3.4 Scope Exceptions From the VIE Model

ASC 810-10

15-17 The following exceptions to the Variable Interest Entities Subsections apply to all legal entities in addition to the exceptions listed in paragraph 810-10-15-12:

Not-for-profit entities (NFPs) are not subject to the Variable Interest Entities Subsections, except that they may be related parties for purposes of applying paragraphs 810-10-25-42 through 25-44. In addition, if an NFP is used by business reporting entities in a manner similar to a VIE in an effort to circumvent the provisions of the Variable Interest Entities Subsections, that NFP shall be subject to the guidance in the Variable Interest Entities Subsections.
Separate accounts of life insurance entities as described in Topic 944 are not subject to consolidation according to the requirements of the Variable Interest Entities Subsections.
A reporting entity with an interest in a VIE or potential VIE created before December 31, 2003, is not required to apply the guidance in the Variable Interest Entities Subsections to that VIE or legal entity if the reporting entity, after making an exhaustive effort, is unable to obtain the information necessary to do any one of the following:
1. Determine whether the legal entity is a VIE
2. Determine whether the reporting entity is the VIE’s primary beneficiary
3. Perform the accounting required to consolidate the VIE for which it is determined to be the primary beneficiary.
This inability to obtain the necessary information is expected to be infrequent, especially if the reporting entity participated significantly in the design or redesign of the legal entity. The scope exception in this provision applies only as long as the reporting entity continues to be unable to obtain the necessary information. Paragraph 810-10-50-6 requires certain disclosures to be made about interests in VIEs subject to this provision. Paragraphs 810-10-30-7 through 30-9 provide transition guidance for a reporting entity that subsequently obtains the information necessary to apply the Variable Interest Entities Subsections to a VIE subject to this exception.
A legal entity that is deemed to be a business need not be evaluated by a reporting entity to determine if the legal entity is a VIE under the requirements of the Variable Interest Entities Subsections unless any of the following conditions exist (however, for legal entities that are excluded by this provision, other generally accepted accounting principles [GAAP] should be applied):
1. The reporting entity, its related parties (all parties identified in paragraph 810-10-25-43, except for de facto agents under paragraph 810-10-25-43(d)), or both participated significantly in the design or redesign of the legal entity. However, this condition does not apply if the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee.
2. The legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties.
3. The reporting entity and its related parties provide more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the legal entity based on an analysis of the fair values of the interests in the legal entity.
4. The activities of the legal entity are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements.
A legal entity that previously was not evaluated to determine if it was a VIE because of this provision need not be evaluated in future periods as long as the legal entity continues to meet the conditions in (d).

A reporting entity that has an interest in a legal entity should first evaluate whether it qualifies for a general scope exception to the consolidation requirements in ASC 810-10-15-12 (see Section 3.3). If it does not, it should determine whether it qualifies for any of the following four scope exceptions to application of the VIE model:

Not-for-profit entities (NFPs).
Separate accounts of life insurance entities.
Exhaustive efforts.
Business entities.

3.4.1 Scope Exception for NFPs

Like the governmental organization scope exception in ASC 810-10-15-12(e), a for-profit entity is exempt from consolidating an NFP under the VIE model unless the NFP is used in a manner similar to a VIE and the intent is to circumvent the provisions of the VIE model (see Section 3.4.1.2 for guidance on identifying circumvention of the VIE model). However, a for-profit entity should evaluate an NFP under the voting interest entity model. Under the voting interest entity model (see Appendix D), a for-profit entity would generally consolidate an NFP if (1) it holds an economic interest in the NFP and (2) the for-profit entity is the sole corporate member or controls the board of directors. All facts and circumstances should be considered, including the existence of kick-out or participating rights.

In addition, an NFP is not required to determine, under the VIE model, whether to consolidate any legal entity in which it holds an interest. However, the NFP may be a related party of a for-profit entity that must be analyzed pursuant to the guidance in ASC 810-10 on related parties (see Chapter 8). See Section 3.4.1.3 for additional guidance on the consolidation model for NFPs.

3.4.1.1 Certain Situations in Which an Entity Does Not Qualify for the NFP Scope Exception

The ASC master glossary defines an NFP as:

An entity that possesses the following characteristics, in varying degrees, that distinguish it from a business entity:

Contributions of significant amounts of resources from resource providers who do not expect commensurate or proportionate pecuniary return
Operating purposes other than to provide goods or services at a profit
Absence of ownership interests like those of business entities.

Entities that clearly fall outside this definition include the following:

All investor-owned entities
Entities that provide dividends, lower costs, or other economic benefits directly and proportionately to their owners, members, or participants, such as mutual insurance entities, credit unions, farm and rural electric cooperatives, and employee benefit plans.

Only entities that meet the Codification’s definition of an NFP can qualify for the NFP scope exception in ASC 810-10-15-17(a). Accordingly, an entity that presents its financial statements in a manner similar to an NFP, but does not meet the Codification’s definition of an NFP, does not qualify for the NFP scope exception. Further, an entity that qualifies as an NFP for regulatory purposes (e.g., under state law), but does not meet the Codification's definition of an NFP, does not qualify for the NFP scope exception.

Example 3-13

Company A (a for-profit organization) sells properties to a common interest realty association (CIRA) in exchange for time-share memberships, which A then sells to consumers. The CIRA presents its financial statements similarly to an NFP pursuant to ASC 972 but does not meet the Codification’s definition of an NFP.

We understand that the SEC staff does not believe that a CIRA is an NFP because typically it does not meet part (a) or part (c) of the Codification’s definition as follows:

Part (a) — The investors (consumers who purchase the time-share units) expect the CIRA to use their contributions to maintain the properties, which maintains (or increases) the value of their time-share units.
Part (c) — The investors have a residual claim on the properties and voting rights with respect to the activities of the CIRA, and the units are exchangeable. These attributes are characteristics of “ownership interests like those of business entities.”

The CIRA, therefore, would not meet the scope exception for NFPs in ASC 810-10-15-17(a).

