Jacob Myers Deloitte & Touche, LLP Accounting for Variable Interest Entities Jacob Myers Deloitte & Touche, LLP

Agenda Introduction Background - FIN 46(R), FAS 140, FAS 167 Comparisons to newly issued FAS 167 guidance Research tools Case study Audit issues Questions & Comments

Introduction Jacob Myers Deloitte Senior Manager – Assurance Services Service clients in various industries Financial Services, Software, Agriculture St. Louis University Majors - Accounting and Finance Other organizations St. Louis Variety Club – Finance Committee St. Louis University Business School Alumni Board

Why Consolidation Guidance Add transparency and consistency to the financial statements Many firms were avoiding reporting debt and losses from special purpose entity (SPE) deals Enron Recent credit crisis Impact of consolidation in marketplace Financial ratios Loan covenants Regulatory capital Cost to implement guidance, processes

FIN 46(R) Variable Interest Entities – VIEs Form & Purpose of VIEs Special Purpose Entities – SPEs, off balance sheet Form & Purpose of VIEs Trust, Partnership, joint ventures, or Corporation Facilitate transactions – Transfer of Assets, leasing, hedging, R&D Low-cost financing structure Characteristics of VIEs Activities are limited Equity investor role minor – less than 10% Sponsoring firm’s involvement Guarantees Contribution of Capital Risks and rewards

FIN46(R) Consolidation of VIEs Prior GAAP - ARB 51 Consolidated based on voting rights Identifying if a VIE exists Equity at risk not sufficient to permit the potential VIE to finance its activities Equity investors lack one of the following: Direct or indirect ability to make decisions about entity through voting or similar rights An obligation to absorb the expected losses of the entity Rights to receive the expected residual returns of the entity

FIN46(R) Identification of the Primary Beneficiary of the VIE Requires the primary beneficiary to consolidate Characteristics include (mirror equity investors in a VIE): The direct or indirect ability to make decisions about the VIEs activities The obligation to absorb the entity’s expected losses The right to receive the entity’s expected residual returns Assessment of control Entity that bears the majority of the risk

FIN46(R) Disclosure Requirements For Primary Beneficiaries VIE’s nature, purpose, size and activities Carrying amount and classification of consolidated assets Lack of Recourse (if any) Significant Variable Interest (Not Primary Beneficiary) Nature of involvement with VIE Nature, purpose and size of VIE Exposure to losses

FAS 140 Transfers of financial assets Mortgage loans, accounts receivable, credit card receivables Qualifying Special-Purpose Entities - QSPE’s Indicated that financial assets transferred to a QSPE are typically derecognized by the transferor Legal isolation concept Permits derecognition of a portion or a component of a financial asset Relates to FIN 46(R) because QSPE’s are exempt from consolidation requirements

Potential Primary Beneficiary Potential VIEs Guarantees Debt   ABC Data Center, LLC Max Return 6% 95% Debt owed by JP Morgan Leases Data Center 5% Equity Microsoft Unrelated Shareholders & Debt holders Facebook Shares of Intel 70% Equity Investment of 1% Outstanding 30% Debt XYZ Office Leasing 95% of Debt owed by Goldman Sachs Leases Office Space 5% Equity Non Voting Metlife

FAS 167 Recently issued guidance for consolidations Why FAS 167 Needed to expand disclosure requirements of FIN 46R and address elimination of QSPEs Broader Scope: Includes Entities covered under FIN46R and QSPE’s FAS 166 eliminated the concept of a QSPE Amends derecognition guidance in FAS 140 Expands the Consolidation and Disclosure Requirements associated with VIE’s

Comparison FIN 46(R) FAS 167 QSPE’s are generally exempt Primary Beneficiary- Quantitative Reasoning: Based on Risks and Rewards 3. Shared Power: Focus is on absorbing expected losses or receiving expected returns 1. Transferors, sponsors, and investors in QSPE’s need to consider consolidation and disclosure 2. Primary Beneficiary- Qualitative Reasoning: Power and economics model Power to direct activities Obligation to absorb losses 3. Shared Power: Do decisions require the consent of both parties

