defining issues DECEMBER 2003 N O. 03-28 Scope Exceptions 2 Sufficiency of Equity at Risk 2 Evaluating a Controlling Financial Interest 3 Reconsidering Whether an Entity is a VIE 3 Quantifying Economic Risks and Rewards 3 Who Should Consolidate 4 Reconsidering Whether to Consolidate 4 Variable Interests 5 Other Clarifications 5 Effective Date and Transition 5 2001, 2003 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. Simon Battensby/GettyImages 200009299-001 FASB Completes Revisions to VIE Accounting A revised version of Interpretation 46 on accounting for variable interest entities will be issued near December 31, 2003 with modifications that will affect many companies. The revisions clarify some requirements, ease some implementation problems, add new scope exceptions, make it more likely that potential variable interest entities will be identified and consolidated, and add some difficult judgments for those who must apply the Interpretation. 1 The revised Interpretation will also incorporate the requirements from several Staff Positions that companies are already required to apply. 2 (1) FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, January 2003. Proposed Interpretation, Consolidation of Variable Interest Entities: A Modification of FASB Interpretation 46, October 31, 2003. The final modified Interpretation (FIN 46R) will be available at the FASB s Web site, www.fasb.org. The source for this edition of Defining Issues is information on the FASB s Web site. (2) FIN 46R will codify the guidance from the following FASB Staff Positions: FIN 46-1, Applicability of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, to Entities Subject to the AICPA Audit and Accounting Guide, Health Care Organizations; FIN 46-3, Application of Paragraph 5 of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, When Variable Interests in Specified Assets of a Variable Interest Entity Are Not Considered Interests in the Entity under Paragraph 12 of Interpretation 46; FIN 46-4, Transition Requirements for Initial Application of FASB Interpretation No. 46, Consolidation of Variable Interest Entities; FIN 46-6, Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities; and FIN 46-7, Exclusion of Certain Decision Maker Fees from Paragraph 8(c) of FASB Interpretation No. 46, Consolidation of Variable Interest Entities. 1
Public companies other than small business issuers, as defined by SEC rules, must apply the new requirements by the end of the first reporting period beginning after December 15, 2003, but all public companies must at a minimum apply the unmodified provisions of the Interpretation to entities that were considered special-purpose entities in practice and under the FASB literature prior to the issuance of the Interpretation by the end of the first reporting period ending after December 15, 2003. 3 This edition of Defining Issues describes the significant changes to Interpretation 46, excluding the requirements already imposed by FASB Staff Positions. Companies are not required to apply the modified Interpretation to an entity that meets the criteria to be considered a business in EITF 98-3, provided that none of the following conditions are present: (a) the company was involved in forming the entity, 5 (b) substantially all of the entity s activities either involve or are conducted on behalf of the company, (c) the company provides more than half of the entity s equity, subordinated debt, and other subordinated financial support, such as guarantees, or (d) the entity s activities primarily relate to securitizations, other forms of asset-backed financings, or single-lessee leasing arrangements. SCOPE EXCEPTIONS Three new scope exceptions have been added. Entities created on or before December 31, 2003 are excluded from Interpretation 46 s requirements only if the reporting entity has made an exhaustive, but unsuccessful, effort to obtain the information necessary to perform the required evaluations. 4 Companies applying this provision must determine whether their efforts have been exhaustive without much guidance from the FASB about what conditions satisfy the notion of exhaustive efforts. Compliance with this provision is expected to come under scrutiny and will require significant supporting documentation. Affected companies will be required to disclose, among other items, the number of entities to which the Interpretation is not being applied because of insufficient information, the reason why the information is not available, and the nature and amount of intercompany transactions (such as sales) between the company and the entity. Companies are not required to consolidate governmental organizations or financing entities established by governmental organizations unless the financing entities are not governmental organizations and are used in an effort to circumvent the provisions of the Interpretation. Thus, for example, financial guarantors that wrap debt issuances by universities through state-sponsored financing conduits are not required to consolidate the conduit. SUFFICIENCY OF EQUITY AT RISK Revised requirements on how to evaluate whether an entity s equity at risk is sufficient slightly expand the Interpretation s reach. The equity investment in an entity is not considered sufficient (and the entity is a variable interest entity) under the modified Interpretation if the entity must obtain additional subordinated financial support in order to finance its activities, even