Variable Interest Entities FIN 46 (Revised Dec. 2003) Complexity of issues is confirmed by the issuance of several FSPs including FASB Staff Position No. FIN 46(R)-6, “Determining the Variability to Be Considered In Applying FASB Interpretation No. 46(R)” which has some really helpful examples Latest: FSP FIN 46(R)-7—Application of FASB Interpretation No. 46(R) to Investment Companies (May 11, 2007)

Variable Interest Entities (VIEs): Defined VIE: A less than majority-owned entity that is subject to consolidation under the provisions of FASB Interpretation 46R. If certain conditions exist, the entity must be consolidated. An entity that has a variable interest in a VIE—an interest that changes with changes in the VIE’s net assets—must determine if it must consolidate the VIE.

Variable Interest Entities (VIEs): “Variable Interest Relationships” Variable Interest Relationships: Situations in which an entity: Receives benefits and/or is exposed to risks similar to those received from having a majority ownership interest. Result from contractual arrangements. Appendix B has illustrations of various types of variable interests

Variable Interest Entities (VIEs): “Contractual Arrangements” Contractual Arrangement Types: Options (e.g., written put options) Leases (with guarantee of value, etc) Guarantees of asset recovery values Guarantees of debt repayment Contractual arrangements may exist simultaneously with a less than majority ownership in a VIE. May exclude a “business” (Appendix C for definition somewhat different from that in EITF 98-3)

Variable Interest Entities (VIEs): Most are “SPEs” Special Purpose Entities: Legally structured entities to serve a specific, predetermined, limited purpose. May be a corporation, partnership, trust, or some other legal entity. Creator is called the “sponsor.” Usually thinly capitalized. Most commonly used for securitizations (of receivables).

Variable Interest Entities (VIEs): “SPEs” Special Purpose Entities: Not subject to consolidation provisions of FIN 46 if sales recognition criteria of FAS 140 is met for transfer of assets to SPE. If met, SPE is called a “Qualifying SPE.” (If not met, the proceeds from the transfer are treated as a loan.) FAS 140 prohibits transferors from consolidating QSPEs (because risk exposure is considered insignificant).

QSPE = a trust of another legal vehicle that Is demonstrably distinct from transferor Has restrictions on its permitted activities Has restrictions on assets and derivatives it may hold Has restrictions on the way it can sell or dispose of non-cash financial assets Has restrictions on agreements entered into between it and the transferor Has restrictions on the ability to reissue beneficial interests

Variable Interest Entities (VIEs): Potential Variable Interests Potential Variable Interests: Subordinated loans to a VIE. Equity interests in a VIE (50% or less). Guarantees to a VIE’s lenders or equity holders (that reduce the true risk of these parties). Written put options on a VIE’s assets held by a VIE or its lenders or equity holders. Forward contracts on purchases and sales.

Variable Interest Entities (VIEs): The Primary Beneficiary PRIMARY BENEFICIARY of a VIE must consolidate the VIE. PRIMARY BENEFICIARY is the entity that: Will absorb a majority (more than 50%) of the VIE’s expected losses and/or Will receive a majority (more than 50%) of the VIE’s expected residual returns. Expected losses are given more weight than expected residual returns in certain situations.

Filling the Buckets Probability Weighted Scenarios Expected Losses Expected Residual Returns + Fees From Deloitte & Touche Presentation

How to Tell if I am NOT a VIE Total equity investment greater than Expected Losses Some equity holder has voting or other rights like a shareholder or General Partner, and as a group, equity holders can directly or indirectly make decisions on entity’s activities Equity holders as a group will absorb expected losses and benefit from expected residual returns without guarantee or cap  “Subordinated Financial Support” is something that will absorb some of the expected losses, if they occur From Deloitte & Touche Presentation

Primary Beneficiary Cascade If anyone holds Variable Interests that expose them to a majority of the expected losses, they are the Primary Beneficiary, otherwise  If anyone holds Variable Interests that would enjoy a majority of the expected residual returns, they are the Primary Beneficiary, otherwise  There is no Primary Beneficiary  “Variable Interests” are financial interests that change in value with changes in the entity’s net asset value From Deloitte & Touche Presentation

Variable Interest Entities (VIEs): The Primary Beneficiary Only one PRIMARY BENEFICIARY can exist for a VIE (by definition). Potential for Erroneously Determined Multiple Primary Beneficiaries Does Exist: When one or more variable interest holders (VIH) has incomplete information about the VIE’s other VIH. Different VIH make different judgments about their variable interests.

