FASB Interpretation No. 46: Assessing the Impact

FIN 46

FIN 46 is effective immediately for variable interests in VIEs created after January 31, 2003 and is effective at the beginning of the first interim or annual period beginning after June 15, 2003 for variable interests VIEs created prior to February 1, 2003 (for public companies with a December 31st year end, the Interpretation is effective at the beginning of the third quarter and for private companies with a December 31st year end, it is effective for the year ended December 31, 2004). If a primary beneficiary is required to consolidate a previously unconsolidated SPE/VIE as a result of the initial application of FIN 46, the primary beneficiary should recognize the assets, liabilities, and equity interests in the VIE at the VIE's carrying amounts. If it cannot determine the carrying amounts, it should recognize the VIE's assets, liabilities, and equity interests at its then-current fair values.

In applying the guidance in FIN 46, accountants should bear in mind that the definition of VIE is different than those entities that were considered to be an SPE under guidance that existed prior to FIN 46. In some cases, VIE will encompass a greater number of entities, such as joint ventures, partnerships, and corporate entities with disproportionate voting rights, that may not have been treated as SPEs previously, while in other cases, it will encompass fewer entities, such as 'virtual' SPEs.

Background

In order to better understand the changes wrought by FIN 46, it may be helpful to review the authoritative literature governing consolidation of SPEs as it existed prior to FIN 46.

The primary sources of authoritative literature addressing consolidation of SPEs used in leasing transactions prior to the issuance of FIN 46 were EITF Issue No. 90-15, 'Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions,' and Issue No. 96-21, 'Implementation Issues in Accounting for Leasing Transactions involving Special-Purpose Entities.' The consensus on Issue 90-15 required consolidation of an SPE-lessor by a lessee if:

• 
  
• substantially all of the activities of the SPE were on behalf of the lessee,
  
• the lessee was exposed to the substantive risks and rewards of ownership, and
  
• the owner of the SPE did not have a substantive residual equity investment at risk.
  
  

The EITF did not specifically address what level of investment would be considered substantive, but the SEC staff, in a letter issued to the EITF shortly after the consensus on Issue 90-15, indicated that the 'investment should be comparable to that expected for a substantive business involved in similar leasing transactions with similar risks and rewards. The SEC staff understands from discussions with Working Group members that those members believe 3% is the minimum acceptable investment. The SEC staff believes a greater investment may be necessary depending on the facts and circumstances ' ' Eventually, practice evolved so that an investment of 3% of the fair value of the SPEs assets became a bright line.

With few exceptions, SPEs used in leasing transactions were structured to enable the lessee to avoid consolidation by having one or more parties make a substantive investment in the residual equity of the SPE. As a result of the importance of that criterion and because of practice issues that had developed over time in applying the 3% test, in September 1996, the EITF addressed a number of SPE-related questions in Issue 96-21, including issues concerning:

• 
  
• the source of an owner's investment in the SPE,
  
• the impact of the owner obtaining insurance to protect its investment in the SPE,
  
• the required form of the owner's investment,
  
• the effect of payments to owners of an SPE, and
  
• when substantially all of an SPEs activities were conducted on a lessee's behalf.
  
  

(The last issue addressed when a multi-purpose lessor should be viewed as a series of 'virtual' SPEs. The perceived advantage of a multi-purpose leasing entity over a single-purpose entity was the ability to eliminate the residual equity investment required in transactions involving the latter, thereby reducing the cost of the transaction to the lessee without resulting in the lessee being required to consolidate the SPE-lessor. Typically, each property would be financed entirely through the issuance of debt that had recourse only to the specific asset it financed, along with the related lease. In essence, the multiple transactions were segregated from each other through the terms of the financing agreements. The EITF concluded that such multipurpose SPEs should be viewed as a series of individual SPEs and that the conditions in Issue 90-15 should be applied to each 'silo.' Eventually, that conclusion also came to be applied by analogy to virtual SPEs created when a substantive business acquired an asset using nonrecourse debt and leased that asset to a third party.)

Neither Issue 90-15 nor Issue 96-21 required that the owner of the substantive residual equity investment be an independent third party. As such, the investor in leasing transactions involving nonpublic companies was often a related party, such as a majority shareholder of the operating business to which the asset was leased. For public companies, the SEC staff required the minimum equity investment to be made by independent investors. Although a related party to the lessee could invest in the SPE, its investment did not count towards satisfying the 3% requirement.

