Assessing the Impact of FASB 46

Once it is concluded that an entity is a Variable Interest Entity (VIE) and does not qualify for one of the scope exceptions, its variable interests (and the holders thereof) need to be identified. A holder of a variable interest is required to consolidate a VIE if that variable interest either absorbs a majority of the VIE's expected losses or receives a majority of the VIE's expected returns, or both. When a variable interest holder has the ability to make decisions regarding the VIE's activities, FIN 46 presumes that the holder is exposed to a majority of the expected losses or entitled to a majority of the expected returns. In case of a tie (one party is exposed to a majority of the expected losses, while an unrelated party is entitled to a majority of the expected returns), the party that is exposed to losses would be required to consolidate. FIN 46 refers to the party that is required to consolidate a VIE as the 'primary beneficiary.' When determining if it is the primary beneficiary, an entity should consider variable interests held by its related parties (see below) as its own.

Should I Consolidate?

The decision as to whether an entity is the primary beneficiary should be made at the inception of an arrangement with a VIE. A variable interest holder that is not the primary beneficiary at the inception of an arrangement may subsequently become the primary beneficiary if:

• 
  
• the entity's governing documents change or;
  
• the variable interest holder acquires additional interests (either from the primary beneficiary, the VIE, or another variable interest holder) that expose it to a majority of the expected losses or entitle it to a majority of the expected returns (so long as no other variable interest holder is exposed to a majority of the expected losses).
  
  

In no circumstance would a party that was not the primary beneficiary at the inception of the arrangement be required to consolidate solely because of losses incurred by the VIE. The primary beneficiary should reconsider its decision to consolidate if it sells all or a portion of its variable interests to unrelated parties or (if the initial decision to consolidate was based on its right to a majority of the VIE's expected returns) if another party acquires interests that expose it to a majority of the VIE's expected losses.

Who Is a Related Party?

FIN 46 expands on the list of related parties in FASB Statement No. 57, Related Party Disclosures, adding the following as related parties of the entity making the assessment of whether it is the primary beneficiary:

• 
  
• a party that is not able to finance its operations without support from the entity (such as another VIE in which the entity is the primary beneficiary);
  

  
  

• a party that received its variable interests as a contribution or loan from the entity;
  
• all officers and employees of the entity (FIN 46 also includes directors, who were already identified as related parties in Statement 57, in its listing); and
  
• any party that has agreed not to sell or assign its interest without the entity's prior approval or that has a 'close business relationship' with the entity.
  
  

FIN 46 provides as an example of a party with a 'close business relationship' a professional service provider for whom the entity is a 'significant client.' Professional service providers that may qualify as a related party under that provision include, but would not be limited to, attorneys and investment bankers. The FASB did not provide further guidance on how to determine when an entity is a significant client of a professional service provider, such as whether the assessment should consider only billings, the prestige associated with being the entity's professional service provider, or some combination of the two.

If a related party is identified as holding a variable interest in the VIE and that interest, if combined with the entity's variable interest, would result in identifying the entity as the VIE's primary beneficiary, FIN 46 requires an assessment as to whether the related party is acting as the entity's agent. If so, the related party's interest is attributed to the entity and the entity is the primary beneficiary. If the related party is not acting as the entity's agent but the activities of the VIE are closely associated with the entity's operations, the entity is the primary beneficiary. Thus, the involvement of a related party becomes a 'heads you lose, tails you lose' proposition for the entity trying to avoid consolidation.

What Is the Impact on Private Companies?

Prior to the issue of FIN 46, it was standard practice for private companies to separate real estate used in the business from the operating business, generally for tax reasons. Under Issue 90-15, as long as one of the three criteria was met, the lessee (the operating business) was not required to consolidate, even when it and the real estate entity had the same owner or owner group. However, the related party provisions of FIN 46 will result in the variable interests held by the owner (or owners) being attributed to the operating business and will result in the lessee being required to consolidate the real estate entity unless it can be concluded that the lessor is not a VIE.

What Is the Impact on Multi-lessor Entities?

