F10: Variable Interest Entities

4 things to consider - normal equity characteristics of owners

1. owners put in the money 2. owners get the profits 3. owners have to absorb the losses 4. owners have to make the decisions

examples of variable interests include:

1. explicit investments at risk 2. explicit guarantees of debt, the values of assets, or residual values of leased assets 3. implicit guarantees with related party involvement 4. most liabilities, excluding short-term trade payables 5. most forward contracts to sell assets owned by the entity 6. options to acquire leased assets at the end of the lease terms at specified prices -"explicit" means in writing and legally enforceable

3 steps

1. identifying a variable interest in a business entity - do we have a variable interest? 2. business entity is a VIE - are they a variable interest? do they lack some characteristics of normal equity owners? 3. primary beneficiary consolidates - are we the primary beneficiary? whoever is the primary beneficiary consolidates

primary beneficiary consolidates

are we the primary beneficiary? STEP 3 -once a company has established that has a variable interest in a business entity that is a VIE, the primary beneficiary must be determined -the primary beneficiary must consolidate the VIE -the company is the primary beneficiary if it has the power to direct the activities of a VIE that most significantly impact the entity's economic performance and the company: 1. absorbs the expected VIE LOSSES 2. receives the expected VIE residual returns/PROFITS

US GAAP VS IFRS

IFRS focuses on accounting for special purposes entities -a sponsoring company controls and must consolidate an SPE when the company: 1. is benefited by the SPE's activities 2. has decision-making powers that allow it to benefit from the SPE 3. absorbs the risks and rewards of the SPE 4. has a residual interest in the SPE

business entity is a VIE - 5 points that make it a VIE / 3 sub points

-that company's equity/characteristics are strange - STEP 2 1. insufficient level of equity investment at risk -didn't put in enough money -it cannot operate on its own without additional subordinated financial support in the form of variable interests 2. inability to make decisions or direct activities---somebody else makes the decisions 3. no obligation to absorb entity's expected losses 4. no right to receive expected residual returns or profits 5. disproportional voting rights**** i. substantially all of the activities of the entity are conducted on behalf of an equity investor or substantially all of the activities are involving an equity investor ii. the voting rights of that equity investor are small in comparison with the focus of the entity on that investor iii. the voting rights of one or more of the equity investors, including that equity investor, are out of line with the investor's obligation to absorb expected losses, the investor's right to receive expected residual returns, or both

identifying a variable interest in a business entity - 2 main things

-we have a financial stake in another company - STEP 1 COMPANY AND BUSINESS ENTITY HAVE AN ARRANGEMENT a VIE may exist when a company has any 1 of 4 arrangements with a business entity: 1. the company or a related party significantly participated in the business entity's design 2. substantially all of the business entity's activities, by its design, involve or are conducted on behalf of the company 3. more than half of the total of the equity, subordinated debt, and other forms of financial support, is provided by the company 4. securitizations or other forms of asset-backed financing agreements or single-lessee leasing arrangements are the primary activities of the entity -------------------------------------------------------------------------------- BUSINESS ENTITY IS A LEGAL ENTITY -NOT a person -legal entities include corporations, partnerships, LLCs, trusts, and majority-owned subsidiaries

VIE

=we have a financial stake in another company -that company's equity/characteristics are strange -a corporation, partnership, trust, LLC, or other legal structure used for business purposes that either does not have equity investors with voting rights or lacks the sufficient financial resources to support its activities

Primary Beneficiary

=we have power over them and get P/L -the entity that is required to consolidate the VIE -the primary beneficiary is the entity that has the power to direct activities of a VIE that most significantly impact the entity's economic performance 1. absorbs the expected VIE LOSSES 2. receives the expected VIE residual returns, PROFITS -has to consolidate regardless of ownership %!

Private Company Accounting Alternative

US GAAP -a private company(an entity that is not a public entity or NFP entity) may elect to apply the following accounting alternative for consolidation of a VIE for **common control lease** -this accounting alternative permits a private company lessee to ***NOT consolidate*** a lessor entity that would otherwise be consolidated under existing VIE guidance if the following four criteria are met 1. the lessee(the reporting entity) and the lessor are under common control 2. the lessee has a leasing arrangement with the lessor 3. substantially all activities between the lessee and lessor are related to leasing activities 4. if the lessee explicitly guarantees or collateralizes any obligation of the lessor, then the principal amount of the obligation at inception of such guarantee or collateral arrangement does not exceed the value of the asset leased by the private company from the lessor