Appendix D — Voting Interest Entity Model

A reporting entity with an economic interest in a legal entity that does not qualify for a general exception to the requirements for consolidation must apply the consolidation guidance in ASC 810-10.1 That guidance is presented in the following three main subsections: (1) “General,” (2) “Variable Interest Entities,” and (3) “Consolidation of Entities Controlled by Contract.”

Only after the reporting entity has determined that the legal entity is not subject to the VIE model (see Chapter 5) does it apply the "general" guidance or the guidance on the consolidation of entities controlled by contract.

The general guidance applies to voting interest entities (referred to hereafter as the “voting interest entity model”). The guidance on the consolidation of entities controlled by contract (referred to hereafter as the “contract-controlled entity model”) applies in certain situations in which a legal entity that is not a VIE is controlled through a contractual management relationship. Under both the voting interest entity model and the contract-controlled entity model, a reporting entity consolidates a legal entity when it has a controlling financial interest in the legal entity. This appendix provides additional guidance on the voting interest entity and contract-controlled entity models. See Table 1-1 in Section 1.4 for differences between the voting interest entity model and the VIE model.

The determination of whether a reporting entity should consolidate a voting interest entity is a continual process. That is, the reporting entity should monitor specific transactions or events that affect whether it holds a controlling financial interest.

D.1 General Consolidation Principles

D.1.1 Limited Partnerships (and Similar Entities)

D.1.2 Legal Entities That Are Not Limited Partnerships (or Similar Entities)

D.1.3 General Concept of Control

D.1.4 Consideration of Potential Voting Rights in Evaluating Control

D.1.5 Consideration of Indirect Ownership Interests in Evaluating Control

D.1.6 Consideration of Kick-Out Rights for Limited Partnerships

D.1.7 Reassessment of Controlling Rights

D.2 The Effect of Noncontrolling Rights on Consolidation

D.2.1 Protective Rights

D.2.2 Participating Rights

D.2.3 Factors to Consider in Evaluating Whether Noncontrolling Rights Are Substantive Participating Rights

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

D.3.1 Subsidiaries in Bankruptcy

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

D.3.3 Research and Development Arrangements

D.3.4 Contract-Controlled Entity Model

Footnotes

As discussed in Section 3.3, there are four general exceptions to the consolidation requirements for a legal entity. Broadly speaking, the exceptions apply to (1) employee benefit plans, (2) investment companies, (3) governmental entities, and (4) money market funds.

D.1 General Consolidation Principles

The flowchart below shows the detailed steps that a reporting entity should follow when evaluating a legal entity under the voting interest entity model.

ASC 810-10

05-3 Throughout this Subtopic, any reference to a limited partnership includes limited partnerships and similar legal entities. A similar legal entity is an entity (such as a limited liability company) that has governing provisions that are the functional equivalent of a limited partnership. In such entities, a managing member is the functional equivalent of a general partner, and a nonmanaging member is the functional equivalent of a limited partner.

15-8 For legal entities other than limited partnerships, the usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule ownership by one reporting entity, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity is a condition pointing toward consolidation. The power to control may also exist with a lesser percentage of ownership, for example, by contract, lease, agreement with other stockholders, or by court decree.

15-8A Given the purpose and design of limited partnerships, kick-out rights through voting interests are analogous to voting rights held by shareholders of a corporation. For limited partnerships, the usual condition for a controlling financial interest, as a general rule, is ownership by one limited partner, directly or indirectly, of more than 50 percent of the limited partnership’s kick-out rights through voting interests. The power to control also may exist with a lesser percentage of ownership, for example, by contract, lease, agreement with partners, or by court decree.

15-9 A majority-owned subsidiary is an entity separate from its parent and may be a variable interest entity (VIE) that is subject to consolidation in accordance with the Variable Interest Entities Subsections of this Subtopic. Therefore, a reporting entity with an explicit or implicit interest in a legal entity within the scope of the Variable Interest Entities Subsections shall follow the guidance in the Variable Interest Entities Subsections.

15-10 A reporting entity shall apply consolidation guidance for entities that are not in the scope of the Variable Interest Entities Subsections (see the Variable Interest Entities Subsection of this Section) as follows:

All majority-owned subsidiaries — all entities in which a parent has a controlling financial interest — shall be consolidated. However, there are exceptions to this general rule.
1. A majority-owned subsidiary shall not be consolidated if control does not rest with the majority owner — for instance, if any of the following are present:
  1. The subsidiary is in legal reorganization
  2. The subsidiary is in bankruptcy
  3. 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.
  4. In some instances, the powers of a shareholder with a majority voting interest or limited partner with a majority of kick-out rights through voting interests to control the operations or assets of the investee are restricted in certain respects by approval or veto rights granted to the noncontrolling shareholder or limited partner (hereafter referred to as noncontrolling rights). In paragraphs 810-10-25-2 through 25-14, the term noncontrolling shareholder refers to one or more noncontrolling shareholders and the terms limited partner and general partner refer to one or more limited or general partners. Those noncontrolling rights may have little or no impact on the ability of a shareholder with a majority voting interest or limited partner with a majority of kick-out rights through voting interests to control the investee’s operations or assets, or, alternatively, those rights may be so restrictive as to call into question whether control rests with the majority owner.
  5. Control exists through means other than through ownership of a majority voting interest or a majority of kick-out rights through voting interests, for example as described in (c) through (e).
2. A majority-owned subsidiary in which a parent has a controlling financial interest shall not be consolidated if the parent is a broker-dealer within the scope of Topic 940 and control is likely to be temporary.
3. Subparagraph superseded by Accounting Standards Update No. 2013-08.
Subparagraph superseded by Accounting Standards Update No. 2015-02.
Subtopic 810-30 shall be applied to determine the consolidation status of a research and development arrangement.
The Consolidation of Entities Controlled by Contract Subsections of this Subtopic shall be applied to determine whether a contractual management relationship represents a controlling financial interest.
Paragraph 710-10-45-1 addresses the circumstances in which the accounts of a rabbi trust that is not a VIE (see the Variable Interest Entities Subsections for guidance on VIEs) shall be consolidated with the accounts of the employer in the financial statements of the employer.

25-1 For legal entities other than limited partnerships, consolidation is appropriate if a reporting entity has a controlling financial interest in another entity and a specific scope exception does not apply (see Section 810-10-15). The usual condition for a controlling financial interest is ownership of a majority voting interest, but in some circumstances control does not rest with the majority owner.

25-1A Given the purpose and design of limited partnerships, kick-out rights through voting interests are analogous to voting rights held by shareholders of a corporation. Consolidation is appropriate if a reporting entity has a controlling financial interest in a limited partnership and a specific scope exception does not apply (see Section 810-10-15). The usual condition for a controlling financial interest in a limited partnership is ownership of a majority of the limited partnership’s kick-out rights through voting interests, but, in some circumstances, control does not rest with the majority owner.

ASC 810-10 — Glossary

Kick-Out Rights (Voting Interest Entity Definition)

The rights underlying the limited partner’s or partners’ ability to dissolve (liquidate) the limited partnership or otherwise remove the general partners without cause.

Under the voting interest entity model, a reporting entity consolidates a legal entity when it has a controlling financial interest in the legal entity through its ownership of voting interests.2 Limited partnerships that are not VIEs are evaluated for consolidation in essentially the same manner as corporations that are not VIEs. More specifically, under the voting interest entity model, if there is a presumption that a party controls an entity (i.e., a party holding over 50 percent of the voting interest in a corporation or a party in a limited partnership holding unilateral kick-out or liquidation rights), a reporting entity must consider whether that presumption is overcome because of the existence of substantive participating rights held by other parties.

D.1.1 Limited Partnerships (and Similar3 Entities)

Under the voting interest entity model, a general partner will not consolidate a limited partnership.4 Rather, the concept of a controlling financial interest is premised on whether a limited partner owns substantive kick-out rights that give it the unilateral right to, without cause, remove the general partner or dissolve the partnership.

D.1.2 Legal Entities That Are Not Limited Partnerships (or Similar Entities)

For legal entities that are not limited partnerships, a controlling financial interest is premised on whether a reporting entity has voting interests that give it control over the financial and operating policies of the legal entity. A controlling financial interest typically exists when a reporting entity owns more than 50 percent of the outstanding voting shares of another entity. However, there are exceptions to this general principle, as discussed below.