Note that the next steps in applying the VIE model are to determine whether A has a variable interest and whether the CIRA entity is a VIE.

3.4.1.2 Use of an NFP in Circumvention of the VIE Model

ASC 810-10-15-17(a) states that if a business reporting entity uses an NFP to circumvent the provisions of the VIE model, the NFP is subject to the VIE model. The determination of whether an NFP has been established to circumvent the VIE model requires significant judgment. As part of this analysis, a reporting entity should consider all facts and circumstances associated with the creation and design of the NFP as well as the NFP’s relationship with business entities. For example, a reporting entity should consider the following:

Whether the party (the sponsor) who will transact with the NFP created or designed the legal entity.
Why the legal entity was formed as an NFP.
The nature of the NFP’s operations (e.g., whether substantially all of its activities are on behalf of the sponsor).

Example 3-14

Enterprise A, a business enterprise, establishes Entity B, an NFP whose sole purpose is to lease a building to A. To purchase this building, B uses the proceeds of various tranches of senior and subordinated debt it has issued. The terms of the lease are designed so that A can attain operating lease treatment. The terms include a first-loss residual value guarantee from A (the guarantee is capped to meet the operating lease criteria), and A has a fixed-price purchase option at the end of the lease term (the option is not considered to be a bargain purchase option). It is expected that all of the lease payments (including those from the residual value guarantee) and the proceeds from final sale of the property will be sufficient to redeem the debt. Although no excess funds are expected after the debt is redeemed, any excess funds must be contributed to a local foundation.

In the absence of a valid business purpose, A cannot use the NFP scope exception in analyzing whether it must consolidate B because the form of B as an NFP was used simply to circumvent the provisions of the VIE model. Therefore, A would need to analyze its arrangement with B under the VIE model.

3.4.1.3 Accounting Guidance for NFPs That Are Outside the Scope of ASC 810-10

NFPs that qualify for the scope exception in ASC 810-10-15-17(a) should apply ASC 958 and ASC 954 instead of ASC 810-10. See Section E.6 for detailed guidance and interpretations for NFPs.

3.4.1.4 Retention of a For-Profit Reporting Entity’s Accounting Policies in the Consolidated Financial Statements of an NFP Reporting Entity

For-profit reporting entities that are owned by NFP reporting entities must apply the VIE model to a legal entity in which it holds an interest. That guidance does not change as a result of consolidation of the for-profit entity by the NFP reporting entity. This position is supported by analogy to ASC 810-10-25-15, which states:

For the purposes of consolidating a subsidiary subject to guidance in an industry-specific Topic, an entity shall retain the industry-specific guidance applied by that subsidiary.

Example 3-15

Company N, a not-for-profit health care company that applies the guidance in ASC 954, has a wholly owned subsidiary, W, a for-profit holding company that directly operates several for-profit businesses. Company W has a variable interest in Company V and consolidates V under the provisions of the VIE model. While ASC 810-10-15-17(a) exempts N from the provisions of the VIE model, W’s accounting for V should be retained in the consolidated financial statements of N (a not-for-profit reporting entity).

3.4.2 Scope Exception for Separate Accounts of Life Insurance Entities

ASC 810-10-15-17(b) exempts life insurance entities and the investors in the separate accounts of life insurance entities from applying the VIE model to a separate account of the life insurance company. However, a separate account must nevertheless apply the VIE model to a legal entity in which it holds a variable interest. That is, when financial statements of a separate account are separately prepared in accordance with GAAP, the financial statements of the separate account are not exempt from the guidance in the VIE subsections.

The scope exception in ASC 810-10-15-17(b) applies to investors in assets held by a separate account of an insurance company. The insurance company would apply the guidance in ASC 944-80-45-1, which states, in part, that “[s]eparate account assets and liabilities shall be included in the financial statements of the insurance entity.” The FASB included this scope exception because it did not intend to change the accounting under ASC 944.

In April 2010, the FASB issued ASU 2010-15, which addresses, among other things, whether an insurance company is required to consolidate a majority-owned investment when such investment is held through the insurance company’s separate accounts (as described in ASC 944-80-25-2) or through a combination of investments in the insurance company’s separate and general accounts. The ASU states that “an insurance entity should not consider any separate account interests held for the benefit of policy holders in an investment to be the insurer’s interests and should not combine those interests with its general account interest in the same investment when assessing the investment for consolidation, unless the separate account interests are held for the benefit of a related party policy holder.” In addition, ASU 2010-15 specifies that in the determination of whether specialized accounting for investments in consolidation should be retained (note that separate accounts that issue stand-alone financial statements are generally considered investment companies), a separate account should be viewed to be the equivalent of a subsidiary (i.e., separate legal entity) even though separate accounts are generally not set up as separate legal entities by the insurance company. Since ASC 810-10-15-12(d) precludes investment companies from consolidating noninvestment companies (with certain exceptions), viewing the separate account as an investment company would generally prevent the insurance company from consolidating an investment in which a separate account holds a controlling financial interest.

3.4.3 Scope Exception for Exhaustive Efforts for Entities Created Before December 31, 2003

In determining whether the exception in ASC 810-10-15-17(c) may be applied, a reporting entity should consider all facts and circumstances associated with its ability to obtain information from a legal entity in which it has an interest. ASC 810-10-15-17(c) states, in part, that the “inability to obtain the necessary information is expected to be infrequent, especially if the reporting entity participated significantly in the design or redesign of the legal entity.”

Therefore, a reporting entity that concludes it is subject to this exemption should compile documentation demonstrating that it has made a significant effort to obtain the information (e.g., date, time, and nature of requests; evidence that the appropriate parties at the legal entity have been contacted; copies of requests for written information; evidence that other holders of similar variable interests are also unable to obtain the information; the nature of any responses from the legal entity). A reporting entity is not required to resort to legal action to obtain information if it does not have a contractual right to obtain the information.

The reporting entity should make an exhaustive effort, supported by appropriate documentation, for each legal entity to which it is unable to apply the VIE model. As long as the reporting entity has an interest in the legal entity in question, the reporting entity should continue to make exhaustive efforts to obtain the necessary information no less frequently than each reporting period.

