FASB's Rules on Consolidation of VIEs
By mid-January FASB expects to finalize strict new rules for what it now calls variable interest entities, the vehicles typically used to remove assets and debt from company balance sheets. (Read FASB's summary of the draft interpretation.) These entities are often created for a single purpose — for example, to facilitate securitization, leasing, hedging, research and development, or reinsurance.
(Editor's note: On January 16 FASB finalized Interpretation No. 46, Consolidation of Variable Interest Entities. You may download the full text of the interpretation by visiting FASB's web site.)
The proposal aims to ensure that unconsolidated VIEs are truly independent from their sponsoring companies (also called "primary beneficiaries" by FASB). A VIE would be subject to consolidation if either of two conditions were to exist.
The first condition is that "the total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support." Generally this investment requirement of outside third parties, currently 3 percent, has been raised to 10 percent, though a lesser investment can be demonstrated sufficient if it meets certain specified criteria.
The second condition is that the equity investors lack a "controlling financial interest." This lack would be established in any one of three ways: Either the investors could not make decisions regarding the entity through voting rights or some similar means, or the investors would not be obliged to absorb any expected losses of the entity, or they would not be entitled to any expected residual return.
Advocates of the rule maintain that FASB's intent is to require consolidation only if VIEs do not effectively disperse the risks among the parties involved. For that reason, "qualifying" entities that meet the criteria of FAS 140 won't be affected by the proposal, says Tom Glynn, an attorney with Wolf, Block, Schorr and Solis-Cohen.
Likewise, entities associated with more-traditional securitizations, such as those that use credit-card receivables, auto-lease receivables, or mortgages as collateral for asset-backed securities, will not be burdened by the rule change. (Read more about these traditional entities in our article "Reining in SPEs.")
Critics argue that the proposed interpretation will distort financial statements because it is too complex to apply consistently, and therefore will be a breeding ground for loopholes. They also cite accounting and economic consequences, including inappropriate consolidation of VIEs that do, in fact, disperse risk effectively; the elimination of synthetic leases; and impaired capital flow that will result in higher costs to lessees, customers, and borrowers.
The rule will apply immediately to VIEs created after the final interpretation is issued in January. Public companies will apply the rule to existing VIEs as of the beginning of the first reporting period (interim or annual) after June 15.
FASB's Interpretation on Loan Guarantees
Passed on November 25, 2002, this new interpretation, FIN No. 45, tightens disclosure rules for loan guarantees and requires companies to record certain liabilities before they are incurred.
The interpretation, which expands on the accounting guidance of FAS 5, 57, and 107, instructs companies to recognize loan-guarantee liabilities, at their market value, at the time the guarantee is issued. Previously, loan guarantees were kept off a company's balance sheet until the company was required to honor them. The value of the guarantees must be disclosed in interim and annual financial statements.
The new rule would apply to letters of standby credit and to manufacturer's recourse loans. It would not apply to guarantees issued by insurance companies, to guarantees accounted for as derivatives, to product warranties, or to lessees' residual value guarantees embedded in capital leases.
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