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Variable Interest Entities

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Title: Variable Interest Entities (FIN46) Subject: Acct 592, Acct 415/515 Author: Teresa Gordon Description: Slides from Pahler 9th Edition Advanced Accounting as ... – PowerPoint PPT presentation

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Title: Variable Interest Entities


1
Variable Interest Entities
  • FIN 46 (Revised Dec. 2003)

Complexity of issues is confirmed by the issuance
of several FSPs including FASB Staff Position
No. FIN 46(R)-6, Determining the Variability to
Be Considered In Applying FASB Interpretation No.
46(R) which has some really helpful
examples Latest FSP FIN 46(R)-7Application of
FASB Interpretation No. 46(R) to Investment
Companies (May 11, 2007)
2
Variable Interest Entities (VIEs) Defined
  • VIE A less than majority-owned entity that is
    subject to consolidation under the provisions of
    FASB Interpretation 46R.
  • If certain conditions exist, the entity must be
    consolidated.
  • An entity that has a variable interest in a
    VIEan interest that changes with changes in the
    VIEs net assetsmust determine if it must
    consolidate the VIE.

3
Variable Interest Entities (VIEs)Variable
Interest Relationships
  • Variable Interest Relationships
  • Situations in which an entityReceives benefits
    and/or is exposed to risks similar to those
    received from having a majority ownership
    interest.
  • Result from contractual arrangements.
  • Appendix B has illustrations of various types of
    variable interests

4
Variable Interest Entities (VIEs) Contractual
Arrangements
  • Contractual Arrangement Types
  • Options (e.g., written put options)
  • Leases (with guarantee of value, etc)
  • Guarantees of asset recovery values
  • Guarantees of debt repayment
  • Contractual arrangements may exist simultaneously
    with a less than majority ownership in a VIE.
  • May exclude a business (Appendix C for
    definition somewhat different from that in EITF
    98-3)

5
Variable Interest Entities (VIEs)Most are SPEs
  • Special Purpose Entities
  • Legally structured entities to serve a specific,
    predetermined, limited purpose.
  • May be a corporation, partnership, trust, or some
    other legal entity.
  • Creator is called the sponsor.
  • Usually thinly capitalized.
  • Most commonly used for securitizations (of
    receivables).

6
Variable Interest Entities (VIEs)SPEs
  • Special Purpose Entities
  • Not subject to consolidation provisions of FIN 46
    if sales recognition criteria of FAS 140 is met
    for transfer of assets to SPE.
  • If met, SPE is called a Qualifying SPE. (If not
    met, the proceeds from the transfer are treated
    as a loan.)
  • FAS 140 prohibits transferors from consolidating
    QSPEs (because risk exposure is considered
    insignificant).

7
QSPE a trust of another legal vehicle that
  • Is demonstrably distinct from transferor
  • Has restrictions on its permitted activities
  • Has restrictions on assets and derivatives it may
    hold
  • Has restrictions on the way it can sell or
    dispose of non-cash financial assets
  • Has restrictions on agreements entered into
    between it and the transferor
  • Has restrictions on the ability to reissue
    beneficial interests

8
Variable Interest Entities (VIEs)Potential
Variable Interests
  • Potential Variable Interests
  • Subordinated loans to a VIE.
  • Equity interests in a VIE (50 or less).
  • Guarantees to a VIEs lenders or equity holders
    (that reduce the true risk of these parties).
  • Written put options on a VIEs assets held by a
    VIE or its lenders or equity holders.
  • Forward contracts on purchases and sales.

9
Variable Interest Entities (VIEs)The Primary
Beneficiary
  • PRIMARY BENEFICIARY of a VIE must consolidate the
    VIE.
  • PRIMARY BENEFICIARY is the entity that
  • Will absorb a majority (more than 50) of the
    VIEs expected losses and/or
  • Will receive a majority (more than 50) of the
    VIEs expected residual returns.
  • Expected losses are given more weight than
    expected residual returns in certain situations.

10
Filling the Buckets
From Deloitte Touche Presentation
Above Average Outcomes
Below Average Outcomes
Fees
Probability Weighted Scenarios
ExpectedResidual Returns
ExpectedLosses
11
How to Tell if I am NOT a VIE
From Deloitte Touche Presentation
  • Total equity investment greater than Expected
    Losses
  • Some equity holder has voting or other rights
    like a shareholder or General Partner, and as a
    group, equity holders can directly or indirectly
    make decisions on entitys activities
  • Equity holders as a group will absorb expected
    losses and benefit from expected residual returns
    without guarantee or cap
  • Subordinated Financial Support is something
    that will absorb some of the expected losses, if
    they occur

12
Primary Beneficiary Cascade
  • If anyone holds Variable Interests that expose
    them to a majority of the expected losses, they
    are the Primary Beneficiary, otherwise
  • If anyone holds Variable Interests that would
    enjoy a majority of the expected residual
    returns, they are the Primary Beneficiary,
    otherwise
  • There is no Primary Beneficiary
  • Variable Interests are financial interests that
    change in value with changes in the entitys net
    asset value

From Deloitte Touche Presentation
13
Variable Interest Entities (VIEs)The Primary
Beneficiary
  • Only one PRIMARY BENEFICIARY can exist for a VIE
    (by definition).
  • Potential for Erroneously Determined Multiple
    Primary Beneficiaries Does Exist
  • When one or more variable interest holders (VIH)
    has incomplete information about the VIEs other
    VIH.
  • Different VIH make different judgments about
    their variable interests.