In applying the third criterion in Issue 90-15 (that the substantive investment be at risk) to many leasing transactions, it became clear that, in most cases, the lessor's risk from a decline in the fair value of the leased property was not significant either because of residual value guarantees provided by the lessee that absorbed the first dollar of any decline in fair value at the end of the lease term or through minimum lease payments that provided the lessor with a recovery of slightly less than 90% (on a present value basis) of the fair value of the asset at lease inception. Instead of residual risk, the lessor was exposed primarily to credit risk. However, the equity investment would meet the third criterion so long as the equity investor would be exposed to the first dollar of any losses resulting either from the lessee's default on the lease (combined with a decline in the fair value of the asset) or from declines in the fair value of the asset that exceeded the stipulated residual value guarantee.

Evolution of the FASB Interpretation

The FASB added the project to interpret ARB 51 and Statement 94 to its agenda in January 2002 with the intent of issuance an Interpretation that would result in more situations where the beneficiary of a transaction structured through an SPE would be required to consolidate the SPE. In June 2002, the FASB issued an Exposure Draft (ED) of a proposed Interpretation, Consolidation of Certain Special-Purpose Entities, for public comment. The ED would have required a primary beneficiary of an SPE to consolidate it, with certain exceptions. Determining when a party was a primary beneficiary under the ED required identifying the variable interests in the SPE and then determining if that party either held a majority of the variable interests or held a significant variable interest that was significantly more than any other party's variable interests. The ED contained a number of scope exceptions, including one for a nominally capitalized entity that was consolidated by a substantive operating company. In addition, the ED created a special type of SPE, known as a Financial SPE, which would have required a different analysis to determine if consolidation was required.

Respondents to the ED and participants at the roundtable meetings held at the FASB in September 2002 were generally critical of the scope of the proposed Interpretation and the complexity and subjectivity of the 'significant and significantly more than' rule. The ED did not include an adequate definition of either 'special-purpose entity' or 'substantive operating entity' that would assist preparers and auditors in determining when an entity would be subject to the guidance in the interpretation. Respondents indicated that the 'significant and significantly more than' provision would not be workable in practice since not all participants in an SPE would be presumed to have relevant information about variable interests held by other participants and that the provision was inconsistent with the notion of control (which looks to whether one party has a majority of the voting interests and, by extension, the risks and rewards of ownership).

As a result of comments from respondents, the FASB redeliberated the provisions of the ED beginning in October 2002 and issued the final Interpretation in January 2003.

Variable Interest Entities ' What's in a Name?

With the issuance of FIN 46, the FASB not only changed the names to protect the innocent (Out ' SPEs; In ' VIEs), but also significantly changed the approach to determining when an entity in which voting rights are not meaningful should be consolidated.

As with the ED, FIN 46 provides for consolidation based on ownership of variable interests in a VIE. Variable interests in an entity are contractual, ownership, or other financial interests that change as the fair value of the entity's net assets change. Appendix B of FIN 46 provides the following examples of possible variable interests:

• 
  
• Equity investments, beneficial interests, and debt instruments;
  
• Guarantees, written put options, and similar obligations;
  
• Forward contracts;
  
• Other derivative interests and compound instruments;
  
• Amounts owed to a VIE;
  
• Service contracts;
  
• Leases;
  
• Retained interests in financial assets.
  
  

Do I have to apply the guidance in FIN 46?

Before considering whether an interest is a variable interest, it must first be determined whether the entity is a VIE. If an entity is not a VIE, the guidance in FIN 46 does not apply to determining whether an investor should consolidate the entity. An entity is considered to be a VIE if either of the following conditions is met:

• 
  
• The total equity investment at risk is not sufficient to absorb the expected losses of the entity. Therefore, the entity is unable to finance its activities without subordinated financial support from other parties.
  
• The holders of the equity interests either do not have the ability to make decisions about the entity's activities through voting or other rights, or are not obligated to absorb the expected losses if they occur, or are not entitled to the expected residual returns if they occur.
  
