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),” April 2006 (most recent thru 3/20/07)
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 VIE—an interest that changes with changes in the VIE’s net assets—must determine if it must consolidate the VIE.
Variable Interest Entities (VIEs):“Variable Interest Relationships” • Variable Interest Relationships: • Situations in which an entity:Receives 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
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)
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).
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).
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
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 VIE’s lenders or equity holders (that reduce the true risk of these parties). • Written put options on a VIE’s assets held by a VIE or its lenders or equity holders. • Forward contracts on purchases and sales.
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 VIE’s expected losses and/or • Will receive a majority (more than 50%) of the VIE’s expected residual returns. • Expected losses are given more weight than expected residual returns in certain situations.
From Deloitte & Touche Presentation Filling the Buckets Above Average Outcomes Below Average Outcomes + Fees Probability Weighted Scenarios ExpectedResidual Returns ExpectedLosses
From Deloitte & Touche Presentation 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 FAS 150) • 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 From Deloitte & Touche Presentation
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 From Deloitte & Touche Presentation
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 VIE’s other VIH. • Different VIH make different judgments about their variable interests.
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.
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 entity’s 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%.)
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 entity’s activities. • The obligation to absorb the entity’s expected losses. • The right to receive the entities expected residual returns.
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 VIE’s losses.
Reconsideration Triggers Para. 7 & 15 From Deloitte & Touche Presentation
Variable Interest Entities (VIEs):Consolidation Procedures • Major Points in Consolidating: • #1 Eliminate primary beneficiary’s interest in the VIE. • #2 Report VIE’s assets & liabilities at fair values—not 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.
Disclosures Required When Involved with VIEs • Disclosures for Primary Beneficiaries: • #1 VIE’s nature, purpose, size, activities. • #2 Carrying value and classification of consolidated assets that are collateral for the VIE’s 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.
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 VIE’s nature, purpose, size, activities. • #3 The entity’s maximum exposure to loss as a result of its involvement with the VIE.