FASB Issues Additional Guidance on FIN 46

On July 23, 2003, the Financial Accounting Standards Board (FASB) approved the issuance of five FASB Staff Positions (FSPs) providing guidance on the application of FASB Interpretation No. 46, Consolidation of Variable Interest Entities. (An FSP is the means by which the FASB staff communicates its views on the proper application of FASB literature when it believes there is only one acceptable interpretation. Prior to February 2003, FASB staff guidance was communicated through Staff Implementation Guides or announcements at meetings of the FASB's Emerging Issues Task Force.) The FSPs issued by the staff include:

• FIN 46-1, “Applicability of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, to Entities Subject to the AICPA Audit and Accounting Guide, Health Care Organizations”
• FIN 46-2, “Reporting Variable Interests in Specified Assets of Variable Interest Entities as Separate Variable Interest Entities under Paragraph 13 of FASB Interpretation No. 46, Consolidation of Variable Interest Entities”
• FIN 46-3, “Application of Paragraph 5 of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, When Variable Interests in Specified Assets of a Variable Interest Entity Are Not Considered Interests in the Entity under Paragraph 12 of Interpretation 46″
• FIN 46-4, “Transition Requirements for Initial Application of FASB Interpretation No. 46, Consolidation of Variable Interest Entities”
• FIN 46-5, “Calculation of Expected Losses under FASB Interpretation No. 46, Consolidation of Variable Interest Entities.”

The FASB staff has also proposed FSPs on: 1) the treatment of fees paid to decision makers and guarantors in determining expected losses and expected residual returns and 2) the impact of rights to remove a decision maker on the computation of expected residual returns, but has not finalized that guidance.

A brief explanation of each of the final FSPs and their impact on FIN 46 follows.

Scope of FIN 46

Paragraph 4(a) of FIN 46 provides a scope exception for not-for-profit organizations that follow the consolidation guidance in SOP 94-3, Reporting of Related Entities by Not-for-Profit Organizations. That scope exception did not extend to not-for-profit health care organizations as they follow the consolidation guidance in the AICPA Audit and Accounting Guide, Health Care Organizations. However, as indicated in FIN 46's Summary, the FASB's original intent was to exclude all not-for-profit organizations, as defined in FASB Statement No. 117, Financial Statements of Not-for-Profit Organizations, from its scope. Accordingly, the FASB staff issued FSP FIN 46-1, “Applicability of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, to Entities Subject to the AICPA Audit and Accounting Guide, Health Care Organizations,” to expand the scope exception.

In addition to modifying FIN 46's scope, FSP FIN 46-1 reiterates that a not-for-profit organization used by a for-profit enterprise to circumvent the provisions of FIN 46 is subject to the Interpretation.

Expected Losses

The FASB staff issued two FSPs addressing issues surrounding the determination of an entity's expected losses. FSP FIN 46-5, “Calculation of Expected Losses under FASB Interpretation No. 46, Consolidation of Variable Interest Entities,” clarifies that an entity that has not experienced net losses historically and has an expectation of future profitability will have “expected losses” as contemplated by FIN 46. The reason for this apparent contradiction is due to FIN 46's focus on variability in returns, one-half of which represents performance that is worse than expectations and one-half of which represents performance that is better than expectations. The portion of the variability representing performance that is worse than expectations is what FIN 46 refers to as “expected losses.” For example, if an entity expects annual appreciation of 6% in the fair value of real estate it owns based on historical market performance but it is possible that the real estate will appreciate by only 2%, the underperformance of 4% translates into an expected loss. FSP FIN 46-5 provides an example illustrating this concept.

