By: Howard Jiang
Since the Enron debacle, the Financial Accounting Standards Board (FASB) has paid a lot of attention to the types of entities that were used by Enron to avoid its financial reporting obligations. The FASB released Accounting Rule Bulletin No. 51 (ARB 51) and later FASB Interpretation No.46, as revised (FIN46(R)) to shed more light on Variable Interest Entities (VIE) in which an investor has control of a company that is not based on ownership of a majority of the voting interests and the factors that trigger financial consolidation obligations.
ARB 51 requires that an enterprise’s consolidated financial statements include all subsidiaries in which an enterprise has a controlling financial interest. That rule had historically been applied to circumstances in which an enterprise had control through holding a majority voting interest. However, the financial structuring engaged in by Enron and other entities of that era revealed a weakness in focusing solely on majority voting control as there are other situations in which a party could have a controlling financial interests but not control the majority of the voting interests or in which the equity investors do not bear the actual financial risk.
Under FIN 46(R), an entity that has one or more of the following characteristics must consolidate its financials into the entity that absorbs the expected losses and wields the powers that the entity investors lack as provided:
- The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided through any parties to absorb some or all of the expected losses of the entity.
- The equity investors lack one or more of the following essential characteristics of a controlling financial interest:
- the direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights;
- the obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities;
- the right to receive the expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses.
This auditing policy addresses exactly the kind of entities Enron used to hide its losses and consequently requires reporting companies to consolidate in its financial statements the losses incurred by those entities which are deemed to be VIEs.
However, it is not that all contractual arrangements bearing the above-mentioned characteristics trigger consolidation. There are exceptions to the scope of Interpretation No. 46:
- Not-for-profit organizations are not subject to this Interpretation unless they are used by business enterprises in an attempt to circumvent the provisions of this Interpretation.
- Employee benefit plans subject to specific accounting requirements in existing FASB Statements are not subject to this Interpretation.
- Registered investment companies are not required to consolidate a variable interest entity unless the variable interest entity is a registered investment company.
- Transferors to qualifying special-purpose entities and “grandfathered” qualifying special-purpose entities subject to the reporting requirements of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, do not consolidate those entities.
- No other enterprise consolidates a qualifying special-purpose entity or a “grandfathered” qualifying special-purpose entity unless the enterprise has the unilateral ability to cause the entity to liquidate or to change the entity in such a way that it no longer meets the requirements to be a qualifying special-purpose entity or “grandfathered” qualifying special-purpose entity.
- Separate accounts of life insurance enterprises as described in the American Institute of Certified Public Accountants Auditing and Accounting Guide, Life and Health Insurance Entities, are not subject to this Interpretation.
FIN 46 (R) also provides that any entity that is deemed to be a business need not be evaluated to determine if it is a VIE unless one of the following conditions exists:
- the reporting enterprise, its related parties, or both participated significantly in the design or redesign of the entity, and the entity is neither a joint venture nor a franchisee;
- the entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting enterprise and its related parties;
- the reporting enterprise and its related parties provide more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the entity based on an analysis of the fair value of the interests in the entity;
- the activities of the entity are primarily related to securitizations, other forms of asset-back financing, or single-lessee leasing arrangements.
An entity is a business if it is a self-sustaining integrated set of activities and assets conducted and managed for the purpose of providing a return to investors. For FIN 46(R) purposes a business consists of inputs, processes applied to those inputs and resulting outputs that are used to generate revenues. For a set of activities and assets to constitute a business, it must contain all of the inputs and processes necessary for it to conduct normal operations.
FIN 46(R) focuses on consolidating entities when the primary beneficiary of the VIE is the party absorbing a majority of the entity’s expected losses, receives a majority of its expected residual returns or both.
Therefore, for a public company negotiating commercial relationships and contracts, it is important to focus on the extent of the rights that it retains for itself in connection with investments in enterprises where it holds less than a majority of the voting interests in order to protect against inadvertently creating a financial consolidation obligation due to contract terms that result in effective control, particularly if the other entity is very thinly capitalized and may need financial assistance from such public company to deal with expected losses .
On the flip side, the VIE structure can also be used creatively in situations where a company wants to consolidate financials which would not have been qualified for consolidation under the old rules. Contractual arrangements providing effective control over the operations and the right to receive residual returns and other additional arrangements providing effective control may allow the consolidation of the financial results of an entity. Alibaba and many other companies used this structure to consolidate the operating results of affiliates and operating entities where direct ownership is barred by local laws. This may also help roll-up transactions where the consolidators may have upfront capital constraints in buying out or establishing a control ownership interest before an IPO.