FIN 46 – Consolidation of Variable Interest Entities Jim Mountain January 2003
It All Starts with “Expected Losses” • Key to identifying VIEs initially • Key to when VIE status needs to be reconsidered • Key to identifying the “Primary Beneficiary,” (if there is one) who consolidates VIEs • “Expected Residual Rewards” related concept, but less prominent
Step by Step • Size Expected Losses • Determine whether entity is VIE or not • Is equity bigger than Expected Losses? • Does it meet the other criteria? • Is it carved out? • Am I the Primary Beneficiary of the VIE? • Am I the only one with a variable interest covering a majority of Expected Losses or Expected Residual Returns? • Break a tie by favoring Expected Losses • Did an event trigger my reconsideration?
Paragraph 8 Definition “’Expected Losses’ and ‘Expected Residual Returns’ include (a) the expected variability in the entity’s net income or loss, (b) the expected variability in the fair value of the entity’s assets if it is not included in net income or loss (with limited exception), (c) fees to the decision maker (if there is a decision maker), and (d) fees to providers of guarantees of the values of all or substantially all of the entity’s assets (including writers of put options and other instruments with similar results) and providers of guarantees that all or substantially all of the entity’s liabilities will be paid.” -FASB
The Word Problem Question: What mathematical equation(s) does Paragraph 8 define? • EL = (a) + (b) + (c) + (d) and ERR = (a) + (b) + (c) + (d) • EL + ERR = (a) + (b) + (c) + (d) • EL = 1/2(a) + 1/2(b) and ERR = 1/2(a) + 1/2(b) +(c) + (d) • None of the above • All of the above
The Word Problem • EL = 1/2(a) + 1/2(b) and ERR = 1/2(a) + 1/2(b) +(c) + (d) At least that’s our best guess for now!
Filling the Buckets Above Average Outcomes Below Average Outcomes + Fees Probability Weighted Scenarios ExpectedResidual Returns ExpectedLosses
How to Tell if I am NOT a VIE • 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 entity’s 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
What Kind of Equity? • Needs to be shown as equity on the books of the entity (Watch out for upcoming FAS 149) • Can include non-voting, but needs to have significant profit/loss participation • Watch out for significant non-voting equity held by someone associated with substantially all of the entity’s activities • Excludes • Exchange for subordinated interests in other VIEs • Amounts representing fees or contributions • Amounts funded or guaranteed by other participants
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 entity’s net asset value
Segregated Assets & Silos • A variable interest in less than a majority of the assets is not a variable interest in the overall entity by itself. Any related expected losses and expected residual returns are excluded from the overall 8(b) amounts. • A holder of variable interests in any identifiable sub-group of assets will treat it as a silo if: • The overall entity is a VIE • Those assets (plus any credit support) are essentially the only source of payment of other liabilities or interests • If one participant consolidates a silo, everyone else ignores it.
FIN 46 – Consolidation of Variable Interest Entities National Financial Services Industries January 2003