Consolidation of Variable-Interest Entities
Applying the Provisions of FIN 46(R)

By Alan Reinstein, Gerald H. Lander, and Stephen Danese

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Many have explained how entities should implement FIN 46(R) [see Jalal Soroosh and Jack T. Ciesielski, “Accounting for Special Purpose Entities Revised: FASB Interpretation 46(R),” The CPA Journal, July 2004; Russ Agosta, “Venture Carefully: FIN 46 May Build Up Your Balance Sheet,” Construction Accounting and Taxation, July/August 2004; and Patrick Casabona, “Off–Balance Sheet Entities: A Second Look,” Practical Accountant, February 2004]. This article is unique, however, in providing an actual case history showing how a complex entity has applied the key provisions of FIN 46(R).

Background

Under GAAP, a company must consolidate any entity in which it has a “controlling interest.” This term was long defined as ownership of more than 50% of the entity’s voting interests. FIN 46(R) makes two critical changes: It defines when a company (sponsor or creator of a variable interest entity) should base “controlling financial interest” on factors other than voting rights, and it applies a new “risk and rewards” model in these situations. Consequently, GAAP now prescribes two accounting models for consolidation:

• The voting-interest model, where the investor owning more than 50% of an entity’s voting interests consolidates the investee’s operation; and
• The risk-and-rewards model, where the party that participates in the majority of the entity’s economic impact consolidates such operations. This party could be an equity investor, other capital provider, or a party with contractual arrangements. FASB coined the term “variable interest entity” (VIE) for entities subject to the risk-and-rewards model.

Entities deemed VIEs must follow the provisions of FIN 46(R). Entities are deemed VIEs if they meet three requirements. First, they should not be self-supportive, as in the following instances:

• The entity is thinly capitalized (i.e., the equity is insufficient to fund the entity’s activities without additional subordinated financial support); or
• The equity holders as a group possess at least one of the following five characteristics:
• Have insufficient equity investment at risk;
• Have inadequate rights to make significant decisions about the entity’s activities;
• Possess no substantive voting rights;
• Fail to absorb the pro-rated share of the entity’s expected losses; or
• Fail to receive the pro-rated share of the entity’s expected residual returns.

Second, the entities must have variable interests in the VIE (e.g., provide it with financial support). The third and final requirement is that the entity must be the VIE’s primary beneficiary (e.g., one absorbing more than half of expected losses or receiving more than half of expected residual returns). If neither entity assumes more than half of the expected losses or expected gains, then there is no primary beneficiary and, therefore, no consolidation exists. When two parties both primary beneficiaries (e.g., one absorbs half of the losses and the other absorbs half of the gains), a bias exists toward considering the decision maker or the party absorbing half of the losses to be the primary beneficiary.

For example, a third-party guarantor of a lessor buying property on credit for leasing purposes should now consider consolidating the lessor’s financial statements into its own. Exhibit 1 shows a third party (Gar & Tee) guaranteeing the loan of a thinly capitalized company, XYZ. XYZ, in turn, leases real estate to the ABC operating company. Gar & Tee should consider consolidating XYZ’s operations. However, if XYZ were not thinly capitalized and could sustain expected losses, then it is not a VIE and no consolidation would be necessary.

A further example of applying the previous characteristics occurs when a company sponsor of a VIE transfers assets or liabilities to create off–balance-sheet VIEs for specific purposes. Formed as trusts, corporations, limited partnerships, or companies, VIEs serve only the transactions for which they were created and share the following characteristics:

• They are often thinly capitalized;
• They often have no independent management or employees;
• Their administrative functions are often performed by a trustee who receives and distributes cash according to the terms of contracts and who serves as an intermediary between the VIE and the parties that created it; and
• They hold and service assets under a servicing agreement.

Sponsors usually form VIEs to finance certain assets or services while keeping associated debt off their balance sheets; to transform such financial assets as trade receivables, loans, or mortgages into liquid securities; or to engage in tax-free exchanges. Besides moving debt from the sponsors’ to the VIE’s balance sheets (e.g., to help meet certain covenant ratios), VIEs can protect sponsors from possible financial failure when they risk only what they invest in the VIE.

