To Consolidate or Not

FINANCIAL REPORTING

For some companies, that IS the question.

To Consolidate or Not

BY THOMAS A. RATCLIFFE

EXECUTIVE SUMMARY

AMONG ENRON’S PROBLEMS WAS ITS USE of variable interest entities, which allowed it to leave significant amounts of debt off its balance sheet. In response to concern about this practice, FASB issued Interpretation no. 46 in January 2003 and a revised version in December 2003 to help companies decide whether to consolidate VIEs into their financial statements.

A VIE MUST BE CONSOLIDATED INTO THE FINANCIAL statements of the primary beneficiary company when it does not have enough equity at risk or its equity investors lack any of three characteristics of controlling financial interest. The equity at risk should be sufficient for the VIE to finance its activities without additional support.

A VIE’S PRIMARY BENEFICIARY TYPICALLY IS ABLE to make decisions about the entity and share in profits and losses. The primary beneficiary is the reporting entity, if any, that receives the majority of expected returns or absorbs the majority of expected losses.

CPAs SHOULD RECONSIDER A DECISION ABOUT WHETHER an entity is a VIE if its situation changes so its equity investment at risk is no longer adequate, some or all of the equity investment is returned to investors or the entity undertakes additional activities, acquires additional assets or receives an additional equity investment that is at risk.

THE GUIDANCE IN INTERPRETATION NO. 46(R) is causing reporting entities to make new decisions about whether affiliated entities need to be consolidated into their financial statements. The practical result of the new rules is that many reporting entities are adding significant assets and liabilities to their balance sheets.

THOMAS A. RATCLIFFE, CPA, PhD, is director of accounting and auditing at Wilson Price in Montgomery, Ala. His e-mail address is tomr@wilsonprice.com.

mong myriad accounting problems that led to the downfall of Enron was its use of variable interest entities (VIEs), allowing it to leave significant amounts of debt off its balance sheet. In response to widespread concerns about this business practice, FASB issued Interpretation no. 46, Consolidation of Variable Interest Entities, in January 2003 and Interpretation no. 46 (Revised) with the same name in December 2003. Both interpret Accounting Research Bulletin (ARB) no. 51, Consolidated Financial Statements, to address consolidation requirements for businesses that are affiliated with VIEs.

Interpretation no. 46(R) addresses the consolidation of business enterprises where the usual consolidation condition—ownership of a majority voting interest—does not apply. It focuses on controlling financial interests achieved by means other than voting. Where there is no voting interest, a company’s exposure to the assets’ risks and rewards represent the best evidence of control. When a company holds a majority of variable interests in another entity, it is considered the primary beneficiary and must consolidate that entity into its financial statements.

Interpretation 46(R) in Action

In the notes to its 2004 financial statements, Coors said it had consolidated three joint ventures in 2004 as a result of the guidance in FASB Interpretation no. 46(R).

In the notes to its 2004 annual report, FirstBank NW Corp. said Interpretation no. 46(R) did not have a material effect on its financial position or on the consolidated results of its operations.

In 2004 La-Z-Boy Furniture Galleries determined that several of the independent dealers operating La-Z-Boy stores were variable interest entities under the terms of Interpretation no. 46(R) and included them in its consolidated financial statements.

The purpose of this article is to explain the substantive provisions of Interpretation no. 46(R) and provide CPAs with practical guidance on the ongoing process of deciding whether a VIE needs to be consolidated, the measurements the primary reporting entity should use in consolidation and the required disclosures.

Public companies were required to implement the consolidation provisions in Interpretation no. 46(R) in 2003 and 2004. Private companies with an interest in a VIE that was created after December 31, 2003, should have consolidated those entities immediately. Most private companies with VIEs that existed on December 31, 2003, made transition disclosures during calendar year 2004 and were required to consolidate those VIEs no later than calendar year 2005.

WHO SHOULD CONSOLIDATE?
Under Interpretation no. 46(R) a VIE must be consolidated into the financial statements of the primary beneficiary company when either of the following conditions exist:

The VIE does not have sufficient equity investment at risk.

Equity investors in the VIE lack any of three characteristics of controlling financial interest. Investors with such an interest

— Participate in decision-making processes by voting their shares.

— Expect to share in returns generated by the entity.

— Absorb any losses the entity may incur.