D.1.3 General Concept of Control

There is no precise definition in the authoritative accounting literature of “control” as it applies to consolidation and related matters. ASC 850-10-20 states that control is the “possession, direct or indirect, of the power to direct or cause the direction of the management and policies of an entity through ownership, by contract, or otherwise.” This definition of control is substantively the same as that in SEC Regulation S-X, Rule 1-02(g).

ASC 810-10-15-8 and 15-8A indicate that an investor with a majority voting interest, or a limited partner with a majority of kick-out rights through voting interests, will generally control a legal entity. However, ASC 810-10-15-8 and 15-8A also provide exceptions to this guidance and indicate that the power to control may also exist with a lesser percentage of ownership, for example, by contract, lease, agreement with other owners of voting interests, or court decree. Therefore, conclusions about control should be based on an evaluation of the specific facts and circumstances. In some situations, an investor with less than a majority voting interest, or a limited partner with less than a majority of kick-out rights, can control a legal entity. In other situations, the power of a stockholder with a majority voting interest, or a limited partner with a majority of kick-out rights, to control a legal entity does not exist with the majority owner because of noncontrolling rights or as a result of other factors.

D.1.3.1 Control Without a Majority Voting Interest

In the absence of participating rights held by other parties, the following factors may indicate substantive control of a legal entity by an investor, even if the investor does not own a majority of the voting interests in the legal entity:

For legal entities other than limited partnerships, control of the board of directors/governing body or other decision-making body that is responsible for making the significant decisions of the entity.
For limited partnerships, ASC 810-10-15-8A states that “kick-out rights through voting interests are analogous to voting rights held by shareholders of a corporation.” Therefore, the usual condition for a controlling financial interest in a limited partnership, as a general rule, is ownership by one limited partner, directly or indirectly, of more than 50 percent of the limited partnership’s kick-out rights through voting interests.
Notwithstanding lack of ownership of a majority of voting interests by contract, lease, agreement with other owners of voting interests, or court decree, an investor has control of sufficient proxy rights for a majority of the voting interests of a legal entity.
The investor has the ability to unilaterally set or significantly change the operating or capital policies of the investee, including budgets, in the ordinary course of business.
Possession of options or other securities convertible into voting interests, if such securities are currently exercisable, at little or no economic cost (see Section D.1.4).

The mere existence of a participating right or a protective right would not give a reporting entity that lacks majority voting interests a controlling financial interest in a legal entity. For guidance on the accounting in such a scenario, including a situation in which a joint venture arrangement may exist, see Deloitte’s Roadmap Equity Method Investments and Joint Ventures.

Example D-1

Company X previously owned 90 percent of the common stock in Company Y (a corporation), controlled the election of directors to Y’s board, and had voting power over Y. All of Y’s significant decisions are made by Y’s board. Company X subsequently sold 40 percent of its common stock investment in Y, reducing its voting interest in Y to 50 percent. However, X continued to control the election of directors to Y’s board, and the other equity holders did not have substantive participating rights. Company Y is not a VIE.

In this example, X would continue to consolidate Y even though it no longer owns a majority voting interest in Y because X controls the board of directors and governing body of Y.

D.1.3.2 Lack of Control With a Majority Voting Interest

The powers of a stockholder with a majority voting interest, or a limited partner with a majority of kick-out rights, to control a legal entity does not exist with the majority owner when other investors have substantive participating rights (see Section D.2 for a discussion of participating rights). In addition, when any of the following conditions exist, an investor does not have control over a legal entity even if the investor owns a majority of the voting interests in the legal entity:

The legal entity is undergoing a legal reorganization.
The legal entity is in bankruptcy.
The legal entity is operating under foreign exchange restrictions, controls, or other governmentally imposed uncertainties that are so severe that they cast significant doubt on the controlling shareholder’s ability to control the legal entity.
The governing provisions of a legal entity other than a limited partnership require greater than a simple majority vote to approve decisions regarding the financial and operating policies of the legal entity that are made in the ordinary course of the legal entity’s business.5
The legal entity is temporarily controlled by a parent that is a broker-dealer within the scope of ASC 940.

See Section D.3 for additional discussion of these situations.

D.1.3.3 Evaluation of the Board of Directors

In circumstances in which the board of directors makes the significant financial and operating decisions of a legal entity, the right to appoint, remove, or replace board members may be indicative of the party that has control over the legal entity. If the board of directors is required to include certain independent directors,6 the governing documents or contractual provisions may specify which party (or parties) appoints the independent directors.

Questions may arise about how to determine which party has control of the board of directors when one party has the ability to unilaterally appoint or remove one or more independent directors. In these situations, we generally attribute the power associated with the right to appoint the independent director to the party (if one exists) that has the unilateral ability to appoint, remove, or replace such independent director. This analysis may be complex in situations in which an investor has the right to appoint and approve an independent director, as illustrated in the examples below.

Example D-2

Investors H and P, two unrelated parties, each have a 50 percent equity interest in LLC, a voting interest entity. LLC has a board of directors that is composed of five individuals, two of whom are elected and appointed by H (one of whom must be independent7), and three of whom are selected by P (two of whom must be independent). The significant decisions of LLC are made through a simple majority vote of the board of directors. At face value, the fact that three of the five members of the board must be independent may suggest that neither party has voting power. However, upon further analysis to determine which party had the right to appoint the independent directors, P would be deemed to have voting power by virtue of its ability to elect, appoint, or remove three of the five board members.

Example D-3

Assume the same facts as in the example above, except that LLC has a board of directors that is composed of five individuals, two of whom are elected and appointed by Investor H and three of whom are elected and appointed by Investor P (two of whom must be independent8). At face value, the fact that two of the five board members must be independent may suggest that no single party would be deemed to have voting power. However, upon further analysis to determine which party had the right to appoint the independent directors, P would be deemed to have voting power by virtue of its ability to elect, appoint, or remove three of the five board members.

Example D-4

Entity G, a voting interest entity, was formed on January 1, 20X2. Assume the following as of that date:

Investors M and L, two unrelated parties, have a 20 percent and a 25 percent equity interest, respectively, in G.
The remaining 55 percent equity interest is held by several unrelated shareholders, none of which individually have more than a 50 percent equity interest and are not required, nor do they intend, to vote in concert with one another.
Entity G has a board of directors that is composed of five individuals. Two are elected and appointed by M, one is elected and appointed by L, and two must be independent.9 The two independent directors are elected and appointed by a majority vote of the shareholders (which include M, L, and the unrelated shareholders that hold the remaining 55 percent equity interest) at the annual shareholder meeting.

The significant decisions of G are made through a simple majority vote of the board of directors. If an analysis were performed to determine which party had voting power, no single party would be deemed to have such power by virtue of its inability to elect and appoint a majority of the five board members.

D.1.4 Consideration of Potential Voting Rights in Evaluating Control

A reporting entity may hold certain contractual rights that allow it to acquire additional voting interests in a legal entity. For example, the reporting entity may have a call option to purchase additional equity in a legal entity that is not a limited partnership (or a limited partner may have the contractual right to purchase limited partnership interests held by other limited partners). Potential voting rights may also exist through other types of securities that are convertible into voting interests (e.g., convertible securities).

ASC 810-10 does not specifically address how to consider potential voting rights in determining whether a reporting entity has a controlling financial interest in a legal entity that is not a VIE (other than the impact that potential voting rights may have on the determination of whether a participating right is substantive — see additional discussion in Section D.2.3). As a general principle, the assessment of control of a legal entity that is not a VIE should be made on the basis of existing voting interests owned (and other existing contractual agreements that permit control at the time of assessment) as opposed to contingent actions or events that must occur before a controlling financial interest is obtained (e.g., exercising a call option and purchasing additional voting interests in a legal entity). Thus, a potential voting right would not typically affect the determination of whether a controlling financial interest is present.10 However, potential voting rights may reflect substantive control over a legal entity if a reporting entity can obtain the additional voting interests at little or no economic cost; that is, when the purchase price is considered nonsubstantive. A reporting entity must use significant judgment and evaluate all relevant facts and circumstances to determine whether the purchase price is nonsubstantive.