If a VIE’s financing arrangements meet existing accounting guidelines, the sponsors need not consolidate assets and the associated debt. Such off–balance-sheet arrangements include synthetic leases; take-or-pay or throughput contracts; securitizations and investments that might be accounted for under the equity method; joint venture research-and-development arrangements; and investments in low-income-housing projects. Investors should carefully review these types
of transactions because many disclosures are required in the notes to the financial statements.

Accounting for VIEs

For many years, sponsors avoided the consolidation regulations of ARB 51 by maintaining de facto control without owning more than half of the voting power (e.g., using legal restrictions on how the SPE used its assets, particularly on which parties could obtain access to the SPE).

In 1990, the FASB Emerging Issues Task Force (EITF) addressed the consolidation of SPEs of nonsubstantive voting rights in Issue 90-15, Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions. It required a lessee to consolidate an SPE-lessor if the SPE’s owners had not made a substantive “at risk” residual equity investment throughout the leases’ term; as practice evolved, this meant that a 3% equity investment of the fair value of the SPE’s assets could avoid consolidation. This seemingly small hurdle often became a large investment, because many projects were huge.

Accounting standards dealing with off–balance-sheet entities had produced inconsistent, incomplete, and fragmented results. In late 2001, the Enron scandal exploded, revealing the company’s elaborate array of SPEs to shift debt away from its books while absorbing substantially all of the risk associated with that debt through either guarantees of the debt or the SPE’s assets. FASB, seeking to put many off–balance-sheet entities (besides SPEs) onto the balance sheet of the companies that created them, issued FIN 46, Consolidation of Variable Interest Entities, an Interpretation of ARB 51, in January 2003. Upon learning that certain provisions were not being interpreted as intended, it issued Interpretation 46(R) in December 2003.

FASB Interpretation 46(R), Variable-Interest Entities

FIN 46(R) contains several new concepts, including describing (but not defining) a VIE as an entity for which a controlling financial interest arises via ownership of interests other than voting stock. Those with a controlling financial interest in a VIE absorb more than half of its expected losses, or are entitled to most of its expected residual rewards, even if such interests are not in voting common stock. FIN 46(R) is complex, requiring careful judgment as to whether entities are VIEs and, if so, whether consolidation is required.

FIN 46(R)’s provisions are especially important to bankers and investors, because they often lend funds to companies or invest in companies with VIEs. Entities “control” subsidiaries without owning most of the outstanding shares (e.g., by controlling the board of directors, managing or general partners, or principal products or services offered for sale). Despite some public companies’ disclosures in the Management’s Discussion and Analysis (MD&A) section of their financial statements, the reported disclosures of off–balance-sheet transactions were too opaque for analysts and investors to reliably assess their effects on the parents’ operations. But implementing FIN 46(R) could so significantly affect an entity’s balance sheet that it could lead to defaulting on loan covenants. Direct or indirect “equity interests” in a VIE arise when the direct or indirect investments in such VIEs are at risk.

Applicability

FIN 46(R) requires consolidating existing unconsolidated VIEs with any existing primary beneficiaries if the entities do not effectively disperse risk among the investing parties. VIEs that effectively disperse risks need not be consolidated unless a single party holds an interest or combination of interests that recombines risks that previously were dispersed.

Control for consolidation of financial statements is now based on “variable interests,” or on voting power, where sponsors provide financial support through other interests to absorb part of the entity’s expected gains or losses. Entities should now evaluate the sufficiency of their equity investments for all reporting periods. Focusing on the substance (rather than on the form) of such financial control, FIN 46(R) establishes a 10% threshhold to demonstrate that the VIE has sufficient equity to finance its activities. Additional qualitative and quantitative factors to be considered include:

• The entity has demonstrated that it can finance its activities without additional subordinated financial support;
• The 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; or
• The amount of equity invested in the entity exceeds the estimate of the entity’s expected losses, based on reasonable quantitative evidence.

Conversely, the 10% threshold does not automatically provide an adequate equity level to permit the entity to finance its activities without additional subordinated financial support. Thus, FIN 46(R) leaves room for flexibility in determining what the equity investment in an entity should be in order to avoid consolidation of such an entity by its variable-interest holder.

