Interpretation 46(R): Consolidation Required in Unexpected
James Schmutte and James R. Duncan
you find the laws the most numerous, there you will find
also the greatest injustice.
- As the Enron crisis unfolded, the Jedi and Raptors, first
introduced as the heroes and villains of fantasy movies, came
to symbolize massive corporate accounting abuses. Jedi and
Raptors were names of two of the many special-purposes entities
(SPE) that Enron created to remove assets and liabilities
from its balance sheet, to hide losses, and to create fictitious
profits. Although SPEs have been used for valid business purposes,
they now carry a sinister connotation.
July 2002, Congress responded to the Enron-era accounting
frauds by passing the Sarbanes-Oxley Act (SOA). This landmark
legislation included the call to study the role and impact
of SPEs. Subsequently, FASB issued an interpretation to
extend the principles of consolidated financial statements
to situations in which an enterprise has less than a majority
voting interest in another entity. FASB Interpretation 46,
Consolidation of Variable Interest Entities, issued
in January 2003, is the result of that process and significantly
expands the pool of entities subject to consolidation. FASB
later issued a revision, Interpretation 46(R), which incorporates
guidance from FASB Staff Positions 46-3, 46-4, 46-6, and
abuses that led to Interpretation 46(R) involved publicly
traded companies that created SPEs through complex transactions
in multilayered entities. The consolidation requirements
of Interpretation 46(R) apply to all entities, however,
and can have surprising and significant implications for
smaller nonpublic enterprises.
example, Jean and Margaret own and operate Custom Designs
Inc., a successful manufacturing business. Several years
ago, the company needed larger production facilities to
accommodate increasing sales and several new planned operations.
Rather than expand the existing structure, the company decided
to acquire a new site and construct a new building. For
liability and income tax reasons, Jean and Margaret formed
a new corporation, Facilities Inc., whose principal assets
are the building and plant site. Facilities’ only
activity is leasing the building to Custom Designs. To finance
the site’s purchase and the building’s construction,
Facilities secured a long-term note from a local bank. Because
of the size of the loan, the bank required Customs Designs
and Jean and Margaret to guarantee Facilities’ note.
Custom Designs and Facilities have been considered related
parties and have not been subject to consolidation requirements,
due to the lack of any intercompany ownership interests.
Their financial reporting has consisted of separate financial
statements with disclosure of the relationship, certain
information regarding the dollar amount of activity between
the entities, and any related receivables and payables at
the end of the period. Implementing FASB Interpretation
46(R), however, could require the consolidation of the two
of Interpretation 46(R) and Related Terminology
Interpretation 46(R) interprets Accounting Research Bulletin
(ARB) 51, Consolidated Financial Statements. Whereas
ARB 51 follows an ownership-control approach to consolidation,
Interpretation 46(R) provides for a substance-over-form
approach. Essentially, Interpretation 46(R) requires consolidation
of any entity by the enterprise that controls the economic
risks and rewards of the entity, regardless of ownership.
By expanding the basis for consolidation from one based
exclusively on voting interests to one based on a risks-and-rewards
model, Interpretation 46(R) increases the number of entities
an enterprise must consider for possible consolidation.
addition to a significant shift in consolidation theory,
Interpretation 46(R) introduces a new set of terminology
and incorporates the measurement concepts of FASB Concepts
Statement 7, Using Cash Flow Information and Present
Value in Accounting Measurements.
the new standard does not use the term SPE. Variable interest
entity (VIE) is the term used by Interpretation 46(R) to
identify such entities. It describes the entity that is
subject to consolidation according to the provisions of
Interpretation 46: “variable interests in a variable
interest entity are contractual, ownership, or other
pecuniary interests in an entity that change with changes
in the fair value of the entity’s net assets exclusive
of variable interests.”
this is not the clearest of definitions, in essence a variable
interest represents a contractual or ownership interest
in another entity that causes the holder to absorb the changes
in fair value of the other entity’s net assets. Potential
variable interests include:
Holding economic interests, voting rights, or obligations
to an entity;
Issuing guarantees on behalf of an entity;
Transferring assets to an entity;
Managing the assets of an entity;
Leasing assets from an entity; and
Providing financing to an entity.
ownership is no longer the sole basis for consolidation,
any entity (i.e., any legal structure used to conduct activities
or to hold assets) could be considered a VIE if, by design,
certain conditions exist. VIEs are structured to include
one of the following characteristics:
Equity investment is not sufficient to finance operations
without additional subordinated financial support;
Equity investors do not control the entity;
Equity investors do not fully participate in the entity’s
economic risks and rewards; or
The entity has nonsubstantive voting interests.
other words, VIEs can exist when the entity is created without
adequate capital, or when the equity instruments do not
provide the holder with a potential controlling financial
interest or share of the risks and rewards of ownership.
key elements in applying Interpretation 46(R) are computing
and assessing the expected losses and expected residual
returns associated with a variable interest. Neither item
is a GAAP measurement, but they reflect amounts derived
from expected cash flows incorporating the methodology of
Concept Statement 7. Specifically, the computations should
reflect the range of possible cash-flow outcomes, weighted
by their probability of occurrence. These probability-adjusted
cash flows are then discounted using an appropriate interest
rate. Both expected losses and expected residual returns
must be separately computed; the expected losses are used
in determining whether the entity is a VIE and, ultimately,
which enterprise must consolidate the entity.
