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Wednesday, October 6, 2010

FASB Codifies New Rules for Consolidation of VIEs


With its recent Accounting Standards Update (ASU) 2009-17, Consolidations (Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities, the Financial Accounting Standards Board (FASB) has codified significant changes to the analysis required when determining whether a company must consolidate variable interest entities (VIEs) — including special purpose entities — on its financial statement.

The new rules incorporate FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R), into the FASB Accounting Standards Codification. In addition to amending the requisite consolidation analysis, the rules require enhanced disclosures about a company’s involvement with VIEs and the related risks.

Primary Beneficiary Analysis

The question of whether a company must consolidate a VIE rests on whether it’s the VIE’s “primary beneficiary” — that is, whether it has a controlling financial interest in the VIE. The previous primary beneficiary analysis, under FASB Interpretation 46(R), focused on quantitative risks and rewards. If a company absorbed the majority of the VIE’s expected losses, received a majority of the VIE’s expected residual returns, or both, it was deemed the primary beneficiary and required to consolidate the VIE.

The new rules, which focus on a qualitative assessment of power, are intended to more effectively identify the company that holds a controlling financial interest in a VIE. They define the primary beneficiary as the company that has:

  • The power to direct the activities of the VIE that most significantly affect the VIE’s economic performance, and
  • The obligation to absorb the VIE’s losses that could potentially prove significant to the VIE or the right to receive benefits from the VIE that could prove significant to the VIE.

The new rules also require the company to evaluate whether it has an implicit financial responsibility to ensure that the VIE operates as designed when determining whether the company satisfies the first criterion for a primary beneficiary.

Shared Power Among Multiple Unrelated Parties

What if the power is shared among multiple unrelated parties, with no single party wielding the power to direct the relevant activities of the VIE? In that case, none of the parties should consolidate the VIE.

Power is considered shared if two or more unrelated parties together hold the power to direct those activities, and decisions about those activities require the consent of each of the parties. An example is a joint venture where every party to the venture must consent to decisions about the relevant activities.

If consent isn’t required but multiple unrelated parties have power over the activities that most significantly affect the VIE’s economic performance, the party with power over the majority of the significant activities has the required power. That party will be the primary beneficiary if it also has the obligation to absorb the VIE’s losses, or the right to receive benefits, that could be potentially significant to the VIE.

If consent isn’t required but multiple unrelated parties have power over significant activities that differ in nature, the party with the power to direct the activities that most significantly affect economic performance has the required power. For example, if unrelated parties are responsible for the manufacture and distribution of a product, and the manufacturing most significantly affects the VIE’s economic performance, the manufacturing party would be deemed to direct the activities that most significantly affect the VIE’s economic performance. In turn, it would be the primary beneficiary if it also has the obligation to absorb the VIE’s losses, or the right to receive benefits, that could be potentially significant to the VIE.

Kick-out, Participating and Protective Rights

“Kick-out rights” refer to the ability to remove the reporting company that has the power to direct the activities of a VIE that most significantly affect the VIE’s economic performance. “Participating rights” grant the ability to block the actions through which the reporting company exercises that power. “Protective rights” are designed to guard the interests of the holder without giving that party a controlling financial interest in the related entity.

Under the new rules, kick-out rights and participating rights aren’t considered when determining whether an entity is a VIE or identifying the VIE’s primary beneficiary, unless the rights are held by a single company. Similarly, the fact that other parties hold protective rights doesn’t automatically prevent a reporting company from holding the necessary power to direct the VIE’s relevant economic-related activities.

Reconsideration of the Analysis

FASB Interpretation 46(R) called for the reconsideration of whether an entity is a VIE and whether a company is the VIE’s primary beneficiary only on the occurrence of specific events. The interpretation explicitly excluded a troubled debt restructuring (TDR) from those triggering events.

The new rules eliminate the exclusion for TDRs and require ongoing reassessments of whether a company is the primary beneficiary. They also add a new triggering event for reconsidering a VIE’s status: when the equity interest holders lose the power — from voting or similar rights of those investments — to direct the entity’s most significant economic activities.

Enhanced Disclosures

The new rules require enhanced disclosures for any company — public or nonpublic — that holds a variable interest in a VIE. A company must disclose any significant changes in risk exposure because of its involvement in a VIE, as well as how its involvement affects the company’s financial statements.

The disclosure requirements relate specifically to a company’s involvement with VIEs and its analyses. Both primary and non-primary beneficiaries of a VIE must disclose their methodology for determining whether they’re the primary beneficiary.

The methodology disclosure should include significant judgments and assumptions the company made and whether the conclusion to consolidate has changed in the most recent financial statements and why. Companies also must disclose the details of any financial or other support provided to the VIE that they weren’t previously contractually obligated to provide and the primary reasons for the support.

The primary beneficiary of a VIE must further disclose the terms of any arrangements, including both explicit arrangements and implicit variable interests, that might require the company to provide future support to the VIE. A nonprimary beneficiary that holds a variable interest must disclose the carrying amounts and classification of the assets and liabilities on its financial statements that relate to the VIE. It also must reconcile those amounts to the company’s maximum exposure to loss from the interest.

Presentation of the VIE’s Assets and Liabilities In the past, a primary beneficiary wasn’t required to present the elements of a consolidated VIE separately on its balance sheet. Now, a primary beneficiary must separately present the assets of consolidated VIEs that can be used only to settle obligations of those VIEs and the liabilities of consolidated VIEs for which creditors don’t have recourse to the primary beneficiary’s general credit.

Next Steps

The new rules reported in ASU 2009-17 take effect as of the start of a company’s first fiscal year beginning after November 15, 2009 — January 1, 2010, for companies reporting earnings on a calendar-year basis. Affected companies should re-examine their previous conclusions about consolidation, particularly regarding whether an entity is a VIE, the company is the VIE’s primary beneficiary and the appropriate disclosures.

Keep in mind that FASB has issued a proposed ASU that would defer the effective date for certain investment funds, such as mutual funds, hedge funds, mortgage real estate investment funds, private equity funds and venture capital funds. Under the proposal, the effective date for these entities would be deferred until the completion of the joint FASB-IASB project on consolidation accounting. Comments on the proposed update were due by January 6, 2010. Please contact us for the latest information — or for assistance in applying the new rules.

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