At the 2004 AICPA Conference on Current SEC and PCAOB Developments, the SEC staff emphasized that management should be prepared to support how it has satisfied the exhaustive-effort requirements.

Note that reporting entities can apply this scope exception only for legal entities created before December 31, 2003.

At the 2003 AICPA Conference on Current SEC Developments, the SEC staff stated the following:

[T]he staff has begun to contemplate the meaning of “an exhaustive effort” in applying this limited scope exception. Consistent with the thoughts of the FASB, as expressed in the modifications to FIN 46 [codified in ASC 810-10], the staff anticipates that the use of the exception will be infrequent. We plan to deal with instances where the information scope exception is being applied on a case-by-case basis, considering all of the relevant facts and circumstances. In assessing those facts and circumstances, the staff can be expected to consider whether registrants operating in the same industry with similar types of arrangements were able to obtain the requisite information.

ASC 810-10-50-6 requires that certain disclosures be made about interests in VIEs that apply this provision. (See Section 11.2.4.1 for further discussion of the disclosure requirements related to the exhaustive-efforts scope exception.) ASC 810-10-30-7 provides transition guidance for a reporting entity that subsequently obtains the information necessary to apply the VIE model to an entity previously subject to this exception.

3.4.3.1 Application of the Exhaustive-Efforts Scope Exception to an Inactive Entity Created Before December 31, 2003

The exhaustive-efforts scope exception in the VIE model applies only when (1) a legal entity was created before December 31, 2003, and (2) the reporting entity meets the other requirements of ASC 810-10-15-17(c). A legal entity may have been created before December 31, 2003, remained inactive for a number of years, and then been activated after December 31, 2003, to carry out new activities and issue new variable interests. In these situations, the exhaustive-efforts scope exception may not be applied. At the 2003 AICPA Conference on Current SEC Developments, the SEC staff stated the following:

For instance, in making a determination whether to apply the scope exception, registrants should carefully consider whether the entity was really created prior to December 31st or was merely in existence prior to that date and re-configured in such a way that the “creation date” of the legal entity is not relevant. For instance, if an entity was inactive for a number of years and then re-activated after December 31st to carry out new activities and issue new variable interests, the staff would consider the use of the information scope exception abusive.

3.4.4 Scope Exception for Entities That Meet the Definition of a Business

The FASB has indicated that determining whether a legal entity is a business is not, in and of itself, relevant to the VIE model’s consolidation objective. The VIE model focuses on the identification of entities for which an analysis of voting interests is not effective in the determination of whether a controlling financial interest is held by a reporting entity. The business scope exception is thus intended to specify conditions that would help identify legal entities in which voting interests would be effective in the determination of whether a controlling financial interest in the legal entity is held by the reporting entity. Accordingly, the FASB created conditions that, if none are met, would obviate the need for further analysis of whether the legal entity should be consolidated pursuant to the VIE model.

The business scope exception is two-pronged and premised on both (1) the legal entity’s characteristics (i.e., whether it is a business, and its activities) and (2) the reporting entity’s relationship with the legal entity (i.e., the extent of involvement by the reporting entity in the design or redesign of the legal entity, whether the legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties, and whether the reporting entity and its related parties provided more than half of the subordinated financial support). A common oversight in evaluating the applicability of the business scope exception is merely assessing whether a legal entity meets the definition of a business and failing to determine whether any of the four conditions in ASC 810-10-15-17(d) are met.

The first three conditions in ASC 810-10-15-17(d) focus on the reporting entity’s relationship with the legal entity and can help reporting entities identify whether legal entities have relationships that are so intertwined with the reporting entity that it would be inappropriate to exclude them from the VIE model merely because they meet the definition of a business. In the fourth condition, the activities of the legal entity itself are considered. If the legal entity does not meet the definition of a business, or is a business but meets any of the following four conditions, the legal entity would not qualify for the business scope exception. ASC 810-10-15-17(d) states, in part:

The reporting entity, its related parties (all parties identified in paragraph 810-10-25-43, except for de facto agents under paragraph 810-10-25-43(d)), or both participated significantly in the design or redesign of the legal entity. However, this condition does not apply if the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee.
The legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties.
The reporting entity and its related parties provide more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the legal entity based on an analysis of the fair values of the interests in the legal entity.
The activities of the legal entity are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements.

3.4.4.1 Applying the Business Scope Exception on a Reporting-Entity-by-Reporting-Entity Basis

The business scope exception should be evaluated on a reporting-entity-by-reporting-entity basis. Each reporting entity involved with the legal entity must evaluate whether the legal entity (or reporting entity) meets any of the conditions in ASC 810-10-15-17(d) and thus fails to qualify for the scope exception. It is possible that one reporting entity with an interest in a legal entity will fail to qualify for this scope exception while another reporting entity with an interest in the same legal entity will qualify.

A determination of whether the following conditions have been met should be based on an analysis of the legal entity (and thus the same analysis should be used for all holders of interests in the legal entity):

Whether the legal entity is a business as defined in ASC 805 (see Section 3.4.4.2).
Whether the activities of the legal entity are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements (see ASC 810-10-15-17(d)(4); also see Section 3.4.4.11 for more information about single-lessee leasing activities).

A determination of whether the following conditions have been met should be based on an analysis of the relationship each interest holder (reporting entity) and its related parties have with the legal entity (the results of the analysis may, therefore, be different for different holders of interests in the legal entity):

Whether the reporting entity, its related parties (for this purpose includes all related parties in ASC 810-10-25-43, except for de facto agents under ASC 810-10-25-43(d)), or both participated significantly in the design or redesign of the legal entity, unless the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee (ASC 810-10-15-17(d)(1)).
Whether the legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties (ASC 810-10-15-17(d)(2)).
Whether the reporting entity and its related parties provide more than half the total of the equity, subordinated debt, and other forms of subordinated financial support to the legal entity (ASC 810-10-15-17(d)(3)).

