For-profit healthcare organizational overviewFor-profit healthcare entities operate in a highly regulated industry. The manner in which licensed physicians organize, perform, and bill for medical services is governed by state and federal laws and regulations. In many states, entities such as physician practices and diagnostic facilities that provide healthcare services to patients and employ physicians and other providers are required to be owned by licensed physicians. This is referred to as the corporate practice of medicine doctrine (CPOM).
According to the Emergency Medicine Residents’ Association, the CPOM “refers to the public policy limiting the practice of medicine to licensed physicians by specifically prohibiting businesses or corporations from practicing medicine or employing physicians to practice medicine.”1
In states where only physicians are permitted to directly own a medical services provider, a separate company – a physician practice management company (PPMC) or management services organization (MSO) – typically is created to perform all nonclinical administrative and support services. The PPMC or MSO will conduct business through entities that it controls that are legally owned by one or more physicians, and it is these physician-owned affiliated entities that employ the physicians who practice medicine.
In CPOM states, a PPMC or MSO generally enters into a contract that restricts the owners of the affiliated entity from transferring their ownership interests in the affiliated entity – usually a restricted stock transfer agreement. Additionally, the PPMC or MSO obtains a controlling financial interest in the affiliated entity and its operations pursuant to a long-term management service agreement between the company and the affiliated entity. Under the management service agreement, a company exclusively manages all nonclinical aspects of the practice.
Prior to the application of the variable interest entity (VIE) guidance, which was updated through amendments to ASC 810, it was common for physician practices and other for-profit healthcare organizations subject to the CPOM to be consolidated under the controlled-by-contract model. With the introduction of the VIE model, the use of the controlled-by-contract model has diminished. This is because a legal entity that is controlled by contract most likely would be a VIE since one of the conditions for not applying the VIE model is that the equity investors at risk must control the most significant activities of the legal entity.
Updates to ASC 810The FASB issued Accounting Standards Update (ASU) No. 2015-02, “Consolidation (Topic 810): Amendments to the Consolidation Analysis,” to address stakeholders’ concerns that current generally accepted accounting principles might require a reporting entity to consolidate another legal entity in the following situations:
- The reporting entity’s contractual rights do not give it the ability to act primarily on its own behalf.
- The reporting entity does not hold a majority of the legal entity’s voting rights.
- The reporting entity is not exposed to a majority of the legal entity’s economic benefits or obligations.
The updated VIE consolidation guidance in ASU 2015-02 addresses instances in which the voting-interest model in ASC 810 is not appropriate. This situation arises when a controlling financial interest is achieved through arrangements that do not involve voting interests.
How to identify and assess variable interestsASU 2015-02 requires entities under consideration for consolidation to first be evaluated as VIEs. Applying this guidance involves the following steps:
Step 1: Determine if the entity under consideration is a legal entity and the reporting entity’s arrangement with the other entity is within the scope of ASC 810 VIE guidance.
The FASB defines a legal entity as any legal structure used to conduct activities or to hold assets. Some examples of such structures are corporations, partnerships, limited liability companies, grantor trusts, and other trusts. All reporting entities should apply the guidance in Topic 810 to determine how to consolidate another entity. If the reporting entity has an interest in another legal entity, it first must determine whether that entity is within the scope of the VIE subsections. Once the entity under evaluation is determined to be a legal entity and within the scope of Topic 810, the reporting entity must determine whether it holds a variable interest in the entity under evaluation.
Step 2: Determine whether the reporting entity holds a variable interest in the entity under consideration.
Variable interests may include, but are not limited to, the following:
- Management service agreements
- Equity interests
- Debt interest (that is, fixed rate debt)
- Debt guarantees
- Mandatorily redeemable preferred stock
- Licensing or royalty agreements
- Put and call options to sell or purchase assets, liabilities, or equity of the entity under consideration
Management service agreements typically outline significant information such as term, service fee, obligations of the practice, obligations of the management company, and insurance and indemnification clauses.
In a nominee-shareholder agreement, the reporting entity generally has the ability to transfer the equity ownership of the physician-owned entity to a physician of its choice for nominal consideration; that physician executes transactions on behalf of the reporting entity. In physician practice situations, the nominee typically will be a physician who provides medical services. The purpose of the agreement is to allow the reporting entity to maintain control through the ability to control the physician ownership.
