1.Statement of the problem
The issue in the formation of Jupiter is how each company will treat their investment in the company. This paper will perform a consolidation analysis that follows the guidelines of the VIE model laid out in ASC 810-10. I will determine whether Jupiter is a Variable Interest Entity and who is the primary beneficiary.
•Saturn and Venus, two unrelated parties, formed Jupiter, a joint venture
•Saturn owns 51% and Venus owns 49%, contributing $561 and $539 (of manufacturing facilities) million respectively
•The purpose of Jupiter is to own and operate organic clothing design and manufacturing facilities to sell organic clothing to unrelated retailers
•Both companies received equity and debt securities for Jupiter •Board is split between Saturn and Venus (4 and 4)
•Both companies can nominate individuals for CEO
•Actions that can be passed with simple majority vote: appointment and removal of CEO, decisions for capital call contributions, admission of new joint venture members, and mergers and acquisitions
•Saturn controls design, manufacturing, pricing and sales of the clothing
•Venus controls all decisions regarding distributing clothing in fulfillment of sales negotiated by Saturn
•Profits and losses are split by ownership percentage
•Saturn and Venus are not related parties
For the consolidation analysis of Jupiter, we will need to consider statements issued in regards to consolidations, Variable Interest Entities, and Joint Arrangements. The codification provides us first with guidance in Section 810-10 for identifying Variable Interest Entities. The formation is a VIE because it has 1 of the characters described in section 810-10-15-14. The first of these is if the total equity investment at risk is not sufficient to permit the legal entity to finance its activities without additional subordinate financial support. Part 1 of the section describes this as entities significantly sharing in profits and losses such as in the creation of Jupiter. The agreement would not apply to the second subsection because they have voting rights, absorb losses and benefit from gains. Lastly the agreement would not apply to section 3 because both Saturn and Venus have voting rights proportionate to their obligations. Thus the formation created Jupiter, a Variable Interest Entity, and established Saturn and Venus as Variable Interest holders since they share in the obligation and benefits of the returns.
In determining the primary beneficiary we turn to FIN 167, which was released in the Accounting Standards Update 2009-17 to update the previous guidance provided in FIN 46(R). The previous guidance was updated to include the concept of power when determining the primary beneficiary. Initially, the absorption of losses and benefit in gains was sufficient. Using this updated guidance we determine whether Saturn or Venus is a primary beneficiary. Statement 167 provides two characteristics they must possess. The first of these is the power to direct activities of a variable interest entity that most significantly impact the entities economic performance. In the case of shared power, there would be no primary beneficiary. The two parties do share power to direct activities; however, since Saturn has the ability to appoint of remove the CEO, make calls for capital contributions, admission of new joint members, and mergers and acquisitions with a majority vote I would argue that they have the ability to direct activities that most significantly affect the financial performance of Jupiter.
Because of this power, Saturn would be determined to have power. The second characteristic of a primary beneficiary is the obligation to absorb losses of the entity that could potentially be significant or to the right to receive benefits that could be significant. Given the 51% interest in the profits and losses of Jupiter, and the initial investment of over $500 million Saturn has potential significant gains or losses. Both Saturn and Venus have an obligation to absorb gains and losses; however, only Saturn has the power to control the activities that significantly impact the entity’s financial performance and as a result is the primary beneficiary. Saturn needs to consolidate Jupiter into its financial statements.
Following the guidance from Statement 167 can also lead to a different answer regarding the determination of a primary beneficiary. The paragraph regarding shared power allows no recognition of a primary beneficiary if the power to direct activities actually is shared. One could argue that this is the case in the formation of Jupiter since Venus controls all the decisions regarding distributing clothing in fulfillment of sales. This is a significant amount of power that could significantly impact the entity’s economic performance. This power would still be in effect regardless of the majority vote decisions. In the instance of shared power, no primary beneficiary has to be determined and Saturn would not consolidate Jupiter. Instead, according to section 810-10-50 Jupiter would be disclosed in the notes to the financial statements. Since few people look through disclosures and even fewer understand them, this method would allow the company to shield this entity from investors.
Although either method mentioned above could be supported, I believe it makes more sense for Saturn to consolidate. Its powers as a majority-voting shareholder to decide on the appointment of CEOs make capital contribution calls, admit new members, and conduct merger and acquisition activities are extremely important. Although Venus has the power over distribution decisions, they are still affected by the decisions over which it has no control. Looking at this transaction in terms of substance, it appears that Saturn has included these terms to guarantee their control over the Variable Interest Entity. In conclusion, I believe that Saturn should consolidate Jupiter into its financial information into their overall financial statements.