I’ll start out this post by reminding you that the entire point of the variable interest entity (VIE) analysis is to determine if a party other than an entity’s majority shareholder should consolidate the entity into its financial statements. The VIE consolidation model is premised on the notion that, under certain conditions, parties other than voting shareholders can control an entity. If the voting interests do not have control, then they should not consolidate the entity.
The VIE model is an outgrowth of the Enron accounting nightmare that saw that company use an extensive, complex network of unconsolidated special purpose entities to shift debt and losses off its books. Had those entities been consolidated, Enron’s financial statements would have shown the company as the sham it was. Alas.
The VIE model is not, however, the only consolidation model. The so-called “voting interests model” is still alive an well and applies when the VIE model does not. The VIE model was not intended to replace the voting interest model. They are co-existing but mutually exclusive consolidation models. When an entity’s voting equity interests control the entity, then the VIE model does not apply. And vice versa. In order to apply the voting interest model, however, the VIE model must first be eliminated. That’s the rule. No exceptions. The VIE model is complex and requires serious analysis. The VIE analysis can be avoided, however, if one of its scope exception applies. The scope exceptions do not offer a way out of consolidation since the voting interest would still apply; rather, the scope exceptions offer a way out of the onerous VIE analysis.
The VIE scope exception list is rather long and reflects the FASB desire to leave much of the previously existing consolidation guidance in place. Of all the scope exception, the so-called “business” scope exception seems to provide the most confusion and that’s what I want to address here.
The business scope exception renders the VIE model inapplicable if the entity is a ‘business”, as defined by the FASB, and as long as certain other conditions are met. These conditions are critical to the scope exception and provide an view as to the FASB’s intent in providing the scope exception in the first place. How? Remember what I said previously. The intent of the VIE model is to force consolidation of an entity by a party other than its majority shareholder when that shareholder does not control entity. When the majority shareholder DOES control the entity, then the VIE model will not apply.
So with that in mind, let’s look at the business scope exception. Accounting Standards Codification (ASC) 815-10-15-12(d) states, in part,
“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 . . . unless any of the following conditions exist . . . :
a) The reporting entity, its related parties . . ., 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 franchise.
b) 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.
c) The reporting entity and its related parties provide more than half of the total 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 entity.
d) The activities of the legal entity are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements.”
An entity that meets the accounting definition of a business and does NOT meet any of the other four conditions is excepted out of the VIE analysis. When you look at this scope exception in its totality, you begin to see how it works. It does not, as many people mistakenly believe, except out a “business”. Instead, it excepts out a “business” that would not be considered a VIE. Just meeting the business definition is not enough. The entity must also not have any characteristics that might lead to the conclusion that it is a VIE. That is the point and purpose of the additional conditions.
Once you have your head around this concept, I believe the actual analysis of the business scope exception becomes rather simple. The accounting definition of a business can be found in ASC 805. ASC 805-10-20 defines as business as, “An 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.” In addition to this definition, ASC 805-10-55-4 through 9 provide implementation guidance that is helpful in determining what constitutes a business.
The evaluation of whether an entity is a business or not can get messy.The definition of a business in ASC 805 is principles based and therefore open to interpretation and judgment. The definition is provided above. ASC 805-10-55-4 provides further guidance by declaring that, “A business consists of inputs and processes applied to those inputs that have the ability to create outputs. Although businesses usually have outputs, outputs are not required for an integrated set to qualify as a business.” This last element is important when evaluating a development stage entity which will likely have no outputs for an extended period of time. In the case of a development stage entity, ASC 805-10-55-7 provides other factors that should be considered.
All of this guidance is principles-based. I believe that most people with some experience will know whether the entity is a “business” based on the nature of its operations, its financing and capital structure, and its overall purpose. There is no rules-based approach to this evaluation. Don’t look for a bright line definition.
Also, it is important to note that ASC 805 changed the definition of a business for this scope exception. Prior to ASC 805, the definition was provided by ASC 810-10-55-19 through 25. An entity determined to be a business under the previous definition did not need to reassess simply because the definition changed. However, if a redetermination event has occurred requiring redetermination of the entity as a VIE, then the new ASC 805 definition must be applied. This may result in an entity previously exempted from the VIE model as a business no longer qualifying for this scope exception.
The conditions necessary to qualify for this scope exception (ASC 810-10-15-17(d)) must be evaluated as of each reporting date. If all of the conditions are not met, then the business scope exception is no longer available.
Remember, all that this scope exception does is except the entity out of the VIE analysis. The voting interest consolidation model is still in play and must be applied if the VIE model is ruled out.