FIN 46: Complex, Far-Reaching, Demanding
By PricewaterhouseCoopers
CFOdirect Network Newsdesk
29-May-2003
First there were Special-Purpose Entities (SPEs), legitimately formed by companies – along with
other investors - for specific business reasons apart from the company's principal activities.
Sponsoring companies' of these SPEs – also descriptively known as off-balance-sheet
structures, off-the-books debt, even straw man entities – looked to Accounting Research Bulletin
No. 51, Consolidated Financial Statements (ARB 51) for guidance on whether or not to
consolidate the entities onto financial statements, as well as subsequent guidance issued by
FASB's Emerging Issues Task Force, specifically EITF Issues 90-15 and 96-21, and by the SEC
in Topic D-14.
Over time, as the formation and use of SPEs by Corporate America became widespread, the
Financial Accounting Standards Board (FASB) sought to more precisely define what exactly
constituted an SPE and when it must be included in the sponsoring company's financials.
"The FASB was close to issuing new and specific rules governing SPEs in 1998," says Tom
Barbieri, Partner at PricewaterhouseCoopers LLP. But gaining broad consensus and agreement
on exposure drafts of the "new rules" ultimately proved unsuccessful, so the "old rules" of ARB
51 continued to apply.
Then came Enron and the concept of SPEs was taken to new and extreme levels.
The energy trader had set-up an elaborate array of SPEs to shift debt away from the company's
books. When these off-balance-sheet liabilities came to light in the company's reporting of its 3rdQuarter 2001 results, stockholder's equity in Enron dropped by $1.2 billion, the financial
statements for the years 1997 – 2001 were restated to show $600 million less in previouslyreported earnings and the company's collapse was underway.
"Enron went too far in how it accounted for SPEs," says Randy Vitray, Partner at PwC. "The
company was on the hook for the debt of those entities and when that debt came due, the Enron
house-of-cards came down."
Now comes the FASB and its Interpretation No. 46, Consolidation of Variable Interest Entities
(FIN 46) – a clear and direct response to the Enron-style abuse of SPEs and a new Standard that
applies to all manner of "entities" – many of which were never intended to be "special purpose."
SPEs Go On The Books
FIN 46 breaks new ground with its broad reach and its consolidation requirements.
Testifying before the House Subcommittee on Commerce, Trade and Consumer Protection on
March 4, 2003, FASB Chairman Robert H. Herz described SPEs (to be known as Variable
Interest Entities, or VIEs, going forward) as a "wide variety of structures and arrangements" that
are used for off-balance-sheet financing, to diversify risks, to issue market-based securities, for
securitizations, leases and other purposes. He said that because of FIN 46, disclosures about
such entities would improve and that "many, but certainly not all, of the SPEs that are currently
not consolidated by anyone would in the future be consolidated."
PwC's Mr. Vitray – who served as a consultant to FASB in the study and articulation of FIN 46 –
agrees. "If FIN 46 had been in force, Enron would have been pushed to put its entities on the
balance sheet and that would have cast an entirely different light on the company." He maintains
that SPEs are set-up as adjuncts to the sponsoring organization and are intended to hold assets
and liabilities for that organization. "It is good financial reporting to combine the results of these
entities with the sponsor's results. It shows that they are all one."
Thus, the essence of FIN 46.
However, its implementation is proving to be anything but simple. For starters, FIN 46 introduces
new terms and concepts never before seen in corporate accounting. Its compliance timeline is
virtually immediate. It requires extensive new financial analyses and calculations. And, while it
does not require restatements, it is likely to change the look of many consolidated balance
sheets.
New Words and Meanings
Woody Wallace, Partner at PwC, describes FIN 46 as a "difficult standard to adopt. It is short and
very complicated. It will prove tough for companies to understand and implement and for auditors
to audit."
FIN 46 was announced by FASB on January 17, 2003. Its consolidation requirements apply
immediately to all VIEs created after January 31, 2003 and on June 15, 2003 for those entities
already established. Companies with entities that may prove to be VIEs have been required since
January 31, 2003 to make a transitional disclosure of that possibility. And if subsequent financial
analysis shows that the entity is a VIE, the company determined to be its "primary beneficiary"
must consolidate that VIE onto its books from July 1, 2003 forward.
The "primary beneficiary" is one of several new terms and concepts introduced by FIN 46 that
are critical to compliance. These include:
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Variable Interest Entities (VIEs): entities subject to consolidation per FIN 46.
Variable Interests: the contractual, ownership or other pecuniary interests in an entity that
change with changes in that entity's net asset value.
Enterprise: the company or other party that is required to determine if an entity is a VIE
and to then provide appropriate financial disclosure.
Primary Beneficiary: the enterprise required to consolidate a VIE in accordance with FIN
46.
Expected Losses: the present value of an entity's expected cash flow risks in conduct of
its business.
Expected Residual Returns: the present value of an entity's expected cash flow benefits
in conduct of its business.
Expected Variability: the sum of the absolute values of the expected residual return and
the expected loss.
Subordinated Financial Support: variable interests that will absorb some or all of an
entity's expected losses, if these occur.
These terms and concepts are proving difficult to grasp and apply, particularly Expected Losses
and Expected Residual Returns.
