Investment Companies Advisor: New Consolidation Guidance will Affect Investment Advisers and Investment Companies

October 7, 2016 by Marshall Harvey, CPA, CFE and Elena Harrill, CPA

In February 2015, The Financial Accounting Standards Board (FASB) issued ASU 2015-02, Consolidation (Topic 810) – Amendments to the Consolidation Analysis. This update will require investment advisers, other related entities and investors in investment companies to re-evaluate the need to consolidate certain variable interest entities (VIEs).

There are two primary models for determining whether consolidation is appropriate:

  1. The voting interest entity model
  2. The variable interest entity model

Under the voting interest entity model, the usual condition for controlling financial interest of investment companies formed as limited partnerships or similar entities is ownership by one limited partner or member, directly or indirectly, of more than 50% of the entity’s kick-out rights through voting interests.

Under the VIE model, a controlling financial interest is assessed differently than under the voting interest entity model. The difference in assessment is required because a controlling interest may be achieved other than by ownership of voting interests. A controlling financial interest in the VIE model requires both of the following:

  1. The power to direct the activities that most significantly impact the VIE’s economic performance
  2. The obligation to absorb losses of the VIE that could potentially be significant to the VIE

A reporting entity with a controlling interest in a VIE is referred to as the primary beneficiary.

Is a Limited Partnership a VIE?

The ASU amends the conditions used to evaluate whether an entity is a VIE. The ASU provides a model for limited partnerships and similar entities to evaluate whether equity investors as a group have the power to direct the activities that most significantly affect the entity’s economic performance. Under the model, a limited partnership would be a VIE regardless of whether it otherwise qualifies as a voting interest entity unless a simple majority or lower threshold of unrelated limited partners have substantive kick-out rights or participating rights.

Consolidation

If substantive kick-out or participating rights are held by investors, a limited partnership is not considered a VIE and, in turn, the general partner would not consolidate a limited partnership that is not a VIE. Rather, analysis under the voting interest entity model would focus on whether limited partners should consolidate a limited partnership that is not a VIE. Under the ASU, a limited partner would consolidate a partnership if the limited partner has the substantive ability to unilaterally dissolve the limited partnership or otherwise remove the general partner without cause. If the limited partner does not have this ability or other limited partners have substantive participating rights neither the general partner nor limited partner would consolidate the partnership.

Under the VIE model, a reporting entity would be considered the primary beneficiary for a VIE when it has the power to direct the significant activities of the VIE that affect its performance (power condition), and if it has an obligation to absorb the losses or to receive benefits from the VIE that could be significant to the VIE (economics condition). An important consideration for general partners or related entities of an investment partnership is that under current guidance, a fee arrangement on its own could be sufficient to satisfy the economics condition. The ASU does not amend the economic exposure threshold in the current guidance, but under the new consolidation guidance, fees paid to a VIE’s decision maker should not be considered in the evaluation of economic exposure if the fees are “commensurate” and “at market.” Since general partners of investment companies typically have small ownership interests in the underlying investment companies, while they might meet the power condition for becoming the primary beneficiary, they could fail to meet the economics condition if fees arrangements are considered “commensurate” and “at market.”

Generally, investment companies do not consolidate investees that are not  investment companies. The fund of funds model is an example of this principle as investments in other funds are accounted for based on the proportionate ownership percentage of the underlying fund’s net asset value. It is unlikely that the ASU will change this guidance because typically a fund investing in other funds would not be able to meet the power and economic conditions that determine the primary beneficiary of a VIE (underlying fund). An exception to the principle that investment companies do not consolidate investees occurs if an investment company has an investment in an operating entity that provides services to the investment company, for example, an investment adviser. If the investment company holds a controlling interest in such an operating entity, the investment company would be required to consolidate the operating entity. If an investment company holds a non-controlling interest in such an operating entity that otherwise qualifies for use of the equity method of accounting, the investment company should use the equity method of accounting for that investment.

Related Party Considerations

When evaluating economic exposure as part of its primary beneficiary analysis, a decision maker considers both direct and indirect interests in the VIE. Under the ASU, a decision maker includes the entire interest held by a related party under common control in its primary beneficiary analysis if the decision maker has a variable interest in the related party. If the decision maker has a variable interest in a related party that is not under common control, the decision maker includes its proportionate interest when evaluating whether or not the decision maker is the primary beneficiary.

The ASU requires each party in a related-party group to determine whether it has a controlling financial interest in a VIE. There is a presumption in the ASU that the parties of the related-party group cannot conclude that they do not have a controlling financial interest if power is shared among the members of the group. When power is shared, the determination of which party within the group is most closely associated with the VIE requires judgement. The following relevant facts and circumstances should be considered in determining which party has a controlling financial interest:

  1. The existence of a principal-agency relationship between members of the group
  2. The relationship and significance of the activities of the VIE to the various parties within the related party group
  3. A party’s exposure to the expected losses of the VIE
  4. The design of the VIE

Related-party groups under common control together typically possess the characteristics of a controlling financial interest. In those cases the facts and circumstances above will be used to determine which party is the primary beneficiary that would consolidate the VIE.

Elimination of ASU 2010-10 Deferral

Investment companies currently qualify for a deferral that only requires consolidation if the reporting entity absorbs a majority of the VIE’s economic exposure or the reporting entity is part of a related party group that absorbs a majority of the VIE’s economic exposure. The ASU eliminates this deferral and requires investment companies to use the guidance of the ASU to determine if it is a VIE.

Effective Date

The ASU is effective for public business entities for annual periods and interim periods within those annual periods beginning after December 15, 2015. For all other entities, the guidance is effective for annual periods beginning after December 15, 2016, and for interim periods beginning after December 15, 2017. Early adoption is allowed for all entities (including during interim periods) but is applied as of the beginning of the annual period containing the adoption date. The guidance is to be adopted under a full or modified retrospective approach.

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