Variable Interest Entities

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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)
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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.

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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

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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)

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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).

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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).

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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

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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.

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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.

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Filling the Buckets
From Deloitte Touche Presentation
Above Average Outcomes
Below Average Outcomes
Fees
Probability Weighted Scenarios
ExpectedResidual Returns
ExpectedLosses
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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

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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
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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.

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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.)

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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.

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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.

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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.

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Reconsideration Triggers
Para. 7 15
From Deloitte Touche Presentation
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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.

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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.

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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

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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

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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

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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.

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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

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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

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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