Appendix D — Voting Interest Entity Model

D.3 Exceptions to Consolidation by Owner of Majority Voting Interests

In addition to considering noncontrolling rights, under ASC 810-10-15-10(a)(1), a majority owner of voting interests would not consolidate a legal entity in the following circumstances:

The subsidiary is undergoing a legal reorganization.
The subsidiary is in bankruptcy.
The subsidiary operates under foreign exchange restrictions, controls, or other governmentally imposed uncertainties that are so severe that they cast significant doubt on the parent’s ability to control the subsidiary.
Control exists through means other than ownership of a majority voting interest or a majority of kick-out rights. For example, a majority owner of voting interests would not consolidate a legal entity if:
- ASC 810-30 is applied to determine the consolidation status of a research and development arrangement.
- The subsections of ASC 810-10 on the consolidation of contract-controlled entities are applied to determine whether a contractual management relationship represents a controlling financial interest.
- ASC 710-10-45-1 is applied. That paragraph addresses the circumstances in which the accounts of a rabbi trust that is not a VIE are consolidated with the accounts of the employer in the financial statements of the employer.

D.3.1 Subsidiaries in Bankruptcy

ASC 810-10-15-10(a)(1)(ii) states that a “majority-owned subsidiary shall not be consolidated if control does not rest with the majority owner — for instance, if [the] subsidiary is in bankruptcy.” In accordance with this guidance, a reporting entity should generally not consolidate a subsidiary that is in bankruptcy. Note, however, that because reporting entities generally cede control of a legal entity in bankruptcy to the bankruptcy court, the legal entity would typically be a VIE since the equity investors no longer control the legal entity (see Section 5.3.1). Nonetheless, regardless of whether a legal entity is a VIE or subject to the voting interest entity model, there may be certain circumstances in which it is appropriate for a reporting entity to continue to consolidate a subsidiary after it has filed for bankruptcy protection. This issue was addressed by an SEC staff member, Professional Accounting Fellow Randolph Green, in a speech at the 2003 AICPA Conference on Current SEC Developments:

Paragraph 13 of Statement 94 [not codified] indicates that “a majority owned subsidiary shall not be consolidated if control does not rest with the majority owner (as, for instance, if the subsidiary is in legal reorganization or in bankruptcy . . .).” I think most would conclude that bankruptcy is indicative of a loss of control and that deconsolidation is appropriate. However, paragraph 32 of SOP 90-7 [codified as ASC 852-10-45-14] suggests that there are conditions in which the continued consolidation of a subsidiary in bankruptcy is appropriate. [Footnotes omitted]

Recently, we were asked to consider whether the deconsolidation of a majority-owned subsidiary in bankruptcy was appropriate. We were willing to undertake such a consideration because, in part, we believe that, even when a subsidiary is in bankruptcy, there are circumstances where the continued consolidation of a subsidiary is more meaningful. For example, consider an instance where the parent has a negative investment, expects the bankruptcy to be brief, and expects further to regain control of the subsidiary. One might be appropriately concerned about the deconsolidation . . . and reconsolidation of a subsidiary by a parent in a short period of time.

In the fact pattern we considered, the parent was the majority common shareholder, a priority debt holder, and the subsidiary's single largest creditor. Due to its creditor position, the parent was able to negotiate a prepackaged bankruptcy with the subsidiary's other creditors. The parent, pursuant to the terms of the prepackaged bankruptcy, expected to maintain majority-voting control after the bankruptcy. The parent also expected the bankruptcy to be completed in less than one year.

While we are inclined to continue to believe that bankruptcy is indicative of the fact that control does not rest with the majority owner, we did not object to the parent’s determination that the continued consolidation of its subsidiary during bankruptcy was more meaningful and that any loss of control would be temporary given the facts and circumstances.

Obviously, a determination that continued consolidation of a subsidiary in bankruptcy is appropriate requires a fairly unique set of facts and is appropriate only in infrequent and uncommon circumstances. It is not a conclusion that a registrant should make without thoroughly consulting with its auditors and one the company should consider discussing with us. In any event, the conclusion and its basis should be adequately disclosed and the company should periodically reassess its facts and circumstances to confirm the appropriateness of such a determination.