  

Equity Investment At Risk

In determining whether the total equity investment at risk is sufficient, only equity investments that participate in the profits or losses of the entity are considered. Equity interests issued in exchange for subordinated interests in a VIE are not considered part of the total equity investment at risk, nor are amounts provided to, or financed for, the investor by the entity or another party involved with the entity.

Although the first exclusion is consistent with the guidance in Issue 96-21, the prohibition against financing of the equity investment does not go as far as the EITF went. Issue 96-21 precluded an equity investment financed by the investor using nonrecourse debt from being considered part of a substantive equity investment at risk, regardless of from whom the loan was obtained. FIN 46 only prohibits the investor from obtaining financing from a party involved with the entity.

FIN 46 establishes a presumption that an equity investment of less than 10% of the VIE's total assets should not be considered sufficient to enable the entity to finance its activities without additional subordinated financial support, such as a residual value guarantee from a lessee that may be necessary to obtain financing to acquire property that will be the subject of the lease agreement. That presumption may be overcome if:

• 
  
• the entity has been able to finance its activities in the past without additional financial support (for example, if the entity has both synthetic leases and true operating leases and has not been required to provide additional financial support to the true lease transactions),
  

  
  

• the amount of equity in the entity is the same as other entities that hold similar assets of similar quality in similar amounts and do not have additional financial support, or
  
• the amount of equity invested exceeds the entity's reasonably expected losses.
  
  

Voting Rights

In discussing voting rights, FIN 46 refers to EITF Issue No. 96-16, 'Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights,' indicating that voting rights that are disproportionate to equity interests would not automatically result in a conclusion that the entity is a VIE. However, the FASB was concerned about situations where the VIE/non-VIE determination would change by providing investors with nonsubstantive voting rights and concluded that, if voting rights are disproportionate to equity invested and substantially all of the activities of the entity are conducted on behalf of the party with disproportionately fewer voting rights, the entity would be a VIE. This conclusion appears to contradict the conclusion in FIN 46 that entities discussed in Issue 96-16 are not VIEs because their investors have the power to control the enterprise and may create uncertainty in those arrangements that did not exist previously because they involved businesses instead of SPEs.

FIN 46 provides one final out for an entity that meets one of the criteria above through the following scope exceptions:

• 
  
• Not-for-profit organizations (NFPs) subject to the guidance in AICPA SOP 94-3, Reporting of Related Entities by Not-for-Profit Organizations, are not required to apply the provisions of the Interpretation. (However, paragraph .05 of SOP 94-3 requires NFPs to apply ARB 51 and Statement 94 in determining whether to consolidate for-profit entities in which they have a financial interest. As FIN 46 interprets ARB 51 and Statement 94, it is logical to conclude that NFPs with a financial interest in a for-profit VIE should apply the guidance in FIN 46 to determine if consolidation is required.)
  
• Portions of entities or aggregations of assets within an entity, unless the entire entity is a VIE. For example, an asset that is acquired by a substantive entity using nonrecourse financing and then was leased to a third party would not be subject to consolidation by the lessee regardless of the risks of ownership to which it is exposed as long as the owner did not legally segregate the asset from its other operations by use of a separate legal entity. Although the asset is in substance segregated from the rest of the entity's operations through the use of the nonrecourse financing (eg, a virtual SPE), the arrangement would not be subject to the guidance in FIN 46 unless the substantive entity that owned the asset was itself a VIE. (Example 1 below illustrates a leasing arrangement where consolidation by a lessee in a synthetic lease is not required, even though each lease transaction is segregated from the others through the terms of the financing agreements and the lessee is exposed to a majority of the expected losses and entitled to a majority of the expected returns, because the lessor entity is deemed not to be a VIE.)
  
  

Employers are not required to consolidate employee benefit plan trusts subject to FASB Statement No. 87, Employers' Accounting for Pensions; FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions; and FASB Statement No. 112, Employers' Accounting for Postemployment Benefits.

• 
  
• Transferors of financial assets to Qualifying Special-Purpose Entities (QSPEs) are not required to consolidate the QSPE.
  
• Holders of beneficial interests in QSPEs are not required to consolidate unless they have the unilateral ability to change the legal documents that established the QSPE or cause it to liquidate (equivalent to voting control).
  