FSP FIN 46-3, “Application of Paragraph 5 of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, When Variable Interests in Specified Assets of a Variable Interest Entity Are Not Considered Interests in the Entity under Paragraph 12 of Interpretation 46,” concludes that the phrase “expected losses of the entity” has the same meaning in paragraph 5 of FIN 46 as it does in paragraph 12. Accordingly, in determining whether an entity has sufficient equity at risk to permit it to finance its activities without additional subordinated financial support (paragraph 5(a) of FIN 46), expected losses in specified assets representing not more than one-half of the total fair value of the entity's assets that will be borne by a variable interest holder that does not have another variable interest in the entity as a whole should be excluded in determining the entity's expected losses. Consider the following example:

Entity A owns two office buildings, each of which has a fair value of $100 million. Entity A leases one of the office buildings to Company X and the other to Company Y, two unrelated parties. Under the terms of the leases, Company X and Company Y each guarantee the residual value of their leased office building at the end of the lease term. The leases qualify for operating lease treatment as the present value of the future minimum lease payments, determined using Entity A's implicit interest rate, is less than 90% of the assets' fair value.

In determining whether Entity A has sufficient equity as discussed in paragraph 5(a), its expected losses would include expected losses resulting from possible defaults by Company X and Company Y on their lease payments, plus expected losses resulting from its ownership of the office buildings. (As illustrated in FSP FIN 46-5, “Calculation of Expected Losses under FASB Interpretation No. 46, Consolidation of Variable Interest Entities,” discussed above, expected losses from ownership of the office buildings could arise from possible increases in the fair value of the office buildings that fall below the expected appreciation.)

When a variable interest relates specifically to an asset owned by a possible VIE and the fair value of the asset is not more than 50% of the fair value of all of the possible VIE's assets, FSP FIN 46-3 requires losses that will be absorbed by the variable interest be excluded from the possible VIE's expected losses in determining if the entity is a VIE. In the example above, there are two possible views as to the amount of expected losses that should be excluded in determining if Entity A is a VIE. One view is that, to the extent expected losses from Entity A's ownership of the office buildings result from decreases in their fair values below the amount guaranteed by the lessees, those losses would be excluded from Entity A's expected losses to the extent that the decrease in fair value is equal to or less than the amount of the Company X and Company Y guarantees as those expected losses will be absorbed by a variable interest (the residual guarantee) in the specified assets. The other view is that the expected losses related to the asset would be excluded from Entity A's expected losses as long as the expected losses were less than the amount guaranteed by the lessee. (When the lessee has a fixed price purchase option in addition to providing a guarantee of the leased assets' residual value, the latter view would appear to be required.) Companies should consult with their accounting adviser in these circumstances when determining the amount of expected losses to exclude.

In summary, Entity A's expected losses would include the following:

• expected losses resulting from decreases in the fair value of the office buildings in excess of the guaranteed amounts, and
• expected losses resulting from possible defaults by Company X and Company Y on their lease payments, which include any payment related to expected decreases in the fair value of the office buildings covered by their residual value guarantees.

It is also possible that Entity A's expected losses would include expected losses arising from possible increases in the fair value of the buildings that are less than the expected appreciation, depending on which of the above views is adopted.

Multi-Lessor Entities

As discussed in the April 2003 edition of LJN's Equipment Leasing Newsletter (Volume 22, Number 3), FIN 46 provides that a single entity may be comprised of multiple VIEs if specified assets of the entity are essentially the only source of payment for specified liabilities or other variable interests, such as when the entity finances the acquisition of three real estate properties through the issuance of debt that is specifically identified as having recourse to a specific real estate property. To clarify the application of paragraph 13 of FIN 46, the FASB staff issued FSP FIN 46-2, “Reporting Variable Interests in Specified Assets of Variable Interest Entities as Separate Variable Interest Entities under Paragraph 13 of FASB Interpretation No. 46, Consolidation of Variable Interest Entities.”

