Accounting for Variable Interest Entities

Variable interest entities (VIEs) came into the spotlight after the downfall of Enron. Before the Enron scandal, these special purpose entities were not reflected in the reporting entity’s financials because the reporting entity did not own a majority of the voting interests.  Enron used these VIEs to hide impaired assets and related debt. In addition, Enron booked revenue from selling assets to these VIEs. By keeping these VIEs off the books, they materially inflated their earnings. 

Under the current consolidation model, reporting entities are required to consolidate variable interest entities if they are considered the primary beneficiary. There are many steps to consider when determining if you need to consolidate a VIE. The more complex the legal entity structure, the more complex the accounting may be. 

What is a variable interest entity?

A variable interest entity is a legal entity in which an investor holds a controlling interest, despite not having a majority of voting shares. A VIE has the following characteristics:

• The entity’s equity is not sufficient to support its operations
• The equity holders as a group lack the power to direct the activities that most significantly impact the entity’s economic performance
• The equity holders as a group are shielded from the gains and losses normally associated with ownership
• The equity holders as a group possess non-substantive voting rights

Variable interest entities are often established as special purpose vehicles (SPVs) to passively hold securitized assets or debt or to actively conduct research and development.  

Why does it matter?

If a reporting entity is required to consolidate a variable interest entity, it must take the following steps: 

• Consolidate the entity’s assets, liabilities, income, and expenses 
• Attribute net income or loss and other comprehensive income or loss to any noncontrolling interests 
• Eliminate intra-entity transactions 
• Translate the currency of the subsidiary financial statements 
• Recognize deferred taxes on outside basis differences 

This results in incremental time and cost to consolidate additional entities and incremental required disclosures. By reflecting VIEs on your balance sheet, the reporting entity would also have a bigger asset base that is subject to impairment testing.

The VIE consolidation model

There are two primary consolidation models under US GAAP: (1) the Variable Interest Model and (2) the Voting Model.  Consolidation evaluations always begin with the Variable Interest Model to determine whether an entity should be evaluated for consolidation based on variable interests or voting interests. If the entity is a VIE, consolidation is based on the entity’s variable interests and not its outstanding voting shares.  If the entity is not a VIE, the consolidation guidance for voting interest entities should be applied.

The Variable Interest Model can be broken down into the following 5 steps. The party that has a controlling financial interest, called the primary beneficiary, will consolidate the VIE. 

1. Is the entity considered a legal entity?

The first step in the VIE consolidation model is to determine whether the entity is a legal entity. The VIE model only applies to legal entities. A legal entity is defined as any legal structure that is used to conduct activities or to hold assets. Examples of such structures include corporations, partnerships, limited-liability companies, trusts, research and development ventures, and majority owned subsidiaries. The form of the legal entity does not matter; however, to be a legal entity, it must have its own separate identity. If it is determined that the entity is not a legal entity, the consolidation analysis under ASC 810 stops and other guidance must be considered.

2. Does a scope exception apply?

The next step in the VIE consolidation model is to determine whether the entity meets any scope exceptions to not have to apply VIE accounting.

The following four types of entities are general scope exceptions to the consolidation guidance in ASC 810: 

• employee benefit plans, 
• governmental organizations, 
• certain investment companies, 
• and money market funds 

In addition to the general scope exceptions above, the following are additional scope exceptions specific to the VIE consolidation model:

• Not-for-profit organizations 
• Separate accounts of life insurance reporting entities 
• A reporting entity is not required to apply the provisions of the Variable Interest Model to entities created before 31 December 2003 
• Business scope exception- A reporting entity does not to have to apply the provisions of the VIM to an entity that is deemed to be a “business” (as defined by ASC 805, Business Combination) unless certain conditions exist
• Private company accounting alternative — A private company is not required to evaluate lessors in certain common control leasing arrangements under the provisions of the variable interest model if certain criteria are met

3. Does the reporting entity have a variable interest in the legal entity?

Once it has been determined that a scope exception does not apply, the next step in the variable interest model is to determine if the reporting entity has a variable interest in the entity. If a reporting entity does not have a variable interest in the entity, the entity is not subject to consolidation under ASC 810 and the reporting entity should account for its interest in accordance with other US GAAP.

A variable interest is an interest through which a party involved with a legal entity is subject to the entity’s variability. Specifically, a variable interest absorbs some of the entity’s expected losses, expected residual returns or both. 

Identifying variable interests generally requires a qualitative assessment that focuses on the purpose and design of an entity. In assessing the purpose and design of the entity, a reporting entity should analyze the entity’s activities, including which parties participated significantly in the design or redesign of the entity, the terms of the contracts the entity entered, and the nature of interests issued. The entity’s governing documents, formation documents, marketing materials and other contractual arrangements should also be reviewed as part of the analysis to determine the risks the entity was designed to create and distribute. Risks that cause variability include credit risk, interest rate risk, foreign currency exchange risk, commodity price risk, equity price risk and operations risk. 