14
Variable Interest Entities (VIEs)Determining if
an Entity is a VIE
  • Condition 1 Equity investment at risk is not
    sufficient to permit the entity to finance its
    activities without additional subordinated
    financial support (SFS).
  • SFS is defined as variable interests that will
    absorb some or all of an entitys expected losses
    (example a debt guarantee or an equity
    guarantee).
  • In general, the equity at risk is deemed
    sufficient if it is at least 10 of total assets.
    (May need more than 10.)

15
Variable Interest Entities (VIEs)Determining if
an Entity is a VIE
  • IN GENERAL, an entity is subject to
    consolidation if, by design, any of three
    conditions exists. These conditions focus on
    1. Sufficiency of equity investment at risk.
    2. Characteristics of the holders of equity
    investment at risk. 3. Whether certain
    disproportionalities exist among the equity
    investors.

16
Determining if an Entity is a VIE (cont.)
  • Condition 2 The holders of the equity
    investment at risk (as a group) lack any of the
    following characteristics
  • The ability to make decisions about an entitys
    activities.
  • The obligation to absorb the entitys expected
    losses.
  • The right to receive the entities expected
    residual returns.

17
Determining if an Entity is a VIE (cont.)
  • Condition 3 Certain disproportionalities exist
    among the equity investors.
  • Example Certain equity holders possess voting
    rights that are not proportional to their
    obligation to share the VIEs losses.

18
Reconsideration Triggers
Para. 7 15
From Deloitte Touche Presentation
19
Disclosures Required When Involved with VIEs
  • Disclosures for Primary Beneficiaries
  • 1 VIEs nature, purpose, size, activities.
  • 2 Carrying value and classification of
    consolidated assets that are collateral
    for the VIEs obligations.
  • 3 Lack of recourse if creditors (or
    beneficial interest holders) of a
    consolidated VIE have no recourse to the
    general credit of the primary beneficiary.

20
Variable Interest Entities (VIEs)Disclosures
Required When Involved
  • Disclosures for anyone that holds a significant
    variable interest in a VIE
  • 1 Nature of involvement with VIE and
    when involvement began.
  • 2 VIEs nature, purpose, size, activities.
  • 3 The entitys maximum exposure to loss
    as a result of its involvement with the
    VIE.

21
PWC publication SIC-12 and FIN 46R
  • Nice flow chart with the following steps
  • 1. Does FIN 46R apply?
  • 2. Is the entity a VIE?
  • 3. Which entity is the primary beneficiary?
  • And so forth
  • Too complicated to fit on a slide but you can
    print page 6 from the pdf file

22
FSP FIN 46R-6
  • The creator of variability is not the VIE
  • The VIE interests ABSORB the variability
  • The FSP provides an step-by-step process to
    analyze situation (next slide)
  • Multiple examples with diagrams

23
FSP FIN 46R-6 Para. 5
  • Step 1 use paragraphs 6-7 to analyze the nature
    of the risks
  • Step 2 Determine purpose for which entity was
    created and determine the variability (created by
    the risks identified in Step 1) the entity is
    designed to create and pass along to its interest
    holders
  • Use paragraphs 8-14 to identify the potential
    variable interest holders

24
Variable Interest Entities (VIEs)Consolidation
Procedures
  • Major Points in Consolidating
  • 1 Eliminate primary beneficiarys
    interest in the VIE.
  • 2 Report VIEs assets liabilities at fair
    valuesnot their book values.
  • 3 Report goodwill if it exists.
  • 4 Extinguish negative goodwill (BPE) if
    it exists.
  • 5 Report noncontrolling interest at FV.
  • 6 Eliminate intercompany transactions.

25
Case 06-1 Objectives
  • Part 1 Determine when an enterprise has a
    variable interest in an entity that MIGHT bring
    it within the scope of FN46R
  • Part 2 Determine if an entity is a Variable
    Interest Entity
  • Neither part of the case goes the last step to
    decide if consolidation is required

26
FIN 46R Appendix B
  • Appendix B provides guidance for identifying
    variable interests and explains in general how
    they may affect the determination of the primary
    beneficiary
  • Use for Case 06-1, Am I in or Am I Out? - Part 1
  • The appendix expands on the basic definition in
    para. 2

27
For Part 2 of Case 06-1
  • FIN 46R, Para. 5 -- An entity shall be subject to
    consolidation if, by design, the conditions in a,
    b, or c exist
  • Condition a (defines equity investment at risk
    4 items and also refers to paragraphs 9-10)
  • Condition b -- 3 criteria which must not be
    lacking
  • Condition c is a clarification for b(1) criteria
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