• Investment companies subject to SEC Regulation S-X, Rule 6-03(c)(1) should not consolidate an entity that is not also an investment company subject to the same Rule.
  
• Separate accounts of life insurance entities are not subject to the provisions of the interpretation.
  
  

Interpretation

The determination of whether an entity is a VIE is made at the time an investor acquires an ownership, contractual, or other financial interest in the entity based on facts and circumstances known at that time, including any future changes in the nature of the entity that are provided for in the entity's governing documents or contractual arrangements. An entity that is not initially considered to be a VIE may become one if:

• 
  
• the entity's governing documents are changed,
  
• the contractual arrangements among the parties involved with the entity change (for example, an investor agreeing to assume a greater risk of loss than it previously was subject to),
  
• an equity investor's investment is partially or wholly returned, exposing other parties to expected losses, or
  
• the entity undertakes additional activities or acquires additional assets that increase its expected losses.
  
  

(Next month, the author continues his analysis of FIN 46 and addresses issues related to how and when to consolidate, who qualifies as a related party, what the impact will be on private companies and multi-lessor entities, and the overall impact of FIN 46 on leasing transactions.)

Jeffrey Ellis is a partner in the Chicago office of Grant Thornton's National Professional Standards Group, where he is responsible for consulting with engagement teams on a wide range of technical accounting issues. His primary areas of emphasis include accounting for leases, stock-based compensation arrangements, and debt and equity transactions. Ellis is currently a member of the EITF working group on Issue No. 01-8, 'Determining Whether an Arrangement Contains a Lease.' He may be reached at [email protected].

This is the first of a two-part article

In a culmination of a project begun in the wake of disclosures concerning Enron Corporations' use of special-purpose entities (SPEs), the Financial Accounting Standards Board (FASB) issued its long-anticipated interpretation of ARB No. 51, Consolidated Financial Statements, and FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries, on January 17, 2003.

ARB 51 and Statement 94 require the preparation of consolidated financial statements when one entity has a controlling financial interest in another entity. Usually a controlling financial interest is established when an investor has a majority voting interest in an investee. However, since most SPEs are established to fulfill a single function, determining whether a controlling financial interest exists through voting control is often difficult since there are typically only limited matters on which the SPE investors are able to vote. FASB Interpretation No. 46, Consolidation of Variable Interest Entities, interprets the phrase controlling financial interest to resolve the difficulty involved with identifying control of SPEs based on voting interests. FIN 46 supersedes various Emerging Issues Task Force (EITF) consensuses and SEC staff pronouncements addressing SPE consolidation issues and creates a new model for determining when SPEs (which under FIN 46 are referred to as variable interest entities, or VIEs) should be consolidated that focuses on ownership of variable interests issued by the entity.

FIN 46

FIN 46 is effective immediately for variable interests in VIEs created after January 31, 2003 and is effective at the beginning of the first interim or annual period beginning after June 15, 2003 for variable interests VIEs created prior to February 1, 2003 (for public companies with a December 31st year end, the Interpretation is effective at the beginning of the third quarter and for private companies with a December 31st year end, it is effective for the year ended December 31, 2004). If a primary beneficiary is required to consolidate a previously unconsolidated SPE/VIE as a result of the initial application of FIN 46, the primary beneficiary should recognize the assets, liabilities, and equity interests in the VIE at the VIE's carrying amounts. If it cannot determine the carrying amounts, it should recognize the VIE's assets, liabilities, and equity interests at its then-current fair values.

In applying the guidance in FIN 46, accountants should bear in mind that the definition of VIE is different than those entities that were considered to be an SPE under guidance that existed prior to FIN 46. In some cases, VIE will encompass a greater number of entities, such as joint ventures, partnerships, and corporate entities with disproportionate voting rights, that may not have been treated as SPEs previously, while in other cases, it will encompass fewer entities, such as 'virtual' SPEs.

Background

In order to better understand the changes wrought by FIN 46, it may be helpful to review the authoritative literature governing consolidation of SPEs as it existed prior to FIN 46.

