The VIE model versus the voting interest model

• Run the Topic 810 analysis in the right order
• Test a legal entity against the characteristics that make it a VIE
• Apply the voting interest model to corporations and limited partnerships
• Decide whether a private company can use the ASU 2018-17 common control alternative

Two models, one question

Topic 810 asks whether a reporting entity has a controlling financial interest in a legal entity. It answers that question with two models. The variable interest entity model looks at power over the activities that drive economic performance and exposure to losses and returns. The voting interest model looks at voting rights. Every legal entity is evaluated under exactly one of them, and the VIE model comes first.

The order of the analysis

1. Scope exceptions. 810-10-15-12 and 15-17 exclude, for example, employee benefit plans subject to Topic 712 or 715, governmental organizations, and investments held by investment companies under Topic 946. Some exceptions apply to the VIE subsections only.
2. Variable interest. Does the reporting entity hold a variable interest: an equity stake, a loan, a guarantee, a residual value guarantee on a lease, or a fee arrangement that absorbs variability? If not, stop.
3. Is the entity a VIE? Test the characteristics below.
4. If it is a VIE, apply the primary beneficiary test (next lesson).
5. If it is not, apply the voting interest model.

What makes a legal entity a VIE

Under 810-10-15-14, a legal entity is a VIE if any one of these is true:

• Insufficient equity at risk. The total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support. Equity of less than 10 percent of total assets is presumed insufficient unless the entity can demonstrate otherwise (810-10-25-45). Ten percent or more is not automatically enough.
• The equity holders as a group lack power. They cannot, through voting or similar rights, direct the activities that most significantly affect economic performance. For a limited partnership, ASU 2015-02 makes this test turn on kick-out or participating rights: unless a simple majority or lower threshold of limited partners (excluding the general partner, entities under common control with it and parties acting on its behalf) can exercise substantive kick-out rights, or the limited partners hold substantive participating rights, the partnership is a VIE.
• The equity holders lack the obligation to absorb expected losses, for example because a guarantee protects them.
• The equity holders lack the right to receive expected residual returns, for example because returns are capped.
• Voting rights are disproportionate, and substantially all of the entity's activities involve or are conducted on behalf of an investor with disproportionately few voting rights. This is the anti-abuse test.

The voting interest model

For a corporation that is not a VIE, the usual condition for a controlling financial interest is ownership of a majority voting interest, directly or indirectly (810-10-15-8). Control does not rest with the majority owner when, for example, the subsidiary is in legal reorganization or bankruptcy, or the noncontrolling shareholders hold substantive participating rights over decisions in the ordinary course of business (810-10-15-10 and 810-10-25-2 through 25-14). Protective rights, such as a veto over a sale of the company, do not overcome majority control.

For a limited partnership that is not a VIE, ASU 2015-02 removed the presumption that the general partner controls. A limited partner that holds a controlling financial interest, which can come through substantive kick-out rights, consolidates. In practice, most limited partnerships where the general partner makes the decisions and the limited partners cannot remove it are VIEs.

The private company alternative

Many private groups place real estate or equipment in a separate LLC owned by the same family that owns the operating company, and the operating company guarantees the LLC's debt. Under the VIE model, the operating company often consolidates the LLC.

ASU 2018-17 lets a private company elect not to apply the VIE subsections to a legal entity when all of these are met (810-10-15-17AD):

• the reporting entity and the legal entity are under common control
• they are not under common control of a public business entity
• the legal entity is not a public business entity
• the reporting entity does not have a controlling financial interest in the legal entity under the voting interest model

The election is a policy applied to every legal entity that meets the criteria, not chosen one entity at a time. The company still applies the voting interest model, and it must provide the disclosures in 810-10-50-2AG through 50-2AI about its involvement with and exposure to the legal entity. Not-for-profit entities and employee benefit plans cannot elect it.

Documenting the conclusion

Keep one evaluation per legal entity, refreshed when facts change. The VIE evaluation worksheet follows this order.

A family real estate LLC and the operating company