Comparison FIN 46(R) FAS 167 4. Reconsideration of Primary Beneficiary: Changes in contractual agreement Addition or disposal of interest 5. Reconsideration of VIE: Interest holders reconsider whether entity is a VIE if certain events occur 4. Reconsideration of Primary Beneficiary Continuous reconsideration 5. Reconsideration of VIE: An additional event requires reconsideration

Comparison FIN 46(R) FAS 167 6. Presentation Requirements: Not required to present consolidated VIE separately on Balance Sheet 6. Presentation Requirements: Must present separately on the face of Balance Sheet the: Assets used to settle obligations Liabilities for which creditors do not have recourse against primary beneficiary

FAS 167 Disclosure Requirements Financial preparers must disclose method for determining whether they are the primary beneficiary of a VIE Disclose significant judgments and assumptions made Must disclose the details of any financial or other support provided to a VIE Disclose reasons for providing the support Disclose all terms of arrangements and agreements with VIE If Shared Power between multiple parties Disclose Significant Factors and Judgments made in determination

Research Tools Orginal FASB pronouncements Third party service providers Lawyers, accountants, etc. Online research tools Other company disclosures Other publications AICPA, SEC, public accounting firms, state societies

Case Study XYZ Oil is an established oil drilling company that wants to expand its operations to offshore drilling platforms in the Gulf of Mexico. XYZ determines that it can obtain the $350 million needed to lease the platform by issuing debt at an annual interest rate of 5%. Instead of leasing the platform itself, XYZ decides to establish a separate legal entity, Saltwater Drilling Co., to lease the drilling platform. In doing so it can obtain the $350 million needed at an annual rate of 4%. An outside investor contributes $30 million for 100% of the nonvoting shares in Saltwater Drilling Co. The remaining $320 million is raised through a debt offering, of which XYZ is the guarantor. XYZ must also pay the investor for any losses incurred if the asset is sold at the end of the lease term.

Questions Would Saltwater Drilling Co. qualify as a VIE under FIN 46? Under FAS 167? Could Saltwater Drilling have obtained financing without XYZ guaranteeing the debt? Does the equity investor have the ability to make decisions about the entities’ activities? Does the equity investor bear the risk of loss? Does the equity investor receive the expected residual returns? Would XYZ qualify as a primary beneficiary? Does XYZ have the power to direct the activities of Saltwater? Does it bear the risk of loss or have the right to receive benefits? Would it qualify as a primary beneficiary under FIN 46? FAS 167?

Questions What documents would you need to examine to determine that Saltwater is a VIE with XYZ as its primary beneficiary? Should Saltwater be consolidated into XYZ? How should this be presented on the Financial Statements?

Answers Would Saltwater Drilling Co. qualify as a VIE under FIN 46(R)? Under FAS 167? The answer is probably ‘Yes’ under both. The equity investor has an insignificant (less than 10% ownership) and the entity probably couldn’t finance the operations without XYZ’s support. The investor also bears little risk as they are guaranteed their money back if the asset is sold at a loss at the end of the lease. Would XYZ Qualify as a Primary Beneficiary? Probably ‘Yes’ under both FIN 46(R) and FAS 167 The investor doesn’t appear to bear much risk and since they own non-voting stock their influence may not be significant. XYZ appears to bear the risk of loss since they are guaranteeing the debt. Examination of the agreements would be needed to see who has the power to direct activities and the obligation to absorb losses and receive benefits.

Answers So, should Saltwater Drilling Co. be consolidated into XYZ? If it is determined that Saltwater Drilling Co. is both a VIE and XYZ Oil is its primary beneficiary then it should be consolidated into the Financial Statements Under FAS 167, certain assets and liabilities would be required to be presented separately on the face of the financial statements and additional disclosures would be required

Audit Issues Audit evidence Company’s accounting memo Entity documents By laws Security holder agreements Legal Opinions Consideration of an effective control environment Timing of closing process for the SPE Use of specialist/expert International coordination Language barriers and translation issues Legal environment

Questions or Comments? jacmyers@deloitte.com