C'est La VIE: FIN 46.

• Author: Stone, Charles A.
• Position: Letter from the Editors - Variable interest entities - Editorial

Financial Interpretation 46 (FIN 46) and its subsequent revision in January of 2003 (FIN 46 R) has changed the rules for the consolidation of variable interest entities (VIEs). An asset-backed commercial paper conduit is a VIE and thus affected by this accounting interpretation. A Qualifying Special Purpose Entity (QSPE) as defined by FAS 140 is exempt from the FIN 46 and need not be consolidated with another entity even though it satisfies the definition of a VIE. Securitization vehicles that art not QSPEs are constrained by Fin 46 R.

Sponsors of asset-backed commercial paper conduits art usually suppliers of credit enhancement and liquidity support to the conduits. Financial institutions that do not sponsor commercial paper conduits also supply credit and liquidity support to commercial paper conduits.

General Electric Capital Corporation sponsors several commercial paper conduits and supplies financial support to these conduits. At year end 2002 GE Capital had approximately $16.9 billion in credit support outstanding to securitization vehicles and $10.3 billion in liquidity support that can be drawn within the year. By placing itself in the position of being the primary financier of the credit risk embedded in the pool of assets funded by the asset-backed commercial paper program in terms of value the sponsor takes the position of being the primary risk bearer and thus the "primary beneficiary".

"The primary beneficiary of a variable interest entity is the party that absorbs a majority of the entity's expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests, which are the ownership, contractual, or other pecuniary interests in an entity that change with changes in the fair value of the entity's net assets excluding variable interests." (FIN 46 R)

Even if each seller of assets to the program must fund the first 10% of credit losses the dispersion of risk across the individual sellers disqualifies any one seller from being designed as the primary beneficiary because no one seller funds a majority of the conduit's expected losses or captures a majority of the residual gains on the program's assets. According to Fin 46 the primary beneficiary of a Variable Interest Entity must consolidate the VIE's assets with its own.

Let's assume that twenty sellers finance assets through an asset-backed commercial paper program. Each seller funds $10 million of assets through the program at all times and each seller is required to finance the first 10% of losses on the outstanding asset pool ($1 million in out case or $10 million x 10%). A credit guarantee for 5% of the value of the assets financed by the program is issued by the bank which sponsors the asset backed commercial paper program. While each seller is in the first loss position financing a multiple of expected losses on the specific pool of assets it finances through the program, the total risk funded by the sponsor is $10 million (5% of S200 million) which is 10 times as large as any single seller's exposure. In our example the asset-backed commercial paper program is a variable interest entity (VIE) and the $10 million financial guarantee issued by the sponsor to fund losses is a "variable interest". We will refer to this hypothetical example as "example 1".

Financial Interpretation 46 (FIN 46) released by the Financial Accounting Standards Board in January of 2003 and revised in December of 2003 interprets Accounting Research Bulletin 51 (ARB 51), Consolidated Financial Statements, for its application to the consolidation of variable interest entities by business enterprises. While ARB 51 requires a business enterprise to consolidate subsidiaries in which it has a controlling interest, Fin 46 requires the primary beneficiary of a VIE to consolidate it. In ARB 51 controlling interests are measured in terms of voting rights while FIN 46 focuses on the rights to receive residual value and the obligation to fund expected losses.

FIN 46 defines a financial entity as a variable interest entity if it has equity that is insufficient to permit the entity...