Management service agreements contain fee arrangements. The affiliated entity will pay the decision-maker (the company or reporting entity) a fee in exchange for administrative and business management services. Under the new guidance, fees paid to a legal entity’s decision-maker or service provider are not variable interests if all of the following conditions are met:
- The fees are compensation for services provided and are commensurate with the level of effort required to provide those services.
- The decision-maker or service provider does not hold other interests in the VIE that individually or in the aggregate would absorb more than an insignificant amount of the entity’s expected losses or receive more than an insignificant amount of the entity’s residual returns.
- The management service agreement includes only terms, conditions, or amounts that customarily are present in the arrangements for similar services negotiated at arm’s length.
Step 3: Determine whether the legal entity is a VIE.
A legal entity shall be subject to consolidation under the guidance in the VIE subsections if, by design, any of the following conditions exist:
- The total equity investment at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support.
- As a group, the holders of the equity investment at risk lack any one of the following characteristics:
- The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly affect the entity’s economic performance
- The obligation to absorb the expected losses of the legal entity
- The right to receive the expected residual returns of the legal entity
- The legal entity is structured with disproportionate voting rights, and substantially all of the activities are conducted on behalf of an investor with disproportionately few voting rights.
Quantitatively, an equity investment at risk of less than 10% of the legal entity’s total assets is presumed to be considered insufficient. This presumption can be overcome based on facts and circumstances. Conversely, equity investment at risk of 10% or more is not automatically considered sufficient. Although a determination can be made qualitatively or using both quantitative and qualitative measures, when equity at risk is below 10%, the hurdle for concluding that equity investment at risk is sufficient is raised significantly.
Qualitative factors to consider include:
- The legal entity has demonstrated that it can finance its activities without additional subordinated financial support.
- The legal entity has at least as much equity invested as other entities that hold only similar assets of similar quality in similar amounts and operate with no additional subordinated financial support.
- The amount of equity invested in the legal entity exceeds the estimate of the legal entity’s expected losses based on reasonable quantitative evidence.
Step 4: Determine whether the reporting entity is the primary beneficiary of the VIE.
A reporting entity with a variable interest in a VIE shall assess whether the reporting entity has a controlling financial interest in the VIE and is therefore the primary beneficiary. A reporting entity shall be deemed to have a controlling financial interest in a VIE if it has both of the following characteristics:
- The power to direct activities of a VIE that most significantly affect the VIE’s economic performance
- The obligation to absorb losses of the VIE that could be significant to the VIE or the right to receive benefits from the VIE that could be significant to the VIE
To assess the reporting entity’s power to direct activities, a financial executive should consider activities that most significantly affect the VIE’s economic performance. To identify these activities, the reporting entity should consider the risks that the VIE is designed to create and pass to its variable interest holders. For most for-profit healthcare practices, these activities may include payer contract negotiation, customer pricing and allowance decision-making, and strategic planning and budget setting, which are under the control of the reporting entity and have a significant influence on the economic performance of the VIE.
This power criterion is further supported through consideration of “forward starting rights” (such as call options) and often is central to the design of a VIE. Often, nominee-shareholder agreements will contain provisions that allow the reporting entity to appoint a new designee to purchase the shares at any time for a nominal amount. While the existence of these rights alone may not be determinative in the identification of the party with power over the activities of the VIE, these rights help the reporting entity understand the purpose and design of a legal entity and may be useful when determining the primary beneficiary.
A for-profit healthcare company financial executive should review the nominee agreements for provisions that allow a reporting entity designee to purchase the shares from the nominee-shareholder for a nominal amount. In practice, this provides evidence that the reporting entity can direct a designee to purchase the shares from the nominee at any time and supports the fact that the reporting entity has power over the legal entity.