Example 3-16

A joint venture (Entity A) is formed by two enterprises. Entity A meets the definition of a business in ASC 805 and does not meet the condition in ASC 810-10-15-17(d)(4). Enterprise 1 provides 50 percent of the equity and a subordinated loan to A. Enterprise 2 provides the other 50 percent of the equity. Other than the equity and the subordinated loan, no other forms of subordinated financial support exist. Enterprise 2’s interests in A would be outside the scope of the VIE model because it did not provide more than half the subordinated financial support. However, Enterprise 1 must analyze its interest under the VIE model because it provided more than half the total subordinated financial support to the joint venture.

3.4.4.2 Definition of a Business

ASC 805-10-55-3A defines a business as follows:

[A]n integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. To be considered a business, an integrated set must meet the requirements in paragraphs 805-10-55-4 through 55-6 and 805-10-55-8 through 55-9.

In January 2017, the FASB issued ASU 2017-01, which narrowed the pool of assets or net assets that are considered a business by providing a “screen” for determining when a set of assets and activities qualifies as a business. The screen ensures that if substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or group of similar identifiable assets, the set is not a business.

However, a legal entity that gets through the screen (i.e., substantially all of the fair value is not concentrated in a single identifiable asset or group of similar identifiable assets) cannot be considered a business unless it possesses an input and a substantive process that together significantly contribute to the ability to create an output. ASC 805 provides a framework to help entities evaluate whether both an input and a substantive process are present, and it removes the need to assess whether a market participant could potentially replace any missing elements. For further guidance on how to determine whether a legal entity meets the definition of a business, see Deloitte’s Roadmap Business Combinations.

Note that the business scope exception indicates that even if a potential VIE meets the definition of a business, a reporting entity would analyze its interest in that potential VIE if any of the four conditions in ASC 810-10-15-17(d) are met.

3.4.4.3 [Reserved]

3.4.4.4 When a Reporting Entity Should Assess Whether It Qualifies for the Business Scope Exception

ASC 810-10-15-17(d) states, in part:

A legal entity that previously was not evaluated to determine if it was a VIE because of this provision need not be evaluated in future periods as long as the legal entity continues to meet the conditions in (d).

Each reporting entity should continually evaluate a legal entity to determine whether the reporting entity still qualifies for the business scope exception. A reporting entity should perform this evaluation (1) on the date it becomes involved with the legal entity, (2) when events occur that would require reconsideration under ASC 810-10-35-4 (see Chapter 9) or other events that cause a change in the design of the legal entity occur, and (3) as of each reporting date (see note below). Further, the reassessment of whether a legal entity continues to qualify for the business scope exception is limited to the four conditions specified in ASC 810-10-15-17(d). Therefore, unless a legal entity is fundamentally redesigned and its entire purpose has changed (e.g., all of the operations are spun off and the remaining legal entity represents a single real estate asset), a reporting entity applying the business scope exception is not required to reassess whether the legal entity is a business. If a reporting entity determines that the legal entity qualifies for the business scope exception, the VIE model does not apply and consolidation should be evaluated under the voting interest entity model.

This reassessment could result in a reporting entity’s inability to claim the business scope exception in subsequent periods.

Conversely, a reporting entity that has not been able to claim the business scope exception should reassess whether it meets the scope exception only if one of the following types of events occurs:

Reconsideration events under ASC 810-10-35-4 regarding whether a legal entity is a VIE (see Chapter 9).
Events that cause a change in the design of the legal entity.

Note that ASC 810-10-15-17(d), read literally, requires a reporting entity to evaluate all the business scope exception factors in each reporting period. The condition in ASC 810-10-15-17(d)(3) indicates that the reporting entity cannot provide more than half the subordinated financial support to the legal entity. However, in performing the ASC 810-10-15-17(d)(3) evaluation, the reporting entity should not conclude that operating losses incurred by the legal entity would, by themselves, cause it to fail to qualify for the scope exception (if it did qualify in previous periods). That is, losses that have reduced the legal entity’s equity such that, on a fair value basis, the reporting entity now provides more than half of the subordinated financial support do not cause a reporting entity to no longer be able to apply the business scope exception. This view is supported by ASC 810-10-35-4, which states, in part:

A legal entity that previously was not subject to the Variable Interest Entities Subsections shall not become subject to them simply because of losses in excess of its expected losses that reduce the equity investment. [Emphasis added]

Connecting the Dots

As discussed in further detail in Section 3.4.4.2, ASU 2017-01 narrowed the definition of a business and consequently reduced the number of legal entities deemed businesses. We do not believe that a reporting entity is generally required upon adoption of ASU 2017-01 to reassess whether a legal entity that previously applied the business scope exception continues to meet the definition of a business. As discussed above, the reassessment of whether a legal entity qualifies for the business scope exception is limited to the four conditions specified in ASC 810-10-15-17(d). Therefore, unless a legal entity is fundamentally redesigned and its entire purpose has changed (e.g., all of the operations are spun off and the remaining legal entity represents a single real estate asset), a reporting entity applying the business scope exception is not required to reassess whether the legal entity is a business.

Example 3-17

Enterprise A and Enterprise B, two unrelated parties, form a joint venture, Entity C. The two venturers contribute an equal amount of equity and have joint control of the joint venture. Entity C sells all of its manufactured product to an unrelated third party. At inception, C is determined to be a business under ASC 805 and neither C nor A or B meet any of the four conditions in ASC 810-10-15-17(d). Therefore, both A and B rely on the business scope exception.

Subsequently, C loses its customer and no longer sells to an unrelated third party. Enterprise A enters into a contract to purchase the entire output of the joint venture. Because the new contract results in a change to “[t]he legal entity’s . . . contractual arrangements . . . in a manner that changes the characteristics or adequacy of the legal entity’s equity investment at risk” in accordance with ASC 810-10-35-4 (a), the determination of whether A is a VIE should be reconsidered. As a result of the reconsideration, A now meets the condition in ASC 810-10-15-17(d)(2) that the “legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity.” As of the date this condition is met, A must apply the VIE model to C.