The above discussion focuses on potential voting rights that may be obtained by a reporting entity through the acquisition of additional voting interests in a legal entity. The same general principle discussed above would also apply when a reporting entity that does not own a majority of voting interests has an existing contract, lease, or other agreement that will give the reporting entity a controlling financial interest in the future. That is, such contract or agreement would typically not result in the reporting entity’s possession of a controlling financial interest until the date at which it obtains control. However, all facts and circumstances must be considered. For example, the reporting entity may be deemed to currently have a controlling financial interest if, on the basis of the terms of the contract, lease, or other agreement, no significant actions regarding the financial and operating policies of the reporting entity may be taken before the date on which the reporting entity obtains the controlling financial interest.

Under the voting interest entity model, potential voting rights that may be (or will be) obtained in the future (e.g., potential voting rights that may be obtained with little or no economic cost on a future date, which would include a limited partner’s ability to remove the general partner or liquidate the limited partnership) will have no impact on the consolidation analysis unless (or until) the possibility is remote (i.e., it is not reasonably possible) that significant decisions in the ordinary course of business will be made before the date on which the potential voting right is exercisable. In making this determination, the reporting entity must exercise significant judgment in light of all relevant facts and circumstances. In many cases, there may be nothing to preclude a majority investor from taking a significant action before the date on which the potential voting right becomes exercisable; that is, unless there is evidence to the contrary, in many cases there will be a greater than remote possibility that a significant decision might be made before the date on which the potential voting right is exercisable.

D.1.5 Consideration of Indirect Ownership Interests in Evaluating Control

In determining whether a controlling financial interest is present, a reporting entity should consider not only its directly owned voting interests but also any voting interests indirectly owned in a legal entity. In certain instances, a reporting entity that does not directly hold a majority of voting interests in a legal entity may have a controlling financial interest in the legal entity through a combination of direct and indirect voting interests.

An indirect voting interest is deemed to exist when a reporting entity controls another owner of voting interests in a legal entity. If a reporting entity controls another investor in the legal entity, the reporting entity should consider the voting interests owned by the other investor in its analysis of whether it has a controlling financial interest in a legal entity. The consideration of indirectly owned voting interests is required even if the reporting entity does not consolidate the other investor (because, for example, the legal entity qualifies for an exception to the consolidation requirements in ASC 810-10).

However, note that under the voting interest entity model, in the absence of a contract or other agreement that gives a reporting entity the right to vote for the interests held by its related parties, the reporting entity is not required to consider the voting interests owned by its related parties that it does not control.

Example D-5

Reporting Entity A owns 60 percent of Entity B (a corporation) and consolidates it under ASC 810-10. Entity B owns 51 percent of Entity C (a corporation) and consolidates it under ASC 810-10. Reporting Entity A indirectly controls C through B and should consolidate C (through A’s consolidation of B) even though the noncontrolling interest would be more than 69 percent (noncontrolling interest in Entity B of 40% × 51% of Entity C = 20.4%, added to 49% “other” ownership in Entity C = 69.4%).

In the above scenario, if A did not control (i.e., consolidate) B, A would not indirectly control C and would not consolidate C.

Example D-6

Reporting Entity A owns 60 percent of the limited partnership interests in Partnership B and 10 percent of the limited partnership interests in Partnership C. Partnership B owns 49 percent of the limited partnership interests in Partnership C. The respective general partner of both B and C may be removed by a simple majority vote of limited partners that have substantive kick-out rights and are not under common control with, or acting on behalf of, the general partner. Other limited partners do not have substantive participating rights. Reporting Entity A controls C through direct ownership (10 percent) and indirect ownership (49 percent held by B, a majority-owned subsidiary) of the limited partnership interests in C and therefore should consolidate C. Although A is required to consolidate C because it has control through direct and indirect ownership of voting interests, B would not consolidate C in its separate financial statements because A’s ownership in C is not attributed to B.

Example D-7

Reporting Entity A owns 49 percent of Entity B (a corporation) and 40 percent of Entity C (a corporation). Entity B owns 40 percent of C. Reporting Entity A does not control and should not consolidate B. Reporting Entity A also would not consolidate C despite having an almost 60 percent combined direct and indirect ownership interest in C because Entity A does not unilaterally control B’s voting interest in C.

D.1.6 Consideration of Kick-Out Rights for Limited Partnerships

As noted in ASC 810-10-25-1A, kick-out rights in a limited partnership are viewed as the equivalent of voting shares in a corporation. Accordingly, in the absence of participating rights held by other limited partners, a limited partner that owns substantive kick-out rights that give it the unilateral right to, without cause, remove the general partner or dissolve the partnership would have a controlling financial interest in the limited partnership. A reporting entity must evaluate the relevant facts and circumstances under ASC 810-10-25-14A through 25-14C to determine whether a kick-out right is substantive (see additional discussion in Section D.2.3.1).

The guidance in ASC 810-10-25-14A through 25-14C on whether kick-out rights are substantive should be applied in the determination of whether (1) a limited partnership is a VIE under ASC 810-10-15-14(b)(1)(ii) and (2) whether a single limited partner has a controlling financial interest in a limited partnership. If a conclusion is reached that the kick-out rights held by limited partners are not substantive (and the limited partners are not able to exercise substantive participating rights), then the limited partnership would be a VIE and not a voting interest entity. It is not possible to conclude that the same kick-out rights are (1) substantive in the evaluation of whether a limited partnership is a VIE and (2) nonsubstantive in the evaluation of whether a majority owner of limited partnership interests has a controlling financial interest in the limited partnership.

D.1.6.1 Kick-Out Rights Held by Related Parties

In discussing the consolidation of limited partnerships that are voting interest entities, ASC 810-10-15-8A refers to ownership by one limited partner “directly or indirectly” of more than 50 percent of the limited partnership’s kick-out rights through voting interests. Although not specifically addressed in ASC 810-10, the concept of owning kick-out rights “indirectly” does not extend beyond the ownership of kick-out rights through the control of another limited partner that also owns kick-out rights through voting interests. That is, for a limited partnership that is not a VIE, in the absence of a contract or other agreement that gives the limited partner the right to vote the kick-out rights held by its related parties, the limited partner is not required to consider the kick-out rights held by its related parties that it does not control. Rather, the limited partner is only required to consider the nature of related-party relationships to determine whether a noncontrolling interest right is a substantive participating right.

Example D-8

Reporting Entity A owns 49 percent of the limited partnership interests of Partnership B and 40 percent of the voting shares of Entity C (a corporation), which owns 40 percent of the limited partnership interests in B. Reporting Entity A accounts for its investment in C by using the equity method of accounting. Reporting Entity A does not control and should not consolidate B. Although A has a combined direct and indirect limited partnership interest of 65 percent in B, which is calculated as 49% + (40% × 40%), A does not unilaterally control the kick-out rights of B because it exerts only significant influence over the limited partnership interests owned indirectly through C.

D.1.6.2 Evaluation of Liquidation and Withdrawal Rights as Kick-Out Rights

As discussed in Section 2.4, two different definitions of kick-out rights apply depending on whether the legal entity is (1) a limited partnership (or similar entity) that uses the voting interest entity definition or (2) other than a limited partnership (or similar entity) that uses the VIE definition. According to the definition of a voting interest entity in the ASC master glossary, the right "to dissolve (liquidate) the limited partnership . . . without cause" is a kick-out right.

Paragraph BC49 of ASU 2015-02 provides the FASB’s thoughts regarding the evaluation of liquidation rights and notes that they “should be considered equivalent to kick-out rights [because they] provide the holders of such rights with the ability to dissolve the entity and, thus, effectively remove the decision maker’s authority.” Paragraph BC49 of ASU 2015-02 further indicates that the Board considered, but rejected, evaluating liquidation rights in a manner similar to kick-out rights “only when it is reasonable that upon liquidation, the investors will receive substantially all of the specific assets under management and can find a replacement manager with sufficient skills to manage those assets.” As noted in paragraph BC49 of ASU 2015-02, the “Board ultimately rejected this view because the outcome for the decision maker is the same regardless of whether the holders of those rights have the ability to obtain the specific assets from the entity upon liquidation or identify an alternative manager [because if] the holders exercise their substantive liquidation rights, similar to kick-out rights, the decision maker’s abilities would be removed.” Therefore, any liquidation right should be considered a kick-out right and would result in a limited partner’s consolidation of a limited partnership that is not a VIE as long as the right (1) is substantive11 and (2) gives a single limited partner the unilateral ability to liquidate a limited partnership. If these conditions are met, the single limited partner would consolidate the limited partnership even if other limited partners have substantive participating rights before liquidation. That is, we believe that a noncontrolling limited partner’s right to exercise a substantive participating right is not relevant to the consolidation analysis when a limited partner has a substantive ability to liquidate the limited partnership, because the potential liquidation effectively negates any participation right.