Entities should also apply both quantitative and qualitative considerations to determine if they have adequate equity to warrant not consolidating. Qualitative “control” factors include equity investments at risk, explicit or implicit guarantees of debt or the residual values of leased assets, the magnitude of fees paid to a decision maker, and options to acquire leased assets at the end of the lease terms at specified prices. Any of these factors can require minority investors to consolidate VIEs.

Quantitative factors are most easily described with an example. A guarantor of a $100 obligation that has a 70% chance of costing $0 and a 30% chance of costing $100 would derive a weighted outcome of 0.70 x $0 + .30 x $100, or $30, which would require a $30 loan guarantee premium to avoid considering consolidation. Thus, guarantors receiving premiums below $30 (i.e., the expected loss) should now consolidate such effects, unless such qualitative factors as the debtor’s credit rating or a long history of similar no-cost transactions among these parties surfaced.

Exceptions to the scope of FIN 46 (R) include the following:

• Not-for-profit organizations (business enterprises use them to circumvent the provisions of this interpretation);
• Employee benefit plans subject to specific accounting requirements of FASB statements;
• Registered investment companies, unless the VIE is a registered investment company; and
• Transferors to qualifying SPEs and “grandfathered” qualifying SPEs subject to the reporting requirements of SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.

Measuring and Reconsidering the Consolidation Issue

In initially accounting for VIEs, primary beneficiaries should measure a VIE’s assets, liabilities, and noncontrolling interests at their fair values, but eliminate any intercompany balances. However, they should use book value to measure entities under common control (e.g., same majority shareholder or owners). Primary beneficiaries should transfer assets and liabilities to the VIE (at, after, or shortly before the date that the entity became the primary beneficiary) at the same value at which they were carried. They should recognize no gain or loss, even if the entity were not the primary beneficiary until shortly after the transfer occurred. Entities should also recognize goodwill upon the initial consolidation of a VIE that EITF 98-3, Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business, defined as a business. However, companies that previously wrote off goodwill using FIN 46’s requirements cannot reinstate that goodwill.

Except for troubled-debt restructurings (which are excluded from reconsideration), entities can also acquire additional assets or undertake additional activities without triggering a reconsideration of their primary beneficiary status as long as they considered such events at the inception of the entity or at the most recent reconsideration event. Otherwise, they should reconsider their primary beneficiary status when such significant events arise.

A Pragmatic Approach to Implementation

Variable interests arise from economic, contractual arrangements that give enterprises the financial support and associated “rights” to gains and losses of an associated entity’s economic risks and rewards. Changes in the fair value of most assets and operating liabilities (e.g., from changes in operating cash flows) create variability in the entity’s net assets. Contractual arrangements or investments that do not create variability in the entity’s fair value are variable interests because the counterparty or investor absorbs the risks and rewards of the entity’s activities.

Deciding whether to consolidate an entity requires considering if it is a VIE and which party should consolidate it, based primarily upon who stands to gain or lose the most from a VIE whose ownership is otherwise unclear. Regardless of the extent of equity owned, a VIE’s primary beneficiary holding most of the variable interests would normally absorb more than half of the VIE’s future losses or expected returns into its own consolidated financial statements.

From the accounting literature, the authors have developed a simple organized format for deciding whether to consolidate a VIE.

Step 1. Identify the holders of equity investments or debt obligations at risk, which helps to ascertain whether the characteristics of a VIE are present. Determining the amount of equity at risk requires analyzing investments recorded as equity in the entity’s financial statements and other analyses to ensure that only holders with FIN 46(R) equity characteristics are included.

Step 2. Evaluate the VIE’s five characteristics:

• Insufficient equity investment at risk. If the total equity investment at risk is insufficient to finance the entity’s activities, then the parties providing the additional subordinated financial support will not allow the equity investors to make decisions that oppose their interests. Voting control does not solely decide who should consolidate the entity.
• Equity lacks decision-making rights. This characteristic focuses on who can make key decisions regarding an entity’s ongoing activities, including distinguishing between voting-interest entities and VIEs. If equity investors at risk have no ability to decide about significant activities, then its true controlling financial-interest holder may be a party other than the equity investors. If nonequity interests are at risk (e.g., debt interests, management contracts) and the holders of those interests have substantive decision-making ability, then the entity would be a VIE.
• Equity with no substantive voting rights. This characteristic is based on two criteria. First, focusing on disproportionate voting rights relative to the economic effects should help identify entities that are structured to avoid consolidation by providing no substantive voting rights to parties. The second criterion is qualitatively assessing the entity’s activities and the relationships among equity investors.
• Lacking the obligation to absorb an entity’s expected losses. This characteristic identifies equity interests that do not behave traditionally as an entity’s residual interest. In a traditional voting-interest entity, entity investors must absorb expected losses as a group on a first-dollar basis until depleting equity (i.e., neither the entity nor other associated parties protect the owners from losing parts of their investment). When such protection exists, the traditional voting-interest model is ineffective, making the entity a VIE.

