| EXECUTIVE
SUMMARY |
 AMONG ENRON’S PROBLEMS WAS
ITS USE of variable interest
entities, which allowed it to leave
significant amounts of debt off its
balance sheet. In response to concern
about this practice, FASB issued
Interpretation no. 46 in January 2003 and
a revised version in December 2003 to help
companies decide whether to consolidate
VIEs into their financial statements.
A VIE MUST BE
CONSOLIDATED INTO THE FINANCIAL
statements of the primary
beneficiary company when it does not
have enough equity at risk or its equity
investors lack any of three
characteristics of controlling financial
interest. The equity at risk should be
sufficient for the VIE to finance its
activities without additional support.
A VIE’S PRIMARY
BENEFICIARY TYPICALLY IS ABLE
to make decisions about the
entity and share in profits and losses.
The primary beneficiary is the reporting
entity, if any, that receives the
majority of expected returns or absorbs
the majority of expected losses.
CPAs SHOULD RECONSIDER A
DECISION ABOUT WHETHER an
entity is a VIE if its situation changes
so its equity investment at risk is no
longer adequate, some or all of the
equity investment is returned to
investors or the entity undertakes
additional activities, acquires
additional assets or receives an
additional equity investment that is at
risk.
THE GUIDANCE IN
INTERPRETATION NO. 46(R) is
causing reporting entities to make new
decisions about whether affiliated
entities need to be consolidated into
their financial statements. The
practical result of the new rules is
that many reporting entities are adding
significant assets and liabilities to
their balance sheets. |
| THOMAS A. RATCLIFFE,
CPA, PhD, is director of accounting and
auditing at Wilson Price in Montgomery,
Ala. His e-mail address is
tomr@wilsonprice.com .
|
 mong myriad accounting problems that
led to the downfall of Enron was its use of
variable interest entities (VIEs), allowing it to
leave significant amounts of debt off its balance
sheet. In response to widespread concerns about
this business practice, FASB issued Interpretation
no. 46, Consolidation of Variable Interest
Entities, in January 2003 and
Interpretation no. 46 (Revised) with the same name
in December 2003. Both interpret Accounting
Research Bulletin (ARB) no. 51, Consolidated
Financial Statements, to address
consolidation requirements for businesses that are
affiliated with VIEs. Interpretation no.
46(R) addresses the consolidation of business
enterprises where the usual consolidation
condition—ownership of a majority voting
interest—does not apply. It focuses on controlling
financial interests achieved by means other than
voting. Where there is no voting interest, a
company’s exposure to the assets’ risks and
rewards represent the best evidence of control.
When a company holds a majority of variable
interests in another entity, it is considered the
primary beneficiary and must consolidate that
entity into its financial statements.
|
Interpretation 46(R) in Action
 In the notes to its 2004
financial statements, Coors said it had
consolidated three joint ventures in
2004 as a result of the guidance in FASB
Interpretation no. 46(R).
In the notes to its 2004
annual report, FirstBank NW Corp. said
Interpretation no. 46(R) did not have a
material effect on its financial
position or on the consolidated results
of its operations.
In 2004 La-Z-Boy Furniture
Galleries determined that several of the
independent dealers operating La-Z-Boy
stores were variable interest entities
under the terms of Interpretation no.
46(R) and included them in its
consolidated financial statements.
| The purpose
of this article is to explain the substantive
provisions of Interpretation no. 46(R) and provide
CPAs with practical guidance on the ongoing
process of deciding whether a VIE needs to be
consolidated, the measurements the primary
reporting entity should use in consolidation and
the required disclosures. Public companies
were required to implement the consolidation
provisions in Interpretation no. 46(R) in 2003 and
2004. Private companies with an interest in a VIE
that was created after December 31, 2003, should
have consolidated those entities immediately. Most
private companies with VIEs that existed on
December 31, 2003, made transition disclosures
during calendar year 2004 and were required to
consolidate those VIEs no later than calendar year
2005.
WHO SHOULD CONSOLIDATE?
Under Interpretation no. 46(R) a
VIE must be consolidated into the financial
statements of the primary beneficiary company when
either of the following conditions exist:
The VIE does not have sufficient
equity investment at risk.
Equity investors in the VIE lack any
of three characteristics of controlling financial
interest. Investors with such an interest
— Participate in decision-making processes by
voting their shares. — Expect to share in
returns generated by the entity. — Absorb
any losses the entity may incur. To avoid
consolidation the total equity investment at risk
should be sufficient for the VIE to finance its
activities without additional support. CPAs can
help reporting entities evaluate the sufficiency
of equity at risk using qualitative or
quantitative methods. Use the qualitative approach
first to make the consolidation vs.
nonconsolidation decision; use the quantitative
approach if qualitative methods don’t result in a
definitive conclusion. Where neither approach
provides an answer, use a combination of the two.