FSP FIN 46-2 concludes that separate entities exist within a larger legal entity if essentially none of the returns of the assets of the deemed entity can be used by the remaining VIE and essentially none of the liabilities of the deemed entity are payable from the assets of the remaining VIE. Some accountants have understood this to mean that a silo would not exist in the following example:

Investors A and B form a joint venture to acquire two office buildings, each of which has a fair value of $100 million. Investors A and B each contribute $10 million to the venture for their 50% equity interests. The venture issues $180 million of debt to finance the balance of the purchase price of the buildings. The debt is issued in two tranches of $90 million each – one tranche secured by the first building and the other tranche secured by the second building. Neither tranche has any right to the collateral securing the other tranche.

The venture enters into lease agreements with Company X and Company Y, two unrelated lessees. The terms of the lease agreements require periodic lease payments that will cover the interest on the debt and a return to Investors A and B during the lease term. At the end of the lease term, each lessee is required to 1) exercise a fixed price purchase option or 2) sell the leased asset. If a lessee elects to sell the leased asset and it is sold for less than the venture's acquisition cost, the lessee is obligated to make up the difference, up to a specified amount. If the asset is sold for more than the venture's acquisition cost, the lessee receives the excess as a rent rebate.

Although it appears in substance that the joint venture is comprised of two separate entities (one with the building leased to Company X and one with the building leased to Company Y), the structure does not meet the conditions in paragraph 13 of FIN 46 or the FSP because each owner shares proportionately in the returns or losses of each asset. In other words, to meet the conditions in paragraph 13 and the FSP to be reported as separate entities, each investor would have to have an interest that is targeted to a specified asset of the entity. The result of this interpretation appears to be that an entity need not issue any equity; instead, it could issue a small amount of subordinated debt that has recourse to all of the entity's assets and not trigger a requirement to divide a larger entity into multiple VIEs.

Initial Application

Because the FASB did not elect to “grandfather” the accounting for existing entities, a company with a potentially significant variable interest in an entity would be required to determine if that entity is a VIE subject to FIN 46. FIN 46 specifies that the determination of whether an entity is a VIE should be made as of the date the company became involved with the entity or, if applicable, as of the date that a reassessment event occurs. In certain circumstances, it will be difficult for a company with investments it has owned for a long period of time to make that determination if there have been no recent reassessment events because the information for determining the entity's expected losses for purposes of assessing whether the condition in paragraph 5(a) was met at the time the investment was made may not have been retained or can no longer be found (which may occur if the variable interest was held by a company that has been acquired multiple times).

When it is not practicable for a company to make the determination as to whether the entity is a VIE as of the date it became involved or, if applicable, as of the date of a reassessment event, FSP FIN 46-4, “Transition Requirements for Initial Application of FASB Interpretation No. 46, Consolidation of Variable Interest Entities,” indicates that the determination should be made as of the date the company adopts FIN 46. In that circumstance, if the entity is a VIE, the company would also determine if it was the primary beneficiary as of the date the determination is made, not at the date it originally became involved with the VIE.

Transition and Effective Dates

The guidance in the FSPs related to multipurpose entities and the computation of expected losses was effective immediately on the date of issuance (July 24, 2003) for VIEs to which the requirements of FIN 46 had already been applied, and should be applied to other VIEs as part of FIN 46's adoption.

The expansion of the scope exception for not-for-profit entities that did not follow the guidance in SOP 94-3 became effective on the date the FSP was issued, while the guidance in the FSP on FIN 46's transition requirements was effective on issuance for all interests in VIEs held by companies that elected to adopt FIN 46 before July 24, 2003.

If the guidance in an FSP resulted in a change to previously reported financial information, the impact of that change should be reported by cumulative effect adjustment in the first reporting period ending after July 24, 2003. Alternatively, the FSPs permit restatement of prior periods, with a cumulative-effect adjustment as of the beginning of the first year restated.

What Next?