Note that because B does not meet any of the conditions in ASC 810-10-15-17(d), it can still rely on the scope exception.

Example 3-18

Assume the same facts as in the example above before Entity C loses its customer and enters into a purchase contract with Enterprise A, except that A also loans C an additional amount to fund the venture. The loan has a bullet maturity of 20 years. Because A has provided more than half the total equity and additional subordinated financial support to C via the loan, and there are no other forms of subordinated financial support, A meets the condition in ASC 810-10-15-17(d)(3) and therefore must apply the VIE model to C. Five years after the inception of the entity, C determines that its cash flows have exceeded original expectations and decides to repay A the entire principal on the debt. Early repayment of the debt results in a change to a contractual arrangement that may change the adequacy of C’s equity investment at risk (which is a reconsideration event under ASC 810-10-35-4(a)); therefore, A should reassess whether it qualifies for the business scope exception. As of that date, A may qualify for the scope exception because the condition in ASC 810-10-15-17(d)(3) no longer applies — the remaining variable interests are two 50-50 equity interests from A and B. On a fair value basis as of the reconsideration date, the reporting entity (A) is no longer providing more than half the total equity and financial support.

3.4.4.5 Whether the Reporting Entity Participated Significantly in the Design or Redesign of the Legal Entity

A reporting entity must consider all relevant facts and circumstances in determining whether it or its related parties participated significantly in the design or redesign of the legal entity. For this determination, related parties include all parties identified in ASC 810-10-25-43 (see Section 8.2 for a list of related parties and de facto agents) except for the de facto agency relationship that results from the transfer restrictions described in Section 8.2.3.4. The following are situations (not all-inclusive) in which the reporting entity would be presumed to have participated significantly in the design or redesign of the legal entity:

The reporting entity’s interest in the legal entity was obtained at the inception of the legal entity or shortly thereafter. This presumption may be overcome in certain circumstances, such as when the interest is not significant to the legal entity. However, if the lack of participation by a reporting entity would have prevented the creation of the legal entity, that reporting entity always will be deemed to have participated significantly in the design of the legal entity.
The reporting entity was involved in the execution of the legal entity’s initial or amended governing documents or contractual arrangements (if the amendment to the governing documents or contractual arrangements effectively redesigns the legal entity).
The legal entity was initially formed, or subsequently restructured, by others on behalf of the reporting entity or its related parties.
The reporting entity participated significantly (or, via protective or participating rights, had the opportunity to participate regardless of whether these rights were exercised) in significant changes to the legal entity’s operations.

Example 3-19

Entity 1 is a corporation formed with investments by two equity holders and an unrelated debt holder. All of the enterprises were involved in determining the amount of equity and debt financing necessary to fund the entity. The equity holders and the debt holder would be deemed to have participated significantly in the design of Entity 1 because all parties were involved in the legal entity’s design (i.e., establishing the funding requirements of the entity) and in executing the contractual arrangements that established the design.

Example 3-20

Entity 2 is a real estate partnership that entered into a service contract with Enterprise D, a developer, concurrently with Entity 2’s formation. The service contract is determined to be a variable interest. According to the terms of the service contract, Enterprise D will construct and manage a majority of Entity 2’s assets and has advised Entity 2 about the type of assets to construct for its operations. Because the service contract is negotiated and executed concurrently with the formation of Entity 2 and allows Enterprise D to significantly influence its activities, Enterprise D would be deemed to have participated significantly in the legal entity’s design.

3.4.4.6 Definition of a Joint Venture and Joint Control

As noted in ASC 810-10-15-17(d)(1), to qualify for the business scope exception, the reporting entity and its related parties (other than de facto agents under ASC 810-10-25-43(d)) cannot have been involved in the design or redesign of the legal entity unless the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee. (See ASC 952-10 for guidance on identifying franchisees.)

ASC 323-10 — Glossary

Corporate Joint Venture

A corporation owned and operated by a small group of entities (the joint venturers) as a separate and specific business or project for the mutual benefit of the members of the group. A government may also be a member of the group. The purpose of a corporate joint venture frequently is to share risks and rewards in developing a new market, product or technology; to combine complementary technological knowledge; or to pool resources in developing production or other facilities. A corporate joint venture also usually provides an arrangement under which each joint venturer may participate, directly or indirectly, in the overall management of the joint venture. Joint venturers thus have an interest or relationship other than as passive investors. An entity that is a subsidiary of one of the joint venturers is not a corporate joint venture. The ownership of a corporate joint venture seldom changes, and its stock is usually not traded publicly. A noncontrolling interest held by public ownership, however, does not preclude a corporation from being a corporate joint venture.

ASC 805-10 — SEC Materials — SEC Staff Guidance

SEC Observer Comment: Accounting by a Joint Venture for Businesses Received at Its Formation

S99-8 The following is the text of SEC Observer Comment: Accounting by a Joint Venture for Businesses Received at Its Formation.

The SEC staff will object to a conclusion that did not result in the application of Topic 805 to transactions in which businesses are contributed to a newly formed, jointly controlled entity if that entity is not a joint venture. The SEC staff also would object to a conclusion that joint control is the only defining characteristic of a joint venture.

ASC 845-10 — SEC Materials — SEC Staff Guidance

SEC Observer Comment: Accounting by a Joint Venture for Businesses Received at Its Formation

S99-2 The following is the text of SEC Observer Comment: Accounting by a Joint Venture for Businesses Received at Its Formation.