Variable Interest Entities (VIEs): Determining if an Entity is a VIE Condition #1: Equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support (SFS). SFS is defined as variable interests that will absorb some or all of an entity’s expected losses (example: a debt guarantee or an equity guarantee). In general, the equity at risk is deemed sufficient if it is at least 10% of total assets. (May need more than 10%.)

Variable Interest Entities (VIEs): Determining if an Entity is a VIE IN GENERAL, an entity is subject to consolidation if, by design, any of three conditions exists. These conditions focus on: 1. Sufficiency of equity investment at risk. 2. Characteristics of the holders of equity investment at risk. 3. Whether certain disproportionalities exist among the equity investors.

Determining if an Entity is a VIE (cont.) Condition #2: The holders of the equity investment at risk (as a group) lack any of the following characteristics: The ability to make decisions about an entity’s activities. The obligation to absorb the entity’s expected losses. The right to receive the entities expected residual returns.

Determining if an Entity is a VIE (cont.) Condition #3: Certain disproportionalities exist among the equity investors. Example: Certain equity holders possess voting rights that are not proportional to their obligation to share the VIE’s losses.

Reconsideration Triggers From Deloitte & Touche Presentation Para. 7 & 15

Disclosures Required When Involved with VIEs Disclosures for Primary Beneficiaries: #1 VIE’s nature, purpose, size, activities. #2 Carrying value and classification of consolidated assets that are collateral for the VIE’s obligations. #3 Lack of recourse if creditors (or beneficial interest holders) of a consolidated VIE have no recourse to the general credit of the primary beneficiary.

Variable Interest Entities (VIEs): Disclosures Required When Involved Disclosures for anyone that holds a significant variable interest in a VIE #1 Nature of involvement with VIE and when involvement began. #2 VIE’s nature, purpose, size, activities. #3 The entity’s maximum exposure to loss as a result of its involvement with the VIE.

PWC publication “SIC-12 and FIN 46R” Nice flow chart with the following steps: 1.Does FIN 46R apply? 2. Is the entity a VIE? 3. Which entity is the primary beneficiary? And so forth… Too complicated to fit on a slide but you can print page 6 from the pdf file

FSP FIN 46R-6 The “creator of variability” is not the VIE The VIE interests ABSORB the variability The FSP provides an step-by-step process to analyze situation (next slide) Multiple examples with diagrams

FSP FIN 46R-6 – Para. 5 Step 1 – use paragraphs 6-7 to analyze the nature of the risks Step 2 – Determine purpose for which entity was created and determine the variability (created by the risks identified in Step 1) the entity is designed to create and pass along to its interest holders Use paragraphs 8-14 to identify the potential variable interest holders

Variable Interest Entities (VIEs): Consolidation Procedures Major Points in Consolidating: #1 Eliminate primary beneficiary’s interest in the VIE. #2 Report VIE’s assets & liabilities at fair values—not their book values. #3 Report goodwill if it exists. #4 Extinguish “negative goodwill” (BPE) if it exists. #5 Report noncontrolling interest at FV. #6 Eliminate intercompany transactions.

Case 06-1 Objectives Part 1 – Determine when an enterprise has a variable interest in an entity that MIGHT bring it within the scope of FN46R Part 2 – Determine if an entity is a Variable Interest Entity Neither part of the case goes the last step to decide if consolidation is required

FIN 46R – Appendix B Appendix B provides guidance for identifying variable interests and explains in general how they may affect the determination of the primary beneficiary Use for Case 06-1, Am I in or Am I Out? - Part 1 The appendix expands on the basic definition in para. 2

For Part 2 of Case 06-1 FIN 46R, Para An entity shall be subject to consolidation if, by design, the conditions in a, b, or c exist: Condition a (defines equity investment at risk – 4 items and also refers to paragraphs 9-10) Condition b -- 3 criteria which must not be lacking Condition c is a clarification for b(1) criteria