The primary sources of authoritative literature addressing consolidation of SPEs used in leasing transactions prior to the issuance of FIN 46 were EITF Issue No. 90-15, 'Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions,' and Issue No. 96-21, 'Implementation Issues in Accounting for Leasing Transactions involving Special-Purpose Entities.' The consensus on Issue 90-15 required consolidation of an SPE-lessor by a lessee if:

• 
  
• substantially all of the activities of the SPE were on behalf of the lessee,
  
• the lessee was exposed to the substantive risks and rewards of ownership, and
  
• the owner of the SPE did not have a substantive residual equity investment at risk.
  
  

The EITF did not specifically address what level of investment would be considered substantive, but the SEC staff, in a letter issued to the EITF shortly after the consensus on Issue 90-15, indicated that the 'investment should be comparable to that expected for a substantive business involved in similar leasing transactions with similar risks and rewards. The SEC staff understands from discussions with Working Group members that those members believe 3% is the minimum acceptable investment. The SEC staff believes a greater investment may be necessary depending on the facts and circumstances ' ' Eventually, practice evolved so that an investment of 3% of the fair value of the SPEs assets became a bright line.

With few exceptions, SPEs used in leasing transactions were structured to enable the lessee to avoid consolidation by having one or more parties make a substantive investment in the residual equity of the SPE. As a result of the importance of that criterion and because of practice issues that had developed over time in applying the 3% test, in September 1996, the EITF addressed a number of SPE-related questions in Issue 96-21, including issues concerning:

• 
  
• the source of an owner's investment in the SPE,
  
• the impact of the owner obtaining insurance to protect its investment in the SPE,
  
• the required form of the owner's investment,
  
• the effect of payments to owners of an SPE, and
  
• when substantially all of an SPEs activities were conducted on a lessee's behalf.
  
  

(The last issue addressed when a multi-purpose lessor should be viewed as a series of 'virtual' SPEs. The perceived advantage of a multi-purpose leasing entity over a single-purpose entity was the ability to eliminate the residual equity investment required in transactions involving the latter, thereby reducing the cost of the transaction to the lessee without resulting in the lessee being required to consolidate the SPE-lessor. Typically, each property would be financed entirely through the issuance of debt that had recourse only to the specific asset it financed, along with the related lease. In essence, the multiple transactions were segregated from each other through the terms of the financing agreements. The EITF concluded that such multipurpose SPEs should be viewed as a series of individual SPEs and that the conditions in Issue 90-15 should be applied to each 'silo.' Eventually, that conclusion also came to be applied by analogy to virtual SPEs created when a substantive business acquired an asset using nonrecourse debt and leased that asset to a third party.)

Neither Issue 90-15 nor Issue 96-21 required that the owner of the substantive residual equity investment be an independent third party. As such, the investor in leasing transactions involving nonpublic companies was often a related party, such as a majority shareholder of the operating business to which the asset was leased. For public companies, the SEC staff required the minimum equity investment to be made by independent investors. Although a related party to the lessee could invest in the SPE, its investment did not count towards satisfying the 3% requirement.

In applying the third criterion in Issue 90-15 (that the substantive investment be at risk) to many leasing transactions, it became clear that, in most cases, the lessor's risk from a decline in the fair value of the leased property was not significant either because of residual value guarantees provided by the lessee that absorbed the first dollar of any decline in fair value at the end of the lease term or through minimum lease payments that provided the lessor with a recovery of slightly less than 90% (on a present value basis) of the fair value of the asset at lease inception. Instead of residual risk, the lessor was exposed primarily to credit risk. However, the equity investment would meet the third criterion so long as the equity investor would be exposed to the first dollar of any losses resulting either from the lessee's default on the lease (combined with a decline in the fair value of the asset) or from declines in the fair value of the asset that exceeded the stipulated residual value guarantee.

Evolution of the FASB Interpretation

The FASB added the project to interpret ARB 51 and Statement 94 to its agenda in January 2002 with the intent of issuance an Interpretation that would result in more situations where the beneficiary of a transaction structured through an SPE would be required to consolidate the SPE. In June 2002, the FASB issued an Exposure Draft (ED) of a proposed Interpretation, Consolidation of Certain Special-Purpose Entities, for public comment. The ED would have required a primary beneficiary of an SPE to consolidate it, with certain exceptions. Determining when a party was a primary beneficiary under the ED required identifying the variable interests in the SPE and then determining if that party either held a majority of the variable interests or held a significant variable interest that was significantly more than any other party's variable interests. The ED contained a number of scope exceptions, including one for a nominally capitalized entity that was consolidated by a substantive operating company. In addition, the ED created a special type of SPE, known as a Financial SPE, which would have required a different analysis to determine if consolidation was required.

