What does it mean? making sense of variable interest entities.

• Author: Dauberman, Mark
• Position: Federalregulations

When FASB issued FIN 46(R), many assumed it applied only to large entities using special purpose entities to keep liabilities to keep liabilities off of their balance sheets. It turns out FIN 46(R) also applies to many situations involving closely held entities.

FIN 46(R) defines a variable interest entity (VIE) as "an entity subject to consolidation according to the provisions of this Interpretation." So, if consolidation is necessary, you have a VIE; if not, you don't. When determining whether an entity is a VIE, I will refer to it as a potential VIE (PVIE).

What's the Fuss?

Consolidation has commonly been limited to circumstances where an entity has a majority voting interest in another. FIN 46(R), however, describes relationships where an entity may have a controlling financial interest in another with little or no equity or voting interest.

[ILLUSTRATION OMITTED]

Assume that engineers have developed a program that a large software company (L) wants. The engineers form a small entity (S) with a small amount of equity and enter into a contract with L. To enable S to hire employees and pay for other business costs, the contract compensates S for its good faith efforts, regardless of whether the product can be delivered to specification. L has no equity in S, but has a seat on its board.

If everything goes as planned, S will develop the software, deliver it to L at a profit and pay its bills. If not, L may incur losses, just like lenders or other parties that contracted with S.

These entities hold variable interests in S, so as the value of its resources change, so do the resources or obligations of the others. Under these circumstances, S may be a VIE and L may have a controlling financial interest.

Now consider a small manufacturing company (M) that is leasing its facilities from R (for rental entity), an LLC. An individual is the sole equity holder in both M and R. A bank provided M and its owner nonrecourse financing to purchase the facilities. As you'll see, R may be a VIE and either M or the bank may have a controlling financial interest.

A reporting entity can apply FIN 46(R) by asking three questions:

1) Is the relationship exempt?

2) Does the PVIE have characteristics of a VIE?

3) Does the reporting entity have a controlling financial interest?

If the answer is yes to all three, the PVIE is a VIE and the reporting entity must prepare consolidated financial statements.

Exhibit A-Estimated Expected Cash Flows * Expected Residual Mean of net cash returns...