FIN 46 incorporates guidance similar to that in Issue 96-21, Question No. 1. If an entity is deemed to be a VIEs and it finances the acquisition of assets that will be the subject of a lease agreement entirely through the issuance of debt that has recourse solely to the leased asset and the underlying lease agreement, the arrangement should be viewed as if multiple, separate VIEs had been created. Each party with a variable interest in specific transactions would make the consolidation decision with respect to that specific transaction. For example, VIE acquires three real estate properties that it will lease to three unrelated parties. VIE finances the acquisition of each property through the issuance of debt. Each debt issuance has recourse to a specific property, as well as to the underlying lease. Lessee A enters into a synthetic lease for one of the properties, while Lessee B and Lessee C enter into long-term true operating leases. Lessee A, Lessee B, and Lessee C should each view the arrangement as if three separate VIEs were involved because the debt is associated with, and dependent on, specific assets, and should consider their variable interests to determine if they should consolidate their separate VIE. Assuming Lessee A is required to consolidate its portion of the VIE but Lessee B and Lessee C are not, a party with a variable interest in the VIE as a whole may be required to consolidate the entire VIE. However, the VIE consolidated will only include the properties leased to Lessee B and Lessee C, along with the related debt financing.

The question becomes a little more difficult (and the guidance in the Interpretation a little more confusing) if the debt financing is not associated with specific assets held by the VIE but is cross-collateralized against all of the assets. In that case, the variable interests, if any, held by parties involved with the VIE are only deemed to be variable interests in the VIE if one of the following conditions is met:

• 
  
• the fair value of specified assets to which a variable interest relates is more than 50% of the fair value of all assets held by the VIE, or
  
• the holder of a variable interest in assets that are less than 50% of the fair value of total VIE assets also has an interest in the overall VIE.
  
  

Assume that, instead of issuing debt that is recourse to a specific property, VIE issues debt that has recourse to all of VIE's assets and all of VIE's leases are synthetic leases. If the fair value of none of the properties exceeds 50% of the fair value of VIE's assets and no lessee has an interest in the overall VIE, neither Lessee A, Lessee B nor Lessee C would be the primary beneficiary of VIE. Further, the expected losses and returns associated with the variable interests held by each lessee would be excluded from VIE's expected losses and returns when determining if any other party involved with VIE is the primary beneficiary. As a result, a party that bears a nominal amount of expected losses (because each of the lessee's will absorb first dollar of loss on the leased properties through their residual value guarantees) may be required to consolidate VIE.

Impact of FIN 46 on Leasing Transactions

The primary impact that FIN 46 will have on leasing transactions will be seen in the manner of structuring synthetic leases and leasing transactions of private companies. A synthetic lease structured using a single-purpose entity (or a multi-purpose entity that issues debt that is recourse only to specific assets) will require the lessee to consolidate the VIE (or portion of a VIE) as the lessee is obligated to absorb a majority of the expected losses and is entitled to receive a majority of the expected residual rewards. FIN 46 permits a lessee to avoid that result but retain the tax advantages of a synthetic lease by entering into a lease directly with a bank or leasing company where the lessor will hold title to the property. Even if the lessor finances the acquisition of the property using non-recourse debt, the lessee will not be required to consolidate since FIN 46 does not apply to portions (silos) of a substantive entity (that is, a non-VIE).

As noted above, leasing arrangements in private companies will likely result in the operating entity consolidating the lessor because of the involvement of related parties as the holders of the variable interests in the lessor. Since many of those arrangements have been structured to achieve a tax objective for the owner, unwinding the arrangement (such as by distributing the property to the owner, who would hold title directly) may have significant tax consequences to the owner.

FIN 46 should not require a lessee under a true operating lease (including leveraged leases that provide the lessee a fixed price purchase option) to consolidate a VIE, even when the present value of the lessee's minimum lease payments are only slightly less than 90% of the leased asset's fair value at inception. Paragraph B10 of FIN 46 clarifies that a long-term lease would not be considered in determining the primary beneficiary of the VIE if the terms of the lease are at market rates at inception and the lessee does not provide a residual value guarantee.