D.3.1.1 Accounting for a Deconsolidated Subsidiary That Is in Bankruptcy

Once a decision is made to deconsolidate a subsidiary that is in bankruptcy, the reporting entity should determine the appropriate method of accounting for its investment in the subsidiary after deconsolidation. In making such a determination, the reporting entity should consider whether it retains the ability to exercise significant influence over the operating and financial decisions of the subsidiary as described in ASC 323.10 ASC 323-10-15-6 specifies factors to consider, which include:

The reporting entity’s representation on the subsidiary’s board of directors.
The significance of the reporting entity’s role in the policy- and decision-making process for the subsidiary, including its role in determining the overall reorganization and plan for emergence from bankruptcy.
The nature and significance of transactions between the reporting entity and its subsidiary.
Whether the reporting entity and subsidiary share management employees.
The technological interdependence of the reporting entity and subsidiary.

If it is determined that, notwithstanding the reporting entity’s loss of control of its subsidiary, the reporting entity continues to have the ability to exercise significant influence over the deconsolidated subsidiary, then the reporting entity should account for its investment in the subsidiary under the equity method. If the reporting entity has neither control nor the ability to exercise significant influence over its deconsolidated subsidiary, the reporting entity should account for its investment at fair value or in accordance with the measurement guidance in ASC 321-10-35-2.

D.3.2 Subsidiaries Operating Under Foreign Exchange Restrictions and Other Uncertainties

ASC 810-10-15-10(a)(1)(iii) states:

A majority-owned subsidiary shall not be consolidated if control does not rest with the majority owner — for instance, if [the] subsidiary operates under foreign exchange restrictions, controls, or other governmentally imposed uncertainties so severe that they cast significant doubt on the parent’s ability to control the subsidiary.

Furthermore, ASC 830-20-30-2 states, in part:

If the lack of exchangeability is other than temporary, the propriety of consolidating, combining, or accounting for the foreign operation by the equity method in the financial statements of the reporting entity shall be carefully considered.

In determining whether foreign exchange restrictions, controls, and other governmentally imposed uncertainties are severe enough to result in a lack of control by a parent entity, a reporting entity must exercise significant judgment and consider factors including, but not limited to, the following:

Volume restrictions on currency exchange activity (either explicit or in-substance), in conjunction with uncertainties about the reporting entity’s or subsidiary’s ability to obtain approval for foreign currency exchange through the established exchange mechanisms.
The ability, currently and historically, to access available legal currency exchange mechanisms in volumes desired or needed by the reporting entity or subsidiary.
Recent economic developments and trends in the foreign jurisdiction that might affect expectations about the future direction of restrictions on currency exchanges.
The extent and severity of restrictions imposed by the government on a subsidiary’s operations and whether those restrictions demonstrate the reporting entity’s inability to control its subsidiary’s operations. The reporting entity must use considerable judgment in making this determination since many governments, including the U.S. federal government, require companies to adhere to a framework of laws and regulations that govern operational matters. Examples of government intervention might include restrictions on (1) labor force reductions, (2) decisions about product mix or pricing, and (3) sourcing of raw materials or other inputs into the production process.

We generally believe that the mere fact that currency exchangeability is lacking does not in and of itself create a presumption that a reporting entity should not consolidate its foreign subsidiary, nor does the ability to exchange some volume of currency create such a presumption. In addition, in situations in which government control exists, the reporting entity should consider such control in its VIE assessment when evaluating whether the reporting entity has power. The existence of the above factors represents negative evidence in the determination of whether consolidation is appropriate on the basis of the reporting entity’s specific facts and circumstances. At the 2015 AICPA Conference on Current SEC and PCAOB Developments, an SEC staff member, Professional Accounting Fellow Chris Semesky, stated:

In the past year, OCA has observed registrant disclosures indicating a loss of control of subsidiaries domiciled in Venezuela. Disclosures indicate that these conclusions have been premised on judgments about lack of exchangeability being other than temporary and, also in some instances, the severity of government imposed controls. The application of U.S. GAAP in this area requires reasonable judgment to determine when foreign exchange restrictions or government imposed controls or uncertainties are so severe that a majority owner no longer controls a subsidiary. In the same way, a restoration of exchangeability or loosening of government imposed controls may result in the restoration of control and consolidation. In other words, I would expect consistency in a particular registrant’s judgments around whether it has lost control or regained control of a subsidiary. In addition, I would expect registrants in these situations to have internal controls over financial reporting that include continuous reassessment of foreign exchange restrictions and the severity of government imposed controls.

