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1.1 Background on the consolidation framework
Publication date: 20 Dec 2023
us Consolidation guide
Determining when one entity should consolidate another can be complex. However, it is important to investors because when one entity consolidates another, it reports the other entity’s assets, liabilities, revenues, and expenses together with its own, as if they are a single economic unit. Consequently, the consolidation decision can have a significant impact on the consolidating entity's results of operations, cash flows, reported leverage, and other metrics.
In accounting, control is required for one entity to consolidate another. Control, as it is described in ASC 810, is the foundation for the consolidation model.
1.1.1 Evolution of two consolidation models
The original US consolidation standard, issued in the 1950s, was based on the notion that control was generally demonstrated by holding a majority of the voting rights of an entity. This consolidation model, which is still used today, is commonly referred to as the voting interest entity (VOE) model.
Later, a separate model, within the broader voting interest entity model, was developed for limited partnerships and similar entities. That model included the presumption that the general partner controlled a partnership unless the limited partners were able to remove the general partner by a simple majority vote.
The use of securitizations, a process to bundle financial assets into securities, increased during the 1990s and 2000s, as did the use of highly-structured entities, commonly referred to as "special purpose entities," which were not consolidated under the accounting guidance as it existed at the time. Some high-profile perceived abuses of the consolidation rules in the early 2000s resulted in the introduction of the "risks and rewards consolidation model." This model is referred to as the variable interest entity (VIE) model.
The original VIE model provided that if an entity expected to assume more than 50% of another entity's expected losses or gains, it should consolidate that entity. This model created a "bright line," and allowed entities to structure transactions to achieve a specific consolidation objective–either to consolidate another entity or not. Additional revisions and further guidance were issued subsequently to address some of the implementation questions that arose with this risk and rewards approach to the VIE model.
The financial crisis that began in 2008 provided another catalyst for change as some financial institutions were exposed to losses related to entities that were not consolidated under the VIE model (i.e., off-balance sheet entities). Stakeholders called for greater transparency into these entities, and in response, the model for assessing control for variable interest entities changed from one focused exclusively on risks and rewards to one focused on having both the power to direct an entity's key activities and exposure to potentially significant gains and losses (a "power and economics" model).
Subsequently, the VIE model was amended several times to address concerns of asset managers, provide relief for private companies in certain circumstances (a private company accounting alternative), alter how a decision maker considers its fees earned and its indirect interests in a VIE held through an entity under common control, eliminate the exception for certain development stage entities from being considered variable interest entities, and provide a measurement alternative for consolidated collateralized financing entities.
The VOE model was also amended to remove the presumption that a general partner controls a partnership unless the limited partners are able to remove the general partner by a simple majority vote.
1.1.2 Equity method of accounting or other applicable guidance
If a reporting entity determines it does not meet the criteria to consolidate a legal entity, it should next determine if the equity method of accounting is appropriate. The equity method of accounting is an approach for an investor to measure investments in common stock or other eligible investments in an investee entity (i.e., investments considered to be “in-substance” common stock, such as certain preferred stock investments) by recognizing its share of the net assets underlying those investments. It also requires the investor to recognize, in net income, its share of the investee’s earnings for each reporting period. The equity method of accounting is required when an investor or a company is able to exercise significant influence over the operating or financial decisions of an investee.
The equity method of accounting guidance also addresses many other items, including:
- An investor’s accounting for subsequent investments in an investee after suspending equity method loss recognition
- Stock-based compensation granted by an investor to employees of the investee, exchanges of equity method investments
- The determination of when limited partnerships and limited liability companies should be subject to the equity method
- The receipt of an equity method investment for the contribution of nonfinancial assets
See EM for details on the equity method of accounting.
Only after a reporting entity has determined that its financial relationship with an entity does not give rise to a controlling financial interest or an equity method investment, would it look to other accounting guidance to determine the appropriate accounting for that relationship. Other guidance that may be applicable includes the accounting for receivables (ASC 310), debt securities (ASC 320), equity securities (ASC 321), other investments (ASC 325), contingencies (ASC 450), guarantees (ASC 460), collaborative arrangements (ASC 808), derivatives (ASC 815), and other industry-specific guidance.
1.1.3 Joint venture accounting
Historically, the equity method was commonly applied to investments in joint ventures. The subsequent introduction of the VIE risks and rewards model led to some entities no longer being viewed as joint ventures and instead needing to be consolidated by one of the venturers.
Today, the starting point for assessing an investment, including one in a potential joint venture, is the consolidation guidance. An investor in an entity needs to first determine if it has a controlling financial interest and, if so, would need to consolidate the venture. Only those entities that are not required to be consolidated by any of the investors can meet the accounting definition of a joint venture.
Some nuances have evolved in practice in the accounting for investments in joint ventures under the equity method and the accounting by the joint venture entity. These differences arise predominantly in the accounting for non-cash contributions to the joint venture prior to the adoption of ASU 2023-05, Business Combinations – Joint Venture Formations (Subtopic 805-60): Recognition and Initial Measurement. After adoption of ASU 2023-05, the joint venture is required to account for all contributions received upon formation by applying a new basis of accounting, which may eliminate some of the differences in accounting between the investor and investee. See EM 6 for further discussion on the accounting by joint ventures and for investments in joint ventures.
Proportionate consolidation is used in limited circumstances in the extractive and construction industries as an alternative to the equity method. See CG 8.4 for further discussion on proportionate consolidation.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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