Lecture Notes for Acct 415/515, Acct 592 Prof. Teresa Gordon

What’s all the Fuss About – Special Purpose Entities

From [http://www.nasd.com] NASD is the National Association of Securities Dealers (I think, they never say what the acronym stands for! Accessed 3/27/03)

Consolidating Special Purpose Entities (SPEs) or Variable Interest Entities (VIEs)

Enron used off-the-books partnerships to disguise debt and inflate profits, supposedly acting within existing rules. Some people argue that this shows detailed rules for Special Purpose Entities (SPEs), like those used in US GAAP, have an Achilles heel, in that a firm can abide by the letter of the rule but violate its spirit. FASB in late January 2003 issued a new Interpretation creating what it calls Variable Interest Entities (VIEs). FASB renamed the special entities to identify more precisely the activity that generates concern.

IAS launched a project on consolidation, including SPEs, in June 2002. Its goal is to reconfirm the basis on which an entity should consolidate its investments and add rigor to guidance about what constitutes control. While most standards look to control, the definition varies across countries.

Consolidation of special entities under IAS

IASB describes SPEs in a general way in SIC-12: Consolidation - Special Purpose Entities (effective June 1999). An SPE is an entity established to accomplish a narrow and well-defined objective (e.g. to effect a lease, research and development activities or a securitization of financial assets).

IAS applies a general test for control to decide whether a reporting firm should consolidate another (see IAS 27, Consolidated Financial Statements and Accounting for Subsidiaries). For SPEs, the SIC-12 interpretation calls for consolidation when in substance the firm controls the SPE. That is, the firm is able to direct or dominate decision-making and intends to benefit from the SPE’s activities. SIC-12 gives examples, such as activities by the SPE on behalf of the reporting entity, decision-making power over the SPE, rights to the majority of benefits, and exposure to significant risks of the SPE. So the IAS tests both control and, sometimes, looks to risk and reward, though it does not define these words.

Consolidation of special entities under FAS

Before January 2003, US GAAP applied different rules to determine when to consolidate different types of SPEs: (a) control in certain cases and (b) risks and rewards in others. Firms were (and still are) required to consolidate SPEs when they have substantive control (decisionmaking power) over the activities of an SPE. A non-majority owner was required to consolidate an SPE if the majority owner made only a nominal capital investment (generally less than 3% of assets) and lacked substantive control (decision-making power) over the SPE’s activities, and if the non-majority owner received virtually all the benefits from those activities, the substantive risks and rewards of the assets, or the debt of the SPE. An exception was made (and continues to exist) for certain qualifying special-purpose vehicles holding securitized financial assets and meeting other stringent criteria.

FASB’s January interpretation creates a new term, Variable Interest Entity (VIE), because it found SPE insufficiently precise. An entity is a VIE if (i) its total equity investment is not large enough for the entity to finance its activities without additional subordinated financial support (equity less than 10% of assets suggests financial dependence) or (ii) the holders of its ownership interests do not have (a) the ability to make decisions about the VIE’s activities through voting or similar rights, (b) the obligation to absorb the expected losses of the entity if they occur, or (c) the right to receive the expected residual returns of the entity if they occur. FASB defined variable interests as pecuniary interests arising through contract or ownership, for example, that change with the VIE’s net asset value. The interests do not need to include voting rights.

FASB’s January interpretation modified its existing tests to consolidate. A VIE will be consolidated with its primary beneficiary, which is the firm, if any, with beneficial interests that give it a majority of the expected losses or a majority of the expected residual returns of the VIE. This elaborates and defines the notion that the primary beneficiary bears a majority of the risk, reaps a majority of the reward, or controls decisions.

