FRIEDMAN LLP Accountants and Advisors

Accounting Pitfalls: Deconsolidation

Author: Michele AmatoNewsletter Category: SEC Impact

by Michele B. Amato, CPA
This article was orginally published in the May 2012 issue of Friedman LLP's SEC Impact newsletter.

Sometimes business decisions or events outside management's control may cause an affiliate or a subsidiary to be deconsolidated. If a parent sells its ownership interest or even part of it, the reporting entity may no longer have control. This may happen when a subsidiary issues shares, reducing its parent's ownership interest so that the subsidiary is no longer controlled by the reporting entity.  
 
Companies that operate in countries with regulatory restrictions that prohibit foreign ownership in certain industries frequently use variable interest arrangements. If an entity was consolidated as a variable
interest entity (VIE), there was probably a contractual agreement that gave control of the VIE to the reporting entity. If this contractual agreement expires, the VIE would no longer be consolidated.
 
Another circumstance that would result in deconsolidation of a subsidiary or VIE is when the subsidiary or VIE becomes subject to the control of a government, court, administrator, or regulator.
 
In each of these situations, the parent would deconsolidate its subsidiary or VIE as of the date the reporting entity ceases to have a controlling financial interest. Sometimes this results in a gain or loss being recognized by the parent. The gain or loss is calculated as the difference between the carrying amount of the former subsidiary's or VIE's assets and liabilities and the aggregate of the following:
 
1. The fair value of any consideration received;
2. The fair value of any retained non-controlling investment in the former subsidiary or VIE at the date it's deconsolidated; and
3. The carrying amount of any non-controlling interest in the former subsidiary or VIE (including any accumulated other comprehensive income attributable to the non-controlling interest) at the date it's deconsolidated.
Because of the accounting consequences of deconsolidation, reporting entities should consider disclosing the significant terms of a contract prior to any deconsolidation event occurring. Investors should know when the contracts expire, how they can be renewed and how the VIE can terminate a contract.
 
Other risks that a company should consider disclosing include the following:
 
1. Uncertainties related to whether an agreement is enforceable if it is not registered with the appropriate governmental authority;
2. Uncertainties related to whether a contractual arrangement may be found to be in violation of a country's regulations; and
3. Risks of misaligned interests when the owners of the VIE are different from the owners of the majority of the company's subsidiary.
Remember that to consolidate a VIE, the reporting company must have the power to direct the activities of a VIE that most significantly affect the VIE's economic performance and the rights to economic benefits or obligations to absorb losses. Refer to SEC Impact, Volume 3, Issue 11, released in November 2011 for more information on VIEs.
   
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This entry posted on Tuesday, May 01, 2012

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