It is important to distinguish liquidation rights from withdrawal rights since ASC 810-10-25-14B indicates that a reporting entity’s unilateral right to withdraw from an entity that does not require dissolution or liquidation of the entire entity “would not be deemed a kick-out right.” Therefore, a reporting entity should carefully analyze withdrawal rights to determine whether, on the basis of the specific facts and circumstances, they represent liquidation rights.

This may be the case when a limited partnership has only a single limited partner or when a limited partnership’s formation documents require the dissolution of the limited partnership upon exercise of the withdrawal right (e.g., as a result of the exercise of the withdrawal right, the amount of the limited partnership’s remaining assets may decline to a level that triggers dissolution). Withdrawal rights that do not require the dissolution or liquidation of the entire limited partnership do not represent liquidation rights and therefore should not be considered kick-out rights.12 Furthermore, when the exercise of a withdrawal right does require the dissolution or liquidation of the entire limited partnership, the right should only result in a limited partner’s consolidation of a limited partnership if the right (1) is substantive13 and (2) gives a single limited partner the unilateral ability to withdraw and cause either the dissolution or liquidation of the limited partnership. In a manner consistent with a liquidation right discussed above, if these conditions are met, the single limited partner with such a withdrawal right would consolidate the limited partnership even if other limited partners have substantive participating rights before liquidation.

Note also that special consideration is necessary when a liquidation right (or a withdrawal right that represents a liquidation right) is exercisable in the future. In these situations, the right should be evaluated in the same manner as other potential voting rights (see Section D.1.4).

D.1.6.2.1 Evaluation of Buy-Sell Clauses as a Liquidation Right

A buy-sell term in a contractual agreement can take various forms. However, in an arrangement in which two investors each own 50 percent of an entity, a buy-sell clause generally gives each investor the ability to offer to buy out the entire equity interest of another investor (the “offeree”) upon giving notice to the offeree. The investor making the offer (the “offeror”) typically names a price for the offeree’s interest at its discretion. After receiving the offer from the offeror, the offeree typically is contractually required to either (1) sell its entire interest in the entity to the offeror at the named price or (2) buy the offeror’s interest at the named price. Buy-sell agreements are not typically considered liquidation rights. See Example 5-37 in Section 5.3.1.2.6.

D.1.7 Reassessment of Controlling Rights

The initial assessment of controlling rights should be made at the time the reporting entity becomes involved with the voting interest entity. However, rights should be reassessed on a continual basis, and the reporting entity should monitor specific transactions or events that may affect whether it still holds a controlling (or noncontrolling) financial interest in the voting interest entity. Examples of events that may affect this assessment and therefore should be considered include, but are not limited to:

Changes in the total number of shareholders or limited partners and total outstanding voting interests.
Changes in ownership percentages and corresponding changes to voting rights or decision-making rights.
Amendments to governance documents that may affect voting interests or decision-making rights.
Changes in exercisability of potential voting rights. See Section D.1.4.

When a reporting entity considers these events, it should also assess whether the events would qualify as VIE reconsideration events (see Chapter 9 for more information).

Footnotes

Hereafter, unless otherwise specifically noted, “voting interests” refer to voting shares for legal entities other than limited partnerships and kick-out rights for limited partnerships.

For a discussion of what is meant by “similar” entities, see Section 5.3.1.2.1.

As discussed in Section 5.3.1.2, if a simple majority or lower threshold (including a single limited partner) of “unrelated” limited partners (i.e., parties that are not under common control with, or acting on behalf of, the general partner) with equity at risk is unable to exercise substantive kick-out rights or substantive participating rights, the limited partnership is a VIE. Thus, limited partnerships that were consolidated by the general partner under the voting interest entity model before ASU 2015-02 are now subject to consolidation under the VIE subsections of ASC 810-10. Accordingly, a general partner will not consolidate a limited partnership under the voting interest entity model. See Chapter 7 for a discussion of when a general partner would consolidate a limited partnership that is a VIE.

If the right to remove the general partner of a limited partnership requires the exercise of more than a simple majority of kick-out rights, the limited partnership is a VIE. See additional discussion in Section 5.3.1.2.

Under SEC rules, an independent director is a member of the board of directors who has no material connection to the entity or its management.

See footnote 6.

Potential voting rights could, however, affect the assessment of whether a legal entity is a VIE when those interests represent variable interests in a legal entity.

Paragraph BC49 of ASU 2015-02 states that “[b]arriers to exercise may be different when considering kick-out rights as compared with barriers for liquidation rights and should be evaluated appropriately when assessing whether the rights are substantive.”

As stated in ASC 810-10-25-14B, “[t]he requirement to dissolve or liquidate the entire limited partnership upon the withdrawal of a limited partner or partners shall not be required to be contractual for a withdrawal right to be considered as a potential kick-out right.” Therefore, a reporting entity must determine, on the basis of the facts and circumstances, whether the practical result of the withdrawal will be the required dissolution of the partnership (e.g., the partnership has only one limited partner and the general partner has a nominal interest) or its liquidation.

See footnote 11.

D.2 The Effect of Noncontrolling Rights on Consolidation

ASC 810-10

25-2 Paragraph 810-10-15-10(a)(1)(iv) explains that, in some instances, the powers of a shareholder with a majority voting interest or limited partner with a majority of kick-out rights through voting interests to control the operations or assets of the investee are restricted in certain respects by approval or veto rights granted to the noncontrolling shareholder or limited partner (referred to as noncontrolling rights). That paragraph also explains that, in paragraphs 810-10-25-2 through 25-14, the term noncontrolling shareholder refers to one or more noncontrolling shareholders and the terms limited partner and general partner refer to one or more limited or general partners. Paragraph 810-10-15-10(a)(1)(iv) explains that those noncontrolling rights may have little or no impact on the ability of a shareholder with a majority voting interest or limited partner with a majority of kick-out rights through voting interests to control the investee’s operations or assets, or, alternatively, those rights may be so restrictive as to call into question whether control rests with the majority owner.

25-3 The guidance in paragraphs 810-10-25-1 through 25-14 shall be applied in assessing the impact on consolidation of noncontrolling shareholder or limited partner approval or veto rights in both of the following circumstances:

Investments in which the investor has a majority voting interest in investees that are corporations or analogous entities (such as limited liability companies that have governing provisions that are the functional equivalent of regular corporations), or investments in which a limited partner has a majority of kick-out rights through voting interests in a limited partnership
Other circumstances in which legal entities would be consolidated in accordance with generally accepted accounting principles (GAAP), absent the existence of certain approval or veto rights held by noncontrolling shareholders or limited partners.

25-4 The guidance in paragraphs 810-10-25-2 through 25-14 on noncontrolling rights does not apply in either of the following situations:

Entities that, in accordance with GAAP, carry substantially all of their assets, including investments in controlled entities, at fair value with changes in value reported in a statement of net income or financial performance
Investments in variable interest entities (VIEs) (see the Variable Interest Entities Subsection of Section 810-10-15).

25-5 The assessment of whether the rights of a noncontrolling shareholder or limited partner should overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee is a matter of judgment that depends on facts and circumstances. The framework in which such facts and circumstances are judged shall be based on whether the noncontrolling rights, individually or in the aggregate, allow the noncontrolling shareholder or limited partner to effectively participate in certain significant financial and operating decisions of the investee that are made in the ordinary course of business. Effective participation means the ability to block significant decisions proposed by the investor who has a majority voting interest or the general partner. That is, control does not rest with the majority owner because the investor with the majority voting interest cannot cause the investee to take an action that is significant in the ordinary course of business if it has been vetoed by the noncontrolling shareholder. Similarly, for limited partnerships, control does not rest with the limited partner with the majority of kick-out rights through voting interests if the limited partner cannot cause the general partner to take an action that is significant in the ordinary course of business if it has been vetoed by other limited partners. This assessment of noncontrolling rights shall be made at the time a majority voting interest or a majority of kick-out rights through voting interests is obtained and shall be reassessed if there is a significant change to the terms or in the exercisability of the rights of the noncontrolling shareholder or limited partner.

