Consolidation models
In the previous section, we introduced the concept of control, which is the key factor that determines whether one entity must consolidate another entity in its financial statements.
Under U.S. GAAP, consolidation is governed primarily by ASC 810 - consolidation. This guidance establishes the framework used to determine whether a reporting entity controls another entity and must therefore include that entity in its consolidated financial statements.
However, determining control is not always straightforward. In some situations, control is clearly linked to ownership of voting shares, while in other situations control arises through economic interests, contractual arrangements, or decision-making authority.
To address these different situations, U.S. GAAP provides two consolidation models. The two consolidation models are:
- the voting interest entity model
- the variable interest entity model
These models provide different ways of evaluating control depending on the structure and characteristics of the entity being evaluated.
Under ASC 810, the reporting entity first evaluates whether the entity being assessed is a VIE. If it is, the VIE model applies. If it is not, the voting interest model applies by default.
The voting interest entity (VOE) model
The voting interest entity model is the traditional approach used to determine whether consolidation is required. Under this model, control is typically determined based on ownership of voting shares.
Under the voting interest model, the reporting entity generally consolidates another entity when it owns more than 50% of the voting shares. Ownership of a majority of voting rights usually gives the parent company the ability to:
- elect the board of directors
- control major corporate decisions
- direct the operating and financial policies of the subsidiary
Because these powers allow the parent to direct the activities of the entity, the parent is considered to control the subsidiary and must therefore include it in its consolidated financial statements.
Example of voting interest control
Suppose Company Alpha acquires 75% of the voting shares of Company Beta.
Because Alpha holds a majority of the voting rights, it can elect Beta’s board of directors and control key corporate decisions. Under the voting interest entity model, Alpha therefore controls Beta and must consolidate Beta in its financial statements.
The voting interest model applies to most traditional corporate subsidiaries, where ownership of voting shares reflects the party that actually controls the entity.
Limitations of the voting interest model
Although the voting interest model works well for many traditional corporate structures, it does not always capture the true economic relationships between entities.
In some situations, companies create entities in which voting ownership does not represent the party that actually controls the entity’s activities.
For example, an entity may be structured so that:
- the equity investors have very little decision-making authority
- another party has contractual power to direct the entity’s activities
- one party absorbs most of the economic risks or benefits
Under these circumstances, relying solely on voting ownership could lead to misleading financial reporting. An entity that is economically controlled by one company might appear to be independent simply because that company does not hold a majority of voting shares.
To address this issue, U.S. GAAP introduced the variable interest entity model.
The variable interest entity (VIE) model
The variable interest entity (VIE) model focuses on economic control rather than voting ownership. This model applies when an entity’s structure indicates that voting rights are not the primary factor determining control.
An entity is classified as a VIE when it has any one of the following characteristics:
- its equity at risk is not sufficient to finance its activities without additional subordinated financial support from other parties
- the equity holders as a group lack the power to direct the entity’s significant activities, the obligation to absorb its expected losses, or the right to receive its expected residual returns
- voting rights are disproportionate to economic exposure, and substantially all of the entity’s activities are conducted on behalf of an investor with disproportionately few voting rights
Under the VIE model, consolidation is determined by identifying the primary beneficiary of the entity.
If a reporting entity is identified as the primary beneficiary, it must consolidate the VIE, even if it does not own a majority of the voting shares.
Identifying the primary beneficiary
To determine whether a reporting entity is the primary beneficiary of a VIE, two key criteria must be evaluated.
| Criterion | Explanation |
| Power criterion | The reporting entity has the power to direct the activities that most significantly affect the entity’s economic performance. |
| Economics criterion | The reporting entity has the obligation to absorb losses or the right to receive benefits that could potentially be significant to the entity. |
Both criteria must be satisfied for a reporting entity to be considered the primary beneficiary, and the primary beneficiary consolidates the VIE.
Example: Primary beneficiary without majority ownership
Sponsor Corp sets up Gamma SPE, a special-purpose entity that purchases trade receivables from Sponsor’s customers. Sponsor contributes only 10% of Gamma’s equity but guarantees Gamma’s debt and manages the collection of Gamma’s receivables under a servicing contract.
- Power criterion: Sponsor manages the receivables and directs the activities that most affect Gamma’s performance.
- Economics criterion: Sponsor’s debt guarantee exposes it to Gamma’s losses.
Answer: Sponsor meets both criteria, so it is the primary beneficiary and must consolidate Gamma, even though it owns only 10% of Gamma’s equity.
Examples of variable interest entities
Variable interest entities often arise in specialized financial structures where traditional voting ownership does not represent economic control.
Examples of situations where the VIE model may apply include:
- securitization vehicles used to finance receivables
- structured finance entities created for specific projects
- real estate development entities
- investment funds with complex ownership structures
- special-purpose entities established for financing transactions
In many of these arrangements, the equity investors provide very little capital relative to the entity’s total activities, while another party provides financing, guarantees, or management services that give it effective control.
Because voting rights do not fully reflect the economic relationship between the parties, the VIE model focuses on economic exposure and decision-making power.
Comparison of the two consolidation models
The two consolidation models differ primarily in how control is evaluated.
| Feature | Voting interest model | Variable interest entity model |
| Basis of control | Voting rights | Economic interests |
| Ownership requirement | Usually majority voting ownership | Majority ownership not required |
| Focus | Legal ownership and voting power | Exposure to risks and rewards |
| Typical application | Traditional corporate subsidiaries | Structured entities and special-purpose entities |
Once a reporting entity determines that consolidation is required under either model, the next step is deciding how to apply it. We cover full, proportionate, and equity consolidation approaches, along with the elimination of intercompany balances and transactions, in the next chapter, Consolidation approaches.