if that additional support is provided by its own equity investors. (3) Including, among others: EITF Topic No. D-14, Transactions involving Special-Purpose Entities, and EITF Issues No. 90-15, Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions, No. 96-21, Implementation Issues in Accounting for Leasing Transactions involving Special-Purpose Entities, No. 97-1, Implementation Issues in Accounting for Lease Transactions, including Those involving Special-Purpose Entities, and No. 98-3, Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business. (4) The required information includes that necessary to determine whether the entity is a variable interest entity, to determine which party is required to consolidate the entity if it is a variable interest entity, or to account for the entity in consolidation. (5) If the entity being evaluated is a franchise or an operating joint venture controlled jointly by the company and at least one other independent party, it is not subject to condition (a). 2
Language in the modified Interpretation emphasizes that, given the subjectivity that may be inherent in quantifying the amount of equity needed by an entity to absorb the entity s economic risks, qualitative considerations have to be applied to determine whether an entity s equity investment at risk is sufficient. The new language elevates the importance of qualitative considerations in determining the sufficiency of an entity s equity at risk. EVALUATING A CONTROLLING FINANCIAL INTEREST members, for example, might hold all of the economic interests in an entity, but the officers or board members have voting equity interests and the company has only nonvoting equity interests. In such situations, all economic interests, not only the equity interests, in the entity held by the relatedparty group must be evaluated in determining whether the entity is a variable interest entity. For development-stage enterprises, both the sufficiency and the characteristics of the entity s equity have to be evaluated when determining whether they are variable interest entities. The Interpretation s reach is also expanded by the modifications to requirements on how to evaluate whether an entity s equity instruments lack the characteristics of a controlling financial interest. An entity is considered a variable interest entity if some of the characteristics that are specified as integral to a controlling financial interest are contained in instruments or contracts other than the equity investment at risk, even if the instruments or contracts are also held by the investors in the equity investment at risk. Characteristics that are integral to a controlling financial interest include (a) the ability to make decisions about the entity s activities through voting or similar rights, (b) the unlimited obligation to absorb the entity s economic risks, and (c) the uncapped right to realize the entity s economic rewards. Thus, for example, an entity with an asset manager that is an equity investor and that has contractual decision-making rights with respect to the entity s activities could be a variable interest entity if the asset manager s non-equity contractual decision-making rights are significant. If substantially all of an entity s activities are conducted on behalf of a group of related parties, any one of which has disproportionately few voting rights, the entity is a variable interest entity. 6 A company and its officers or board RECONSIDERING WHETHER AN ENTITY IS A VIE In contrast to the expansions above, the circumstances under which a company must reconsider whether an entity is a variable interest entity are narrowed. Modifications to the entity s governing documents or contractual arrangements have to be reconsidered to determine whether the entity is within the scope of the Interpretation only when the modifications change the characteristics or adequacy of the entity s equity at risk. In addition, entities can undertake additional activities or acquire additional assets without triggering a reconsideration requirement as long as those additional activities or assets were anticipated at the inception of the entity or the most recent reconsideration event. Troubled debt restructurings are explicitly excluded from the circumstances under which a company must reconsider whether an entity is a variable interest entity. 7 QUANTIFYING ECONOMIC RISKS AND REWARDS Two changes in Interpretation 46, one clarifying and another that is a major departure from previous guidance, pertain to the quantification and allocation of an entity s economic risks and rewards (i.e., its expected losses and expected residual returns). (6) This includes all related parties as described in paragraph 16 of the Interpretation except for parties that are considered related because of transferability restrictions on their economic interests. (7) Troubled debt restructurings are defined in paragraph 2 of FASB Statement No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings. 3