Nice description from KPMG available at [http://www.fei.org/download/January03_3.pdf] – includes an example. Accessed 3/28/03

An internal educational document from Deloitte & Touche is available at [http://www.deloitte.com/dtt/cda/doc/content/Heads%20Up%20Vol%2010%20Issue%201(1).pdf]. Accessed 3/28/03


Note that there is a new file with the DEC 2003 Revisions

FASB Up-Date – FIN 46

FIN No. 46 – Consolidation of Variable Interest Entities (January 2003)

Special purpose entities (SPEs) typically are partnerships or joint ventures that are often used by companies to move debt off their balance sheet. Many have legitimate uses, but others are structured specifically with the intent of concealing debt from investors. They came into the spotlight after the collapse of energy trader Enron, which used sophisticated partnerships it controlled to move debt off its balance sheet. The murky deals were instrumental in Enron's demise and the company is accused of using them to fool investors about the true state of its finances. [From Tougher Rules on Enron-type Deals Approved, By Deepa Babington, 01/15/2003, Reuters English News Service, accessed 3/28/03 at http://www.stern.nyu.edu/News/news/2003/january/0115reuters.html

VARIABLE INTEREST ENTITIES

Variable interest entity refers to an entity subject to consolidation according to the provisions of Interpretation No. 46. There are two conditions, either one of which, if met, would cause a particular entity to be consolidated within the financial statements of the primary beneficiary.

The term includes “special purpose entities” but FASB decided that SPE was too narrow a term and these rules should apply to a broader group of entities.

Variable interest entities are subject to consolidation if, by design, either of the following conditions apply:

a. The total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties. That is, the equity investment at risk is not greater than the expected losses of the entity.

b. As a group the holders of the equity investment at risk lack any one of the following three characteristics of a controlling financial interest:

(1) The direct or indirect ability to make decisions about an entity’s activities through voting rights or similar rights.

(2) The obligation to absorb the expected losses of the entity if they occur.

The investor or investors do not have that obligation if they are directly or indirectly protected from the expected losses or are guaranteed a return by the entity itself or by other parties involved with the entity.

(3) The right to receive the expected residual returns of the entity if they occur.

The investors do not have that right if their return is capped by the entity’s governing documents or arrangements with other variable interest holders or with the entity. The equity investors as a group also are considered to lack characteristic (b)(1) if (i) the voting rights of some investors are not proportional to their obligations to absorb the expected losses of the entity, to receive the expected residual returns of the entity, or both and (ii) substantially all of the entity’s activities (for example, providing financing or buying assets) either involve or are conducted on behalf of an investor that has disproportionately few voting rights.

Determination of status

The initial determination of whether an entity is a variable interest entity is made on the date at which an enterprise becomes involved with the entity.

Involvement with an entity is defined to be ownership, contractual, or other pecuniary interests that may be determined to be variable interests.

Status as a variable interest entity is reconsidered only if one or more of the following occur:

a. The entity’s governing documents or the contractual arrangements among the parties involved change.

b. The equity investment or some part thereof is returned to the investors, and other parties become exposed to expected losses.

c. The entity undertakes additional activities or acquires additional assets that increase the entity’s expected losses.

NOT CLASSIFIED AS VIE:

The following are exceptions to the scope of FIN46:

1. Not-for-profit organizations unless they are used by business enterprises in an attempt to circumvent the provisions of this Interpretation.

2. Employee benefit plans subject to specific accounting requirements in existing FASB Statements

3. Registered investment companies are not required to consolidate a variable interest entity unless the variable interest entity is a registered investment company.

4. Separate accounts of life insurance enterprises as described in AICPA Auditing and Accounting Guide, Life and Health Insurance Entities.

5. 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.

6. 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.

DEFINITONS OF TERMS

By design. This phrase refers to entities that meet the conditions for treatment as a variable interest entity because of the way they are structured. For example, an enterprise under the control of its equity investors that originally was not a variable interest entity does not become one because of operating losses.

Entity refers to any legal structure used to conduct activities or to hold assets. Some examples of such structures are corporations, partnerships, limited liability companies, grantor trusts, and other trusts. Portions of entities or aggregations of assets within an entity shall not be treated as separate entities for purposes of applying this Interpretation unless the entire entity is a variable interest entity. Some examples are divisions, departments, branches, and pools of assets subject to liabilities that give the creditor no recourse to other assets of the entity. Majority-owned subsidiaries are entities separate from their parents that are subject to this Interpretation and may be variable interest entities.