Qualitatively, a VIE must be able to
demonstrate it can get nonrecourse financing from
an unrelated party without additional subordinated
financial support from other entities or
individuals, including equity investors. Examples
of such support include equity investments, loans,
guarantees and commitments to fund operations.
When provided by related parties, such support is
considered provided by the primary reporting
entity. In many cases involving private companies,
these additional support arrangements exist
between and among affiliated entities and indicate
there is not sufficient equity at risk for the VIE
to operate on a stand-alone basis.
Quantitatively, the general rule is that at
least 10% of the fair value of the VIE’s assets
must be provided as an equity investment. (A
lesser investment does not give the entity
sufficient equity to operate alone.) The 10% rule
is not a safe harbor—having more equity at risk
should not lead CPAs to presume the VIE has
sufficient equity at risk to cover any expected
losses. If the equity investors lack any
of the three characteristics described above, the
VIE’s primary beneficiary must consolidate the
entity. Conversely, where equity investors have
these characteristics and the other requirements
in Interpretation no. 46(R), no investor needs to
consolidate the VIE. A VIE’s primary
beneficiary is the entity that will consolidate it
in its financial statements. In some cases, it is
relatively easy to determine which entity is the
primary beneficiary through a qualitative analysis
of the entity’s ability to make decisions about
the VIE and share in its profits or losses. In
those circumstances where one entity receives the
majority of expected returns and another absorbs
the majority of expected losses, the entity that
absorbs the losses is the primary beneficiary.
This means the ability to absorb expected losses
is a tie-breaker CPAs should use to determine
which entity, if any, is a VIE’s primary
beneficiary. However, CPAs should base the
consolidation vs. nonconsolidation decision on a
determination of which entity holds a majority of
the variable interests in another entity.
Exhibit 1 describes a public company that
had already implemented Interpretation no. 46(R).
Exhibit 2 includes some practical issues
CPAs working with private companies should
consider in deciding whether to consolidate.
| Exhibit 1
: Consolidation of
Variable Interest Entities—Public
Company Example |
| In evaluating whether an
affiliated entity needed to be
consolidated using the guidance in
Interpretation no. 46(R), some reporting
entities initially concluded they were
not the primary beneficiary of a VIE and
later concluded they were the primary
beneficiary. The relationship between
Dell Inc. and Dell Financial Services
illustrates this point.
Initial Conclusion
( excerpted from 2003
10-K filing ). The company is
currently a partner in Dell Financial
Services LP (DFS), a joint venture with
CIT Group Inc. (CIT). The joint venture
allows the company to provide customers
with various financing alternatives and
asset management services as a part of
the total service offered to the
customer. CIT, as a financial services
company, is the entity that finances the
transaction between DFS and the
customer. In accordance with the
partnership agreement between the
company and CIT, losses generated by DFS
are allocated to CIT. Net income in DFS
is allocated 70% to the company and 30%
to CIT, after CIT has recovered any
cumulative losses. The company’s share
of DFS new income is reflected in
investment and other income, net.
The company recognized approximately
$4 million of cumulative pretax earnings
as of the end of fiscal 2003. In the
event DFS is terminated with a
cumulative deficit, Dell is not
obligated to fund any losses. Although
the company has a 70% equity interest in
DFS, because the company cannot and does
not exercise voting or operational
control over DFS, the investment is
accounted for under the equity method.
The company’s investment in DFS at
January 31, 2003, was $35 million.
Equity income in DFS and any
intercompany balances were immaterial to
the company’s results of operations and
financial position for fiscal 2003, 2002
and 2001. Had the company controlled—and
as a result consolidated—DFS, the impact
to the company’s reported revenue and
earnings would not have been material
for fiscal 2003, 2002 and 2001.
Resolution (
excerpted from 2004 10-K filing
). Dell is currently a partner in
DFS, a joint venture with CIT. The joint
venture allows Dell to provide its
customers with various financing
alternatives while CIT provides the
financing for the transaction between
DFS and the customer. In general, DFS
facilitates customer-financing
transactions through either loan or
lease financing. Dell currently
owns a 70% equity interest in DFS. In
accordance with the partnership
agreement between Dell and CIT, losses
generated by DFS are fully allocated to
CIT. Net income generated by DFS is
allocated 70% to Dell and 30% to CIT,
after CIT has recovered any cumulative
losses. If DFS is terminated with a
cumulative deficit, Dell is not
obligated to fund any losses, including
any potential losses on receivables
transferred to CIT. Although Dell has a
70% equity interest in DFS, prior to the
third quarter of fiscal 2004, the
investment was accounted for under the
equity method because the company
historically could not, and currently
does not, exercise control over DFS.