The clarified guidance regarding the calculation of an entity s economic risks and rewards (i.e., expected losses and expected residual returns) now says that the expected variability in an entity s net income or loss and in the fair value of its assets means the expected variability in the fair value of the entity s net assets (including variability resulting from the entity s operating results), exclusive of variable interests. 8 The previous bias toward consolidation by a decision maker or guarantor of substantially all of an entity s assets or liabilities has been removed. 9 Only the variability in fees to a decision maker or guarantor affects the consolidation outcome. Prior to this change, a decision maker or guarantor was likely to have been required to consolidate an entity as the recipient of a majority of its economic rewards unless another party absorbed a majority of the entity s economic risks. WHO SHOULD CONSOLIDATE The requirements governing how to evaluate which party must consolidate a variable interest entity will likely require companies to make difficult judgments. rewards, the party in the group that is most closely associated with the variable interest entity is required to consolidate the entity. Companies are required to consider all relevant facts and circumstances in order to determine which party is most closely associated with the entity, including (a) whether there is an agency relationship or a de facto agency relationship, (b) the relationship and significance of the entity s activities to the parties in the related-party group, (c) the parties exposure to the entity s economic risks, and (d) the design of the entity. Some changes allow companies to apply different methodologies to different entities to determine how to allocate the expected losses or expected residual returns of a variable interest entity for purposes of determining which variable interest holder should consolidate the entity. These changes will, for example, permit companies to determine which party should consolidate a variable interest entity by separately calculating expected cash flows for each variable interest rather than merely allocating the entity s expected losses to variable interests in order of most to least subordinate. The related-party provisions are relaxed. For purposes of aggregating related parties interests to determine whether a variable interest entity must be consolidated, a transferability restriction will not establish a related-party relationship if contractual approval rights held by one party do not effectively constrain the restricted party s ability to manage the economic risks or realize the economic rewards of its interests. Judgment will be required to determine whether a restriction on a party s right to sell, transfer, or encumber its interest in an entity creates such a constraint. If a group of related parties holds interests that convey a majority of a variable interest entity s economic risks and RECONSIDERING WHETHER TO CONSOLIDATE The circumstances that require reconsideration of whether a company must consolidate a variable interest entity are clarified. Parties not currently consolidating a variable interest entity that acquire additional variable interests in the entity must perform a reconsideration analysis regardless of the source of those additional interests. A party currently consolidating a variable interest entity must perform a reconsideration analysis if it disposes of some or all of its interests in the entity or if the entity issues additional interests to unrelated parties. Troubled debt restructurings are explicitly excluded from the circumstances under which a company must reconsider what party (if any) is the primary beneficiary. (8) For this purpose, net assets represent the entity s economic rights and obligations excluding variable interests, rather than its net assets under generally accepted accounting principles. The analysis is therefore based on economic, rather than accounting, considerations. (9) A decision maker s fee would not affect whether the entity is a variable interest entity or what party should consolidate the entity if (a) the fees to the decision maker are commensurate with the services provided (i.e., at market), (b) the fees are not subordinate to other operating liabilities of the entity, (c) the decision maker holds no other variable interests in the entity, and (d) the entity s other variable interest holders have substantive kick-out rights with which to remove the decision maker. 4
STAFF POSITION ON PARAGRAPH 5(B)(1) A recently issued Staff Position explains how to evaluate the requirement in paragraph 5(b)(1) of the Interpretation that an entity s equity investors have the ability to make decisions about the entity s activities through voting or similar rights.* According to the new Staff Position, if the entity s equity investors have the ability to make decisions that significantly affect the success of the entity and are obligated to absorb the entity s expected losses and entitled to receive its expected residual returns, the equity investors likely meet the requirement in paragraph 5(b)(1), even if other parties also have decision-making rights. An exhibit to the Staff Position illustrates how the evaluation under paragraph 5(b)(1) should be performed for a franchisee that does not meet the conditions to be eligible for the new scope exception for entities that meet the EITF 98-3 definition of a business. The effective date and transition provisions for the Staff Position are the same as for the modified Interpretation 46 for all arrangements to which Interpretation 46 has been or will be applied. If applying the Staff Position s guidance results in changes to previously reported information, the cumulative effect of the accounting change should be reported as of the beginning of the quarter that includes December 19, 2003. * FASB Staff Position No. FIN 