A number of accountants have been asking themselves that very question. While the FASB's decision to defer FIN 46's effective date(see sidebar, below)has helped alleviate some of the concerns of both preparers and auditors that conclusions reached in adopting the provisions of the Interpretation could change as the FASB issues additional interpretive guidance, the question is still very applicable. On Oct. 31, 2003, the FASB issued a proposed Interpretation that would interpret FIN 46. Some of the more significant provisions of the proposed Interpretation include:

• Defer the application of FIN 46 for companies that are unable to obtain information necessary to (a) determine whether 1) an entity formed prior to Feb. 1, 2003 is a VIE or 2) the company is its primary beneficiary, or (b) consolidate the entity if it is a VIE and the company its primary beneficiary, and require certain disclosures in that circumstance.
• Exclude from FIN 46's scope mutual funds in the form of trusts and trusts managed by a bank trust department.
• Clarify: (i) that rights and obligations from all variable interests in an entity should be considered in determining whether voting rights are disproportionate to the right to receive expected returns or the obligation to absorb expected losses; (ii) that operating losses and modifications of agreements in response to those losses do not require a reassessment of an entity's status as a VIE or the identity of the entity's primary beneficiary unless the losses or modifications impact the characteristics of the controlling equity interest (paragraph 5(b) of FIN 46); (iii) the application of the related party provisions in paragraph 17 to require the holders of variable interests to first consider whether the VIE's activities are more closely associated with the activities of one of the variable interest holders; (iv) that a de facto agency relationship cannot be rebutted such that, if the VIE's activities are not more closely associated with the de facto agent's activities, the “de facto principal” is the primary beneficiary (even if the de facto agent would not be considered an agent under the guidance in EITF Issue No. 96-19, “Debtor's Accounting for a Modification or Exchange of Debt Instruments,” or EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”).
• Require the primary beneficiary to account for goodwill resulting from the initial consolidation of a VIE in accordance with FASB Statement No. 141, Business Combinations, when the VIE meets the definition of a business in EITF Issue No. 98-3, “Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business.”

In addition to the proposed Interpretation, the FASB staff is continuing to work on FSPs addressing the following, both of which could impact conclusions reached by companies that have already adopted FIN 46:

• the computation of expected losses and expected returns, including: (i) the amount of fees to be included under paragraphs 8(c) and 8(d); (ii) the effect of those fees on the determination of the entity's expected losses; (iii) whether the ability of other parties to remove the decision maker is relevant in determining the amount of fees to be included under paragraphs 8(c) and 8(d); (iv) the impact of fees on the computation of expected variability in paragraph 8(a) (the FSP would clarify that the computation of expected variability is before the effects of variable interests, such as fees).
• how to allocate expected losses and expected residual returns to the variable interest holders when the holders' interests are not pro-rata.

Based on the above listing of proposed implementation guidance, it appears that accountants will be struggling to implement the guidance in FIN 46 for a while longer.

(see sidebar)

FASB Defers Effective Date of FIN 46

On Oct. 9, 2003, the FASB staff issued FSP FIN 46-6, “Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities,” which delays FIN 46's effective date for variable interests held by public companies in VIEs or potential VIEs created before Feb. 1, 2003.

Under FIN 46, public companies were required to apply the provisions in FIN 46 to entities created before Feb. 1, 2003 no later than the beginning of the first interim or annual reporting period beginning after June 15, 2003 (the beginning of the third quarter for a calendar year company). FSP FIN 46-6 defers the effective date until the end of the first interim or annual reporting period ending after Dec. 15, 2003 (the end of the fourth quarter for a calendar year company).

The deferral of the effective date did not apply to companies that had already issued financial statements reflecting the application of FIN 46 to VIEs created prior to Feb. 1, 2003.

FIN 46-6 also temporarily extends the scope exclusion for registered investment companies to nonregistered investment companies that follow the guidance in the AICPA Audit and Accounting Guide, Audits of Investment Companies (the Audit Guide). The FASB will revisit the scope exclusion once the Accounting Standards Executive Committee of the AICPA finalizes its project to clarify the scope of the Audit Guide.