An entity with no history of net losses and that expects to be profitable in the future should still assume the probability of expected losses in calculating future expected gains and losses. The estimated outcomes used to calculate expected losses are those outcomes that contribute to the expected negative variability in the fair value of the entity’s net assets exclusive of variable interests. FASB Staff Position on Interpretation 46(R) [FSP FIN 46(R)-2] also provides guidance to measure expected losses.

• Lacking the right to receive an entity’s expected residual returns. This attribute helps identify equity interests that behave inconsistently with any expected residual interests. Specifically, if equity holders’ rights to returns are capped or shared with holders of a variable interest that does not qualify as an equity at risk, the entity is a VIE.

After determining that an entity is a VIE, the next step is ascertaining whether a primary beneficiary exists. FIN 46(R) defines a primary beneficiary as an entity or individual that has a variable interest (or combination of variable interests) that will absorb more than 50% of the VIE’s expected losses or receive more than half of the VIE’s expected residual returns. The expected losses and residual returns formula excludes fees paid to decision makers. These fees are generally considered a variable interest, subject to a special exception.

In determining whether it will absorb more than half of the expected losses or receive more than half of the VIE’s expected residual returns, an entity or individual should consider the rights and obligations of its variable interests and the relationship of its variable interests held by other parties.

A tie goes to the loser. If one entity or individual has a variable interest in a VIE that absorbs most of the VIE’s expected losses, and another entity or individual has a variable interest that receives most of the VIE’s expected residual returns, then the entity or individual that absorbs most of the expected losses is considered the VIE’s primary beneficiary.

A VIE can have only one primary beneficiary. After initially identifying a VIE and its primary beneficiary, FIN 46(R) provides that certain events could trigger a reporting company to reevaluate if an entity is a VIE (paragraph 7):

An entity that previously was not subject to this Interpretation shall not become subject to it simply because of losses in excess of its expected losses that reduce the equity investment. The initial determination of whether an entity is a variable interest entity shall be reconsidered if one or more of the following occur:

A. Changing entity-governing documents or contractual arrangements place its equity at risk;
B. It returns all or part of its equity investment to its investors, and other interests become exposed to the entity’s expected losses;
C. It undertakes additional activities or acquires additional assets, beyond those anticipated at the later of its inception or the latest reconsideration events that increase its expected losses;
D. It receives additional equity investments that are at risk, or it modifies its activities to decrease expected losses.

Implementing FIN 46(R): A Case Study

As a hypothetical example, the Alcor brothers, through Danson Financial, Inc., are actively involved in the Atlanta-area real estate market. As highlighted in Exhibit 2, the Alcors solicit funds from investors to purchase unit investment trusts (UIT), which in turn acquire or operate limited liability companies (LLC) that use these invested funds to acquire and manage certain real estate projects. Net rents from the real estate projects flow to the investors, who receive 8% (nonguaranteed) returns on their investments. Danson also receives a 1% management fee from the UITs and the real estate projects. Exhibit 2 illustrates the Danson organization. Investors bear any losses incurred, and all gains from the sale of projects are reinvested. Danson also periodically advances capital to the UITs in order to maintain goodwill with the investors.

Danson asked a CPA consultant to review this situation and determine which entities require consolidation under FIN 46(R).

If Danson is expected to receive more than half of present or future profits or losses from the real estate projects’ ultimate sales or before liquidation, then it should consolidate such operations. If remaining profits remain with the LLCs, then Danson need not consolidate these operations; if profits (or losses) go to the LLCs, no consolidation would be necessary. Other assumptions include Danson’s management fees being based upon total (including bank-loaned) available funds; the shareholders having no voting power in the UITs; and Danson holding no stock in the UITs.

