Issues in accounting

The FASB to special-purpose entities: "come out, come out, wherever you are!" Put simply, the goal of FIN 46(R) is to make it harder for companies to hide problems or other questionable activities. Its provisions are important to bankers who lend funds to companies with variable-interest entities (the new version of special-purpose entities)

Although special-purpose entity and off-balance-sheet are not defined as "dark forces," Enron and others have inspired the Financial Accounting Standards Board to think of them that way. FIN 46(R) (1)--a FASB interpretation of when entities should consolidate certain other "associated" entities--now requires investors to consolidate all affiliated enterprises in which they have incurred "variable" interest relationships, which are those where net assets increase or decrease when certain conditions arise.

Unconsolidated special-purpose entities (SPEs) were formed to hold--off balance sheet--certain debt and equity financial instruments that do not relate directly to the parent's primary business functions. Enron's claim to infamy came in large measure from placing many potentially "losing" financial instruments in such SPEs, thereby improperly transferring losses from Enron to the SPEs and transferring gains from the SPEs to Enron.

Focusing on substance rather than form of a transaction, FIN 46(R) establishes the concept of variable-interest entities (VIEs), which absorb or pay net assets to the controlling (parent) entity. The FASB also clarified that when the investments in such VIEs are at risk, they are to be called "equity interests."

A Matter of Control

Entities can control subsidiaries without owning most of the outstanding shares by controlling the board of directors, managing or general partners, or principal products or services offered for sale. SPEs may help an airline buy a fleet of airplanes or a retail store acquire a credit card company. As long as such arrangements meet existing accounting guidelines, the sponsoring companies need not consolidate the assets and associated debt. Such off-balance-sheet arrangements include synthetic leases, joint venture research-and-development arrangements, investments in low-income housing projects, and even funds established to fund and service defined-benefit pension obligations. The problem is that since many companies using SPEs don't place the associated assets and related liabilities on their balance sheets, bankers, investors, and other users must carefully read footnote disclosures to identify these types of transactions. As it turns out, not many do that extra homework, as seen in the case of Enron, and the FASB had to revisit the matter.

So FIN 46(R) requires companies to consolidate existing unconsolidated VIEs with their primary beneficiaries if the entities do not effectively disperse risk among the investing parties. VIEs that effectively disperse risks needn't be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that used to be dispersed.

FIN 46(R) expands the definition of "control" for consolidation of financial statements to include consolidation based on variable interest or on voting power--in the latter case, sponsors provide financial support through other interests that will absorb some or all of the entity's expected gains or losses. Entities should use good judgment to adhere to this criterion, including evaluating the sufficiency of the equity investment at each reporting period. Focusing on the substance (rather than on the form) of such voting interests, FIN 46(R) also allows the VIE to finance its activities with an equity investment of less than 10% if it meets at least one of the following criteria:

* The entity has demonstrated that it can finance its activities without additional subordinated financial support.

* The entity has at least as much equity invested as other entities that hold only similar assets of similar quality in similar amounts and operate with no additional subordinated financial support.

* The amount of equity invested in the entity exceeds the estimate of the entity's expected losses, based on reasonable quantitative evidence.

Conversely, the 10% threshold does not automatically provide an adequate equity level to permit the entity to finance its activities without additional subordinated financial support. Thus, FIN 46(R) leaves room for flexibility in determining the equity investment needed to avoid consolidation of an entity by its variable-interest holder.

Exceptions

Exceptions to FIN 46(R) include:

1. Not-for-profit organizations, or business enterprises using them to circumvent the provisions of this interpretation.

2. Employee benefits plans subject to specific accounting requirements of FASB statements.

3. Registered investment companies, unless the VIE is a registered investment company.

4. Transferors to qualifying SPEs and "grandfathered" qualifying SPEs subject to the reporting requirements of SFAS No. 140, Accounting, for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.

Other Key Points

Entities should recognize goodwill on the initial consolidation of VIEs defined as a business by EITF No. 98-2, Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business. However, firms that wrote off goodwill using FIN 46's previous requirements cannot reinstate that goodwill.

Also, an entity should consolidate significant gains and losses of transactions that it recently transferred to its VIEs. For example, it cannot recognize a $100 unrealized appreciation gain on a transferred note receivable to a VIE with a $250 fair value and a $150 carrying value.

Disclosure Example

Many entities have already considered the effects of the new provisions. For example, the Community Bank & Trust Company of New Hampshire's September 30, 2004 Form 10-Q report to the SEC included the following statement:

In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), in an effort to expand upon and strengthen existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. In December 2003, the FASB revised Interpretation No. 46, also referred to as Interpretation 46 (R) ("FIN 46(R)"). The objective of this interpretation is not to restrict the use of variable interest entities but to improve financial reporting & companies involved with variable interest entities. Until now, one company generally has included another entity in its consolidated financial statements only if it controlled the entity through voting interests. This interpretation changes that, by requiring a variable interest entity to be consolidated by a company on& if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. The Company is required to apply FIN 46, as revised, to all entities subject to it no later than the end q[ the first fiscal year or interim period ending after March 15, 2004. However, prior to the required application of FIN 46, as revised, the Company shall apply FIN 46 or FIN 46(R) to those entities that are considered to be special-purpose entities as of the end of the first reporting period ending after December 15, 2003. The adoption of this interpretation did not have a material effect on the Company's consolidated financial statements.

Summary

The goal of FIN 46(R) is fuller disclosure. By expanding the number of entities that parent companies should include in their consolidated financial statements, FIN 46(R) requires those with "controlling" financial interests to include their associated VIEs' assets, liabilities, and results of the activities in their consolidated financial statements. Working with their CPAs under FIN 46(R), bankers can gain a more credible picture of their customers' financial statements.

(1.) FASB Interpretation No. 46 (Revised) [FIN 46 (R)], Consolidation of Variable Interest Entities interprets Accounting Research Bulletin (ARB) No. 51, Consolidated Financial Statements, relating to when entities should consolidate certain other "associated" entities. ARB 51 and other authoritative pronouncements allowed entities to not consolidate affiliated companies when they held less than 50% of their stock, even though these special purpose entities (SPEs) operated primarily for the investors' interests.

Alan Reinstein may be contacted by e-mail at a.reinstein@wayne.cdu.

Alan Reinstein, CPA, DBA, is the George R. Husband Professor of Accounting at Wayne State University. A frequent contributor to The RMA Journal, Reinstein is experienced in litigation support, business valuations, audit committees, and other professional issues.

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