The affiliate is a VIE. Now what?Once it’s been determined the entity under consideration is required to be consolidated as a VIE, the following disclosures are required in the reporting entity’s financial statements:
- Significant judgments and assumptions made by a reporting entity in determining whether it must do either of the following:
- Consolidate a VIE
- Disclose information about its involvement in a VIE
- The nature of restrictions on a consolidated VIE’s assets and on the settlement of its liabilities reported by a reporting entity in its statement of financial position, including the carrying amounts of such assets and liabilities
- The nature of, and changes in, the risks associated with a reporting entity’s involvement with the VIE
- How a reporting entity’s involvement with the VIE affects the reporting entity’s financial position, financial performance, and cash flows
Disclosures about VIEs may be reported in the aggregate for similar entities if separate reporting would not provide more useful information to financial statement users. A reporting entity shall disclose how similar entities are aggregated and shall distinguish between the following:
- VIEs that are not consolidated because the reporting entity is not the primary beneficiary but has a variable interest
- VIEs that are consolidated
ExampleThe following is an example of an evaluation to determine whether a physician practice owned by the reporting entity through a contract and nominee-shareholder agreement is considered a VIE and whether it should be consolidated under the variable interest model in ASC 810.
A physician practice (the legal entity) entered into management service and nominee-shareholder agreements with the reporting entity. Key terms of the agreement are as follows:
- Management service agreement:
- Term length: 50 years
- Variable/adjustable service fee: not at market value
- Insurance and indemnification clauses against unexpected losses: included
- Nominee-shareholder agreement:
- The equity interest is owned by a physician who was part of the original transaction structure.
- The reporting entity has the ability to designate a nominee to purchase the equity interest for nominal consideration.
- Sufficient equity is at risk in the physician-owned entity.
- The physician practice equity holder has the power, through voting rights or similar rights, to direct the activities of the legal entity that most significantly affect the legal entity’s economic performance. However, the reporting entity, through its nominee-shareholder agreement, has the right to direct a designee to purchase the shares for a nominal price at any time. This, in effect, negates the power of the nominee-shareholder.
Step 1: Determine if the entity under consideration is a legal entity and whether the reporting entity’s arrangement with the other entity is within the scope of ASC 810 VIE guidance.
The example assumes that the entity is a legal entity and does not fall within the scope exceptions in the general consolidation guidance in Topic 810 or the VIE subsections.
Step 2: Determine whether the reporting entity holds a variable interest in the entity.
As defined in ASC 810, variable interests are the investments or other interests that will absorb portions of a VIE’s expected losses or receive portions of the entity’s expected residual returns. Variable interests in a VIE are contractual, ownership, or other pecuniary interests in a VIE that change with changes in the fair value of the VIE’s net assets exclusive of variable interests.
The management service agreement is considered a variable interest because the terms that provide for adjustment of the fee by the reporting entity are not considered market terms.
Step 3: Determine whether the entity is a VIE.
The equity at risk in the example is assumed to be sufficient; therefore, the entity passes the quantitative test. However, through the provisions set forth in the management and nominee-shareholder agreements, the reporting entity maintains control through its right to acquire the nominee-shareholder interests in the event the reporting entity does not approve of the nominee-shareholder’s actions. As such, the physician owner lacks the ability to direct the activities of the legal entity.
Step 4: Determine whether the reporting entity is the primary beneficiary of the VIE.
To assess the reporting entity’s power to direct activities, one must consider the activities that most significantly affect the legal entity’s economic performance. The activities of most medical practices that have significant impact on the economic performance of the legal entity include payer contract negotiations, customer pricing and allowance decision-making, and strategic planning and budget setting. If these activities are under the control of the reporting entity, then the reporting entity may be deemed to have significant influence over the economic performance of the potential VIE.
Within this example, the nominee-shareholder has the power, through voting rights or similar rights, to direct the activities of the legal entity that most significantly affect its economic performance. However, the reporting entity has the ability to appoint a new designee at any time to purchase the shares from the nominee-shareholder for a nominal amount. In practice, this feature gives the reporting entity control of the shares. Additionally, based on a qualitative judgment that considers the facts and circumstances, the reporting entity is deemed to have the obligation to absorb losses of the VIE that would be material to the VIE.
In this example the entity would be consolidated as a VIE, and the reporting entity would make disclosures in line with ASC 810-10-50.
ConclusionFor-profit healthcare executives should re-evaluate how they consolidate certain legal entities when applying the VIE guidance model. The model is complex, and management should complete a detailed analysis before reaching a conclusion.
1 Nathaniel R. Schlicher and Alison Haddock, editors, “Emergency Medicine Advocacy Handbook,” fourth edition, Emergency Medicine Residents’ Association, 2016, https://www.emra.org/globalassets/emra/publications/books/2016advocacyhandbook-online.pdf