Respondents to the ED and participants at the roundtable meetings held at the FASB in September 2002 were generally critical of the scope of the proposed Interpretation and the complexity and subjectivity of the 'significant and significantly more than' rule. The ED did not include an adequate definition of either 'special-purpose entity' or 'substantive operating entity' that would assist preparers and auditors in determining when an entity would be subject to the guidance in the interpretation. Respondents indicated that the 'significant and significantly more than' provision would not be workable in practice since not all participants in an SPE would be presumed to have relevant information about variable interests held by other participants and that the provision was inconsistent with the notion of control (which looks to whether one party has a majority of the voting interests and, by extension, the risks and rewards of ownership).

As a result of comments from respondents, the FASB redeliberated the provisions of the ED beginning in October 2002 and issued the final Interpretation in January 2003.

Variable Interest Entities ' What's in a Name?

With the issuance of FIN 46, the FASB not only changed the names to protect the innocent (Out ' SPEs; In ' VIEs), but also significantly changed the approach to determining when an entity in which voting rights are not meaningful should be consolidated.

As with the ED, FIN 46 provides for consolidation based on ownership of variable interests in a VIE. Variable interests in an entity are contractual, ownership, or other financial interests that change as the fair value of the entity's net assets change. Appendix B of FIN 46 provides the following examples of possible variable interests:

• 
  
• Equity investments, beneficial interests, and debt instruments;
  
• Guarantees, written put options, and similar obligations;
  
• Forward contracts;
  
• Other derivative interests and compound instruments;
  
• Amounts owed to a VIE;
  
• Service contracts;
  
• Leases;
  
• Retained interests in financial assets.
  
  

Do I have to apply the guidance in FIN 46?

Before considering whether an interest is a variable interest, it must first be determined whether the entity is a VIE. If an entity is not a VIE, the guidance in FIN 46 does not apply to determining whether an investor should consolidate the entity. An entity is considered to be a VIE if either of the following conditions is met:

• 
  
• The total equity investment at risk is not sufficient to absorb the expected losses of the entity. Therefore, the entity is unable to finance its activities without subordinated financial support from other parties.
  
• The holders of the equity interests either do not have the ability to make decisions about the entity's activities through voting or other rights, or are not obligated to absorb the expected losses if they occur, or are not entitled to the expected residual returns if they occur.
  
  

Equity Investment At Risk

In determining whether the total equity investment at risk is sufficient, only equity investments that participate in the profits or losses of the entity are considered. Equity interests issued in exchange for subordinated interests in a VIE are not considered part of the total equity investment at risk, nor are amounts provided to, or financed for, the investor by the entity or another party involved with the entity.

Although the first exclusion is consistent with the guidance in Issue 96-21, the prohibition against financing of the equity investment does not go as far as the EITF went. Issue 96-21 precluded an equity investment financed by the investor using nonrecourse debt from being considered part of a substantive equity investment at risk, regardless of from whom the loan was obtained. FIN 46 only prohibits the investor from obtaining financing from a party involved with the entity.

FIN 46 establishes a presumption that an equity investment of less than 10% of the VIE's total assets should not be considered sufficient to enable the entity to finance its activities without additional subordinated financial support, such as a residual value guarantee from a lessee that may be necessary to obtain financing to acquire property that will be the subject of the lease agreement. That presumption may be overcome if:

• 
  
• the entity has been able to finance its activities in the past without additional financial support (for example, if the entity has both synthetic leases and true operating leases and has not been required to provide additional financial support to the true lease transactions),
  

  
  

• the amount of equity in the entity is the same as other entities that hold similar assets of similar quality in similar amounts and do not have additional financial support, or
  
• the amount of equity invested exceeds the entity's reasonably expected losses.
  