46-8, Evaluating Whether as a Group the Holders of the Equity Investment at Risk Lack the Direct or Indirect Ability to Make Decisions about an Entity's Activities through Voting Rights or Similar Rights under FASB Interpretation No. 46, Consolidation of Variable Interest Entities, December 19, 2003. VARIABLE INTERESTS The guidance describing various types of economic interests and whether they represent variable interests has been replaced. According to the new guidance, whether an economic interest is a variable interest depends on whether the interest contributes variability to the entity or absorbs the entity s variability. If the interest contributes variability to the entity, it is not considered a variable interest, but if it absorbs the entity s variability, it is considered a variable interest. Arrangements such as service contracts and derivatives may be variable interests as a result of that principle. Such a determination can only be made based on an economic analysis of those contracts in relation to the entity. OTHER CLARIFICATIONS Most of the other clarifications pertain to the accounting procedures to be followed in consolidating a variable interest entity. Companies are required to recognize goodwill on initial consolidation of a variable interest entity that is a business as defined in EITF 98-3. This is similar to the accounting requirements for business combinations except that the assets, liabilities, and noncontrolling interests of the variable interest entity are measured at full, rather than allocated, fair value. However, companies that previously wrote-off goodwill at initial consolidation of a variable interest entity under Interpretation 46 s previous requirements are prohibited from reinstating that goodwill. This issue has been of particular concern to companies with equity-method investees. Language clarifies that a company that consolidates a variable interest entity must measure assets and liabilities that it has transferred to the variable interest entity shortly before, at, or after the date that the company first consolidated the entity at their carrying amounts prior to the transfer. For example, if a company transfers a note receivable with a $125 fair value and a $100 carrying amount to a variable interest entity and is simultaneously required to consolidate that entity, the company cannot recognize the $25 of unrealized appreciation as a gain. Language clarifies that the effects of intercompany eliminations on a consolidated variable interest entity s net income or expense should be attributed to the primary beneficiary in the consolidated financial statements. For example, a service provider that consolidates a variable 5
interest entity should recognize the amount of its fee (which is eliminated in consolidation) as its share of the entity s operating results. No portion of the fee should be attributed to other interests. EFFECTIVE DATE AND TRANSITION The effective dates vary depending on the type of reporting company and the type of entity that the company is involved with. Public companies must, at a minimum, apply the unmodified provisions of the Interpretation to entities that were considered special-purpose entities in practice and under the FASB literature prior to the issuance of the Interpretation by the end of the first reporting period ending after December 15, 2003. They may apply the original Interpretation or the revised version to special-purpose entities at the initial effective date on an entity-by-entity basis (i.e., a calendar-year-end company must apply the Interpretation to special-purpose entities no later than December 31, 2003, but may choose to apply the original Interpretation to some specialpurpose entities and the revised Interpretation to other special-purpose entities as of that date). Public companies other than small business issuers must apply the revised Interpretation by the end of the first reporting period beginning after December 15, 2003 (i.e., as of March 31, 2004, for calendar-year-end companies) to all entities that are not special-purpose entities. Non-public companies must apply the revised Interpretation immediately to all entities created after December 31, 2003, and to all other entities no later than the beginning of the first reporting period beginning after December 15, 2004 (i.e., as of January 1, 2005, for a calendar-year-end company). This is a publication of KPMG s Department of Professional Practice Audit (212) 909-5600 Contributing authors: Kimber K. Bascom David C. Britt E. Michael Pierce Copies are available at: www.kpmg.com and www.aro.kpmg.com 20306NYGR Early adoption is permitted for all companies. Companies must reflect the effect of adopting the modified Interpretation either as a cumulative effect of an accounting change or as a restatement of previously issued financial statements. Given the tight timeframe for understanding and applying the new requirements, companies will need to work closely with their accountants and other advisors to meet the implementation deadlines. Companies should not treat the descriptive statements above about the proposed guidance in revised Interpretation 46 as if it is applicable to their specific circumstances. They should consult the relevant FASB Staff Positions, the revised Interpretation, and their accounting and legal advisors. Defining Issues is a proprietary trademark of KPMG LLP. 2001, 2003 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. 6