To avoid consolidation the total equity investment at risk should be sufficient for the VIE to finance its activities without additional support. CPAs can help reporting entities evaluate the sufficiency of equity at risk using qualitative or quantitative methods. Use the qualitative approach first to make the consolidation vs. nonconsolidation decision; use the quantitative approach if qualitative methods don’t result in a definitive conclusion. Where neither approach provides an answer, use a combination of the two.

Qualitatively, a VIE must be able to demonstrate it can get nonrecourse financing from an unrelated party without additional subordinated financial support from other entities or individuals, including equity investors. Examples of such support include equity investments, loans, guarantees and commitments to fund operations. When provided by related parties, such support is considered provided by the primary reporting entity. In many cases involving private companies, these additional support arrangements exist between and among affiliated entities and indicate there is not sufficient equity at risk for the VIE to operate on a stand-alone basis.

Quantitatively, the general rule is that at least 10% of the fair value of the VIE’s assets must be provided as an equity investment. (A lesser investment does not give the entity sufficient equity to operate alone.) The 10% rule is not a safe harbor—having more equity at risk should not lead CPAs to presume the VIE has sufficient equity at risk to cover any expected losses.

If the equity investors lack any of the three characteristics described above, the VIE’s primary beneficiary must consolidate the entity. Conversely, where equity investors have these characteristics and the other requirements in Interpretation no. 46(R), no investor needs to consolidate the VIE.

A VIE’s primary beneficiary is the entity that will consolidate it in its financial statements. In some cases, it is relatively easy to determine which entity is the primary beneficiary through a qualitative analysis of the entity’s ability to make decisions about the VIE and share in its profits or losses. In those circumstances where one entity receives the majority of expected returns and another absorbs the majority of expected losses, the entity that absorbs the losses is the primary beneficiary. This means the ability to absorb expected losses is a tie-breaker CPAs should use to determine which entity, if any, is a VIE’s primary beneficiary. However, CPAs should base the consolidation vs. nonconsolidation decision on a determination of which entity holds a majority of the variable interests in another entity. Exhibit 1 describes a public company that had already implemented Interpretation no. 46(R). Exhibit 2 includes some practical issues CPAs working with private companies should consider in deciding whether to consolidate.

Exhibit 1: Consolidation of Variable Interest Entities—Public Company Example

In evaluating whether an affiliated entity needed to be consolidated using the guidance in Interpretation no. 46(R), some reporting entities initially concluded they were not the primary beneficiary of a VIE and later concluded they were the primary beneficiary. The relationship between Dell Inc. and Dell Financial Services illustrates this point.

Initial Conclusion (excerpted from 2003 10-K filing). The company is currently a partner in Dell Financial Services LP (DFS), a joint venture with CIT Group Inc. (CIT). The joint venture allows the company to provide customers with various financing alternatives and asset management services as a part of the total service offered to the customer. CIT, as a financial services company, is the entity that finances the transaction between DFS and the customer.

In accordance with the partnership agreement between the company and CIT, losses generated by DFS are allocated to CIT. Net income in DFS is allocated 70% to the company and 30% to CIT, after CIT has recovered any cumulative losses. The company’s share of DFS new income is reflected in investment and other income, net.

The company recognized approximately $4 million of cumulative pretax earnings as of the end of fiscal 2003. In the event DFS is terminated with a cumulative deficit, Dell is not obligated to fund any losses. Although the company has a 70% equity interest in DFS, because the company cannot and does not exercise voting or operational control over DFS, the investment is accounted for under the equity method.

The company’s investment in DFS at January 31, 2003, was $35 million. Equity income in DFS and any intercompany balances were immaterial to the company’s results of operations and financial position for fiscal 2003, 2002 and 2001. Had the company controlled—and as a result consolidated—DFS, the impact to the company’s reported revenue and earnings would not have been material for fiscal 2003, 2002 and 2001.

Resolution (excerpted from 2004 10-K filing). Dell is currently a partner in DFS, a joint venture with CIT. The joint venture allows Dell to provide its customers with various financing alternatives while CIT provides the financing for the transaction between DFS and the customer. In general, DFS facilitates customer-financing transactions through either loan or lease financing.

Dell currently owns a 70% equity interest in DFS. In accordance with the partnership agreement between Dell and CIT, losses generated by DFS are fully allocated to CIT. Net income generated by DFS is allocated 70% to Dell and 30% to CIT, after CIT has recovered any cumulative losses. If DFS is terminated with a cumulative deficit, Dell is not obligated to fund any losses, including any potential losses on receivables transferred to CIT. Although Dell has a 70% equity interest in DFS, prior to the third quarter of fiscal 2004, the investment was accounted for under the equity method because the company historically could not, and currently does not, exercise control over DFS.