On July 23, 2003, the Financial Accounting Standards Board (FASB) approved the issuance of five FASB Staff Positions (FSPs) providing guidance on the application of FASB Interpretation No. 46, Consolidation of Variable Interest Entities. (An FSP is the means by which the FASB staff communicates its views on the proper application of FASB literature when it believes there is only one acceptable interpretation. Prior to February 2003, FASB staff guidance was communicated through Staff Implementation Guides or announcements at meetings of the FASB's Emerging Issues Task Force.) The FSPs issued by the staff include:

• FIN 46-1, “Applicability of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, to Entities Subject to the AICPA Audit and Accounting Guide, Health Care Organizations”
• FIN 46-2, “Reporting Variable Interests in Specified Assets of Variable Interest Entities as Separate Variable Interest Entities under Paragraph 13 of FASB Interpretation No. 46, Consolidation of Variable Interest Entities”
• FIN 46-3, “Application of Paragraph 5 of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, When Variable Interests in Specified Assets of a Variable Interest Entity Are Not Considered Interests in the Entity under Paragraph 12 of Interpretation 46″
• FIN 46-4, “Transition Requirements for Initial Application of FASB Interpretation No. 46, Consolidation of Variable Interest Entities”
• FIN 46-5, “Calculation of Expected Losses under FASB Interpretation No. 46, Consolidation of Variable Interest Entities.”

The FASB staff has also proposed FSPs on: 1) the treatment of fees paid to decision makers and guarantors in determining expected losses and expected residual returns and 2) the impact of rights to remove a decision maker on the computation of expected residual returns, but has not finalized that guidance.

A brief explanation of each of the final FSPs and their impact on FIN 46 follows.

Scope of FIN 46

Paragraph 4(a) of FIN 46 provides a scope exception for not-for-profit organizations that follow the consolidation guidance in SOP 94-3, Reporting of Related Entities by Not-for-Profit Organizations. That scope exception did not extend to not-for-profit health care organizations as they follow the consolidation guidance in the AICPA Audit and Accounting Guide, Health Care Organizations. However, as indicated in FIN 46's Summary, the FASB's original intent was to exclude all not-for-profit organizations, as defined in FASB Statement No. 117, Financial Statements of Not-for-Profit Organizations, from its scope. Accordingly, the FASB staff issued FSP FIN 46-1, “Applicability of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, to Entities Subject to the AICPA Audit and Accounting Guide, Health Care Organizations,” to expand the scope exception.

In addition to modifying FIN 46's scope, FSP FIN 46-1 reiterates that a not-for-profit organization used by a for-profit enterprise to circumvent the provisions of FIN 46 is subject to the Interpretation.

Expected Losses

The FASB staff issued two FSPs addressing issues surrounding the determination of an entity's expected losses. FSP FIN 46-5, “Calculation of Expected Losses under FASB Interpretation No. 46, Consolidation of Variable Interest Entities,” clarifies that an entity that has not experienced net losses historically and has an expectation of future profitability will have “expected losses” as contemplated by FIN 46. The reason for this apparent contradiction is due to FIN 46's focus on variability in returns, one-half of which represents performance that is worse than expectations and one-half of which represents performance that is better than expectations. The portion of the variability representing performance that is worse than expectations is what FIN 46 refers to as “expected losses.” For example, if an entity expects annual appreciation of 6% in the fair value of real estate it owns based on historical market performance but it is possible that the real estate will appreciate by only 2%, the underperformance of 4% translates into an expected loss. FSP FIN 46-5 provides an example illustrating this concept.

FSP FIN 46-3, “Application of Paragraph 5 of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, When Variable Interests in Specified Assets of a Variable Interest Entity Are Not Considered Interests in the Entity under Paragraph 12 of Interpretation 46,” concludes that the phrase “expected losses of the entity” has the same meaning in paragraph 5 of FIN 46 as it does in paragraph 12. Accordingly, in determining whether an entity has sufficient equity at risk to permit it to finance its activities without additional subordinated financial support (paragraph 5(a) of FIN 46), expected losses in specified assets representing not more than one-half of the total fair value of the entity's assets that will be borne by a variable interest holder that does not have another variable interest in the entity as a whole should be excluded in determining the entity's expected losses. Consider the following example:

Entity A owns two office buildings, each of which has a fair value of $100 million. Entity A leases one of the office buildings to Company X and the other to Company Y, two unrelated parties. Under the terms of the leases, Company X and Company Y each guarantee the residual value of their leased office building at the end of the lease term. The leases qualify for operating lease treatment as the present value of the future minimum lease payments, determined using Entity A's implicit interest rate, is less than 90% of the assets' fair value.