primary beneficiary is the enterprise that consolidates
the VIE under the provisions of Interpretation 46(R). It
is this enterprise that is obligated to absorb the majority
of the VIE’s expected losses. Appendix
B to Interpretation 46(R) describes various types of variable
interests and explains how they may affect the determination
of the primary beneficiary of a variable interest.
determine whether an enterprise is the primary beneficiary
of a variable interest entity, the enterprise with the variable
interest must treat variable interests in that same entity
held by its related parties as its own. For Interpretation
46(R) purposes, related parties include those parties identified
in SFAS 57, Related Party Disclosures, and certain
other parties that act as de facto agents or de facto principals
of the variable interest holder.
following are considered de facto agents of an enterprise:
A party that cannot finance its operation without subordinated
financial support from the enterprise.
A party that received its interest as a contribution or
loan from the enterprise.
An officer, employee, or member of the governing board
of the enterprise.
A party that has a close business relationship with the
enterprise or an agreement limiting its ability to sell,
transfer, or encumber its interest in the entity without
46(R) also addresses identifying the primary beneficiary
in situations where two or more related parties hold variable
interests in the same VIE, and the aggregate variable interests
held by those parties would, if held by a single party,
identify that party as the primary beneficiary.
Interpretation 46(R) Apply?
decision process for applying Interpretation 46(R) to the
relationship between an enterprise and another entity can
be viewed as a series of questions. The example above illustrates
the process and requires addressing each of the following
Are the operating enterprise and the leasing entity within
the scope of Interpretation 46(R)?
Is the operating enterprise “involved” with
the leasing entity?
Is the interest in the leasing entity an example of a
Is the leasing entity financially viable?
Is the operating enterprise the “primary beneficiary”
of the leasing entity?
exceptions. Although Interpretation 46(R)
generally applies to all entities, the interpretation excludes
Employee benefit plans covered by other FASB standards.
Registered investment companies (unless the primary beneficiary
is also a registered investment company).
Transferors to qualified special-purpose entities (QSPE)
subject to SFAS 140 requirements, as well as those entities
that can change the status of QSPEs.
Separate accounts of life insurance companies.
Companies with an interest in a VIE that cannot obtain
the necessary information after making “an exhaustive
Governmental organizations or financing entities established
by governmental organizations, unless used to circumvent
the provisions of Interpretation 46(R).
Business entities, as defined in the interpretation, unless:
The reporting company designed the entity.
The activities of the entity are conducted on behalf
of the reporting company.
The reporting company provided more than half the
entity’s equity and financing.
The entity’s activities relate to asset-backed
financings or single-lessee transactions.
The initial determination of whether an entity is a VIE
should be performed on the date that the enterprise first
becomes involved with the entity. Examples of activities
that demonstrate involvement include the following:
Transfer of assets to the entity;
Guarantees of asset or liability values or returns to
Contracts to manage the entity’s assets or activities;
Leasing assets from the entity; and
Providing financing to the entity.
the enterprise should regularly monitor its relationships
with other entities. Subsequent events, activities, or circumstances
could alter the nature of the relationship so as to change
the Interpretation 46(R) determination, resulting in new
VIEs to be consolidated and existing VIEs to be deconsolidated.
the example above, Custom Designs clearly demonstrated involvement
when it leased assets from Facilities.
examples. Many entities are designed so that
equity investors do not fully participate in the risks and
rewards of ownership, which are instead passed to other
parties through various contractual arrangements. The following
conditions, if by design, indicate that an entity is a VIE
and subject to consolidation:
Total equity is not sufficient for financing the entity’s
activities without further subordinated financial support
(i.e., loans or guarantees);
The owners, as a group, lack the voting or similar rights
to make significant decisions about the entity;
The owners, as a group, lack the obligation to absorb
the entity’s losses or the right to receive residual
Voting rights are disproportionate to obligations for
losses and rights for returns from the entity; or
Substantially all of the entity’s activities are
conducted on behalf of investors with few voting rights.
the example above, Facilities satisfies the first point,
indicating that it is a VIE.
viability. An entity is not considered financially
viable if it has insufficient equity investment to finance
its activities without further subordinated financial support.
For the purposes of Interpretation 46(R), equity investment
is the equivalent GAAP measure reduced for equity holders
not participating significantly in profits or losses, and
for other equity holders and amounts related to specified
46(R) also includes the presumption that an equity investment
at risk of less than 10% of total assets is insufficient
to indicate financial viability. This presumption may be
overcome if the entity can demonstrate sufficient equity
by qualitative or quantitative considerations or both. One
qualitative factor would be a demonstrated ability to finance
activities without additional subordinated financial support.