In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities. FIN 46 provides that, if an entity is the primary beneficiary of a VIE, the assets, liabilities, and results of operations of the VIE should be consolidated in the entity’s financial statements. Based on the guidance in FIN 46, Dell concluded that DFS is a VIE and Dell is the primary beneficiary of DFS’s expected cash flows. Accordingly, Dell began consolidating DFS’s financial results at the beginning of the third quarter of fiscal 2004. The consolidation of DFS had no impact on Dell’s net income or earnings per share during fiscal 2004 because Dell has historically been recording its 70% equity interest in DFS under the equity method. The impact to any individual line item on Dell’s consolidated statement of income was not material; however, the consolidation of DFS increased Dell’s consolidated assets and liabilities by $55 million. CIT’s equity ownership in the net assets of DFS as of January 30, 2004, was $17 million, which is recorded as minority interest and included in other noncurrent liabilities on Dell’s consolidated statement of financial position. The consolidation has not altered the partnership agreement or risk-sharing arrangement between Dell and CIT.

BUSINESS CONSOLIDATIONS
In replacing the original Interpretation no. 46, FASB concluded a primary reporting entity need not evaluate activities deemed to be businesses to determine whether they are VIEs unless certain conditions exist. Excluded entities should use other accounting literature to determine whether consolidation is required. CPAs should consider an entity for consolidation if one or more of these conditions exist:

The reporting entity, its related parties or both participated significantly in the design or redesign of the entity. This condition does not apply if the entity is an operating joint venture under control of the reporting entity and one or more independent parties or a franchisee.

The entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties.

The reporting entity, its related parties or both provide more than half of the total equity, subordinated debt or other forms of subordinated financial support based on an analysis of the fair values of interests in the entity.

The entity’s activities are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements.

Exhibit 2: Consolidation of VIEs by Private Companies

It’s not uncommon for the owners of private companies to personally own the real estate used in the business and to lease it under an operating lease. In those cases the company must decide whether the real estate and any related mortgage need to be recognized in its financial statements. In the past, only rents paid by the business were reflected in the financial statements.

Here’s a three-step decision-making process CPAs should use to determine if this is necessary.

Step 1: Is the real estate “housed” in an entity? If the answer is no, there is no consolidation requirement under Interpretation no. 46(R).

Entities subject to this provision might be corporations, partnerships, limited liability companies and grantor and other trusts.

If the owners of the business own the real estate outside an entity, there is no requirement to consolidate it into the financial statements of the business.

Step 2: If the answer in step 1 is yes, the next question would be, Is that entity a VIE? If the answer is no, there is no consolidation requirement under Interpretation no. 46(R).

There should be sufficient equity at risk for the VIE to operate on a stand-alone basis.

Equity investors should have the characteristics typically associated with a controlling financial interest.

There should be no guarantees from other entities or owners.

There should be no additional collateral.

There should be no subordinated debt outstanding (second mortgages or intercompany loans).

There should be no loans from equity investors or related parties to those equity investors.

There should be no above-market lease payments or management fees.

Step 3: If the answer in step 2 is yes, then which entity, if any, is the primary beneficiary of the VIE? If no entity is the primary beneficiary, there is no consolidation requirement under Interpretation no. 46(R).

There can only be one primary beneficiary associated with a VIE.

The primary beneficiary may be determined qualitatively without undertaking an exhaustive quantitative analysis.

The primary beneficiary provides the majority of the VIE’s financial support.

The primary beneficiary receives the majority of expected returns and absorbs the majority of expected losses.

If one investor is entitled to the majority of expected returns and another must absorb the majority of expected losses, the latter is the primary beneficiary.

Using the guidance in Interpretation no. 46(R), not all VIEs need to be consolidated, paralleling the requirement that not all voting interest entities are consolidated under ARB no. 51. To the extent risk has been effectively disbursed between and among investors, the result might be that no entity is considered a VIE’s primary beneficiary.

MEASUREMENT ISSUES
When determining whether primary beneficiaries should initially measure assets, liabilities and noncontrolling interests in VIEs at fair value or carrying value, CPAs need to evaluate whether the primary beneficiary and the VIE are commonly controlled. Examples of common control include cases where one individual owns a controlling interest in several corporations with related operations or multiple entities under common management.

