It’s nice when I can reuse some language from a previous post on a different topic. Today, the topic is materiality in the context of the variable interest entity (VIE) consolidation model. Here’s the recycled language from my post on derivatives and materiality:
“When I think about materiality I do so from both a qualitative and quantitative perspective. In most cases, the quantitative approach is sufficient since there is generally not a lot of sensitivity around the ‘what’ it is. It’s mostly about ‘how much’ it is. So materiality becomes primarily a percentage of total assets, net assets (i.e., equity), revenue, net income/loss, or whatever the most appropriate measure is in the circumstances. The qualitative aspect is less relevant in these instances and usually enters when the item in question takes a reporting entity over a threshold…from profit to loss, for example. Some issues, on the other hand, are material from a qualitative perspective without regard to the amount.”
A VIE falls into the netherworld of the not-so-well-understood accounting areas. The analysis is time consuming and very complicated and I fully understand the desire to avoid the cost and brain damage. But, sorry to say, this is one of those areas that is in my opinion virtually always qualitatively material. That does not mean ALWAYS, but it does mean you’re probably begging for a fight with your auditors.
Here are my reasons:
- Recall that the VIE guidance is a direct result of the Enron scandal. This makes it a lightning rod. Failure to apply the guidance based on a quantitative materiality theory begs for “What are you hiding?” questions from users of the financial statements.
- Quantitative materiality is rarely, if ever, brought up in the context of the voting interest consolidation model. It is assumed that if you own a subsidiary, you will consolidate. Period. So what is the justification for applying a different standard to the VIE consolidation model?
- For many VIE’s, the material issues are in the disclosures, not on the face of the balance sheet, operating statement or cash flow statement.
- The VIE model is a two-edged sword in that it can force consolidation when the voting interest model does not, and it can force deconsolidation when the voting interest model would require consolidation. A materiality claim starts to look like selective application of the guidance when you find yourself in both situations. I just don’t think it is wise to deconsolidate a VIE but not consolidate another VIE based on materiality. And vice versa. Apply the guidance uniformly.
- In most circumstances you will have to do the analysis whether you choose to consolidate or not based on materiality. You have to determine whether or not you have a VIE first. All of the cost and effort of applying the VIE guidance is incurred in the analysis phase. The actual process of consolidation is mechanical and trivial in comparison. A cost-benefit argument does not hold water when the cost is already sunk.
- The guidance requires application when the reporting entity first has a relationship with a potential VIE and/or when the relationship with the potential VIE changes in some way such that the reporting entity now holds, or now no longer holds, a variable interest. So, again, you have to perform this determination at inception of the relationship and at each change in the relationship. Even if the amounts are not quantitatively material, you still have to go through the vast majority of the effort and expense regardless.