Although FIN 46 may result in lessee's being required to consolidate prior transactions because of the significant cost likely to be incurred to restructure the arrangement, it is unlikely that it will result in significant consolidation of transactions entered into in the future. It is also unlikely that FIN 46 will result in any greater amount of equity being invested in leasing transactions. While the 3% investment required to avoid consolidating an SPE under Issue 90-15 may have seemed small, FIN 46 permits, unlike current practice, non-consolidation with no equity invested through its scope exclusion for virtual SPEs.

Lastly, FIN 46 does not provide guidance on the accounting in transition for a lessee who, as a result of its application of previous guidance to virtual SPEs, was required to consolidate the leased asset and related non-recourse financing. Since the FASB did not address this issue, the only guidance addressing the question is contained in the letter from the SEC staff to the EITF shortly after the consensus on Issue 90-15 was reached. That letter expressed the SEC staff's views on certain issues, one of which related to whether de-consolidation would be appropriate if the owner of an SPE that failed the third criterion (substantive equity investment at risk) in Issue 90-15 made an additional equity investment so that the equity investment was considered substantive. The SEC staff's view was that a lease entered into with a consolidated SPE, which is then unconsolidated when a substantive equity investment is made, is analogous to a sale-leaseback transaction and results in a new lease that should be assessed pursuant to the conditions of Issue 90-15 at the time the changes are made. The lessee would also need to evaluate the lease in accordance with Statement 13, as amended, and Statement 98 for transactions within its scope.

Conclusion

If the terms of the lease do not preclude recognizing a sale (which generally will only be an issue in leases of real estate), the lessee would remove the asset from the balance sheet and determine any gain (where the proceeds from the 'sale' is the unamortized balance of the nonrecourse financing and the equity, if any, held by unrelated third parties).

Jeffrey Ellis is a partner in the Chicago office of Grant Thornton's National Professional Standards Group, where he consults with engagement teams on a wide range of technical accounting issues.

This is the second of a two-part article.

Last month's article discussed the effect that FASB Interpretation No. 46 will have on leasing and other variable interest entities. This month, we continue our analysis of FIN 46 in relation to how and when to consolidate, who qualifies as a related party, what the impact will be on private companies and multi-lessor entitites, and the overall impact of FIN 46 on leasing transactions.

Under the Financial Accounting Standards Board (FASB) Interpretation No. 46, Consolidation of Variable Interest Entities, one the critical questions addressed is how to know whether an entity should consolidate.

Once it is concluded that an entity is a Variable Interest Entity (VIE) and does not qualify for one of the scope exceptions, its variable interests (and the holders thereof) need to be identified. A holder of a variable interest is required to consolidate a VIE if that variable interest either absorbs a majority of the VIE's expected losses or receives a majority of the VIE's expected returns, or both. When a variable interest holder has the ability to make decisions regarding the VIE's activities, FIN 46 presumes that the holder is exposed to a majority of the expected losses or entitled to a majority of the expected returns. In case of a tie (one party is exposed to a majority of the expected losses, while an unrelated party is entitled to a majority of the expected returns), the party that is exposed to losses would be required to consolidate. FIN 46 refers to the party that is required to consolidate a VIE as the 'primary beneficiary.' When determining if it is the primary beneficiary, an entity should consider variable interests held by its related parties (see below) as its own.

Should I Consolidate?

The decision as to whether an entity is the primary beneficiary should be made at the inception of an arrangement with a VIE. A variable interest holder that is not the primary beneficiary at the inception of an arrangement may subsequently become the primary beneficiary if:

• 
  
• the entity's governing documents change or;
  
• the variable interest holder acquires additional interests (either from the primary beneficiary, the VIE, or another variable interest holder) that expose it to a majority of the expected losses or entitle it to a majority of the expected returns (so long as no other variable interest holder is exposed to a majority of the expected losses).
  
  

In no circumstance would a party that was not the primary beneficiary at the inception of the arrangement be required to consolidate solely because of losses incurred by the VIE. The primary beneficiary should reconsider its decision to consolidate if it sells all or a portion of its variable interests to unrelated parties or (if the initial decision to consolidate was based on its right to a majority of the VIE's expected returns) if another party acquires interests that expose it to a majority of the VIE's expected losses.

