationship between the holders of equity at risk and other variable interest holders.
If the equity at risk was deemed sufficient to finance the entity’s expected activities in the initial VIE analysis, and no events that could be considered a “redesign” of the entity have occurred, then there would be no basis to conclude that the entity has become a VIE just because it has incurred operating losses.
However, if a reconsideration event does occur, the entity’s VIE status will need to be re-evaluated as of that date, and a prior history of operating losses that have reduced the equity investment at risk may need to be considered as part of that analysis.
4.8.3 VIE reconsideration event — change in governing documents
The legal entity’s governing documents or contractual arrangements are changed in a manner that changes the characteristics or adequacy of the legal entity’s equity investment at risk.
This reconsideration event focuses on the redesign or restructuring of an entity’s governing documents or contractual arrangements among the parties involved with the entity. The clarifying phrase “that changes the characteristics or adequacy of the entity’s equity investment at risk” will help determine whether a change in these documents/arrangements should trigger a reconsideration of the entity’s VIE status.
Only modifications that affect the characteristics or adequacy of the entity’s equity investment at risk are considered reconsideration events.
4.8.4 Changes in characteristics of equity
It will be easier to determine whether a modification of the governing documents or contractual arrangements affects the characteristics of the entity’s equity investment at risk than to determine changes impacting the adequacy of the equity at risk.
Consider a situation where the equity investors at risk in a VIE cede certain voting rights to another variable interest holder. The reporting entity (investor) would need to consider whether the modifications in the governing documents changed the characteristics of the equity investment. In this example, the following two factors may be considered by the reporting entity to assess whether a reconsideration event has occurred:
- Whether the rights ceded to the other variable interest holders were participating or protective rights
- Whether the entity’s VIE status would change based solely on the changed characteristics
If the modification changes the characteristics of the entity’s equity investment at risk, it would be deemed a reconsideration event under the VIE model.
4.8.5 Change in adequacy of equity at risk
Determining whether or not a modification of the governing documents or contractual arrangements affects the adequacy of the entity’s equity investment at risk can be challenging. This difficulty arises from the need to determine what caused the change in the adequacy of the equity investment at risk. Only significant modifications that directly impact the adequacy of the equity investment at risk would be considered triggering events that would require a reassessment of the entity’s VIE status.
4.8.6 VIE reconsideration event — return of equity investment
The equity investment or some part thereof is returned to the equity investors, and other interests become exposed to expected losses of the legal entity.
A return of an equity investment may constitute a redesign of the entity. Since one of the five characteristics of a VIE focuses on the sufficiency of the equity investment at risk, a reduction in that amount would generally trigger a reassessment of an entity’s VIE status.
The reporting entity should consider whether the return of equity at risk is significant before concluding that the reduction in equity at risk constitutes a reconsideration event. This reconsideration event is intended to focus on situations in which a return of capital has caused a voting interest entity to become a VIE.
4.8.7 VIE reconsideration event — changes in operating activities
The legal entity undertakes additional activities or acquires additional assets, beyond those that were anticipated at the later of the inception of the entity or the latest reconsideration event, that increase the entity’s expected losses.
This reconsideration event is also intended to focus on situations in which a voting interest entity (not previously subject to consolidation under the VIE model) may become a VIE. Specifically, it focuses on whether the unanticipated activities or newly acquired assets actually increase the entity’s expected losses.
When analyzing this reconsideration event, reporting entities should consider whether there has been a redesign of the entity. During the initial VIE analysis, a reporting entity is required to assess the sufficiency of the equity at risk by evaluating the entity’s current and anticipated activities and the amount of equity needed to finance those expected activities (either quantitatively or qualitatively). In a quantitative analysis, that assessment would involve calculating the potential VIE’s expected losses—a calculation that would be derived from the variability or risk associated with the current and anticipated future activities of the entity. Consider Example CG 4-26.
EXAMPLE CG 4-26
Determining whether a change in an entity’s activities requires a reconsideration of an entity’s status as a VIE
Determining whether a change in an entity’s activities requires a reconsideration of an entity’s status as a VIE
Company A holds two financial assets: one share of stock in a “Blue Chip” utility company and one share of stock in a tech start-up company that has yet to earn a profit. At inception, Company B (one of Company A’s equity investors) determined that Company A was not a VIE.
Six months later, Company A sells its share of stock in the utility company and buys an additional interest in the start-up company.
Does Company A’s sale of the utility stock and acquisition of an additional interest in the start-up company require Company B to reassess Company A’s status as a VIE?
Analysis
If the acquisition of this new asset was not anticipated at Company A’s inception and Company A’s expected losses have increased as a result of the purchase, Company B would be required to reassess Company A’s VIE status.
