defining
issues
®
2 0 0 3
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
Va r i a b l e I n t e r e s t s
5
Other Clarifications
5
Effective Date and
Tr a n s i t i o n
5
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cooperative. All rights reserved.
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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.”
I S S U E S
2
D E F I N I N G
Scope Exceptions
Sufficiency of Equity
at Risk
N O . 03-28
K P M G ’ S
D E C E M B E R
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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.
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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.
This edition of Defining Issues describes the significant changes
to Interpretation 46, excluding the requirements already
imposed by FASB Staff Positions.
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.
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.
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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).
I S S U E S
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D E F I N I N G
SCOPE EXCEPTIONS
K P M G ’ S
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
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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.
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.
■
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.
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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
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.
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).
K P M G ’ S
(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.
I S S U E S
EVALUATING A CONTROLLING FINANCIAL
INTEREST
D E F I N I N G
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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.
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■
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
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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.
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.
I S S U E S
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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.
D E F I N I N G
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
K P M G ’ S
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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 983 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
■
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
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
I S S U E S
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.
D E F I N I N G
■
K P M G ’ S
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.
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.
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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).
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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.
This is a publication of
K P M G ’s D e p a r t m e n t
Kimber K. Bascom
▼ ▼ ▼
David C. Britt
E. Michael Pierce
Copies are available at:
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.
w w w. k p m g . c o m a n d
w w w. a r o . k p m g . c o m
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.
20306NYGR
D E F I N I N G
Contributing authors:
K P M G ’ S
(212) 909-5600
I S S U E S
of Professional
Practice—Audit
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