47. Variable Interest Entities (VIEs)

Example VIE Fact Pattern

- VIEco established to construct and lease buildings to house Pamco's headquarters - Pamco then leases buildings from VIEco - Pamco thus enjoys the use of the building without carrying the asset or debt - VIEco carries building as asset and uses lease payments from Pamco to pay off its debts to 3rd party bank - VIEco has no employees, all of its actions are predetermined (take cash from Pamco, pay Bankco) Primary beneficiary of VIEco is Pamco 1. Power criterion (Pamco is actual leasor) 2. Losses/benefits criterion: Pamco has obligation to absorb losses from or right to receive benefits of VIEco.

MC Questions

- When sub is in bankruptcy, it won't be reported as consolidated because bankruptcy courts own it (parents have no control) - ONLY acquisition form of business combination needs consolidated financial statements (merger and consolidation only needs one set of statements since there will be only one firm left over after the action)

Voting and VIE (Variable Interest Entity) model for consolidation

1. Is the entity a VIE? - If yes, is the investor the primary beneficiary? If investor is primary beneficiary of VIE, VIE must be consolidated 2. If investor is not primary beneficiary of VIE, does the investor have more than 50% voting ownership? - If yes, consolidate If no, do not consolidate; report as investment

Consolidation of VIE

Primary beneficiary of a VIE is the one who will consolidate it Two conditions to be primary beneficiary: 1. Power criterion: Power to direct the activities of VIE that significantly impact the VIE's economic performance 2. Losses / benefits (risk/reward) criterion: Has obligation to absorb losses from or the right to receive benefits of the VIE.

VIE Characteristics

Legal Characteristics: 1. Can be partnership, joint venture, legal trust, or corporation (corp not common) 2. Set up for a well-defined, limited purpose 3. Sponsor or sponsors provide most of its resources 4. Activities are governed largely by contract or agreement and the control lies with the sponsors, not the shareholders 5. Risks and rewards largely attributable to sponsors 6. Value of sponsor interest increases / decreases with changes in net asset value of VIE

Variable Interest Entity (VIE) Defined

Legal entity which by design: 1. Cannot finance its activities without additional subordinated financial support 2. Expected losses exceed its total equity investment at risk 3. Its equity holders, as a group, do not have the direct or indirect ability to make decisions about the VIE's activities (activities are normally pre-planned) 4. Shareholders do not control the entity