  

Voting Rights

In discussing voting rights, FIN 46 refers to EITF Issue No. 96-16, 'Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights,' indicating that voting rights that are disproportionate to equity interests would not automatically result in a conclusion that the entity is a VIE. However, the FASB was concerned about situations where the VIE/non-VIE determination would change by providing investors with nonsubstantive voting rights and concluded that, if voting rights are disproportionate to equity invested and substantially all of the activities of the entity are conducted on behalf of the party with disproportionately fewer voting rights, the entity would be a VIE. This conclusion appears to contradict the conclusion in FIN 46 that entities discussed in Issue 96-16 are not VIEs because their investors have the power to control the enterprise and may create uncertainty in those arrangements that did not exist previously because they involved businesses instead of SPEs.

FIN 46 provides one final out for an entity that meets one of the criteria above through the following scope exceptions:

• 
  
• Not-for-profit organizations (NFPs) subject to the guidance in AICPA SOP 94-3, Reporting of Related Entities by Not-for-Profit Organizations, are not required to apply the provisions of the Interpretation. (However, paragraph .05 of SOP 94-3 requires NFPs to apply ARB 51 and Statement 94 in determining whether to consolidate for-profit entities in which they have a financial interest. As FIN 46 interprets ARB 51 and Statement 94, it is logical to conclude that NFPs with a financial interest in a for-profit VIE should apply the guidance in FIN 46 to determine if consolidation is required.)
  
• Portions of entities or aggregations of assets within an entity, unless the entire entity is a VIE. For example, an asset that is acquired by a substantive entity using nonrecourse financing and then was leased to a third party would not be subject to consolidation by the lessee regardless of the risks of ownership to which it is exposed as long as the owner did not legally segregate the asset from its other operations by use of a separate legal entity. Although the asset is in substance segregated from the rest of the entity's operations through the use of the nonrecourse financing (eg, a virtual SPE), the arrangement would not be subject to the guidance in FIN 46 unless the substantive entity that owned the asset was itself a VIE. (Example 1 below illustrates a leasing arrangement where consolidation by a lessee in a synthetic lease is not required, even though each lease transaction is segregated from the others through the terms of the financing agreements and the lessee is exposed to a majority of the expected losses and entitled to a majority of the expected returns, because the lessor entity is deemed not to be a VIE.)
  
  

Employers are not required to consolidate employee benefit plan trusts subject to FASB Statement No. 87, Employers' Accounting for Pensions; FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions; and FASB Statement No. 112, Employers' Accounting for Postemployment Benefits.

• 
  
• Transferors of financial assets to Qualifying Special-Purpose Entities (QSPEs) are not required to consolidate the QSPE.
  
• Holders of beneficial interests in QSPEs are not required to consolidate unless they have the unilateral ability to change the legal documents that established the QSPE or cause it to liquidate (equivalent to voting control).
  
• Investment companies subject to SEC Regulation S-X, Rule 6-03(c)(1) should not consolidate an entity that is not also an investment company subject to the same Rule.
  
• Separate accounts of life insurance entities are not subject to the provisions of the interpretation.
  
  

Interpretation

The determination of whether an entity is a VIE is made at the time an investor acquires an ownership, contractual, or other financial interest in the entity based on facts and circumstances known at that time, including any future changes in the nature of the entity that are provided for in the entity's governing documents or contractual arrangements. An entity that is not initially considered to be a VIE may become one if:

• 
  
• the entity's governing documents are changed,
  
• the contractual arrangements among the parties involved with the entity change (for example, an investor agreeing to assume a greater risk of loss than it previously was subject to),
  
• an equity investor's investment is partially or wholly returned, exposing other parties to expected losses, or
  
• the entity undertakes additional activities or acquires additional assets that increase its expected losses.
  
  

(Next month, the author continues his analysis of FIN 46 and addresses issues related to how and when to consolidate, who qualifies as a related party, what the impact will be on private companies and multi-lessor entities, and the overall impact of FIN 46 on leasing transactions.)

Jeffrey Ellis is a partner in the Chicago office of Grant Thornton's National Professional Standards Group, where he is responsible for consulting with engagement teams on a wide range of technical accounting issues. His primary areas of emphasis include accounting for leases, stock-based compensation arrangements, and debt and equity transactions. Ellis is currently a member of the EITF working group on Issue No. 01-8, 'Determining Whether an Arrangement Contains a Lease.' He may be reached at [email protected].