The ASC master glossary defines a corporate joint venture and provides specific characteristics of a joint venture within that definition. In addition to those characteristics, there is a consensus that venturers must have joint control over an entity for it to be considered a joint venture, as evidenced by the codified comments from the SEC staff observer captured originally in EITF Issue 98-4. Further, the Accounting Standards Executive Committee (AcSEC) indicated in the advisory conclusion of its July 17, 1979, AICPA Issues Paper, “Joint Venture Accounting,” that the element of “joint control” of major decisions should be the central distinguishing characteristic of a joint venture. The AcSEC recommended that the definition in Section 3055 of the Canadian Institute of Chartered Accountants Handbook (subsequently amended) be adopted in substance as the definition of a joint venture. The Handbook defines a joint venture as:

An arrangement whereby two or more parties (the venturers) jointly control a specific business undertaking and contribute resources towards its accomplishment. The life of the joint venture is limited to that of the undertaking which may be of short or long-term duration depending on the circumstances. A distinctive feature of a joint venture is that the relationship between the venturers is governed by an agreement (usually in writing) which establishes joint control. Decisions in all areas essential to the accomplishment of a joint venture require the consent of the venturers, as provided by the agreement; none of the individual venturers is in a position to unilaterally control the venture. This feature of joint control distinguishes investments in joint ventures from investments in other enterprises where control of decisions is related to the proportion of voting interest held.

Although joint control is a joint venture’s most distinguishing feature, it is not the only characteristic of a joint venture, and as indicated in ASC 805-10-S99-8 and ASC 845-10-S99-2, the SEC staff “would object to a conclusion that joint control is the only defining characteristic of a joint venture.”

On the basis of the definition of a corporate joint venture in ASC 323-10-20, we believe that a joint venture has all3 the following characteristics:

It is a separate legal entity. It is owned by a small group of entities.
Its operations are for the mutual benefit of the venturers.
Its purpose is to share risks and rewards in developing a new market, product, or technology; to combine complementary technological knowledge; or to pool resources in developing production or other facilities.
It allows each venturer to participate, directly or indirectly, in the overall management. The members have an interest or relationship other than that of passive investors.
It is not a subsidiary of one of the members (commonly referred to as the “joint control” provision).

See Section 7.2 of Deloitte’s Roadmap Equity Method Investments and Joint Ventures for additional details.

3.4.4.7 Whether Substantially All of the Activities Either Involve or Are Conducted on Behalf of the Reporting Entity

A reporting entity should base its determination of whether substantially all of a legal entity’s activities either involve or are conducted on behalf of the reporting entity and its related parties on the design of the legal entity and should compare the nature and extent of the activities between the reporting entity and the legal entity with the entire set of the legal entity’s activities. For this determination, related parties include all parties identified in ASC 810-10-25-43 except for de facto agents as described in ASC 810-10-25-43(d). Generally, if 90 percent or more of the legal entity’s activities are conducted on behalf of a reporting entity and its related parties, it is presumed to be “substantially all” of the legal entity’s activities. However, less than 90 percent is not a safe harbor. The evaluation should not necessarily be based on the reporting entity’s economic interest(s) in a legal entity. However, significant economic interests in a legal entity may indicate that substantially all of the legal entity’s activities either involve, or are conducted on behalf of, the reporting entity and its related parties.

The following conditions may indicate (depending on their relative significance) that substantially all of a legal entity’s activities are conducted on behalf of a reporting entity and its related parties:

The reporting entity has entered into an agreement to purchase the output of the legal entity.
The legal entity purchases the inputs for its products, services, or both from the reporting entity, and the activities of the legal entity are an extension of the reporting entity’s activities.
The legal entity acts as a reseller of the reporting entity’s finished products or services.
The legal entity was designed or redesigned to provide goods, services, or both exclusively to the reporting entity’s customers.
The legal entity’s assets are leased to or from the reporting entity.
The legal entity depends on the reporting entity when conducting its ongoing business activities (without a similar level of dependency on other parties).
The legal entity enters into an outsourcing or tolling arrangement in which the reporting entity agrees to (1) provide raw materials, other inputs, or both and (2) purchase all of the related finished product from the legal entity.
The legal entity enters into a technical service agreement in which the reporting entity provides the legal entity with a variety of technical, consulting, and administrative services.
The legal entity is dedicated to developing pharmaceutical, biotech, software, or other in-process technology, and the reporting entity has rights to the resulting product.
The reporting entity holds options or other securities to acquire the other investors’ interests in the legal entity.
The other investors in the legal entity hold options or other securities that allow them to put their interests to the reporting entity.
The reporting entity is obligated to provide additional funding when operating losses occur, current funding is insufficient, or both.
The economics of the legal entity are designed or redesigned to be heavily weighted toward the reporting entity.
The reporting entity’s employees act as management for the legal entity.
The legal entity’s employees receive incentive compensation that depends on the financial results of the reporting entity.

Note that these conditions are also important to the determination of whether a legal entity is a VIE under ASC 810-10-15-14(c). See Section 5.4.2 for additional examples.

Example 3-21

Enterprise A owns an equity interest in Entity B, a public utility company that meets the definition of a business in ASC 805. Entity B provides electricity to unrelated third parties. There are no other interests or agreements between A and B. Because B conducts activities (i.e., producing electricity) on behalf of third-party customers, it does not conduct its activities on behalf of A. Therefore, substantially all of B’s activities neither involve nor are conducted on behalf of A. However, A would still need to determine whether the other conditions in ASC 810-10-15-17(d) are met.

Conversely, assume that A enters into a long-term power purchase agreement (PPA) for 100 percent of B’s output. In this case, A would not be able to apply the business scope exception because substantially all of B’s activities are conducted on A’s behalf.

Example 3-22

Entity G is created solely to lease diagnostic equipment to hospitals. Enterprise H owns several hospitals and enters into an agreement to exclusively lease its diagnostic equipment from G. This arrangement represents 40 percent of G’s total leasing activities. Assume that there are no other arrangements between G and H and that G is a business as defined in ASC 805.

Although H leases 100 percent of its diagnostic equipment from G, the exclusive leasing arrangement does not, in itself, represent substantially all of G’s activities because G conducts the remaining 60 percent of its leasing activities with unrelated parties. However, H would still need to determine whether the other conditions in ASC 810-10-15-17(d) are met.

Example 3-23

A joint venture entity (Entity C) is formed by two unrelated parties, Enterprises A and B. Each investor has a 50 percent equity interest. Entity C’s activities consist solely of purchasing a product from A and selling and distributing it to third-party customers.

