Impact of New "Risk-Based" Consolidation Rules on Privately Held Businesses

Beyond Numbers, Jun/Jul 2005 by Cummings, Gord

A new US "risk-based" consolidation model has been imported into Canadian practice. Accounting Guideline 15 "Consolidation of Variable Interest Entities" (AcG-15) is the accounting profession's response to the financial services industry's ingenuity and creativity in creating ever more complex financial structures. The new standard extends consolidation requirements beyond entities subject to voting control, making it possible for one entity to consolidate another without holding any voting shares. AcG-15 greatly expands the circumstances under which consolidation is required.

Remember Enron's use of "special purpose entities" (which are included within the concept of "variable interest entities") to remove depreciable assets and indebtedness from its consolidated financial statements? Enron was able, under the rules existing at that time, to avoid consolidating these net assets while remaining exposed, by contract, to some or all of the risks associated with them. Though the non-consolidation of its special purpose entities wasn't the singular cause of Enron's ultimate failure, there seems to be a consensus that Enron's consolidated financial statements did not reflect-fairly, and in all material respects-its financial position, results of operations, and/or cash flow.

Practitioners who don't have experience with structured financial arrangements will likely find AcG-15 a very difficult standard to read and understand. This is partly due to the fact that the language in the standard is vague and highly generalized; but, while easy to criticize, this aspect of the standard is necessary to ensure the adequacy of the standard's scope.

The following article is an attempt the give small and mid-size practitioners some practical guidance on the impact AcG-15 will have on privately held businesses. It is by no means a comprehensive analysis of the standard.

Understanding the impact of AcG-15

The best way to understand AcG-15's implications is to look at its impact on a couple of simple fact patterns:

Example #1

Consider a case where a husband runs a successful business owned by a corporation he controls (let's call it Opco"). Suppose that the husband's corporation loans a large sum of money-say $100,000-without security to a corporation ("Lossco") wholly owned by a corporation controlled by his wife ("Spouseco"). Lossco is doing poorly and needs financing. Spouseco's interest in Lossco is limited to $100 of share capital and a $20,000 loan, all of which has been lost in the normal course of business.

Using the traditional understanding of consolidation, Opco would not consolidate Lossco, as it holds no Lossco shares; Spouseco, holding 100% of Lossco's shares, would consolidate Lossco. However, under the new risk-based concept of consolidation, Opco must consolidate Lossco because Opco is the primary beneficiary of a variable interest entity. Understanding why this is so requires a careful review of the AcG-15 fundamentals.

Variable interest entities (VIEs)

What is an "interest"?

The term "interest" in the context of this standard includes loans, shares, and just about any other contractual relationship with another entity; however, this is merely a working definition given the virtually unlimited degree of complexity inherent in the standard.

For privately held enterprises, interests include the four most common relationships: common shares, redeemable preferred shares, loans, and loan guarantees.

What is a "variable" interest?

The concept of a variable interest is better understood when contrasted with that of a fixed interest. Though not defined in AcG-15, a fixed interest has a value ("fair value," which means how much you could sell it for) that does not change, irrespective of the activities of the borrower or investee1; for example, a loan secured by land would normally be viewed as a fixed interest.

Common sense would indicate that most interests are not fixed interests, as the value of most loans, shares, and other interests will vary over time.

Fixed interests are likely to be rare in the context of privately held businesses- limited to interests supported by substantial security, such as loans secured by land or meaningful guarantees, where the guarantor is unlikely to default. But even in these cases, the circumstances would have to be carefully considered on a case-by-case basis; for example, a loan secured by land could be a variable interest if the value of the land is insufficient to repay the loan.

What is a "variable interest entity"?

Variable interests are commonly encountered in the business world, whether by design or circumstance.

Variability alone does not trigger a requirement to consolidate. Consolidation becomes a possibility when one of the following three criteria (which turn a variable interest into an interest in a VIE), are met:

1) The entity has insufficient equity capital at risk to fund its operations without additional financing; or

2) The equity holders as a group do not possess one of three fundamental characteristics: a) control, b) the obligation to absorb expected losses, or c) the right to receive expected residual returns; or