Variable Interest Entities

An entity subject to FIN 46 is called a VIE. A VIE often holds financial assets (e.g., loans or receivables), real estate or other property. It may be passive or it may engage in activities such as research and development on behalf of another company. FIN 46 defines a VIE as a corporation, partnership, trust, or any other legal structure used for business purposes whose equity, by design, has any of the following characteristics:

• The total equity at risk is not sufficient to finance the entity’s activities without additional subordinated financial support (i.e., its equity at risk is less than or equal to the expected losses¹);
• The equity investors do not have the direct or indirect ability to make decisions about the entity’s activities through voting or similar rights;
• The voting rights of equity investors are not proportional to their expected losses or residual returns and substantially all of the entity’s activities are on behalf of an investor that has disproportionately few voting rights;
• The equity investors do not have the obligation to absorb the expected losses of the entity (e.g., the equity investors are protected from bearing their share of the entity’s potential losses through a guaranteed return); or
• The equity investors do not have the right to receive the expected residual returns (e.g., their return is capped).

Equity investments at risk are interests that should be reported as equity in the issuer’s (VIE’s) financial statements. These equity investments:

• include only investments that participate significantly in profits and losses, even if those investments do not carry voting rights;
• exclude equity interests that the entity issued in exchange for subordinated interests in other VIEs;
• exclude amounts provided to the equity investor (e.g., by fees, charitable contributions, or other payments) by others involved in the VIE, unless the provider is included in the same set of consolidated financial statements as the investor; and
• exclude amounts financed for the equity investor (e.g., by loans or guarantees of loans) by others involved in the VIE, unless the financing party is included in the same set of consolidated financial statements as the investor.

If an entity has equity capital of less than 10% of its total assets, the capital generally is considered insufficient to allow the entity to finance its activities without additional subordinated financial support.² This presumption can be overcome, however, if (1) the VIE has demonstrated that it can finance its activities without additional subordinated financial support; (2) the VIE has at least as much equity capital as similar entities that operate without additional subordinated support; or (3) the amount of equity invested in the VIE exceeds the estimate of the entity’s expected losses based on quantitative evidence. Although equity capital of less than 10% is presumed to be insufficient, equity capital of 10% or more is not presumed to be sufficient. An enterprise should consider whether the entity with which it is involved needs an equity investment greater than 10% of its assets to finance its activities without subordinated financial support, particularly if the entity is involved with risky activities (see Example 1).

Example 1 Is It A VIE? An entity that lease assets to a single lessee may be a VIE that the lessee should consolidate. One common situation is a private company that leases real estate from a partnership owned by the company's controlling family. Whether the lessor partnership is a VIE depends on the amount of its equity investment and the rights and obligations of its equity investors. Generally, in our experience, the partners have the same rights and obligations as the controlling equity interests in other entities, so the amount of the equity investment becomes the key determinant. If the lessor's equity is less than the normal down payment requirements specified in paragraph 54 of Statement 66, the lessor partnership is presumed to be a VIE. The presumption could be overcome if the lessee could show that the lessor partnership has equity comparable to similar lessors or that the partnership has demonstrated that it can finance its activities without additional subordinated financial support. If the lessor partnership is a VIE and the lessee is providing subordinated financial support through residual value guarantees, debt guarantees, or both, the lessee should evaluate whether it bears a majority of the expected losses of the lessor. If so, the lessee would be the primary beneficiary and would consolidate the lessor partnership. If the lessor's equity equals or exceeds the normal down payment requirements specified in paragraph 54 of Statement 66, the lessee should assess the adequacy of the lessor's equity based on the criteria in paragraph 9 of Interpretation 46. The down payment requirements in paragraph 54 do not create a "safe harbor" or relieve the lessee of the responsibility of assessing the adequacy of the lessor's equity. If the lessee concludes that the lessor has adequate equity and is not a VIE, the lessee would not consolidate the lessor partnership. (Because of the common control of the lessor and lessee and the magnitude of the transactions between them, it might be desirable to prepare combined financial statements, but the lessee would not consolidate the lessor.) Another example would be a lessor entity that leases property to a lessee under a “synthetic lease.” A synthetic lease is a lease in which the lessee guarantees the residual value of the leased property and also holds an option to buy the leased property at the end of the lease term. Typically the lessor under a synthetic lease has nominal equity and receives the bulk of its funding from nonrecourse debt, that is, debt that has a claim only on the lease payments and the leased property. Because of the nominal equity and the additional subordinated financial support from the residual value guarantee, the lessor typically would be a VIE. The lessee’s residual guarantee and purchase option would be variable interests that typically would give the lessee a majority of the expected losses and expected residual returns of the lessor, making the lessee the primary beneficiary.

An enterprise should determine whether an entity is a VIE on the date the enterprise first becomes involved with the entity (i.e., when ownership, contractual or other financial relationships begin) unless it is apparent that the enterprise’s interest would not be a significant variable interest and the enterprise was not involved in forming the entity.³ The determination should be based on the circumstances on that date including future transactions that are required by existing governing documents or existing contractual arrangements. (For example, the equity capital of an entity may be sufficient at the moment of formation, but the entity is contractually committed to incur debt and purchase specified assets. If the equity capital will be insufficient after the committed borrowing and investment, the entity is a VIE.) An entity that previously was not subject to FIN 46 does not become subject to it simply because losses reduce the equity investment. The enterprise need not reconsider the initial determination unless one or more of the following triggering events occur: (1) the entity’s governing documents or the contractual arrangements among the parties change; (2) any part or all of the equity investment is returned⁴ and other parties become exposed to expected losses; (3) the entity undertakes additional activities or acquires additional assets that increase the entity’s expected losses. Thus, the enterprise need not reconsider the VIE status if the enterprise acquires equity or other variable interests from other investors or there is a decrease in the entity’s assets or activities. As discussed later, however, if the entity is a VIE, an enterprise that is not a primary beneficiary may become a primary beneficiary through its acquisitions of additional interests.

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¹ The definition and computation of expected losses are explained later in this Financial Reporting newsletter.
² Previous accounting guidance required a minimum independent equity at risk of 3% of total assets.
³ The FASB did not provide guidance to determine whether a variable interest is significant.
⁴ Distributions in excess of cumulative undistributed earnings measured in accordance with GAAP represent a return of equity investment.