Another would be that the entity has at least as much equity
as similar entities that operate without additional subordinated
qualitative factors are not conclusive, one must perform
a quantitative assessment comparing the equity at risk to
expected losses, as defined in Interpretation 46(R). The
10% presumption is overcome if equity exceeds the expected
losses. Nonetheless, an enterprise should consider the need
for an equity investment greater than 10% of assets if an
entity is engaged in high-risk activities or holds high-risk
the financial viability of Facilities is an issue in the
above example, Custom Designs may have to consolidate Facilities.
beneficiary. The primary beneficiary consolidates
the VIE. This determination is made at the point the company
commences involvement with the VIE, and includes the following
The enterprise considers its rights and obligations via
its variable interests in relation to those of all other
variable interest holders;
The party that absorbs 50% or more of the VIE’s
expected losses and expected residual returns consolidates
If one party absorbs the majority of expected losses while
others receive the majority of expected residual returns,
the party that absorbs the majority of expected losses
is the primary beneficiary;
Reconsideration of the primary beneficiary occurs whenever
there is a change in the contractual arrangements, governing
documents, or variable interests; and
For purposes of determining whether an enterprise is the
primary beneficiary, the enterprise should also consider
the variable interests held by its related parties and
de facto agents as its own.
the example above, Custom Designs guarantees the Facilities’
debt, and would absorb the expected losses of Facilities,
so it would be considered the primary beneficiary and should
consolidate Facilities Inc.’s financial statements
with its own.
Measurement and Consolidation
the primary beneficiary measures the assets, liabilities,
and noncontrolling interest of the VIE at fair value based
upon the guidance in SFAS 141, Business Combinations,
at the date that the enterprise first becomes the primary
beneficiary. In cases where the primary beneficiary and
the VIE are under common control or the primary beneficiary
transfers assets to the VIE, the measurement is at book
value. Subsequent accounting follows ARB 51 as if consolidation
was based on the voting-interest model.
addition to disclosures required by other standards, Interpretation
46(R) requires the primary beneficiary of a VIE to disclose
the following (unless the primary beneficiary also holds
a majority voting interest):
The nature, purpose, size, and activities of the VIE;
The carrying amount and classification of consolidated
assets that are collateral for the VIE’s obligations;
The lack of recourse if creditors (or beneficial interest
holders) of a consolidated VIE have no recourse to the
general credit of the primary beneficiary.
enterprise that holds a significant variable interest in
a VIE, but is not the primary beneficiary, must disclose
The nature of its involvement with the VIE and when the
The nature, purpose, size, and activities of the VIE;
The enterprise’s maximum exposure to loss as a result
of its involvement with the VIE.
nonpublic companies, FASB Interpretation 46(R) must be applied
immediately to all VIEs created after December 31, 2003.
Interpretation 46(R) applies to all previously created VIEs
beginning in the first reporting period after December 15,
Interpretation 46(R) involves a number of practical issues.
It requires measurements and assessments of variable interests
at the time the enterprise first becomes involved with an
entity or meets the criteria as primary beneficiary. In
many cases, this will require a careful review and analysis
of relationships that have existed for a number of years.
computation of expected losses and expected residual returns,
which are critical in making the VIE assessment, are not
GAAP measures but are products of the measurement methodology
of Concept Statement 7. Rather than point estimates of accounting
outcomes, this concept embraces the use of multiple cash-flow
outcomes weighted by related probabilities. To approximate
fair-value measures, expected cash flows must be determined
in present value. Applying Concept Statement 7 brings the
associated issues of projecting outcomes, assigning probabilities,
and determining an appropriate interest rate for discounting
purposes. Interpretation 46(R) provides a limited illustration
of this methodology; practical applications, however, are
more complex and subjective. Guidance in the areas of prospective
financial reporting and business valuation should be studied
requirement for consolidation is no longer limited to majority
ownership; it includes a risk-and-reward analysis of relationships
and associations with other entities as well as those of
the enterprise’s related parties. Consequently, Interpretation
46(R) represents a significant shift in accounting theory,
and has broadened the pool of entities potentially subject
to consolidation. Examples of potential VIE situations include
the sale-leaseback of real estate or equipment, partnerships
and joint ventures, management/service contracts, and residual
value or performance guarantees, as well as guarantees associated
with previously unconsolidated entities.
financial reporting impact of Interpretation 46(R) may have
unanticipated consequences. For example, the consolidation
of a VIE could affect various performance measures and financial
ratios that are tied to loan covenants, contracts, and compensation
plans. Accordingly, management should review such documents
to determine whether changes or corrective actions are warranted.
46(R) can appear deceptively simple. Although only 41 paragraphs—18
pages—long, the document includes some 60 pages of
appendices for additional guidance and explanation. One
public accounting firm has published a 150-page booklet
discussing the intricacies involved in implementation. While
the driving force behind the development of Interpretation
46(R) was the Enron-era accounting abuses, it has completely
altered the landscape of financial reporting.
Schmutte, PhD, CPA, is a professor, and James
R. Duncan, PhD, CPA, is an assistant professor, both
in the department of accounting at Ball State University,
Note: For additional information on Interpretation
46(R), see also “Accounting for Special Purpose Entities
Revised: FASB Interpretation 46(R),” by Jalal Soroosh
and Jack T. Ciesielski, The CPA Journal, July 2004.