Because of its current design, C represents another distribution or sales channel for A’s merchandise. Entity C appears to be an extension of A’s business because it is so closely aligned in appearance and purpose. Therefore, substantially all of C’s activities either involve or are conducted on A’s behalf and, accordingly, the business scope exception cannot be applied by A.

Example 3-24

A joint venture entity (Entity C) is formed by two unrelated parties, Enterprises A and B. Each investor has a 50 percent equity interest in C. Entity C has contracted to purchase all of its raw materials from A. Entity C uses these raw materials to manufacture finished goods to sell to third-party customers.

In this example (unlike the previous example), C does not appear to be an extension of A’s business. Even though A provides all of C’s raw materials, C uses those raw materials to manufacture finished goods as opposed to just selling, without modifying, the raw materials purchased from A. Thus, C has not been designed so that substantially all of its activities either involve or are conducted on A’s behalf. However, A would still need to determine whether the other conditions in ASC 810-10-15-17(d) are met.

Example 3-25

An investment hedge fund is established by a 99 percent limited partner and a 1 percent general partner. The fund has no other activities, and profits and losses are allocated according to ownership interests. In this scenario, the only activity of the fund is to invest its money and to provide returns to the general partner and limited partner. As currently designed, the fund’s activities, as well as its economics, are heavily weighted toward the limited partner. Therefore, substantially all of the fund’s activities involve or are conducted on behalf of the limited partner and, accordingly, the business scope exception cannot be applied by the limited partner.

3.4.4.8 Whether a Financing Represents Subordinated Financial Support

ASC 810-10-20 defines subordinated financial support as “[v]ariable interests that will absorb some or all of a [legal entity’s] expected losses” (see also Section 2.13). In general, all forms of financing are “subordinated financial support” unless the financing is the most senior class of liabilities and is considered “investment-grade.” Standard & Poor’s and Moody’s categorize investment-grade debt as that rated BBB or higher and Baa or higher, respectively. If the debt is not rated, it should be considered investment-grade only if it possesses characteristics that warrant such a rating. Evaluating whether a nonrated instrument possesses the same characteristics to be considered investment-grade requires careful consideration.

The determination that non-investment-grade debt is subordinated is based on the view that the debt holder is exposed to a more than remote chance of experiencing a credit loss. Therefore, unless the financing is investment-grade or, if the debt is not rated, possesses the same characteristics as investment-grade debt, the financing should be considered subordinated. This conclusion is consistent with ASC 810-10-55-23, which states, in part, that the “return to the most subordinated interest usually is a high rate of return (in relation to the interest rate of an instrument with similar terms that would be considered to be investment grade)” (emphasis added).

Example 3-26

Two unrelated parties, Enterprise A and Enterprise B, form a joint venture, Entity C, that meets the definition of a business in ASC 805. Enterprises A and B each contribute equity with a fair value of $20 and share equally in all voting matters. In addition, A lends $10 to C. The fair value of the loan is $10 and it is not considered investment-grade. Enterprise A has provided subordinated financial support with a fair value of $30 ($20 in equity and $10 in debt), which is more than half the total subordinated financial support of C ($50). Therefore, A cannot apply the business scope exception. However, if none of the other conditions in ASC 810-10-15-17(d) are met, B should apply the business scope exception because it does not provide more than half of the subordinated financial support.

3.4.4.9 Whether More Than Half of the Total of Equity, Debt, and Other Subordinated Financial Support Has Been Provided by the Reporting Entity and Its Related Parties

Under ASC 810-10-15-17(d)(3), a reporting entity must identify all forms of subordinated financial support that it or its related parties have provided to the legal entity. Related parties would include all parties identified in ASC 810-10-25-43 except for the de facto agency relationship that results from the transfer restrictions described in Section 8.2.3.4. (See the previous section for a discussion of how to determine whether the financing is subordinated.)

In determining whether the reporting entity or its related parties have provided more than half of the equity, debt, and other forms of subordinated financial support to a legal entity, the reporting entity should aggregate the fair value of the total equity, subordinated debt, and other forms of subordinated financial support that it (and its related parties) provides to the legal entity. If that amount is greater than half the fair value of the total equity, subordinated debt, and other forms of subordinated financial support of the legal entity, the reporting entity would meet this condition and therefore should not be able to apply the business scope exception.

A reporting entity must consider whether any variable interests that it (or its related parties) holds (in addition to equity or subordinated debt) constitute additional subordinated financial support. Many of the examples of variable interests cited in Table 4-1 in Section 4.3 (such as certain guarantees, put options, and agreements to provide services to the legal entity) will be considered a form of subordinated financial support if there is more than a remote chance that they absorb some or all of the expected losses of a legal entity.

Example 3-27

Company A contributes $5 million cash, and a guarantee of debt with a fair value of $1 million, in exchange for 67 percent of the equity of Entity X. Other equity holders contribute $3 million in cash to the entity in exchange for the remaining 33 percent of the equity in X, and X raises additional funds via a $2 million note payable (guaranteed by A) to a financial institution that is considered additional subordinated financial support. The guarantee absorbs expected losses of the entity and is therefore also considered to be additional subordinated financial support. Since the aggregate fair value of A’s equity and the guarantee ($6 million) is more than half of the total equity, debt, and other forms of subordinated financial support of X, A would not be able to avail itself of the business scope exception.

3.4.4.10 Additional Subordinated Financial Support — Put and Call Options

A put or call option between equity owners in a legal entity (e.g., between joint venture partners) can have an impact on whether a reporting entity meets the condition in ASC 810-10-15-17(d)(3) and, therefore, on whether it can apply the business scope exception. The examples below illustrate situations in which (1) a put option (purchased by one investor from the reporting entity) results in the reporting entity’s ineligibility for the business scope exception since the reporting entity effectively provides more than half of the total equity, subordinated debt, and other forms of subordinated financial support to the legal entity and (2) a call option would not have the same impact.

Example 3-28

Put Options

Investor A and Investor B form Entity X with equal contributions of equity. Investor B purchases a put option from A that permits it to put its interest in X to A at a fixed price.