Who Is a Related Party?

FIN 46 expands on the list of related parties in FASB Statement No. 57, Related Party Disclosures, adding the following as related parties of the entity making the assessment of whether it is the primary beneficiary:

• 
  
• a party that is not able to finance its operations without support from the entity (such as another VIE in which the entity is the primary beneficiary);
  

  
  

• a party that received its variable interests as a contribution or loan from the entity;
  
• all officers and employees of the entity (FIN 46 also includes directors, who were already identified as related parties in Statement 57, in its listing); and
  
• any party that has agreed not to sell or assign its interest without the entity's prior approval or that has a 'close business relationship' with the entity.
  
  

FIN 46 provides as an example of a party with a 'close business relationship' a professional service provider for whom the entity is a 'significant client.' Professional service providers that may qualify as a related party under that provision include, but would not be limited to, attorneys and investment bankers. The FASB did not provide further guidance on how to determine when an entity is a significant client of a professional service provider, such as whether the assessment should consider only billings, the prestige associated with being the entity's professional service provider, or some combination of the two.

If a related party is identified as holding a variable interest in the VIE and that interest, if combined with the entity's variable interest, would result in identifying the entity as the VIE's primary beneficiary, FIN 46 requires an assessment as to whether the related party is acting as the entity's agent. If so, the related party's interest is attributed to the entity and the entity is the primary beneficiary. If the related party is not acting as the entity's agent but the activities of the VIE are closely associated with the entity's operations, the entity is the primary beneficiary. Thus, the involvement of a related party becomes a 'heads you lose, tails you lose' proposition for the entity trying to avoid consolidation.

What Is the Impact on Private Companies?

Prior to the issue of FIN 46, it was standard practice for private companies to separate real estate used in the business from the operating business, generally for tax reasons. Under Issue 90-15, as long as one of the three criteria was met, the lessee (the operating business) was not required to consolidate, even when it and the real estate entity had the same owner or owner group. However, the related party provisions of FIN 46 will result in the variable interests held by the owner (or owners) being attributed to the operating business and will result in the lessee being required to consolidate the real estate entity unless it can be concluded that the lessor is not a VIE.

What Is the Impact on Multi-lessor Entities?

FIN 46 incorporates guidance similar to that in Issue 96-21, Question No. 1. If an entity is deemed to be a VIEs and it finances the acquisition of assets that will be the subject of a lease agreement entirely through the issuance of debt that has recourse solely to the leased asset and the underlying lease agreement, the arrangement should be viewed as if multiple, separate VIEs had been created. Each party with a variable interest in specific transactions would make the consolidation decision with respect to that specific transaction. For example, VIE acquires three real estate properties that it will lease to three unrelated parties. VIE finances the acquisition of each property through the issuance of debt. Each debt issuance has recourse to a specific property, as well as to the underlying lease. Lessee A enters into a synthetic lease for one of the properties, while Lessee B and Lessee C enter into long-term true operating leases. Lessee A, Lessee B, and Lessee C should each view the arrangement as if three separate VIEs were involved because the debt is associated with, and dependent on, specific assets, and should consider their variable interests to determine if they should consolidate their separate VIE. Assuming Lessee A is required to consolidate its portion of the VIE but Lessee B and Lessee C are not, a party with a variable interest in the VIE as a whole may be required to consolidate the entire VIE. However, the VIE consolidated will only include the properties leased to Lessee B and Lessee C, along with the related debt financing.

The question becomes a little more difficult (and the guidance in the Interpretation a little more confusing) if the debt financing is not associated with specific assets held by the VIE but is cross-collateralized against all of the assets. In that case, the variable interests, if any, held by parties involved with the VIE are only deemed to be variable interests in the VIE if one of the following conditions is met:

• 
  
• the fair value of specified assets to which a variable interest relates is more than 50% of the fair value of all assets held by the VIE, or
  
• the holder of a variable interest in assets that are less than 50% of the fair value of total VIE assets also has an interest in the overall VIE.
  
