Variable Interest Entities

Variable Interest Entities

(Chapter 17)

As discussed in Chapter 17, the use (or misuse) of special purpose entities by firms such as Enron has left a very bad taste in the public’s mouth. Hence the FASB addressed this issue in Interpretation No. 46 (all paragraph numbers refer to that document). The first thing the FASB did was to change the name of the arrangement from special purpose entity to variable interest entity. This leads to the problem throughout the interpretation of referring to variable interests in variable interest entities. For example in Paragraph 13 the interpretation states that “an enterprise with a variable interest in specified assets of a variable interest entity shall treat a portion of the entity as a separate variable interest entity if the specified assets…are essentially the only source of payment for specified liabilities.

The crux of the interpretation broadens the requirements for consolidating variable interest entities. Previously as little as a 3% equity interest by an outside investor allowed the controlling enterprise to avoid consolidation. The minimum investment to avoid consolidation has been raised to 10% in Para. 9. Even here consolidation can be avoided if the equity investment in the variable entity is sufficient to cover estimated losses.

However, consolidation criteria moves to a new arena in the interpretation. An enterprise will consolidate a variable interest entity if it would “receive a majority of the (variable interest) entity’s losses if they occur, receive a majority of the (variable interest) entity’s expected residual returns if they occur, or both.” (Para. 14). If there is a split between enterprises sharing losses and residual returns, the losses predominate relative to the issue of which enterprise should consolidate. A direct or an indirect ability to make major decisions for the variable interest entity is a good determinant for whether an enterprise is expected to absorb losses or receive residual gains.

Expected losses and expected residual gains are briefly illustrated in Appendix A of the interpretation. Both involve the use of expected values. These future amounts are discounted to present value using the interest rate for risk-free investments. The measurement approach of the interpretation is reminiscent of the methodology used for determining whether fixed assets should be written down (SFAS Nos. 121 and 144 and Chapter 10) but the purposes are entirely different: who controls a variable interest entity versus determining a fixed asset’s revenue generating ability.

This interpretation for determining who is to consolidate variable interest entities is extremely cumbersome. Depending upon who is doing the calculating, we suspect that it would be possible for no firm to do the consolidating or for more than one firm to be consolidating the same variable entity. This arises because there could be considerable differences in how future cash flows are estimated, weighted, and discounted (verifiability). We believe that a present magnitude such as who controls the highest proportion of the firm’s net assets might be more verifiable and less cumbersome than the FASB’s approach. To what extent FASB Interpretation No. 46 will improve special purpose entity reporting is a very open question.