Introduction
A variable interest entity is defined as a legal entity in which an investor has a controlling interest even without having a majority share of its ownership. It is, however, reported by the Financial Accounting Standards Board (FASB) in the U.S. as an entity in which the investor has some controlling interest, although the controlling interest is not based on majority voting rights. Therefore, for this reason, variable interest entities (VIEs) become subject to consolidation under various conditions. Also, variable interest entities have primary beneficiaries, and the party that holds the major variable interests may be the primary beneficiary; thus, the relevant holdings should be listed within the company’s consolidated balance sheets when consolidation is required (Board of Governors of the Federal Reserve System, 2021).
Variable interest entities are one of the accounting structures used within financial institutions in connection with assets such as subprime mortgage-backed securities (MBS). This means that they can be developed as special-purpose vehicles (SPVs) in order to allow firms, where accounting rules permit, to avoid listing certain assets directly on their balance sheets. VIE analysis shows how different financial firms become exposed to special-purpose vehicles and how these relationships can affect whether the entities are consolidated into financial statements. However, corporations may use an entity such as a VIE to provide or develop investments that have financial potential without putting the entire firm in jeopardy. Moreover, the main issues involving VIEs are similar to issues involving SPVs in past years; therefore, they have frequently been associated with methods of obscuring factors such as subprime exposures.
FASB Interpretation Number 46R
This is an accounting interpretation that deals with consolidation of different variable interest entities. Federal securities laws require a publicly traded company to submit financial reports and information about its operations. Therefore, its relationships with VIEs should be disclosed in the 10-K forms that these companies file. This enables FIN 46 to outline the accounting rules that apply to such businesses. In this case, companies generally establish variable interest entities in order to hold financial assets or support activities. This includes entities involved in conducting research and development operations (R&D) and entities that perform more passive roles.
An example of variable interest entities in today’s world involves off-balance-sheet financing schemes. A common arrangement is the establishment of special-purpose entities whose purposes include limiting losses and liabilities shown in financial statements because of technicalities in consolidation rules. However, under old rules, companies were generally required to consolidate partially owned subsidiaries if they had controlling interests, which were commonly understood to mean 50% or greater ownership or voting rights. In other words, some organizational structures, including LLCs and other entities, are flexible in terms of voting and ownership. This means that they could previously be used in some cases to hide liabilities. One example of a variable interest entity is as follows (Investor.gov, 2021).
VIE Ownership and Consolidation Example
A Friends Company initiates a Little Company as a third party and takes a small ownership interest of 5%, even though it provides 90% of Little Company’s capital. The new company then obtains a loan to construct a manufacturing facility. Because Little Company is small, young, and new, Friends Company is required to guarantee the loan given to it. For instance, the facility produces small parts that are utilized by Friends Company in its manufacturing processes. Thus, Friends Company purchases everything that is manufactured or produced by Little Company. In a situation where Little Company incurs losses, Friends Company will provide it with more capital in order to keep Little Company operating. From this example, it is clear that Friends Company benefits most from the operations of Little Company; therefore, covering and financing Little Company’s losses with capital is a clear responsibility. Under normal consolidation rules based only on ownership, Friends Company might not be required to report Little Company’s assets and the related loan in its consolidated statements.
Under FIN 46R, determining whether an organization’s subsidiary needs to be consolidated under the variable-interest rules involves a two-step analysis. For a variable interest to exist, there must first be a situation in which cash flows to and from the entity could change based on the composition of its liabilities and assets. However, in the example above, Friends Company might lose more money from its investment in Little Company if Little Company does not control its production costs or defaults on its loan. When it is determined that variable interests exist, the primary beneficiary of the entity may have to consolidate the entity’s liabilities and assets even if it does not have an ownership interest of 50% or more. VIEs, in other words, can be complex organizations that require deeper analysis in accounting and financial reporting. Furthermore, some specifics about company consolidation processes may not be necessary for a basic understanding of variable interest entities and how they should be accounted for.