  

Assume that, instead of issuing debt that is recourse to a specific property, VIE issues debt that has recourse to all of VIE's assets and all of VIE's leases are synthetic leases. If the fair value of none of the properties exceeds 50% of the fair value of VIE's assets and no lessee has an interest in the overall VIE, neither Lessee A, Lessee B nor Lessee C would be the primary beneficiary of VIE. Further, the expected losses and returns associated with the variable interests held by each lessee would be excluded from VIE's expected losses and returns when determining if any other party involved with VIE is the primary beneficiary. As a result, a party that bears a nominal amount of expected losses (because each of the lessee's will absorb first dollar of loss on the leased properties through their residual value guarantees) may be required to consolidate VIE.

Impact of FIN 46 on Leasing Transactions

The primary impact that FIN 46 will have on leasing transactions will be seen in the manner of structuring synthetic leases and leasing transactions of private companies. A synthetic lease structured using a single-purpose entity (or a multi-purpose entity that issues debt that is recourse only to specific assets) will require the lessee to consolidate the VIE (or portion of a VIE) as the lessee is obligated to absorb a majority of the expected losses and is entitled to receive a majority of the expected residual rewards. FIN 46 permits a lessee to avoid that result but retain the tax advantages of a synthetic lease by entering into a lease directly with a bank or leasing company where the lessor will hold title to the property. Even if the lessor finances the acquisition of the property using non-recourse debt, the lessee will not be required to consolidate since FIN 46 does not apply to portions (silos) of a substantive entity (that is, a non-VIE).

As noted above, leasing arrangements in private companies will likely result in the operating entity consolidating the lessor because of the involvement of related parties as the holders of the variable interests in the lessor. Since many of those arrangements have been structured to achieve a tax objective for the owner, unwinding the arrangement (such as by distributing the property to the owner, who would hold title directly) may have significant tax consequences to the owner.

FIN 46 should not require a lessee under a true operating lease (including leveraged leases that provide the lessee a fixed price purchase option) to consolidate a VIE, even when the present value of the lessee's minimum lease payments are only slightly less than 90% of the leased asset's fair value at inception. Paragraph B10 of FIN 46 clarifies that a long-term lease would not be considered in determining the primary beneficiary of the VIE if the terms of the lease are at market rates at inception and the lessee does not provide a residual value guarantee.

Although FIN 46 may result in lessee's being required to consolidate prior transactions because of the significant cost likely to be incurred to restructure the arrangement, it is unlikely that it will result in significant consolidation of transactions entered into in the future. It is also unlikely that FIN 46 will result in any greater amount of equity being invested in leasing transactions. While the 3% investment required to avoid consolidating an SPE under Issue 90-15 may have seemed small, FIN 46 permits, unlike current practice, non-consolidation with no equity invested through its scope exclusion for virtual SPEs.

Lastly, FIN 46 does not provide guidance on the accounting in transition for a lessee who, as a result of its application of previous guidance to virtual SPEs, was required to consolidate the leased asset and related non-recourse financing. Since the FASB did not address this issue, the only guidance addressing the question is contained in the letter from the SEC staff to the EITF shortly after the consensus on Issue 90-15 was reached. That letter expressed the SEC staff's views on certain issues, one of which related to whether de-consolidation would be appropriate if the owner of an SPE that failed the third criterion (substantive equity investment at risk) in Issue 90-15 made an additional equity investment so that the equity investment was considered substantive. The SEC staff's view was that a lease entered into with a consolidated SPE, which is then unconsolidated when a substantive equity investment is made, is analogous to a sale-leaseback transaction and results in a new lease that should be assessed pursuant to the conditions of Issue 90-15 at the time the changes are made. The lessee would also need to evaluate the lease in accordance with Statement 13, as amended, and Statement 98 for transactions within its scope.

Conclusion

If the terms of the lease do not preclude recognizing a sale (which generally will only be an issue in leases of real estate), the lessee would remove the asset from the balance sheet and determine any gain (where the proceeds from the 'sale' is the unamortized balance of the nonrecourse financing and the equity, if any, held by unrelated third parties).

Jeffrey Ellis is a partner in the Chicago office of Grant Thornton's National Professional Standards Group, where he consults with engagement teams on a wide range of technical accounting issues.