If the reporting entity anticipated the undertaking of new activities or the acquisition of additional assets in its initial assessment under the VIE model, the occurrence of such events may not be considered a reconsideration event.
We believe assessing whether the acquisition of additional assets or the undertaking of additional activities constitutes a reconsideration event will often be driven by specific facts and circumstances, and will depend heavily on the entity’s current business activities (e.g., an operating joint venture versus an SPE that holds financial assets). The threshold for concluding that a reconsideration event has occurred will likely be higher for an operating joint venture than an SPE.
In making the assessment, the reporting entity should consider whether the acquisition/undertaking represents a significant change in the business activities of the entity. When a reporting entity evaluates whether a reconsideration event has occurred in an SPE that holds financial assets, the reporting entity should emphasize the significance of new acquisitions/undertakings relative to the current portfolio of the SPE’s assets, including changes in the volatility or risk of the overall portfolio resulting from the new acquisitions/undertakings.
4.8.8 VIE reconsideration event – change in equity or expected losses
The legal entity receives an additional equity investment that is at risk, or the legal entity curtails or modifies its activities in a way that decreases its expected losses.
The previous two reconsideration events focus on events that may cause a voting interest entity to become a VIE. Alternatively, there may be situations in which a VIE could become a voting interest entity. This reconsideration event considers those situations in which an entity receives additional equity investments that potentially increase the sufficiency of the equity at risk.
Additionally, if the entity modifies its activities in a way that decreases its expected losses, equity at risk that was once deemed insufficient may become sufficient under Characteristic 1.
4.8.9 VIE reconsideration event — equity group at risk loses power
Changes in facts and circumstances occur such that the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity’s economic performance.
Under the VIE model, an entity will become a VIE if, as a result of changes in facts and circumstances, the group of at-risk equity investors lose the power through voting or similar rights to direct the activities of the entity that most significantly impact its economic performance.
4.8.10 VIE reconsideration in bankruptcy
Generally, when an entity files for bankruptcy protection, the group of at-risk equity investors lose the power to make decisions that have a significant impact on the economic performance of the entity. Decision making over an entity that is in bankruptcy typically transfers to the bankruptcy court or creditor committee while the entity is in the process of reorganizing or liquidating. Therefore, we believe that the act of filing for bankruptcy typically constitutes a reconsideration event under the VIE model.
Similarly, when an entity emerges from bankruptcy, this would generally represent an event that requires reconsideration of entity’s status as a VIE. This is due to the fact that the entity’s governing documents and contractual arrangements are typically modified in a manner that impacts the sufficiency and characteristics of the entity’s equity investment at risk.
4.8.11 VIE reconsideration — decision maker/service provider changes
As discussed in CG 3.4.3, the VIE model does not specify whether the determination of whether a decision maker or service provider arrangement is a variable interest should be reassessed upon the occurrence of a reconsideration event or on a continuous basis.
We believe that reconsideration of whether or not a decision maker or service provider arrangement is a variable interest is a policy choice. If such arrangements are evaluated on a continuous basis, a change in the conclusion as to whether the decision maker or service provider’s arrangement is a variable interest could trigger a reconsideration event of the entity as described in ASC 810-10-35-4. If a policy to reassess on a continuous basis is elected, the ongoing assessment should focus on identifying changes that have occurred that would cause the decision maker to begin acting as a principal when it was previously determined to be acting as an agent, or vice versa.
We do not believe the introduction of new terms in similar structures or an increase in new market entrants (which would put downward pressure on fees) would change a service provider’s decision-making philosophy (i.e., incentivize the service provider to begin acting in the capacity of a principal). Therefore, absent a modification of the contractual terms, we would not expect a reassessment of the At Market and Commensurate criteria as part of this ongoing reassessment.
We would, however, expect a reporting entity that has made a policy election to reassess its decision maker or service provider fee on an ongoing basis to re-evaluate the significance of its other economic interests at each reporting date. We believe a decision maker should focus on its acquisition of other economic interests, including direct and indirect variable interests, each time this reassessment is performed. In addition, we believe the decision maker should also re-evaluate whether a change in the fair value of its economic interests has occurred since the prior reassessment date. If the fair value of the decision maker’s other economic interests have decreased from significant to worthless, we would view this to be the equivalent of in-substance disposition of that interest.
Conversely, we would view an increase in the fair value of the decision maker’s other economic interest from insignificant to significant as an in-substance acquisition of additional interests. In both cases, we believe these events could change the behavior of the decision maker and potentially causes its decision-making philosophy to migrate from that of a principal to an agent, or vice versa.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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