Equity investments in an entity are interests that are required to be reported as equity in that entity’s financial statements.

Expected losses and expected residual returns refer to amounts derived from discounted expected cash flows using a credit-adjusted risk-free rate. Expected variability is the sum of the absolute values of the expected residual return and the expected loss. All three concepts are illustrated in Appendix A.

Primary beneficiary refers to an enterprise that consolidates a variable interest entity under the provisions of this Interpretation.

Subordinated financial support refers to variable interests that will absorb some or all of an entity’s expected losses if they occur.

Total equity investment at risk (for the purpose of applying FIN 46)

(1) Includes only equity investments in the entity that participate significantly in profits and losses even if those investments do not carry voting rights

(2) Does not include equity interests that the entity issued in exchange for subordinated interests in other variable interest entities

(3) Does not include amounts provided to the equity investor directly or indirectly by the entity or by other parties involved with the entity (for example, by fees, charitable contributions, or other payments), unless the provider is a parent, subsidiary, or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor

(4) Does not include amounts financed for the equity investor (for example, by loans or guarantees of loans) directly by the entity or by other parties involved with the entity, unless that party is a parent, subsidiary, or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor.

Variable interests in a variable interest entity are contractual, ownership, or other pecuniary interests in an entity that change with changes in the entity’s net asset value. Equity interests with or without voting rights are considered variable interests if the entity is a variable interest entity.

FIN 46, Paragraph 12 explains how to determine whether a variable interest in specified assets of an entity is a variable interest in the entity. Appendix B in FIN 46 describes various types of variable interests and explains in general how they affect the determination of the primary beneficiary of a variable interest entity.


Death Knell for Synthetic Leases?

From [http://www.globest.com/csuite.html] accessed 3/28/03

The silence punctuating the real estate community is the reaction to FASB finalizing its revision of rules impacting special purpose entities and synthetic leases. After a year of development and review, the final regulations, entitled FASB Interpretation #46, Consolidation of Variable Interest Entities Interpretation of ARB #51, are out, bringing to a close the saga of special purpose entities synthetic leases and the disaster created by the Enron scandal.

The regulators' intent was not aimed at restricting the use of SPEs (and by default, synthetic leases), but rather to clarify the reporting requirements surrounding their use. Major changes in the new regulations include:

* Changing the name "special purpose entity" to "variable purpose entity" (whew!);

* Requiring the consolidation (off-the-book treatment of synthetic leases to become on-the-book treatment) for those entities receiving a majority of their risk or benefits from variable purpose entities;

* Disclosure of any variable-purpose entities, even if the risk or benefit is not accrued to the holding company; and

* In the future, ownership participation, previously pegged at 3%, will be increased to 10%.

From a timing perspective, new entities created in 2003 will be subject to reporting requirements effective immediately. For existing entities, e.g., the majority of previously issued synthetic leases, companies have until June 15, 2003 to consolidate or report existing SPEs and by default, their existing synthetic leases.

So, what is the impact on existing synthetic leases--now and in the future? Companies with existing synthetic leases or other VPEs will need to consolidate; convert to another structure (most likely sale-leaseback); or disclose.

Many companies who utilized synthetic leases, e.g., high-tech companies bent on growth without balance sheet encumbrances, have already had to deal with these assets due to deteriorating business conditions. Many of the remaining companies with synthetic leases will simply consolidate, move them onto the balance sheet and be done with it. Company explanations will cite recent accounting-treatment revisions to lessen negative reactions. Other companies will convert to a sale-leaseback structure--a more costly alternative. Despite early predictions of severe negative impacts, in fact, the worst may be past. Disclosures have already been made by most companies with existing synthetic leases in the period since Enron erupted. As a result, there will probably be little impact from disclosures of consolidation in the future resulting from the new regulations.