FIN 46R Variable Interest Entity Consolidation Rules: Not Just A Big Company Issue!

Chapter 1

Consolidation of Variable Interest Entities - FASB Interpretation No. 46R of ARB No. 51

Learning Objectives

• Review the old rules for consolidation of SPEs.
• Understand the background on consolidations.
• Discuss the new variable interest entity consolidation rules.

Introduction

Interpretation No. 46R was issued in December 2003 and replaces the original Interpretation No. 46 that was issued in January 2003. The Interpretation, as revised, addresses the consolidation rules found in ARB No. 51, Consolidated Financial Statements, and FASB No. 94, Consolidation of All Majority-Owned Subsidiaries, as they relate to off-balance-sheet entities, referred to as variable interest entities (VIEs).

The general rule for consolidation of entities found in ARB No. 51, Consolidated Financial Statements is that consolidation occurs when one entity directly or indirectly has a controlling financial interest in another entity. A controlling financial interest is deemed to occur when one entity (the parent) owns more than 50% of the voting shares of another entity (the subsidiary.) With respect to an entity that controlled, but did not own, another entity, the rules have been scattered among a series of FASB Emerging Issues Task Force opinions. In most cases, an entity that has controlled another (through contract, support, or otherwise), but has not owned the majority of its voting equity, has not been required to consolidate with that entity provided certain criteria were met. Thus, the concept of "off-balance-sheet" entities (that is, unconsolidated entities), has evolved over the years.

Interpretation No. 46R now addresses those so called "off-balance-sheet" entities (referred to as variable interest entities or VIEs) and establishes rules as to when one entity must consolidate another entity that it effectively controls (through financial support) even though there may be no controlling ownership between the two entities.

The Interpretation replaces the previously used term "special purpose entity" or "SPE" with the term "variable interest entity" or "VIE," to identify those entities that now may have to be consolidated.

Background

Emphasis on so-called "off-balance-sheet" entities became fashionable during the Enron scandal. At that time, Congress, the financial press, talk shows, and investors watched the unraveling of Enron which exposed that Enron had used as many as 3,000 "off-balance-sheet" entities to account for certain transactions. (Prior to Interpretation 46R being issued, the accounting guidance for "off-balance-sheet" entities referred to such entities as special purpose entities (SPEs).) Yet, most, if not all, of those SPEs were not consolidated with Enron, much less disclosed in the notes to its financial statements. Ultimately, Enron announced that it should have consolidated four SPEs going back to 1997 resulting in a cumulative restatement of Enron’s financial statements for 1997 through 2001, including a reduction in net income of $568 million, $2.6 billion of additional debt, and a reduction in stockholders’ equity of $1.2 billion.

Both Congress and the SEC used Enron as their primary example of the abuses that existed with SEC companies’ use of SPEs. Even though most entities have used SPEs for valid business purposes (such as leasing, securitization of investments, and research and development), others have involved use of a "shell" entity, established solely to eliminate unwanted assets and debt from the sponsor’s balance sheet with most of the SPE’s financial support being provided by the sponsor. Yet the rules for consolidating SPEs with the sponsor were weak and ambiguous, supported by a series of Emerging Issues Task Force (EITF) Consensus Opinions. Together, these EITFs offered easy options to structure SPE transactions to avoid consolidation, resulting in few SPEs actually being consolidated with their sponsor companies.

With the passage of the Sarbanes-Oxley Act of 2002, pressure grew for radical change to ensure that more SPEs were consolidated and for greater transparency to be given to shareholders and other third-party users about company transactions involving SPEs. Sarbanes introduced a new requirement to adopt rules for greater disclosure of off-balance-sheet transactions. Further, Sarbanes gave broad power for the adoption of GAAP rules to a new public oversight board. The powers of this new board placed pressure on the FASB to make changes to the SPE rules.

In the summer 2002, the FASB issued an exposure draft on "variable interest entities (VIEs)." The term "VIE" was used to replace the term "SPE." A VIE is an off-balance-sheet entity that is not self-supportive and that relies on another entity or individual for its financial support.

After deliberating on the exposure draft, the FASB issued Interpretation No. 46 in January 2003. Six out of seven Board Members approved the final document with only one, John Foster, dissenting.

Upon the issuance of the Interpretation, public criticism of the document was rampant, as critics claimed the document was ambiguous and that the FASB Staff was not supporting its document by assisting in its interpretation. In fact, the document was so controversial, that the FASB staff issued or proposed to issue eleven FASB Staff Bulletins (FSBs) to clarify the language found in the Interpretation.

Ultimately, the FASB decided to modify Interpretation No. 46 and, in October 2003 issued an exposure draft to supersede the originally issued Interpretation No. 46. In December 2003, the Board approved the issuance of a revised Interpretation No. 46 (referred to as Interpretation No. 46R). Two of the seven FASB Board Members dissented based on their conclusion that the revised Interpretation still lacked clarity in offering guidance as to how to implement the new rules.

In its final and revised form, Interpretation No. 46R makes dramatic changes to the landscape for consolidating variable interest entities (VIEs).

As a result, many entities may be required to consolidate VIEs that they supported even though they have no equity ownership in them. Even non-public entities will be impacted by the new rules under which many operating companies will be required to consolidate with related-party entities with which they are engaged in leasing transactions, shared operating expense arrangements, cross-guarantees of bank loans, and subordinated inter-company debt.

For purposes of this course, reference to "Interpretation No. 46" and "Interpretation No. 46R" shall mean the revised Interpretation issued in December 2003.

Why the Need to Change the Old SPE Rules?

The FASB stated that they decided to issue the Interpretation for several reasons including the following:

• Transactions involving off-balance-sheet entities had become increasingly common.
• Existing accounting literature for SPEs was fragmented and incomplete.
• The existing rules for consolidation, based solely on having a controlling financial interest (through ownership of more than 50% voting shares), were outdated and did not properly capture those entities that controlled other entities through means other than ownership.

The Old Rules for Investments and Consolidations

This section summarizes the general accounting rules for investments and consolidations. In this section, the author discusses how the consolidation rules have worked prior to the issuance of Interpretation No. 46. Following a review of the consolidation rules is an analysis of the new Interpretation No. 46 requirements.

The accounting for investments is generally based on the percentage ownership one entity has in another.

The three tiers of ownership and the accounting rules related to each are summarized as follows:

The following chart summarizes the accounting treatment in greater detail for all three tiers.