Examples of common arrangements that may be variable interests include equity interests, debt instruments, guarantees, management contracts, service contracts, franchise arrangements, leases, derivatives, technology license arrangements, and collaborative R&D arrangements.

4. Is the legal entity a variable interest entity?

Once it is determined the reporting entity has a variable interest in the entity, the next step is to determine if the legal entity meets the criteria to be a variable interest entity. An entity is a VIE if it has any of the following characteristics: 

• The entity does not have enough equity to finance its activities without additional subordinated financial support (thinly capitalized). Only equity that is at risk is included in the evaluation of whether an entity’s equity is sufficient to finance its operations.
• The equity holders, as a group, lack the characteristics of a controlling financial interest, which include the power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance, the obligation to absorb an entity’s expected losses and the right to receive an entity’s expected residual returns

• The entity was set up with non-substantive voting rights (i.e., an anti-abuse clause). This occurs when the voting rights of certain investors are not proportional to their obligations to absorb the expected losses or their right to receive the expected residual returns and substantially all the entity’s activities involve or are conducted on behalf of an investor that has disproportionately few voting rights.

The initial determination is made on the date on which a reporting entity becomes involved with the entity, which is generally when a reporting entity obtains a variable interest in the entity. If the entity is not a VIE, the entity then evaluates whether it consolidates the entity under the Voting Model.

The Variable Interest Model requires a reporting entity to reevaluate whether an entity is a VIE upon the occurrence of certain significant events, and not at each reporting date. A significant event is when it changes the design of the entity and calls into question whether (1) the entity’s equity investment at risk is sufficient or (2) the holders of the entity’s equity investment at risk, as a group, have the characteristics of a controlling financial interest. Common reconsideration events include additional contributions by existing equity investors, issuances of additional equity interests, revisions to equity holders’ voting rights, entry into a significant new line of business that increases the entity’s expected losses, lapse of certain rights such as participating or substantive kick-out rights, debt refinancing, and retirement of debt at other than its contractual maturity date. 

5. Who is the primary beneficiary?

The final step in the VIE model is to determine who the primary beneficiary is. A VIE’s primary beneficiary is the party that consolidates the VIE. The primary beneficiary is the variable interest holder that has a controlling financial interest in the VIE. 

To be the primary beneficiary of a VIE, the party must meet both criteria below:

• Power Criterion: Power to direct activities of the VIE that most significantly impact the VIE’s economic performance.
• Losses/Benefits Criterion: Obligation to absorb losses from or the right to receive benefits of the VIE that could potentially be significant to the VIE.

In assessing both the power and the losses/benefits criteria, the VIE’s purpose and design, including the risks the entity was designed to create and pass through to its variable interest holders, should be considered.

To apply the power criterion, a reporting entity should identify the activities that most significantly impact a VIE’s economic performance, determine how decisions are made about those significant activities, and then identify the party that makes the decisions about the significant activities. In determining who makes the decisions, an evaluation of kick-out, participating, and protective rights is required.

Only one party should be identified as the primary beneficiary of a VIE. Although more than one parties could meet the losses/benefits criterion, only one party will have the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance.

A reporting entity should also consider the variable interests of any related parties, including de facto agents. The Variable Interest Model has specific provisions around related parties which require further consideration. If a reporting entity concludes that neither it nor one of its related parties individually meets the criteria to be the primary beneficiary, the reporting entity then evaluates whether as a group, the reporting entity and its related parties have those characteristics. When a related party group has power and benefits, further analysis is required to determine if one party within the group is the primary beneficiary. For purposes of the Variable Interest Model, the term “related parties” includes parties identified in ASC 850 and certain other parties that are acting as de facto agents of the variable interest holder. 

Power can also be shared by a group of unrelated parties. If a reporting entity determines there is shared power and no one party has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, there is no primary beneficiary. Power is shared if each of the unrelated parties is required to consent to the decisions relating to the activities that significantly impact the VIE’s economic performance. The legal entity governance documents should be evaluated to determine if the consent provisions are substantive.

The VIE model requires an ongoing reconsideration of the primary beneficiary. A change in the primary beneficiary might result from a transfer of power from one reporting entity to another. Some common examples of when this might occur include:

• the expiration of kick-out rights or participating rights,
• the realization of a contingent event that causes kick-out rights or participating rights to become exercisable, and
• an acquisition of interests or contractual arrangements that allow a party to exercise power over the entity.