25-6 All noncontrolling rights could be described as protective of the noncontrolling shareholder’s or limited partner’s investment in the investee, but some noncontrolling rights also allow the noncontrolling shareholder or limited partner to participate in determining certain significant financial and operating decisions of the investee that are made in the ordinary course of business (referred to as participating rights). Participation means the ability to block actions proposed by the investor that has a majority voting interest or the general partner. Thus, the investor with the majority voting interest or the general partner must have the agreement of the noncontrolling shareholder or limited partner to take certain actions. Participation does not mean the ability of the noncontrolling shareholder or limited partner to initiate actions.

25-7 Noncontrolling rights that are only protective in nature (referred to as protective rights) would not overcome the presumption that the owner of a majority voting interest or the limited partner with a majority of kick-out rights through voting interests shall consolidate its investee. Substantive noncontrolling rights that allow the noncontrolling shareholder or limited partner to effectively participate in certain significant financial and operating decisions of the investee that are made in the investee’s ordinary course of business, although also protective of the noncontrolling shareholder’s or limited partner’s investment, shall overcome the presumption that the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests shall consolidate its investee.

25-8 For purposes of this Subsection, decisions made in the ordinary course of business are defined as decisions about matters of a type consistent with those normally expected to be addressed in directing and carrying out the entity’s current business activities, regardless of whether the events or transactions that would necessitate such decisions are expected to occur in the near term. However, it must be at least reasonably possible that those events or transactions that would necessitate such decisions will occur. The ordinary course of business definition would not include self-dealing transactions with controlling shareholders or limited partners.

Reporting entities must evaluate rights that are granted by law or by contract that are retained by noncontrolling shareholders (or noncontrolling limited partners in a limited partnership) to assess whether such rights have an impact on the determination of whether the reporting entity has a controlling financial interest in a legal entity. Noncontrolling rights can be broadly categorized as either (1) protective rights or (2) participating rights. Only participating rights can preclude consolidation of a legal entity by an investor with a majority voting interest or a limited partner with a majority of kick-out rights.

D.2.1 Protective Rights

ASC 810-10

25-10 Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder or limited partner to block corporate or partnership actions would be considered protective rights and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. The following list is illustrative of the protective rights that often are provided to the noncontrolling shareholder or limited partner but is not all-inclusive:

Amendments to articles of incorporation or partnership agreements of the investee
Pricing on transactions between the owner of a majority voting interest or limited partner with a majority of kick-out rights through voting interests and the investee and related self-dealing transactions
Liquidation of the investee in the context of Topic 852 on reorganizations or a decision to cause the investee to enter bankruptcy or other receivership
Acquisitions and dispositions of assets that are not expected to be undertaken in the ordinary course of business (noncontrolling rights relating to acquisitions and dispositions of assets that are expected to be made in the ordinary course of business are participating rights; determining whether such rights are substantive requires judgment in light of the relevant facts and circumstances [see paragraphs 810-10-25-13 and 810-10-55-1])
Issuance or repurchase of equity interests.

ASC 810-10 — Glossary

Protective Rights (Voting Interest Entity Definition)

Rights that are only protective in nature and that do not allow the limited partners or noncontrolling shareholders to participate in significant financial and operating decisions of the limited partnership or corporation that are made in the ordinary course of business.

By definition, protective rights do not allow the noncontrolling shareholders or noncontrolling limited partners to participate in significant financial and operating decisions made in a corporation’s or limited partnership’s ordinary course of business. These types of rights do not overcome the presumption of consolidation of the corporation or limited partnership by the controlling financial interest holder. See Section D.2.3 for additional discussion of the evaluation of whether noncontrolling rights are substantive participating rights.

D.2.2 Participating Rights

ASC 810-10

25-11 Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder or limited partner to effectively participate in either of the following corporate or partnership actions shall be considered substantive participating rights and would overcome the presumption that the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests shall consolidate its investee. The following list is illustrative of substantive participating rights, but is not necessarily all-inclusive:

Selecting, terminating, and setting the compensation of management responsible for implementing the investee’s policies and procedures
Establishing operating and capital decisions of the investee, including budgets, in the ordinary course of business.

25-12 The rights noted in paragraph 810-10-25-11 are participating rights because, in the aggregate, the rights allow the noncontrolling shareholder or limited partner to effectively participate in certain significant financial and operating decisions that occur as part of the ordinary course of the investee’s business and are significant factors in directing and carrying out the activities of the business. Individual rights, such as the right to veto the termination of management responsible for implementing the investee’s policies and procedures, should be assessed based on the facts and circumstances to determine if they are substantive participating rights in and of themselves. However, noncontrolling rights that appear to be participating rights but that by themselves are not substantive (see paragraphs 810-10-25-13 and 810-10-55-1) would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. The likelihood that the veto right will be exercised by the noncontrolling shareholder or limited partner should not be considered when assessing whether a noncontrolling right is a substantive participating right.

ASC 810-10 — Glossary

Participating Rights (Voting Interest Entity Definition)

Participating rights allow the limited partners or noncontrolling shareholders to block or participate in certain significant financial and operating decisions of the limited partnership or corporation that are made in the ordinary course of business. Participating rights do not require the holders of such rights to have the ability to initiate actions.

Participating rights allow the holder of such rights to participate in certain financial and operating decisions of an investee that occur “in the ordinary course of business” but do not require the holder to initiate actions. The retention of substantive participating rights by noncontrolling shareholders or noncontrolling limited partners would overcome the presumption that an investor with a majority voting interest should consolidate the investee. ASC 810-10-25-11 provides the following two examples of substantive participating rights that would preclude an investor with a majority voting interest from consolidating an investee: (1) selecting, terminating, and setting the compensation of management responsible for implementing the investee’s policies and procedures and (2) establishing operating and capital decisions of the investee (including budgets) in the ordinary course of business. See Table 1-1 in Section 1.4 for differences between the definition of participating rights under the voting interest entity model and the VIE model.

D.2.3 Factors to Consider in Evaluating Whether Noncontrolling Rights Are Substantive Participating Rights

ASC 810-10

25-13 The following factors shall be considered in evaluating whether noncontrolling rights that appear to be participating are substantive rights, that is, whether these factors provide for effective participation in certain significant financial and operating decisions that are made in the investee’s ordinary course of business:

Consideration shall be given to situations in which a majority shareholder or limited partner with a majority of kick-out rights through voting interests owns such a significant portion of the investee that the noncontrolling shareholder or limited partner has a small economic interest. As the disparity between the ownership interest of majority and noncontrolling shareholders or between the limited partner with a majority of kick-out rights through voting interests and noncontrolling limited partners increases, the rights of the noncontrolling shareholder or limited partner are presumptively more likely to be protective rights and shall raise the level of skepticism about the substance of the right. Similarly, although a majority owner is presumed to control an investee, the level of skepticism about such ability shall increase as the investor’s or limited partner’s economic interest in the investee decreases.
The governing documents shall be considered to determine at what level decisions are made — at the shareholder or limited partner level or at the board level — and the rights at each level also shall be considered. In all situations, any matters that can be put to a vote of the shareholders or limited partners shall be considered to determine if other investors, individually or in the aggregate, have substantive participating rights by virtue of their ability to vote on matters submitted to a shareholder or limited partner vote.
Relationships between the majority and noncontrolling shareholders or partners (other than an investment in the common investee) that are of a related-party nature, as defined in Topic 850, shall be considered in determining whether the participating rights of the noncontrolling shareholder or limited partner are substantive. For example, if the noncontrolling shareholder or limited partner in an investee is a member of the immediate family of the majority shareholder, general partner, or limited partner with a majority of kick-out rights through voting interests of the investee, then the rights of the noncontrolling shareholder or limited partner likely would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee.
Certain noncontrolling rights may deal with operating or capital decisions that are not significant to the ordinary course of business of the investee. Noncontrolling rights related to decisions that are not considered significant for directing and carrying out the activities of the investee’s business are not substantive participating rights and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. Examples of such noncontrolling rights include all of the following:
1. Location of the investee’s headquarters
2. Name of the investee
3. Selection of auditors
4. Selection of accounting principles for purposes of separate reporting of the investee’s operations.
Certain noncontrolling rights may provide for the noncontrolling shareholder or limited partner to participate in certain significant financial and operating decisions that are made in the investee’s ordinary course of business; however, the existence of such noncontrolling rights shall not overcome the presumption that the majority owner shall consolidate, if it is remote that the event or transaction that requires noncontrolling shareholder or limited partner approval will occur. Remote is defined in Topic 450 as the chance of the future event or events occurring being slight.
An owner of a majority voting interest or limited partner with a majority of kick-out rights through voting interests who has a contractual right to buy out the interest of the noncontrolling shareholder or limited partner in the investee for fair value or less shall consider the feasibility of exercising that contractual right when determining if the participating rights of the noncontrolling shareholder or limited partner are substantive. If such a buyout is prudent, feasible, and substantially within the control of the majority owner, the contractual right to buy out the noncontrolling owner or limited partner demonstrates that the participating right of the noncontrolling shareholder or limited partner is not a substantive right. The existence of such call options, for purposes of the General Subsections, negates the participating rights of the noncontrolling shareholder or limited partner to veto an action of the majority shareholder or general partner, rather than create an additional ownership interest for that majority shareholder. It would not be prudent, feasible, and substantially within the control of the majority owner to buy out the noncontrolling shareholder or limited partner if, for example, either of the following conditions exists:
1. The noncontrolling shareholder or limited partner controls technology that is critical to the investee.
2. The noncontrolling shareholder or limited partner is the principal source of funding for the investee.

