FSP FIN 46: what lenders should know about the FASB's new consolidation guidance

RMA Journal, The, April, 2004 by Gregory L. Prescott, Donald L. Moak

What's a VIE? Lenders and credit executives need to know its definition as well as the requirements of the FASB's Interpretation No. 46 concerning off-balance-sheet entities and the resulting implications the Interpretation might have on the financial statements of commercial borrowers.

The Financial Accounting Standards Board (FASB) issued Interpretation No. 46, Consolidation of Variable Interest Entities, in January 2003 and subsequently revised it in December 2003. The new guidance included in the Interpretation (FSP FIN 46) is specifically directed at the use of off-balance-sheet entities--often referred to as special-purpose entities--by some firms. While many believe the FASB acted in response to perceived abuses of SPEs by Enron and other companies, such off-balance-sheet entities are prevalent in a number of industries, such as real estate, utilities, energy, and financial institutions.

A Summary of FSP FIN 46

The FASB concluded that the accounting literature dealing with off-balance-sheet entities was fragmentary and incomplete. Historically, firms were required to include in their consolidated financial statements the accounts of entities in which they held a controlling financial interest. That requirement usually has been applied to entities in which a firm held a majority voting interest. However, the FASB noted that in many cases a firm's consolidated financial statements do not include the accounts of off-balance-sheet entities even though the relationship between the investor entity and the investee entity is strikingly similar to a controlling financial interest relationship. Hence, the FASB determined that the voting interest approach is not effective in identifying controlling financial interests in entities that are not controllable through voting interests or in which the equity investors in such entities do not bear the residual economic risks. FSP FIN 46 provides a model for use in situations where control is established through means other than voting interests. Specifically, the level of equity at risk in an entity determines whether a company has a controlling financial interest in that entity.

The interpretation essentially requires a two-step approach. First, a company must determine if an entity with which it is associated is considered a variable interest entity (VIE), as defined in FSP FIN 46. If so, the company must then determine if it is the primary beneficiary of that entity. Under the new rule, the primary beneficiary of a VIE is required to include in its consolidated financial statements the assets, liabilities, results of operations, and cash flows of the VIE.

Instead of using the term special-purpose entity, the FASB created a new term)--variable interest entity--so it could create its own definition. A VIE, then, is a corporation, partnership, trust, or any other legal structure used for business purposes that 1) does not have sufficient equity investment at risk to finance its activities; 2) has equity investors that lack one or more of the essential characteristics of a controlling financial interest; or 3) has equity investors with voting rights that are not proportionate to their economic interests. The activities of the entity involve, or are conducted on behalf of, an investor with a disproportionately small voting interest.

Once a Firm has determined that it has an interest in a VIE, it is necessary to determine if the firm is the primary beneficiary of the VIE. The primary beneficiary is the party that absorbs the majority of the VIE's expected losses or the party that receives the majority of the VIE's expected returns, or both. If one party absorbs the majority of the VIE's expected returns and another party absorbs the majority of its expected losses, the party absorbing the majority of the expected losses is the primary beneficiary.

In addition to including the accounts of the VIE in its consolidated financial statements, the primary beneficiary also must disclose the terms of its involvement with the VIE. Such disclosures include the carrying amount and classification of any assets that are collateral for the VIE's obligations as well as, if applicable, the lack of recourse of the VIE's creditors against the primary beneficiary. If a company has a significant interest in a VIE but is not its primary beneficiary, the company must disclose the essence of its relationship with the VIE; the nature, purpose, size, and activities of the VIE: and the company's maximum exposure to loss as a result of its involvement with the VIE.

Implications of FSP FIN 46 for Lenders & Credit Analysts

The requirements of FSP FIN 46 represent a significant departure from existing practice in accounting for off-balance-sheet entities. At a minimum, upon application of the Interpretation's provisions, the effect of adoption must be reported as the cumulative effect of an accounting change in the income statement for the period when first adopted. For most companies, this is likely to be a charge against earnings. However, it is important to understand that, as with other cumulative effect adjustments, it is a noncash charge. The provisions of the Interpretation also may be applied by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. Restatement is encouraged but not required. It is doubtful whether companies will go to the effort of restating prior years' financial statements. Instead, most are likely to take the cumulative-effect charge against earnings in the period of adoption.