FASB Interpretation 46(R): Consolidation Required in Unexpected Situations

By James Schmutte and James R. Duncan

Where you find the laws the most numerous, there you will find also the greatest injustice.
—Arcesilous

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In 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 46-7.

Scope

The 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.

For 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.

Historically, 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 entities.

Overview of Interpretation 46(R) and Related Terminology

FASB 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.

In 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.

Interestingly, 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.”

Although 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.

Because 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.

In 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.

The 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.

The 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.

To 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.

The 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 prior approval.

Interpretation 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.

Does Interpretation 46(R) Apply?

The 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 questions:

• 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 VIE?
• Is the leasing entity financially viable?
• Is the operating enterprise the “primary beneficiary” of the leasing entity?

Scope exceptions. Although Interpretation 46(R) generally applies to all entities, the interpretation excludes the following:

• Not-for-profit organizations.
• 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 effort.”
• 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.

Involvement. 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 equity investors;
• Contracts to manage the entity’s assets or activities;
• Leasing assets from the entity; and
• Providing financing to the entity.

Furthermore, 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.

In the example above, Custom Designs clearly demonstrated involvement when it leased assets from Facilities.

VIE 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 returns;
• 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.

In the example above, Facilities satisfies the first point, indicating that it is a VIE.

Financial 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 funding sources.

Interpretation 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 financial support.

If 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 assets or
liabilities.

If the financial viability of Facilities is an issue in the above example, Custom Designs may have to consolidate Facilities.

Primary 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 considerations:

• 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 the VIE;
• 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.

In 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.

Initial Measurement and Consolidation

Normally, 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.

Disclosure

In 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; and
• 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.

An enterprise that holds a significant variable interest in a VIE, but is not the primary beneficiary, must disclose the following:

• The nature of its involvement with the VIE and when the involvement began;
• The nature, purpose, size, and activities of the VIE; and
• The enterprise’s maximum exposure to loss as a result of its involvement with the VIE.

Other Issues

For 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, 2004.

Applying 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.

The 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 carefully.

An Accounting-Theory Shift

The 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.

The 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.

Interpretation 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.