What Is the Voting Interest Model for Consolidation?

The voting interest model is an accounting method used to determine if one company must combine its financial statements with another. This process, known as consolidation, is required when a company has a controlling financial interest in another entity. The model’s purpose is to present a parent company and its subsidiaries as a single economic unit, providing stakeholders with a comprehensive view of the group’s financial health.

Determining the Applicable Consolidation Model

Before applying the voting interest model, a company must first determine if the entity it has invested in is a Variable Interest Entity (VIE). This assessment is a mandatory first step under U.S. Generally Accepted Accounting Principles (GAAP). The voting interest model is only applied if the entity is not a VIE, as the two models address different ways a company can exercise control.

An entity is considered a VIE if it has insufficient equity at risk, meaning the equity investment cannot finance the entity’s activities without additional subordinated financial support. Another condition is when the equity holders, as a group, lack the ability to make decisions that have a significant impact on the entity’s economic performance.

If an entity is a VIE, the analysis must follow the VIE model, which focuses on which party has power over the entity’s significant activities and absorbs its losses or receives its benefits. The voting interest model is the default framework for any entity that is not a VIE.

The determination of whether an entity is a VIE is not a one-time event. A company must reassess an entity’s status if certain events occur, such as changes in contractual arrangements or shifts in the equity structure. This distinction is important for proper financial reporting, as misclassifying an entity could lead to non-compliance with GAAP.

Assessing Control Under the Voting Interest Model

Under the voting interest model, control is presumed when an investor holds more than 50% of an entity’s outstanding voting shares. This majority ownership provides the power to direct the financial and operating policies of the other company.

This presumption of control is not absolute and can be overcome. An exception exists when noncontrolling shareholders hold substantive participating rights, which allow minority owners to block or participate in significant operating decisions. For a right to be considered substantive, the minority shareholder must have the practical ability to exercise it.

Examples of substantive participating rights include the power to veto the annual operating budget or to approve or reject major capital expenditures. The ability of a minority owner to approve the hiring or firing of key management personnel can also be a substantive right. The existence of these rights indicates that control is shared, rather than held exclusively by the majority owner, which would prevent consolidation.

Another factor in the control assessment involves kick-out rights, which allow noncontrolling owners to remove the managing party without cause. If these rights are held by a single, unrelated party and are easily exercisable, they can negate the control presumed by a majority voting interest.

Application to Different Legal Entity Structures

The voting interest model applies differently depending on an entity’s legal form. For corporations, the analysis is straightforward, as control is linked to owning more than 50% of the voting common stock.

The assessment is more complex for partnerships and limited liability companies (LLCs), where control may not be determined by capital ownership alone. For these entities, the operating agreement is the primary document for identifying which party directs the most significant activities. These agreements can grant management rights to a partner or member that are disproportionate to their equity stake.

In a limited partnership, for example, control is not automatically held by the general partner. The analysis must consider if limited partners hold a majority of the kick-out rights or have substantive participating rights that prevent the general partner from having exclusive control.

For LLCs, the operating agreement dictates if the entity is managed by its members or a designated manager. If a manager is designated, that party may hold control regardless of their ownership percentage. Analyzing the governing agreements is necessary to understand where decision-making power resides.

The Consolidation Process

Once a company determines it has a controlling financial interest, it begins the consolidation process. This involves combining the financial statements of the parent and subsidiary on a line-by-line basis. For example, the subsidiary’s cash balance is added to the parent’s cash balance, and the same is done for all other assets and liabilities.

A step in this process is the elimination of intercompany transactions and balances to prevent overstating the consolidated entity’s financial position and performance. For instance, if a parent sold goods to its subsidiary, the related revenue and cost of goods sold must be eliminated, as a single economic entity cannot earn revenue from itself. Any loans between the parent and subsidiary must also be removed from the consolidated balance sheet.

After combining accounts and eliminating intercompany activity, the portion of the subsidiary’s equity not owned by the parent is addressed. This is reported as a “noncontrolling interest” and presented as a separate component of equity on the consolidated balance sheet. The portion of the subsidiary’s net income attributable to noncontrolling owners is also reported separately on the consolidated income statement. This ensures the financial statements distinguish between the equity and income belonging to the parent’s shareholders and that belonging to the minority owners.