Besides the 50% criterion, Danson’s only risk of loss on transactions arose in the unlikely case of projects selling for less than 25% of the investors’ capital. The participation in gain probably would create consolidatable VIEs. Danson also could not arbitrarily manipulate its management fees to absorb such gains (or losses), which would create VIEs. As shown in the client summary letter (Exhibit 3), Danson could thus leave potential gains in these LLCs without consolidating them, but it should consolidate its financial statements upon receiving (variable) gains or losses from redeemed projects. In addition, while its management fees should not vary with the properties’ profits or losses, Danson could adjust (i.e., cost-justify) these management fees based upon such operating variables as its cost of insurance, heating fuel, or labor. Danson could also lend or borrow funds to or from the UITs or LLCs—and earn management fees from the LLCs—without affecting its consolidation status.

Consider the example of the Lanstone Corporation, one of Danson’s LLCs, to which Danson lent $3 million. Due to operating losses, Lanstone’s net equity has fallen to about $250,000, and it soon expects to cease operations. If the investors in Lanstone Corporation bore the total burden of losses on the sale, Danson need not consolidate this transaction, even if part of the proceeds were used to repay Danson for funds advanced or lent to Lanstone.

Requirement 1. The overall question is whether Danson should consolidate its operations with the UITs or LLCs. To answer this question, the CPA consultant needs to first determine whether the holders of the equity investment were at risk in the UITs, using the following criteria:

• Insufficient equity at risk. Because the investors of the UIT corporations seem to have risked adequate equity/capital, it is not a VIE. At this stage, the UITs (not Danson) possess all the risks of ownership.
• Equity lacks decision-making rights. Because the UIT shareholders have no decision-making rights (e.g., voting power or rights to elect members to boards), it is a VIE, but not necessarily a VIE consolidatable to Danson. Variable interests and primary beneficiary determinations still must be made. Because it is not a shareholder, Danson has no voting rights.
• Equity with nonsubstantive voting rights. Because Danson does not have voting rights in the UITs (no one has any voting rights in the UITs), it is not a consolidatable VIE.
• Lacking the obligation to absorb an entity’s expected losses. It was unnecessary to carry out the expected loss calculation to determine who would absorb more than half of any expected investment losses in this case because it is clear Danson is not responsible for losses.
• Lacking the right to receive an entity’s expected residual returns. If Danson (not the investors) receives all profits upon liquidation, then it should consolidate both profits and losses from the LLCs because Danson would be the primary beneficiary. If present profits (losses) go to Danson, it is a consolidatable VIE. In short, if Danson shares in present or future profits or losses, then it should consolidate. If, however, present profits (and losses) go the UIT (holders), it is not a consolidatable VIE.

Given the circumstances of the case, the UITs would be considered VIEs because of the lack of normal voting rights of the UIT’s shareholders.

Requirement 2. After determining that the UITs are VIEs, the entities or individuals must have variable interests in the VIE (e.g., provide it with financial support). In this case, the shareholders and creditors meet these criteria. Danson has no variable interest in that it collects only a fixed management fee and has no ownership or loan guarantee interests.

Requirement 3. An entity or individual must be the primary beneficiary for the VIE; that is, give it more than 50% of financial support to the VIE. Danson gave no financial support to the VIE, and therefore does not have to consolidate.

Focus on Substance, Not Form

The CPA consultant’s analysis following the guidelines of FIN 46(R) concluded that the UITs were VIEs because the shareholders lacked the usual decision-making rights. The consultant concluded, however, that Danson did not need to consolidate the VIEs, because it did not have a variable interest nor was it the primary beneficiary. The UIT shareholders possessed the variable interest and were the primary beneficiaries. Danson was merely a management company receiving a fixed fee for its services.

This case demonstrates how an organized format can help implement the provisions of FIN 46(R). Focusing on the substance, rather than the form, allows one to derive more meaningful and useful financial statements.

The authors greatly appreciate the input from John M. Fleming (Loscalzo Associates), Russ Agosta (Grant Thornton), and Steve Moehrle (University of Missouri—St. Louis).