PwC's Randy Vitray points out that these two concepts are confusing many. "These are not
merely cash flow measures, these are measures of the variability of the fair value of the entity's
assets," he says. "Thus, even if an entity is expected to always have positive cash flows, it will
still have expected losses caused by scenarios where the cash flows and other increases in the
value of the entity's assets are less than expected."
The FASB describes – "in general" – a VIE as being:
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A corporation, partnership, trusts, or any other legal structure used for business purposes
that either (a) does not have equity investors with voting rights or (b) has equity investors
that do not provide sufficient financial resources for the entity to support it activities.
An entity that often holds financial assets, including loans or receivables, real estate or
other property.
An entity that may be essentially passive or it may engage in research and development
or other activities on behalf of another company.
"The sleeper provisions of FIN 46 are surprising people. Entities that were never intended to be
SPEs are now caught up in the VIE sweep," notes Mr. Wallace. These can include hedge funds,
venture capital partnerships, joint ventures, general partnerships, limited partnerships, trusts and
leases, among many others.
Identifying VIEs
To determine if an SPE, or other entity, is a VIE and thus subject to consolidation, the entity must
have one or both of the following:
Characteristic One: The total equity investment at risk is not sufficient to permit the entity to
finance its activities without additional subordinated financial support from other parties, which is
provided through other interests that will absorb some or all of the expected losses of the entity.
Characteristic Two: As a group, the equity investors lack one or more of the following essential
characteristics of a controlling financial interest:
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The direct or indirect ability to make decisions about the entity's activities through voting
rights or similar rights.
The obligation to absorb the expected losses of the entity, if losses occur, which makes it
possible for the entity to finance its activities.
The right to receive the expected residual returns of the entity, if those returns occur,
which is the compensation for the risk of absorbing the expected losses.
Once a company has determined that an entity is a VIE, the company and other investors have to
determine who is the primary beneficiary. The FASB says that this is the party that is "subject to a
majority of the risk of loss from the VIE's activities, or entitled to receive a majority of the VIE's
residual returns, or both." That primary beneficiary consolidates the assets and liabilities of the
VIE onto its financial statements.
Additionally, FIN 46 calls for a company that is not the primary beneficiary of a VIE but
nonetheless holds a significant "variable interest" in that VIE to disclose that holding in its
financials.
"All of this will require a waterfall of financial analysis," says PwC's Randy Vitray, pointing-out that
determining the primary beneficiary alone will take a "massive number of calculations and there
are questions about what model to use to do the calculations."
Broad Scope and Impact
Before the mathematical equations and models, however, is the question of gathering the
information necessary to do the math. Since FIN 46 has such a broad definition of what entities
may be VIEs, the information development process itself can be a challenge.
As an example, Mr. Vitray cites real estate leasing vehicles that were not designed as SPEs and
may never have been involved in any off-balance-sheet transactions. Yet, compliance with FIN 46
requires that these vehicles be evaluated as potential VIEs. To do that requires financial
information from all the investors in the lease vehicle, some of whom may not be known to the
corporate sponsor of the vehicle and others who may not be inclined to provide that information.
Other business sectors that will particularly feel the FIN 46 impact are banking, finance and
insurance. PwC's Tom Barbieri says, "the commercial paper conduits that banks have set-up are
the biggest issues they face in complying with the new rules."
These vehicles hold financial assets, such as loans and receivables, are packaged and offered as
investment vehicles with the bank receiving an administrative fee for managing the structure.
"Under FIN 46, many of these will have to be consolidated onto the bank's books," Mr. Barbieri
says, adding that the worldwide asset value of such vehicles runs nearly one trillion dollars.
Illustrating that point are announcements already made by financial institutions such as:
Salomon Smith Barney Holdings who says it may have to consolidate up to $1.4 billion to comply
with FIN 46.
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HSBC Bank says it may have $2.0 billion to consolidate.
Eaton Vance, an investment manager, says FIN 46 could have a $1.6 billion impact on its
books.
And GE Capital Corporation reports that at the end of 2002, it had asset-backed
commercial paper receivables of about $42 billion that are potentially subject to
consolidation under FIN 46.
And how could the consolidation of such numbers onto the balance sheets of companies affect
them?
Mr. Barbieri says that by consolidating these entities, the company is showing that it is liable for
the entity's debts and this could have a number of consequences ranging from affecting the
company's debt covenants, its value measurements such as return on assets or return on equity,
its credit ratings, and even its stock price.
Organizing for Compliance
Thus, FIN 46 has arrived as a solution to the abuse of the concept of Special Purpose Entities
and brought with it an abundance of new and complicated challenges that corporate finance
teams must face right now in order to meet the Interpretation's tight compliance timetable.
John Bishop, Partner at PwC, suggests that companies prepare for "the rigors of FIN 46" by:
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Appointing teams and designating individuals to do a broad-based review of all entities
that the company may be involved with.
Looking closely at the nature of those entities. Looking at their purpose at the time of
formation. Asking the questions: could these be VIEs? Could our company be the primary
beneficiary?
From this first appraisal, determining the entities that can be eliminated because they are
not affected by FIN 46 and focusing resources on studying more closely those that might
be.
Then, conducting a comprehensive financial analysis to determine, those entites that are
VIEs, to identify the primary beneficiary and to make necessary decisions about
consolidating the entity onto financial statements.
"The burden is on the company," he adds.