Further, to the extent a majority owner concludes that it no longer has a controlling financial interest in a subsidiary as a result of foreign exchange restrictions and/or government imposed controls, careful consideration should be given to whether that subsidiary would be considered a variable interest entity upon deconsolidation because power may no longer reside with the equity-at-risk holders. As a result, registrants should not only think about clear and appropriate disclosure of the judgments around, and the financial reporting impact of, deconsolidation but also of the ongoing disclosures for variable interest entities that are not consolidated.

If a reporting entity ultimately concludes that nonconsolidation of a foreign subsidiary is appropriate, the reporting entity must determine the appropriate date for any deconsolidation, including the appropriate currency exchange rate to use for remeasuring its deconsolidated investment and any other outstanding monetary balances that are no longer eliminated in consolidation (if they are not considered fully impaired). Furthermore, a reporting entity should provide clear disclosure of the basis for its consolidation/nonconsolidation conclusion regarding an investment in a foreign subsidiary for which negative evidence exists about whether it controls the foreign subsidiary. A reporting entity that continues to consolidate may wish to consider disclosing its intention to continue monitoring developments, along with a description of the possible financial statement impact, if estimable, if deconsolidation were to occur. In addition, if a reporting entity concludes that nonconsolidation of a foreign subsidiary is appropriate, the reporting entity should continue to monitor developments each reporting period to determine whether it has regained control and thus should reconsolidate the foreign subsidiary.

D.3.2.1 Accounting for a Nonconsolidated Foreign Subsidiary Under Foreign Exchange Restrictions and Other Uncertainties

When a reporting entity does not consolidate a majority-owned foreign subsidiary as a result of foreign exchange restrictions, controls, or other governmentally imposed uncertainties, it should generally use one of the following methods to account for its nonconsolidated subsidiary:

If the reporting entity exercises significant influence over the subsidiary, it should use the equity method. The reporting entity should carefully consider all relevant facts and circumstances to determine whether it continues to have significant influence over the subsidiary.
If the reporting entity does not have significant influence, it should account for its investment at fair value or in accordance with the measurement guidance in ASC 321-10-35-2.
If the reporting entity meets the relevant conditions specified in ASC 205-20 and ASC 360-10-45-5, it should account for the subsidiary as a disposal group.

In many cases, the reporting entity may conclude that given the combination of foreign exchange restrictions and other governmentally imposed uncertainties, it is appropriate to account for the investment in the nonconsolidated subsidiary in accordance with the measurement guidance in ASC 321-10-35-2 (if certain conditions are met).

D.3.3 Research and Development Arrangements

ASC 810-30 discusses research and development arrangements in which a sponsor spins off a new company (“Newco”) and then provides Newco with all of the funds for the research and development activities. ASC 810-30-25-3 states that the sponsor should (1) “[r]eclassify the cash contributed to the [Newco] as restricted cash,” (2) “[r]ecognize research and development expense as the research and development activities are performed,” and (3) “[a]ccount for the distribution of the [Newco] common stock as a dividend to common stockholders of the sponsor.” These arrangements would typically provide the sponsor with a call option on Newco’s common stock.

The scope of ASC 810-30 is specifically limited to those research and development arrangements in which (1) all of the funds for the research and development activities are provided by the sponsor of the research and development arrangement and (2) the legal entity that performs the research and development activities is not a VIE.

Example D-12

An employee of Reporting Entity A announced his intention to leave A and start a new technology company. The individual and three other individuals unrelated to A incorporated a new company, Entity B. Reporting Entity A agreed to effectively act as venture capitalist for B. The founders of B contributed nominal consideration to their start-up venture for B common stock, while A contributed $10 million in exchange for B preferred stock. The terms of the agreement between A and B stipulate that both parties would agree on the plan for developing a new technology but that B would perform the development efforts at its expense, subcontracting any of its obligations only with A’s approval. After delivery of the technology to A, B has the right to put to A, and A has the right to call from B, all outstanding common shares of B. The terms of the put and call are identical and provide for the price of the technology to be fixed on certain dates, with the put and call terminating if the technology is not delivered by the deadline established in the agreement.

This arrangement is not within the scope of ASC 810-30. Key differences between the scenario above and the example in ASC 810-30-55 include the following:

The formation of the new company is not completed through capitalization of a new entity and a subsequent spin-off.
The research and development work is completed by the new company and not by the sponsor.
The put and call are exercisable only if the product is delivered.
The new company’s operations, except for subcontracting, are not subject to the approval of the sponsor.