The fair value of the fixed-price put option should be considered additional subordinated financial support provided by A to X because A will absorb expected losses of X upon exercise of that put option (i.e., it meets the definition of subordinated financial support in ASC 810-10-20). Therefore, A would consider the fair value of the fixed-price put option (presumably the price paid) in determining whether the condition in ASC 810-10-15-17(d)(3) is met. If the fair value of the put option is greater than zero, A would meet this condition and therefore would not be able to use the business scope exception since the fair value of the equity provided by A and the fair value of the put option written by A would constitute more than half the total of the equity, subordinated debt, and other forms of subordinated financial support to the legal entity.

Example 3-29

Call Option

Investor A and Investor B form Entity X with equal contributions of equity. Investor A purchases a call option from B that permits it to call B’s interest at a fixed price (the call option’s strike price is at or above the fair value of the equity interest at inception of the option).

The fair value of the fixed-price call option should not be considered additional subordinated financial support to X because A will not absorb expected losses of X upon exercise of that call option (i.e., the option does not meet the definition of subordinated financial support in ASC 810-10-20). Investor A can exercise its call and obtain additional residual returns of X, but the call option does not expose it to additional expected losses. Therefore, A would not consider the fair value of the fixed-price call option in determining whether it meets the condition in ASC 810-10-15-17(d)(3). Investors A and B would not meet this condition since the fair value of the equity provided by each investor would not constitute more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the legal entity. To use the business scope exception, A and B must determine whether the other conditions in ASC 810-10-15-17(d) are met.

3.4.4.11 Single-Lessee Leasing Activities

The business scope exception in ASC 810-10-15-17(d) may not be applied to legal entities whose activities are primarily related to single-lessee leasing arrangements, regardless of whether the leasing arrangements are accounted for as operating leases or finance leases. Lessee reporting entities sometimes question whether it is necessary to evaluate the potential consolidation of a lessor entity that holds a single asset that it leases to the lessee reporting entity and accounts for as a finance lease. While the accounting treatment of a finance lease under ASC 842 may be similar to the consolidation of the asset and related debt obligation, the accounting result may be different (see Section 4.3.9.2) and therefore a lessee must evaluate its interest in the lessor for consolidation unless it qualifies for a scope exception.

Whether a legal entity is considered a single-lessee leasing arrangement depends on whether the primary activity of the legal entity is leasing (as lessor) to a single lessee. This evaluation is based on various qualitative and quantitative factors, including why the legal entity was created, the terms of the lease contracts the legal entity has entered into, the significance of the legal entity’s cash flows derived from leasing activities compared with its other activities, and the significance of the assets being leased compared with the legal entity’s other assets.

For legal entities whose primary activity is leasing, the next step is to determine whether the assets or group of assets is being leased by a single lessee. In making this determination, a reporting entity should look to the substance of the arrangement. For example, although governing documents may permit the leasing of assets of the legal entity to more than one party, the reporting entity should consider the intent of the legal entity and the actual leasing arrangements. The leasing of assets to multiple parties that are all part of a related-party group would generally be equivalent to leasing assets to a single lessee.

Example 3-30

Entity A is designed to own and lease retail buildings as well as an office park with multiple office buildings to various commercial and noncommercial tenants, and it meets the definition of a business in ASC 805. About 60 percent of A’s leasing activities are conducted with Enterprise B, an equity investor that leases office buildings; the remaining 40 percent of the leasing activities are conducted with unrelated third-party customers. There are no other arrangements between B and A. In this example, although A’s primary activity is leasing, A was designed to lease its properties (and is actually leasing its properties) to B as well as to unrelated third-party customers. Therefore, A would not meet the condition in ASC 810-10-15-17(d)(4) and should apply the business scope exception if none of the other conditions in ASC 810-10-15-17(d) are met.

Example 3-31

Assume the same facts as in the example above except that Entity A does not have any leasing activity with unrelated third-party customers and Enterprise B leases 100 percent of A’s properties (the retail buildings and all office park buildings). In this example, A meets the condition in ASC 810-10-15-17(d)(4), and B cannot apply the business scope exception because this transaction is considered a single-lessee leasing arrangement.

Example 3-32

Entity A (a business) leases construction equipment to unrelated third parties, which represents 30 percent of A’s cash flows. Entity A’s remaining business activities do not involve leasing, securitizations, or asset-backed financings. Enterprise B enters into a contract in which it will lease several pieces of construction equipment from A. Once executed, the lease contract will represent all the cash flows from A’s leasing business. There are no other arrangements between A and B.

Although the cash flows from the lease contract represent all of A’s leasing business, A was not specifically designed to enter into single-lessee leasing arrangements. In addition, A’s activities are not primarily related to either leasing or asset-backed financings, as demonstrated by its significant business activities with parties other than B. Therefore, A does not meet the condition in ASC 810-10-15-17(d)(4), and B should apply the business scope exception if none of the other conditions in ASC 810-10-15-17(d) are met.

Example 3-33

Entity A owns 10 office buildings and 10 parking garages. It leases each of these buildings and parking garages to a different enterprise that is either partially or wholly owned by the same parent, Enterprise X. Entity A meets the definition of a business in ASC 805. Further, A’s governing documents do not restrict it from entering into lease contracts with parties other than X and its related-party group, nor was A designed solely to lease its properties to X. However, even though A’s governing documents allow it to enter into lease contracts with parties other than X and its related-party group, the actual activities of A involve leasing the office buildings and parking garages to a single related-party group. The individual lease contracts should therefore be viewed as a single-lessee leasing arrangement. Consequently, X cannot apply the business scope exception to A because the condition in ASC 810-10-15-17(d)(4) is met.

Footnotes

The requirement that all the conditions must be met is consistent with the views expressed by SEC Professional Accounting Fellow Chris Rogers at the 2014 AICPA Conference on Current SEC and PCAOB Developments. Deloitte’s Roadmap Equity Method Investments and Joint Ventures provides more information.

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