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GAAP Change: Is a Variable Interest Entity in Your Future?

The story of Enron’s resulting collapse has been well publicized. Enron highlighted a company’s ability to place financial transactions and balances in the financial statements of special purpose entities or SPEs. These SPEs were off-balance sheet entities not consolidated with Enron’s main financial statements, and thus< losses were hidden in SPE books and Enron’s financial condition looked much better than it really was.

Financial Accounting Standards Board Interpretation No. 46R (FIN 46), Consolidation of Variable Interest Entities, applies to privately held companies issuing financial statements in accordance with generally accepted accounting principles (GAAP) for the first annual period beginning after December 15, 2004 (i.e. December 31, 2005 yearends). Only entities issuing GAAP financial statements, whether audited, reviewed or compiled, need to consider these new rules.

FIN 46 introduces the concept of a Variable Interest Entity (VIE). A VIE is an off-balance sheet entity that “may” be required to be consolidated by another entity, from which the VIE receives the majority of its financial support. For example, many private business owners create an operating company that leases the real estate facilities it uses from another real estate entity. Often the real estate entity is significantly owned by the same persons who own the operating company. FIN 46 may require the financial statements of the operating company to include the financial statements of the related< party real estate entity since the operating company is the primary beneficiary of the variable interest

Generally, the operating entity provides financial support to the real estate VIE in the form of a guarantee, loan, below market lease payment, or a management fee. This financial support is an indicator that the VIE is not self-supportive, that is, it cannot finance its activities without receiving additional subordinated financial support from another entity or individual. When the operating company provides the financial support (directly or indirectly), an analysis must be prepared to determine if the operating company is required to consolidate the VIE.

Each reporting entity needs to analyze all potential relationships in which the entity provides subordinated financial support to another entity. Each fact pattern must then be analyzed to determine whether a particular primary beneficiary may be required to consolidate a VIE. This process can be time consuming and complicated; the answers are not always clear-cut.

What could this mean to your company’s GAAP financial statements?

Assume you own a real estate partnership with an older, significantly depreciated property on its books. Over the years, the real estate partnership may have refinanced the related mortgage and distributed the refinanced proceeds to the partners. This situation generally creates a partner deficit on a real estate partnership’s books. This deficit, under certain circumstances, may be required to be consolidated with the operating company’s GAAP financial statements. The result would be a decrease in the operating company’s financial statement equity and an increase in debt to equity ratios. These changes could have negative implications to any loan covenants you may currently have with your lender.

You should discuss the potential impact with your lenders. They need to understand FIN 46’s possible impact on any debt-to-equity ratio covenant. It is likely such a covenant was drafted before FIN 46 was issued. You may also consider not complying with the rules and allow a GAAP exception paragraph to be included in the accountant’s report. Again, such a decision should be discussed with your lender.

If it is determined that a VIE will be consolidated, that VIE is subject to the same level of service as the operating company. Thus, if the operating company is audited, so is the VIE.

By F. Jeffrey Kovacs, CPA, Shareholder and Director of Quality Control

 

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