D.3.4 Contract-Controlled Entity Model

ASC 810-10

15-20 The guidance in the Consolidation of Entities Controlled by Contract Subsections applies, in part, to contractual management arrangements with both of the following characteristics:

Relationships between entities that operate in the health care industry including the practices of medicine, dentistry, veterinary science, and chiropractic medicine (for convenience, entities engaging in these practices are collectively referred to as physician practices)
Relationships in which the physician practice management entity does not own the majority of the outstanding voting equity instruments of the physician practice, whether because the physician practice management entity is precluded by law from owning those equity instruments or because the physician practice management entity has elected not to own those equity instruments.

As stated in the preceding paragraph, there may be industries other than the health care industry in which a contractual management arrangement is established under circumstances similar to those addressed in the Consolidation of Entities Controlled by Contract Subsections.

15-21 A physician practice management entity can establish a controlling financial interest in a physician practice through contractual management arrangements. Specifically, a controlling financial interest exists if, for a requisite period of time, the physician practice management entity has control over the physician practice and has a financial interest in the physician practice that meets all six of the requirements listed in the following paragraph. That paragraph contains guidance that describes how those six requirements are to be applied. Paragraph 810-10-55-206 contains a decision tree illustrating the basic analysis called for by both the six requirements and the presumptive, but not the other, interpretive guidance.

15-22 If all of the following requirements are met, then the physician practice management entity has a controlling financial interest in the physician practice:

Term. The contractual arrangement between the physician practice management entity and the physician practice has both of the following characteristics:
1. Has a term that is either the entire remaining legal life of the physician practice entity or a period of 10 years or more
2. Is not terminable by the physician practice except in the case of gross negligence, fraud, or other illegal acts by the physician practice management entity, or bankruptcy of the physician practice management entity.
Control. The physician practice management entity has exclusive authority over all decision making related to both of the following:
1. Ongoing, major, or central operations of the physician practice, except for the dispensing of medical services. This must include exclusive decision-making authority over scope of services, patient acceptance policies and procedures, pricing of services, negotiation and execution of contracts, and establishment and approval of operating and capital budgets. This authority also must include exclusive decision-making authority over issuance of debt if debt financing is an ongoing, major, or central source of financing for the physician practice.
2. Total practice compensation of the licensed medical professionals as well as the ability to establish and implement guidelines for the selection, hiring, and firing of them.
Financial interest. The physician practice management entity must have a significant financial interest in the physician practice that meets both of the following criteria:
1. Is unilaterally saleable or transferable by the physician practice management entity
2. Provides the physician practice management entity with the right to receive income, both as ongoing fees and as proceeds from the sale of its interest in the physician practice, in an amount that fluctuates based on the performance of the operations of the physician practice and the change in the fair value thereof.

Term, control, financial interest, and so forth are further described in paragraphs 810-10-25-63 through 25-79.

Under the contract-controlled entity model, a reporting entity should consolidate a legal entity (that is not a VIE) in which it has a controlling financial interest, even if the reporting entity owns little or none of the outstanding equity of the legal entity. To have a controlling financial interest under the contract-controlled entity model, a reporting entity must meet all of the criteria in ASC 810-10-15-22 regarding (1) the term of the contractual arrangement, (2) control over decision-making, and (3) a significant financial interest in the arrangement. The evaluation of control should take into account whether other parties have substantive participating rights.

With the introduction of the VIE model, the relevance of the contract-controlled entity model has diminished. This is because a legal entity that is controlled by contract would most likely be a VIE since one of the conditions for exemption from the VIE model is that the equity investors at risk must control the most significant activities of the legal entity (see Section 5.3). However, in the rare instances in which such a legal entity is not a VIE, the guidance in ASC 810-10-15-20 through 15-22 applies.

While the contract-controlled entity model is typically applied only for specific, limited arrangements in the health care industry (i.e., physical practice management entities), the guidance could potentially apply in other situations, as discussed below. ASC 810-10-25-63 through 25-79 provide additional interpretative guidance on the contract-controlled entity model.

D.3.4.1 Application to Arrangements Other Than Physician Practice Management Entities

During deliberations of EITF 97-2, the SEC observer indicated that the conclusions reached (now codified in the Consolidation of Entities Controlled by Contract subsections of ASC 810-10) may apply to similar arrangements in industries other than physician practice management and that the SEC staff considers this guidance when assessing the appropriate accounting for such arrangements.