Paragraph 810-10-55-1 provides additional guidance on assessing substantive participating rights.

25-14 An entity that is not controlled by the holder of a majority voting interest or holder of a majority of kick-out rights through voting interests because of noncontrolling shareholder or limited partner veto rights described in paragraphs 810-10-25-2 through 25-13 and 810-10-55-1 is not a VIE if the shareholders or partners as a group (the holders of the equity investment at risk) have the power to control the entity and the equity investment meets the other requirements of paragraphs 810-10-15-14 and 810-10-25-45 through 25-47, as applicable.

Kick-Out Rights

25-14A For limited partnerships, the determination of whether kick-out rights are substantive shall be based on a consideration of all relevant facts and circumstances. For kick-out rights to be considered substantive, the limited partners holding the kick-out rights must have the ability to exercise those rights if they choose to do so; that is, there are no significant barriers to the exercise of the rights. Barriers include, but are not limited to, the following:

Kick-out rights subject to conditions that make it unlikely they will be exercisable, for example, conditions that narrowly limit the timing of the exercise
Financial penalties or operational barriers associated with dissolving (liquidating) the limited partnership or replacing the general partners that would act as a significant disincentive for dissolution (liquidation) or removal
The absence of an adequate number of qualified replacement general partners or the lack of adequate compensation to attract a qualified replacement
The absence of an explicit, reasonable mechanism in the limited partnership’s governing documents or in the applicable laws or regulations, by which the limited partners holding the rights can call for and conduct a vote to exercise those rights
The inability of the limited partners holding the rights to obtain the information necessary to exercise them.

25-14B The limited partners’ unilateral right to withdraw from the partnership in whole or in part (withdrawal right) that does not require dissolution or liquidation of the entire limited partnership would not be deemed a kick-out right. The requirement to dissolve or liquidate the entire limited partnership upon the withdrawal of a limited partner or partners shall not be required to be contractual for a withdrawal right to be considered as a potential kick-out right.

25-14C Rights held by the limited partners to remove the general partners from the partnership shall be evaluated as kick-out rights pursuant to paragraph 810-10-25-14A. Rights of the limited partners to participate in the termination of management (for example, management is outsourced to a party other than the general partner) or the individual members of management of the limited partnership may be substantive participating rights. Paragraphs 810-10-55-4N through 55-4W provide additional guidance on assessing kick-out rights.

55-1 Examples of how to assess individual noncontrolling rights facilitate the understanding of how to assess whether the rights of the noncontrolling shareholder or limited partner should be considered protective or participating and, if participating, whether the rights are substantive. An assessment is relevant for determining whether noncontrolling rights overcome the presumption of control by the majority shareholder or limited partner with a majority of kick-out rights through voting interests in an entity under the General Subsections of this Subtopic. Although the following examples illustrate the assessment of participating rights or protective rights, the evaluation should consider all of the factors identified in paragraph 810-10-25-13 to determine whether the noncontrolling rights, individually or in the aggregate, provide for the holders of those rights to effectively participate in certain significant financial and operating decisions that are made in the ordinary course of business:

The rights of the noncontrolling shareholder or limited partner relating to the approval of acquisitions and dispositions of assets that are expected to be undertaken in the ordinary course of business may be substantive participating rights. Rights related only to acquisitions that are not expected to be undertaken in the ordinary course of the investee’s existing business usually are protective and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. Whether a right to approve the acquisition or disposition of assets is in the ordinary course of business should be based on an evaluation of the relevant facts and circumstances. In addition, if approval by the shareholder or limited partner is necessary to incur additional indebtedness to finance an acquisition that is not in the investee’s ordinary course of business, then the approval by the noncontrolling shareholder or limited partner would be considered a protective right.
Existing facts and circumstances should be considered in assessing whether the rights of the noncontrolling shareholder or limited partner relating to an investee’s incurring additional indebtedness are protective or participating rights. For example, if it is reasonably possible or probable that the investee will need to incur the level of borrowings that requires noncontrolling shareholder or limited partner approval in its ordinary course of business, the rights of the noncontrolling shareholder or limited partner would be viewed as substantive participating rights.
The rights of the noncontrolling shareholder or limited partner relating to dividends or other distributions may be protective or participating and should be assessed in light of the available facts and circumstances. For example, rights to block customary or expected dividends or other distributions may be substantive participating rights, while rights to block extraordinary distributions would be protective rights.
The rights of the noncontrolling shareholder or limited partner relating to an investee’s specific action (for example, to lease property) in an existing business may be protective or participating and should be assessed in light of the available facts and circumstances. For example, if the investee had the ability to purchase, rather than lease, the property without requiring approval of the noncontrolling shareholder or limited partner, then the rights of the noncontrolling shareholder or limited partner to block the investee from entering into a lease would not be substantive.
The rights of the noncontrolling shareholder or limited partner relating to an investee’s negotiation of collective bargaining agreements with unions may be protective or participating and should be assessed in light of the available facts and circumstances. For example, if an investee does not have a collective bargaining agreement with a union or if the union does not represent a substantial portion of the investee’s work force, then the rights of the noncontrolling shareholder or limited partner to approve or veto a new or broader collective bargaining agreement are not substantive.
Provisions that govern what will occur if the noncontrolling shareholder or limited partner blocks the action of an owner of a majority voting interest or general partner need to be considered to determine whether the right of the noncontrolling shareholder or limited partner to block the action has substance. For example, if the shareholder or partnership agreement provides that if the noncontrolling shareholder or limited partner blocks the approval of an operating budget, then the budget simply defaults to last year’s budget adjusted for inflation, and if the investee is a mature business for which year-to-year operating budgets would not be expected to vary significantly, then the rights of the noncontrolling shareholder or limited partner to block the approval of the operating budget do not allow the noncontrolling shareholder or limited partner to effectively participate and are not substantive.
Noncontrolling rights relating to the initiation or resolution of a lawsuit may be considered protective or participating depending on the available facts and circumstances. For example, if lawsuits are a part of the entity’s ordinary course of business, as is the case for some patent-holding companies and other entities, then the noncontrolling rights may be considered substantive participating rights.
A noncontrolling shareholder or limited partner has the right to veto the annual operating budget for the first X years of the relationship. Based on the facts and circumstances, during the first X years of the relationship this right may be a substantive participating right. However, following Year X there is a significant change in the exercisability of the noncontrolling right (for example, the veto right terminates). As of the beginning of the period following Year X, that right would no longer be a substantive participating right and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee.

D.2.3.1 Evaluating Whether Participating Rights Are Substantive

ASC 810-10-25-13 and ASC 810-10-55-1 provide factors and examples to help reporting entities determine whether noncontrolling rights represent substantive participating rights. The premise of this guidance is that even if rights granted to a noncontrolling shareholder (or limited partner) appear to be substantive, there may be other factors that limit the effect of those rights. Generally, rights to participate in decisions that are not expected to be made in the ordinary course of business (i.e., those related to matters whose likelihood of occurrence is remote or that apply only in exceptional circumstances) are considered protective rights. Rights to participate in decisions related to matters whose occurrence is at least reasonably possible in the ordinary course of business are participating rights. Reporting entities must use judgment to determine whether participating rights are substantive participating rights. The likelihood that an entity will exercise its rights is not considered in the assessment. Rather, if an entity has the right to participate in decisions, it is assumed that those rights will be exercised.