Except for entities under common control and assets and liabilities consolidated shortly after transfer from a primary beneficiary to a VIE, a primary beneficiary must initially measure the VIE’s assets, liabilities and noncontrolling interests at their fair values at the date the reporting entity first becomes the primary beneficiary. That date is the first day the reporting entity, if it issued financial statements, would report the entity in its consolidated statements.

A primary beneficiary under common control with the VIE must initially measure the assets, liabilities and noncontrolling interests as they are carried in the controlling entity’s accounts. It must measure assets and liabilities it transferred to the VIE at, after or shortly before the date the entity became the primary beneficiary at the same amounts as if they had not been transferred. No gain or loss can be recognized.

The primary beneficiary must allocate and report the excess, if any, of (a) the fair value of the newly consolidated assets and (b) the reported amount of assets the primary beneficiary transferred to the VIE over (1) the sum of the fair value of the consideration paid, (2) the reported amount of any previously held interests and (3) the fair value of the newly consolidated liabilities and noncontrolling interests as a pro-rata adjustment to the amounts that would have been assigned to the newly consolidated assets—as delineated in FASB Statement no. 141, Business Combinations—as if the consolidation had resulted from a business combination.

The excess, if any, of (a) the sum of the fair value of the consideration paid, (b) the reported amount of any previously held interests and (c) the fair value of the newly consolidated liabilities and noncontrolling interests over (1) the fair value of the newly consolidated identifiable assets and (2) the reported amount of identifiable assets transferred by the primary beneficiary to the VIE must be reported in the period the reporting entity becomes the primary beneficiary as

Goodwill, if the VIE is a business.

An extraordinary loss, if it is not.

The principles of consolidated financial statements in ARB no. 51 apply to primary beneficiaries’ accounting for consolidated VIEs. After initial measurement, the assets, liabilities and noncontrolling interests of a consolidated VIE must be accounted for in consolidated financial statements as if the entity were consolidated based on voting interests. This entity must follow the requirements to eliminate intercompany balances and transactions described in ARB no. 51 and existing practices for consolidated subsidiaries. Fees or other sources of income and expense between a primary beneficiary and a consolidated VIE must be netted against the VIE’s related expense and income. In the consolidated financial statements the resulting effect on net income and expense must be attributed to the primary beneficiary—not to noncontrolling interests.

WHEN TO RECONSIDER
An entity not previously subject to the requirements of Interpretation no. 46(R) does not become subject to it simply because of higher than expected losses that reduce the equity investment. CPAs should reconsider an initial determination of whether an entity is a VIE if one or more of the following occur:

The entity’s governing documents or contractual arrangements change in a way that alters the characteristics or adequacy of the entity’s equity investment at risk.

Some or all of the equity investment is returned to investors, and other interests become exposed to the entity’s expected losses.

The entity undertakes additional activities, or acquires additional assets, beyond those anticipated at the later of its inception or the latest event that increases expected losses.

The entity receives an additional equity investment that is at risk, or curtails or modifies its activities in a way that decreases expected losses.

For purposes of applying these provisions, a troubled debt restructuring, as defined in FASB Statement no. 15, Accounting by Debtors and Creditors for Troubled Debt Restructuring, must be accounted for according to that statement and is not an event that requires reconsideration of whether the entity is a VIE.

DISCLOSURES
Unless the beneficiary also holds a majority voting interest, in addition to disclosures required by other standards, the primary beneficiary of a VIE must disclose

The VIE’s nature, purpose, size and activities.

The carrying amount and classification of consolidated assets that are collateral for the VIE’s obligations.

Whether creditors or beneficial interest holders of a consolidated VIE have no recourse to the primary beneficiary’s general credit.

NEW THINKING
The guidance in Interpretation no. 46(R) is causing reporting entities to think differently in deciding whether affiliated entities need to be consolidated in the primary reporting entity’s financial statements. Historically, they based that decision almost exclusively on an analysis of voting interests. Now, a primary beneficiary will consolidate based on new criteria. The practical result is that many reporting entities will be adding significant assets and liabilities to their balance sheets.

AICPA RESOURCES

CPE

The AICPA’s Guide to Business Consolidations, Goodwill and Other Consolidation Issues (text, # 735129JA).

Variable Interest Entities—FIN 46 (InfoBytes, BYT-XXJA).

For more information or to order, call the Institute at 888-777-7077 or go to www.cpa2biz.com.