The consolidation of variable interest entities became a separate focus in modern accounting for several reasons. There were several accounting scandals in which some types of variable interest entities were used to structure transactions that excluded liabilities and assets from consolidated financial statements. The purposes and structures of VIEs vary considerably (Lange). However, in practice, owners of private companies frequently establish smaller entities as VIEs for tax, liability, and estate-planning reasons rather than for the purpose of creating off-balance-sheet arrangements. Under Accounting Standards Codification (ASC), VIEs may be consolidated with other related entities, such as a lessor and an operating company under common control. Therefore, in private companies, financial-statement auditors and preparers have proposed approaches intended to avoid misleading reporting and ensure that third parties receive useful financial information about common-control leasing arrangements.
Variable interest entities have led to new rules for reporting financial statements for several reasons. Through updates to accounting standards on consolidation, the FASB codified rules for variable interest entities and made significant changes to the analysis required when determining whether a company should consolidate a variable interest entity. This includes special-purpose entities in financial statements. These new rules were amended to incorporate variable-interest considerations into consolidation analysis. The rules require enhanced disclosures about a company’s involvement in VIEs and the related financial-reporting risks. They focus on qualitative assessments of power and are intended to be more effective in identifying the company that holds controlling financial interests in a VIE. They also address situations in which power is shared among multiple unrelated parties that together direct the organization’s activities or where decisions about those activities require the consent of each party (U.S. Securities and Exchange Commission, 2021).
Auditing and Reporting Problems
Some problems encountered in the recent history of VIEs include poor auditing of liabilities and assets. This led to poor reporting on balance sheets and, in some cases, general losses. In other cases, consolidation may appear less relevant to some users, particularly in private companies. This is because many users focus on the tangible net worth and cash flows of companies that stand alone as private operating companies and lessees rather than on consolidated assets and cash flows. They may also encounter problems such as distortion of consolidated financial-statement positions when the assets of both lessee and lessor entities are combined even though some assets may be beyond the reach of certain creditors.
Accounting standards can affect investors when assets, income, gains, or liabilities are not properly recorded in balance sheets and other financial statements. However, accounting standard setters and auditors have developed various financial-reporting approaches to help address these situations. Such challenges to investors can be reduced through the appropriate use of financial standards. For mid-sized companies with two or three entities, one common approach is to let outside accountants or advisers deal with consolidation issues. If a company is primarily accountable to its bank or a few owners, consolidated statements may sometimes be considered less important by those users. Its accounting may also be prepared only once a year or less frequently. Furthermore, if auditors are required to follow strict independence rules, they should not perform management’s consolidation decisions for the company. Small accounting firms can nevertheless provide permitted services in a normal way while avoiding conflicts and losses.
In conclusion, the guidance interpreted by FIN 46R requires reporting entities to assess whether affiliated entities need to be consolidated into the primary reporting entity’s financial statements. Historically, the decision was based almost exclusively on analysis of voting interests. Today, primary beneficiaries may be required to base consolidation on additional criteria. Therefore, the practical result is that many reporting entities may have to add significant liabilities and assets to their balance sheets (Chen, 2021).
References
Chen, F. (2021). Variable interest entity structures in China: Are legal uncertainties and risks to foreign investors part of China’s regulatory policy? Asia Pacific Law Review, 29(1), 1–40. https://www.repository.cam.ac.uk/items/570aa208-2cbb-46ad-8a77-c7d3d440a91b
U.S. Securities and Exchange Commission. (2021). Sample letter to China-based companies. https://www.sec.gov/rules-regulations/staff-guidance/disclosure-guidance/sample-letter-china-based-companies
Investor.gov. (2021). Investor bulletin: U.S.-listed companies operating Chinese businesses through a VIE structure. https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/investor-bulletin-us-listed-companies-operating-chinese-businesses-through-vie-structure
Board of Governors of the Federal Reserve System. (2021). Variable interest entity consolidation analysis: Accessible version. https://www.federalreserve.gov/aboutthefed/accessible-version.htm
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