For example, the noncontrolling shareholder may have a right to veto the operating and capital decisions of the investee in the ordinary course of business, but its economic interest may be small, and the majority owner may have a call option on the noncontrolling shares whose exercise would be prudent, feasible, and substantially within the control of the majority owner. In such a scenario, the right to participate in the operating and capital decisions may not overcome control by the majority owner.

A variation of the above example might involve a situation in which the majority shareholder and the noncontrolling shareholder each have buy-sell rights. As discussed in Section D.1.6.2, a buy-sell term in a contractual agreement can take various forms, including one in which each investor has the ability to offer to buy out the entire equity interest of another investor (the “offeree”) upon giving notice to the offeree. The investor making the offer (the “offeror”) names a price for the offeree’s interest at its discretion, or it may offer the interest at fair value. After receiving the offer, the offeree typically is contractually required to either (1) sell its entire interest in the entity to the offeror at the named price or (2) buy the offeror’s interest at the named price.

The evaluation of a buy-sell right in the context of determining whether a participating right held by a noncontrolling interest holder is substantive was discussed at the 2020 AICPA Conference on Current SEC and PCAOB Developments. In prepared remarks, SEC Professional Accounting Fellow Jeffrey Nick discussed the assessment of substantive participating rights in situations in which the majority shareholder has an option to acquire the noncontrolling shareholder’s shares at fair value in the event of a disagreement (and, similarly, the noncontrolling shareholder holds the same rights). Mr. Nick stated the following:

Consider a fact pattern presented to OCA staff relating to the consolidation analysis for a voting interest entity. This legal entity, a limited liability corporation with governing provisions that are the functional equivalent of a regular corporation, had its equity ownership divided between two investors, of which the reporting entity was one. These investors had a long-standing relationship, where one, the reporting entity, historically provided funding for investments, and the other provided know-how relating to identifying the investment opportunity and managing the investment on an ongoing basis. The shares in the legal entity conveyed economic rights in varying degrees at varying times, initially providing the registrant with the bulk of the economics of the legal entity until a stated rate of return was achieved, at which point the economics shifted to more equally distribute earnings among the parties. While the registrant held a majority voting interest through its share ownership, the other investor’s consent was required to effect certain significant decisions, including approving or modifying operating and capital budgets. In the event of a disagreement in these circumstances requiring the other investor’s consent, the arrangement included a buy/sell clause by which three outcomes could occur: either party could acquire the other party’s shares at fair value, or consent could be provided on the decision subject to disagreement. The registrant concluded that the buy/sell clause provided the registrant with the ability to break a deadlock unilaterally, believing that the other investor would not disagree with the registrant and risk its own removal from the venture. For [these reasons] the registrant concluded that the other investor did not have substantive participating rights, and thus that the registrant should consolidate the investee.

OCA staff objected to the registrant’s conclusion that it should consolidate the legal entity under the voting interest entity model.

We would not view a buy-sell provision in which the majority investor has the ability to purchase a noncontrolling interest holder’s interest at fair value (and a noncontrolling interest holder possesses the same right for the majority shareholder) as a situation that would prevent a noncontrolling interest holder from having an ability to exercise substantive participating rights should such an investor possess those rights.

For more information about the evaluation of call options and other forward starting rights in connection with the voting interest entity model, see Section D.1.4. For further discussion of buy-sell rights, see Section D.1.6.2.1.

Likewise, a noncontrolling shareholder (or limited partner) may have a right to consent to the operating and capital decisions of the investee in the ordinary course of business, but the contractual agreement may specify that such consent “shall not be unreasonably withheld or delayed.” If an agreement includes such language related to the participating rights granted to the noncontrolling shareholder (or limited partner), the reporting entity should not presume that the participating rights are not substantive. While the ability of the noncontrolling shareholder (or limited partner) to exercise its rights may be constrained on the basis of that language, its presence in an agreement would not automatically result in a conclusion that the participating rights are not substantive. Rather, a reporting entity should assess why the agreement contains the language and obtain a detailed understanding of the consent process.

When determining whether consent rights are truly substantive, the reporting entity should also carefully assess whether the rights allow the noncontrolling shareholder to participate in decisions that are made in the ordinary course of business. The reporting entity must use significant judgment and consider all relevant facts and circumstances in making this determination. It may be helpful to consider what would happen if the noncontrolling shareholder tried to exercise a consent right related to an activity to which such language applied. There may be significant uncertainty related to whether the action of withholding or delaying consent is, in fact, reasonable (and an arbitrator or court proceeding might be needed to make that determination). Such uncertainty might call into question whether the majority interest holder actually has control over the decision. Further, a reporting entity should generally not analogize to situations in which the contractual language (e.g., “unreasonably withheld”) might apply to a more narrow set of decisions (e.g., transfer restrictions as described in Sections 5.3.1.1.2 and 8.2.3.4).

In addition, since ASC 810-10-25-14A defines substantive kick-out rights that are specific to limited partnerships, a reporting entity may analogize to that guidance when evaluating (1) kick-out rights related to legal entities other than limited partnerships or (2) approval or veto rights granted to a noncontrolling interest holder.

Example D-9

Assume that Entity A and Entity B contributed certain assets to Entity C and that A and B own 60 percent and 40 percent, respectively, of the voting common shares of C. Assume that C is not a VIE. The operations of C are controlled by five managers, three of whom are appointed by A and two by B. Managers can be replaced only by the party that elected them. The following actions require the unanimous consent of all five managers:

Borrowing money on behalf of C in an amount in excess of $500,000.
Renewing, extending, modifying, rearranging, or refinancing borrowings by C in excess of $500,000.
Acquiring, leasing, holding, or selling any or all real or personal property of C (or any interest therein) involving amounts or values in excess of $500,000.
Paying or incurring any expense, debt, or obligation of C in excess of $500,000.
Approving any long-term (more than one year) supply contract or other contract involving amounts in excess of $500,000.

The $500,000 approval limit represents less than 1 percent of C’s estimated fair value upon formation. If the managers cannot reach unanimous agreement about an action, the action will be decided through an independent binding arbitration process.

In this scenario, A should not consolidate C. The rights granted in connection with the actions outlined above are expected to allow B to effectively participate in significant decisions that would be made in C’s ordinary course of business. They therefore qualify as participating rights under ASC 810-10-25-11. Because A does not control C, A should account for its investment in C under the equity method.

Consider, however, a scenario in which the $500,000 approval limit represented 40 percent of C’s estimated fair value upon formation. In such a case, because of the high approval threshold relative to the entity’s estimated fair value, B is unable to effectively participate in significant decisions that would be made in C’s ordinary course of business. Therefore, the rights granted to B would be considered protective, and A would consolidate C.

Example D-10

Entity A has a majority voting interest in Entity C, a voting interest entity; however, Entity B has the right to consent to decisions related to the following:

Operating expenses in a fiscal year that exceed 135 percent of the aggregate amount of operating expenses for the immediately preceding fiscal year.
Capital expenditures in any fiscal year that exceed an aggregate amount equal to 200 percent of the capital expenditures for the immediately preceding fiscal year.

Because C operates in a mature business for which year-to-year budgeted operating expenses would not be expected to vary significantly, A determines that its inability to unilaterally increase the budgeted operating expenses in a fiscal year by more than 135 percent of the expenses from the immediately preceding fiscal year does not prevent A from unilaterally making all of the necessary financial and operating decisions in the ordinary course of C’s business.

Further, because C is not a capital-intensive business, A determines that its inability to increase the budgeted capital expenditures by more than 200 percent of the expenditures from the immediately preceding fiscal year does not prevent A from unilaterally making all of the necessary financial (including capital) and operating decisions in the ordinary course of C’s business.

On the basis of these specific facts and circumstances, A may determine that B’s consent rights (individually and in the aggregate) do not represent substantive participating rights and that A therefore has a controlling financial interest in C.

Example D-11

Entity A and Entity B form Entity C, a voting interest entity, and have 70 percent and 30 percent, respectively, of the ownership interests in C. Entity C was formed to own, develop, and operate a single commercial real estate property that is not subject to any lien or other form of indebtedness.