In January 2003, the FASB issued
FIN 46, Consolidation of Variable
Interest Entities. FIN 46
provides that, if an entity is the
primary beneficiary of a VIE, the
assets, liabilities, and results of
operations of the VIE should be
consolidated in the entity’s financial
statements. Based on the guidance in FIN
46, Dell concluded that DFS is a VIE and
Dell is the primary beneficiary of DFS’s
expected cash flows. Accordingly, Dell
began consolidating DFS’s financial
results at the beginning of the third
quarter of fiscal 2004. The
consolidation of DFS had no impact on
Dell’s net income or earnings per share
during fiscal 2004 because Dell has
historically been recording its 70%
equity interest in DFS under the equity
method. The impact to any individual
line item on Dell’s consolidated
statement of income was not material;
however, the consolidation of DFS
increased Dell’s consolidated assets and
liabilities by $55 million. CIT’s equity
ownership in the net assets of DFS as of
January 30, 2004, was $17 million, which
is recorded as minority interest and
included in other noncurrent liabilities
on Dell’s consolidated statement of
financial position. The consolidation
has not altered the partnership
agreement or risk-sharing arrangement
between Dell and CIT.
|
BUSINESS CONSOLIDATIONS
In replacing the original
Interpretation no. 46, FASB concluded a primary
reporting entity need not evaluate activities
deemed to be businesses to determine whether they
are VIEs unless certain conditions exist. Excluded
entities should use other accounting literature to
determine whether consolidation is required. CPAs
should consider an entity for consolidation if one
or more of these conditions exist:
The reporting entity, its related
parties or both participated significantly in the
design or redesign of the entity. This condition
does not apply if the entity is an operating joint
venture under control of the reporting entity and
one or more independent parties or a franchisee.
The entity is designed so that
substantially all of its activities either involve
or are conducted on behalf of the reporting entity
and its related parties.
The reporting entity, its related
parties or both provide more than half of the
total equity, subordinated debt or other forms of
subordinated financial support based on an
analysis of the fair values of interests in the
entity.
The entity’s activities are primarily
related to securitizations or other forms of
asset-backed financings or single-lessee leasing
arrangements.
| Exhibit 2
: Consolidation of
VIEs by Private Companies
| | I t’s not
uncommon for the owners of private
companies to personally own the real
estate used in the business and to lease
it under an operating lease. In those
cases the company must decide whether the
real estate and any related mortgage need
to be recognized in its financial
statements. In the past, only rents paid
by the business were reflected in the
financial statements. Here’s a
three-step decision-making process CPAs
should use to determine if this is
necessary.
Step 1: Is the
real estate “housed” in an entity? If
the answer is no, there is no
consolidation requirement under
Interpretation no. 46(R).
Entities subject to this
provision might be corporations,
partnerships, limited liability
companies and grantor and other trusts.
If the owners of the
business own the real estate outside an
entity, there is no requirement to
consolidate it into the financial
statements of the business.
Step 2: If the
answer in step 1 is yes, the next
question would be, Is that entity a VIE?
If the answer is no, there is no
consolidation requirement under
Interpretation no. 46(R).
There should be sufficient
equity at risk for the VIE to operate on
a stand-alone basis.
Equity investors should
have the characteristics typically
associated with a controlling financial
interest.
There should be no
guarantees from other entities or
owners.
There should be no
additional collateral.
There should be no
subordinated debt outstanding (second
mortgages or intercompany loans).
There should be no loans
from equity investors or related parties
to those equity investors.
There should be no
above-market lease payments or
management fees.
Step 3: If the
answer in step 2 is yes, then which
entity, if any, is the primary
beneficiary of the VIE? If no entity is
the primary beneficiary, there is no
consolidation requirement under
Interpretation no. 46(R).
There can only be one
primary beneficiary associated with a
VIE.
The primary beneficiary may
be determined qualitatively without
undertaking an exhaustive quantitative
analysis.
The primary beneficiary
provides the majority of the VIE’s
financial support.
The primary beneficiary
receives the majority of expected
returns and absorbs the majority of
expected losses.
If one investor is entitled
to the majority of expected returns and
another must absorb the majority of
expected losses, the latter is the
primary beneficiary. Using the
guidance in Interpretation no. 46(R),
not all VIEs need to be consolidated,
paralleling the requirement that not all
voting interest entities are
consolidated under ARB no. 51. To the
extent risk has been effectively
disbursed between and among investors,
the result might be that no entity is
considered a VIE’s primary beneficiary.