The SEC observer noted during the deliberations on EITF 97-2 that similar arrangements could include circumstances in which one entity had a controlling financial interest in another entity through either a nominee structure or another contractual arrangement. Examples may include research and development arrangements, franchise arrangements, hotel management contracts, and service corporations for real estate investment trusts (REITs), and may involve the transfer of significant rights from the legal owners of an entity to another through a contract. See Example 4-31 in Section 4.4.1.3 for an illustration of an entity with a contractual arrangement that is designed to transfer the residual risks and rewards of ownership.

Because these structures appear to be similar to those contemplated in the contract-controlled entity model, it may be appropriate for reporting entities to consult that guidance when assessing whether to consolidate such an entity.

If a management company consolidates the management entity under the contract-controlled entity model, the SEC most likely will look for disclosure of (1) what a controlling financial interest is and (2) how the terms of the management agreement (or nominee shareholder arrangement) give the manager that controlling financial interest. In addition, the registrant’s MD&A should describe the impact of this controlling financial interest on the company’s business, risks, operations, and accounting.

D.3.4.2 Application to Joint Ventures

ASC 810-10-15-22(b)(1) and (b)(2) indicate that for a management entity to hold a controlling financial interest, it must have exclusive authority over all decision making related to significant ordinary-course-of-business actions such as ongoing, major, or central operations of the entity and compensation, selection, hiring, and firing of personnel. In a joint venture arrangement in which both parties must approve significant ordinary-course-of-business actions, neither party has such exclusive authority. Therefore, in a joint venture in which each investor must approve significant ordinary-course-of-business actions, no investor would consolidate the joint venture (i.e., the contract-controlled entity model would not be applicable).

Example D-13

The law in Country X prohibits foreign majority ownership. For this reason, Company B, which resides in Country Y, owns 50 percent of Joint Venture A, which resides in Country X along with another 50 percent owner, Company C, an independent third party with no expertise in A’s business. Assume that A is not a VIE. Company B has a management and services agreement with A for the entire remaining legal life of the joint venture as long as B continues to own its equity interest in A. This agreement can be terminated only by mutual agreement or because of gross negligence, fraud, or other illegal acts by B. Company B has appointed, and has the continuing right to appoint, the CEO and CFO of A. If B were to withdraw from the arrangement, C could not run the business itself and would have to sell or liquidate A unless it could find another venture partner with funding and expertise similar to B’s. Company A’s board of directors consists of six individuals, three of whom are assigned by B and three by C. The board of directors must approve A’s ordinary-course-of-business operating and capital decisions, including operating and capital budgets.

Although B possesses many of the control elements listed in ASC 810-10-15-22, B does not have the exclusive right to approve operating and capital decisions, including the respective budgets. Company C is thus able to veto certain actions and preclude B from having exclusive decision-making authority over ongoing, major, and central operations. Company B should not consolidate A unless the ability of C to veto actions related to the ongoing, major, and central operations of A is eliminated.

D.3.4.3 SEC Views on Reporting and Disclosure by Physician Practice Management Entities

The SEC staff has said that it would expect revenues and expenses of medical groups to be displayed separately from those of a physician practice management entity either on the face of the income statement or in a footnote to the financial statements.

A physician practice management entity is expected to clearly and accurately describe its business and contractual relationships. It should disclose the following:

The nature of the entity’s business, including:
- Contractual agreements and associated rights and limitations.
- How fees were determined.
- Specific services provided.
The entity’s relationship with the care providers, including:
- Whether physician groups contract directly with the entity (or its assignee) or a managed care company.
- Who assumes the risk under managed care contracts and, if the entity does, whether there are issues related to medical licensing.
- Who assumes the risk associated with capitated payment contracts and, if the entity does, whether the entity is subject to regulation as an insurance company.
State or federal regulations that affect the entity, including:
- State prohibitions against corporate medical practice.
- Regulation of the entity as an insurer.
- The impact of federal anti-kickback and self-referral restrictions.

The SEC staff has said that it expects a physician practice management entity to completely discuss the contractual terms in MD&A, including rights and obligations, the basis for the determination of fees, and the ability of the entity to profitably manage the practices. Further, the staff has noted that the entity is generally not required to provide the financial statements of a medical practice that the entity either has acquired or will acquire as long as the entity will not consolidate or provide any guarantees to the medical practice and is not materially dependent on it.

Footnotes

See Chapter 3 of Deloitte’s Roadmap Equity Method Investments and Joint Ventures for additional details.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.