Entity A, as the manager, executes the day-to-day operations of C, for which A receives a separate management fee. However, the following major decisions related to the governance of C require unanimous approval of both A and B:

Any decision to effect or undertake a material alteration in excess of $20 million, which represents 5 percent of C’s estimated fair value upon formation.
Acquisition by C of any real property or other material asset apart from the single commercial real estate property.
Extension of credit or the undertaking or modification of loans outside of the approved budget.

Since C was formed to manage a single commercial real estate property that was not expected to be altered after its development, A concludes that a material alteration is considered outside the normal course of business. In addition, because C was designed to hold the single commercial real estate property and not to acquire and manage other properties, A concludes that acquisition of additional properties is outside the normal course of business. Further, since the single commercial real estate property is not subject to any lien or other form of indebtedness, A concludes that the extension of credit or the undertaking or modification of loans is outside the ordinary course of business.

On the basis of these facts and circumstances, A may determine that B’s consent rights (individually and in the aggregate) do not represent substantive participating rights and that A therefore has a controlling financial interest in C.

Example D-12

Assume the same facts as in the previous example except that Entities A and B must unanimously approve the business plan, which includes the operating budget and capital budget for the single commercial real estate property.

If A and B approve the annual business plan, A, as the manager, is afforded the discretion to increase spending by no more than 10 percent or $1 million of the approved business plan for each line item as long as the total spending does not exceed the total budgeted spending by more than 5 percent.

As the manager, A concludes that its decision-making authority is constrained by the business plan because it is expected to operate Entity C within the confines of the operating and capital budgets, which must be approved by B. However, as a result of failure to reach agreement on the proposed business plan (i.e., failure to obtain B’s approval), the operating budget automatically reverts to the prior-year budget (or the most recent unanimously approved budget).

Although the prospect of defaulting to the prior-year budget (or most recent unanimously approved budget) could potentially suggest that B’s participating right is not substantive, the specific facts and circumstances regarding C’s underlying property would also need to be considered. For example, if the capital expenditures for the underlying commercial real estate property that were expected to be required in the ordinary course of business over the life of the entity were greater than those in the original approved budget, the fact that B must approve a budget increase may indicate that B has a substantive participating right.

Further, A and B must unanimously approve any execution, modification, or termination of a lease of the single commercial real estate property. Under ASC 810-10-25-13, a participating right is substantive if the holder has the ability to prevent a majority owner from making certain significant ordinary-course financial or operating decisions related to the entity. Therefore, B may have a substantive participating right since it has the right and the ability to block A from making the leasing decisions regarding the commercial real estate property (in the near term).

If the single commercial real estate property were under a long-term lease arrangement (and a substantive lease term remained) before A and B entered into the limited partnership, it may be unlikely that B would be able to exercise any substantive participating rights related to the leasing activities. However, if the property were vacant upon the formation of the limited partnership or if it were under a short-term lease, the facts and circumstances may lead to a conclusion that B has a substantive participating right.

However, the specific facts and circumstances should be carefully considered in the analysis of whether the above rights represent (individually or in the aggregate) substantive participating rights.

D.2.3.2 Noncontrolling Approval or Veto Rights Qualified by the Phrase “Other Than in the Ordinary Course of Business”

Situations have arisen in which a noncontrolling interest holder was granted substantive approval or veto rights and the terms of those rights were qualified by the phrase “other than in the ordinary course of business.” In situations in which that phrase was used to qualify a noncontrolling interest holder’s approval or veto rights and was vaguely defined, the SEC objected to consolidation by the majority owner. Accordingly, the contractual inclusion of undefined phrases such as “except in the normal course of business” or “other than in the ordinary course of business” is not considered sufficient to preclude a noncontrolling right, that would otherwise be considered a substantive participating right, from being treated as a substantive participating right. Rather, the reporting entity should evaluate the substance of the noncontrolling rights to determine whether the rights are substantive participating rights. Such an evaluation may include consideration of the following factors (not all-inclusive):

The likelihood that the activity associated with the approval or veto rights will occur on the basis of the purpose and design of the entity, and the expected frequency of such occurrence(s).
What could “trigger” the approval or veto rights held by the noncontrolling interest holder. In other words, the point at which the majority voting interest holder is no longer able to unilaterally direct the operating and capital decisions of the entity under the provision qualified by the phrase “except in the ordinary course of business” provision (i.e., whether frequency, size, or a combination of both triggers the approval or veto rights).
Whether the majority voting interest holder has alternative means by which to complete the activity that would eliminate the need to consider or invoke the provision qualified by the phrase “except in the ordinary course of business” (e.g., approval of the operating and capital budget or other mechanisms).
Other rights held by the noncontrolling interest holder, or the lack thereof, to participate in other activities of the legal entity.

Reporting entities may need the assistance of legal counsel in determining the substance of the noncontrolling interest holder’s rights.

This guidance also applies to non-SEC registrants.

Example D-13

Entity A and Entity B each hold 50 percent of Entity C, which leases high-value construction equipment to its customers. Assume that C is not a VIE. The entities have an agreement under which A has the ability to appoint three members of C’s five-member board of directors, and B can appoint the two remaining members. The agreement also specifies that for several significant decisions, unanimous approval of the board must be obtained “other than in the normal course of business,” which the agreement does not define. Specifically, the applicable provision states, in part, that “the directors have no authority or power to take the following action without unanimous approval: purchase, take, receive, lease or otherwise acquire, own, hold, improve, sell, dispose, use, or otherwise deal in or with real or personal property or any interest in real or personal property, wherever situated, having a value greater than $100,000, other than in the normal course of business.” Making purchases or acquisitions of this nature is considered an action that will take place as part of directing and carrying out C’s current business activities.

In this example, the use of the phrase “other than in the normal course of business” does not preclude the unanimous-approval requirement from being a participating right because the meaning of that phrase is not defined and is not a “safe harbor” in which such a right is simply a protective right. Accordingly, to determine whether the right is participating or protective, the reporting entity must perform additional analysis of the relevant facts and circumstances (e.g., the purpose and design of the legal entity, legal counsel’s interpretation of the substance of the unanimous approval requirement), including how and when the right would be subject to approval with respect to directing and carrying out C’s business activities.

D.2.3.3 Noncontrolling Rights to Block Acquisitions and Dispositions of Assets

Under ASC 810-10-25-10, noncontrolling rights to block acquisitions and dispositions of assets that are not expected to be undertaken in the ordinary course of business are protective rights and would not overcome the presumption of consolidation by the investor with a majority voting interest or a limited partner with a majority of kick-out rights in its investee. Under previous guidance in EITF 96-16, there was a presumption that a noncontrolling interest holder’s right to block “[a]cquisitions and dispositions of assets greater than 20 percent of the fair value of the investee’s total assets” would be indicative of a protective right, whereas a noncontrolling interest holder’s right to block “[a]cquisitions and dispositions of 20 percent or less do not necessarily lead to the conclusion that it is a substantive participating right.” However, the FASB removed this 20 percent presumption when issuing EITF 04-5 and, instead, revised the language to focus on acquisitions and dispositions in the ordinary course of business. Therefore, a reporting entity must use judgment in determining whether, on the basis of the facts and circumstances, noncontrolling rights are participating or protective in nature.

Example D-14

Entity A and Entity B restructured a 50-50 (respective voting and economic ownership) corporate joint venture agreement involving Entity C. Under the agreement, A has 90 percent of the voting and economic interest in C, and control of the board. Entity A appoints all management of C and thus has management control of C’s operations. Assume that C is not a VIE. The stated purpose of the restructuring was to transfer control of C to A. The restructuring allows B to obtain liquidity for its investment in C and to extricate itself in part from C’s operations but also allows B to retain its financial interest in certain royalties and fixed payments through its remaining 10 percent economic ownership interest in C. However, one specific provision of the restructured operating agreement is that A cannot agree to make any transfer, in any transaction or series of transactions, of any asset or assets of C, the absence of which, singly or in the aggregate, would materially diminish or impair C’s primary business activities or C’s ability to conduct its primary business activities.

In this example, the rights granted to B do not allow B to participate in the management or in the financial and operating decisions of C but rather protect its financial interest in the event that A decides to substantially change the nature, purpose, and design of C’s primary business. The purpose of the provision is to ensure that A cannot eviscerate C’s operations to the detriment of B. Therefore, the rights granted to B would not be sufficient to preclude A from consolidating C.

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 323.14 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-15

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 4-32 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-16

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.