Advanced Financial Accounting Chapter 6

Example of Variable Interests in VIEs

1. Participant Rights: entitles holder to residual profits. 2. Asset Purchase Options: Entitles holders to benefit from increase in asset FV. 3. Gaurantees of Debt: If a VIE cannot repay liabilities, honoring a debt gaurantee will produce a loss. 4. Subordinate Debt Instruments: If a VIE cash flow is insufficient to repay all senior debt, subordinate debt may be required to absorb the loss. 5. Lease Residual Value Gaurantees: If leased asset declines below the residual value, honoring the gaurantee will produce a loss. 6. Common Stock: Entities holder to residual profits, losses, and dividends.

Identification of a Primary Beneficiary

A primary beneficiary and will have both of the following characteristics: (1) The power to direct the activities of a VIE that most significantly impact the entity's economic performance. (2) The obligation to absorb losses that could potentially be significant to the VIE or the right to receive benefits from it that could be significant to the VIE.

Identification of a VIE

An entity qualifies as a VIE if either of the following conditions exist: 1. Inability to secure financing w/o additional subordinate financial support. 2. Equity investors in VIE, as a group, lack 1 of the following 3 characters of controlling financial interest: (1) The power, through voting rights or similar rights, to direct activities of the entity that most significantly impact the entity's economic perforance. (2) The obligation to absorb the expected losses of the entity. (3) The right to receive expected residual returns of the entity.

What is a Variable Interest Entity (VIE)?

Known as a Special Purpose Entity (SPEs) General purpose for creating VIEs: 1. Accomplish a well defined and limited business entity. 2. Provide low cost financing. Why are VIE eligible for low cost financing? 1. VIEs operate w/ a very limited set of assets: (a) By isolating an asset in a VIE, the asset risk is isolated from the overall risk of the business enterprise. (b) VIE creditors remain protected by the specific collateral in the asset. 2. Governing agreements limit activities and decision making: (a) Prevent the VIE from engaging in any activities not specified in the agreement. A VIE is an entity that an interestor has controlling interest in, but this controlling interest is not based on majority of voting rights. Fun Fact: VIEs are most common among financial insitution for use w/ their subprime mortgage-backed securities. They are utilized as special-purpose vehicles (SPVs) to let the firms avoid having to list the assets on their balances sheets. Corporations make use of a vehicle such as a VIE to provide an investment w/ financing w/o putting the entiritly of the firm in jepordy.

Primary Beneficiary

Primary Beneficiary: Party who has financial control of VIE: (1) Primarily benefits (or risks loss) from the economic activities of the VIE and has the power to direct the VIE's actvities. (2) Typically exercises its financial control through governance documents or contractual agreements. (3) May NOT own any of its voting stock. (4) Must consolidate in its financial statements the VIEs assets, liabilities, revenues, and noncontrolling interest.

Characteristics of VIEs

Similar to most business entities: (1) VIEs generally have assets, liabilities, and investors w/ equity interest. Unlike most businesses: (1) Role of the equity investors can be fairly minor as activities and decision making can be strictly limited. (a) Equity investors may serve simply to all the VIE to function as a legal entity (2) B/c they bare relatively low economic risk, investors may be provided only a small rate of return 1. Another party (e.g., the primary beneficiary) contributes substantial resources - loans and/or guarentees - to enable a VIE to secure additional financing: (a) Ex: Primary beneficiary may gaurantee the VIEs debt, assuming the risk of default. 2. Risk and reward are NOT distributed according to stock ownership but according to other variable interest. (a) Variable interest: Contractual, ownership, or other monetary interest in an entity that changes w/ changes in the entity's net asset value.