|
MEASUREMENT ISSUES
When determining whether primary
beneficiaries should initially measure assets,
liabilities and noncontrolling interests in VIEs
at fair value or carrying value, CPAs need to
evaluate whether the primary beneficiary and the
VIE are commonly controlled. Examples of common
control include cases where one individual owns a
controlling interest in several corporations with
related operations or multiple entities under
common management. Except for entities
under common control and assets and liabilities
consolidated shortly after transfer from a primary
beneficiary to a VIE, a primary beneficiary must
initially measure the VIE’s assets, liabilities
and noncontrolling interests at their fair values
at the date the reporting entity first becomes the
primary beneficiary. That date is the first day
the reporting entity, if it issued financial
statements, would report the entity in its
consolidated statements. A primary
beneficiary under common control with the VIE must
initially measure the assets, liabilities and
noncontrolling interests as they are carried in
the controlling entity’s accounts. It must measure
assets and liabilities it transferred to the VIE
at, after or shortly before the date the entity
became the primary beneficiary at the same amounts
as if they had not been transferred. No gain or
loss can be recognized. The primary
beneficiary must allocate and report the excess,
if any, of (a) the fair value of the newly
consolidated assets and (b) the reported amount of
assets the primary beneficiary transferred to the
VIE over (1) the sum of the fair value of the
consideration paid, (2) the reported amount of any
previously held interests and (3) the fair value
of the newly consolidated liabilities and
noncontrolling interests as a pro-rata adjustment
to the amounts that would have been assigned to
the newly consolidated assets—as delineated in
FASB Statement no. 141, Business Combinations
—as if the consolidation had resulted from a
business combination.
 The
excess, if any, of (a) the sum of the fair value
of the consideration paid, (b) the reported amount
of any previously held interests and (c) the fair
value of the newly consolidated liabilities and
noncontrolling interests over (1) the fair value
of the newly consolidated identifiable assets and
(2) the reported amount of identifiable assets
transferred by the primary beneficiary to the VIE
must be reported in the period the reporting
entity becomes the primary beneficiary as
Goodwill, if the VIE is a business.
An extraordinary loss, if it is not.
The principles of consolidated financial
statements in ARB no. 51 apply to primary
beneficiaries’ accounting for consolidated VIEs.
After initial measurement, the assets, liabilities
and noncontrolling interests of a consolidated VIE
must be accounted for in consolidated financial
statements as if the entity were consolidated
based on voting interests. This entity must follow
the requirements to eliminate intercompany
balances and transactions described in ARB no. 51
and existing practices for consolidated
subsidiaries. Fees or other sources of income and
expense between a primary beneficiary and a
consolidated VIE must be netted against the VIE’s
related expense and income. In the consolidated
financial statements the resulting effect on net
income and expense must be attributed to the
primary beneficiary—not to noncontrolling
interests.
WHEN TO RECONSIDER
An
entity not previously subject to the requirements
of Interpretation no. 46(R) does not become
subject to it simply because of higher than
expected losses that reduce the equity investment.
CPAs should reconsider an initial determination of
whether an entity is a VIE if one or more of the
following occur:
The entity’s governing documents or
contractual arrangements change in a way that
alters the characteristics or adequacy of the
entity’s equity investment at risk.
Some or all of the equity investment
is returned to investors, and other interests
become exposed to the entity’s expected losses.
The entity undertakes additional
activities, or acquires additional assets, beyond
those anticipated at the later of its inception or
the latest event that increases expected losses.
The entity receives an additional
equity investment that is at risk, or curtails or
modifies its activities in a way that decreases
expected losses. For purposes of applying
these provisions, a troubled debt restructuring,
as defined in FASB Statement no. 15,
Accounting by Debtors and Creditors for
Troubled Debt Restructuring, must be
accounted for according to that statement and is
not an event that requires reconsideration of
whether the entity is a VIE.
DISCLOSURES
Unless the beneficiary also holds
a majority voting interest, in addition to
disclosures required by other standards, the
primary beneficiary of a VIE must disclose
The VIE’s nature, purpose, size and
activities.
The carrying amount and
classification of consolidated assets that are
collateral for the VIE’s obligations.
Whether creditors or beneficial
interest holders of a consolidated VIE have no
recourse to the primary beneficiary’s general
credit.
NEW THINKING
The guidance in Interpretation
no. 46(R) is causing reporting entities to think
differently in deciding whether affiliated
entities need to be consolidated in the primary
reporting entity’s financial statements.
Historically, they based that decision almost
exclusively on an analysis of voting interests.
Now, a primary beneficiary will consolidate based
on new criteria. The practical result is that many
reporting entities will be adding significant
assets and liabilities to their balance
sheets.
| AICPA RESOURCES
| CPE
The AICPA’s Guide to Business
Consolidations, Goodwill and Other
Consolidation Issues (text, # 735129JA).
Variable Interest
Entities—FIN 46 (InfoBytes, BYT-XXJA).
For more information or to order,
call the Institute at 888-777-7077 or go
to
www.cpa2biz.com . | |
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