In determining whether Entity A has sufficient equity as discussed in paragraph 5(a), its expected losses would include expected losses resulting from possible defaults by Company X and Company Y on their lease payments, plus expected losses resulting from its ownership of the office buildings. (As illustrated in FSP FIN 46-5, “Calculation of Expected Losses under FASB Interpretation No. 46, Consolidation of Variable Interest Entities,” discussed above, expected losses from ownership of the office buildings could arise from possible increases in the fair value of the office buildings that fall below the expected appreciation.)

When a variable interest relates specifically to an asset owned by a possible VIE and the fair value of the asset is not more than 50% of the fair value of all of the possible VIE's assets, FSP FIN 46-3 requires losses that will be absorbed by the variable interest be excluded from the possible VIE's expected losses in determining if the entity is a VIE. In the example above, there are two possible views as to the amount of expected losses that should be excluded in determining if Entity A is a VIE. One view is that, to the extent expected losses from Entity A's ownership of the office buildings result from decreases in their fair values below the amount guaranteed by the lessees, those losses would be excluded from Entity A's expected losses to the extent that the decrease in fair value is equal to or less than the amount of the Company X and Company Y guarantees as those expected losses will be absorbed by a variable interest (the residual guarantee) in the specified assets. The other view is that the expected losses related to the asset would be excluded from Entity A's expected losses as long as the expected losses were less than the amount guaranteed by the lessee. (When the lessee has a fixed price purchase option in addition to providing a guarantee of the leased assets' residual value, the latter view would appear to be required.) Companies should consult with their accounting adviser in these circumstances when determining the amount of expected losses to exclude.

In summary, Entity A's expected losses would include the following:

• expected losses resulting from decreases in the fair value of the office buildings in excess of the guaranteed amounts, and
• expected losses resulting from possible defaults by Company X and Company Y on their lease payments, which include any payment related to expected decreases in the fair value of the office buildings covered by their residual value guarantees.

It is also possible that Entity A's expected losses would include expected losses arising from possible increases in the fair value of the buildings that are less than the expected appreciation, depending on which of the above views is adopted.

Multi-Lessor Entities

As discussed in the April 2003 edition of LJN's Equipment Leasing Newsletter (Volume 22, Number 3), FIN 46 provides that a single entity may be comprised of multiple VIEs if specified assets of the entity are essentially the only source of payment for specified liabilities or other variable interests, such as when the entity finances the acquisition of three real estate properties through the issuance of debt that is specifically identified as having recourse to a specific real estate property. To clarify the application of paragraph 13 of FIN 46, the FASB staff issued FSP FIN 46-2, “Reporting Variable Interests in Specified Assets of Variable Interest Entities as Separate Variable Interest Entities under Paragraph 13 of FASB Interpretation No. 46, Consolidation of Variable Interest Entities.”

FSP FIN 46-2 concludes that separate entities exist within a larger legal entity if essentially none of the returns of the assets of the deemed entity can be used by the remaining VIE and essentially none of the liabilities of the deemed entity are payable from the assets of the remaining VIE. Some accountants have understood this to mean that a silo would not exist in the following example:

Investors A and B form a joint venture to acquire two office buildings, each of which has a fair value of $100 million. Investors A and B each contribute $10 million to the venture for their 50% equity interests. The venture issues $180 million of debt to finance the balance of the purchase price of the buildings. The debt is issued in two tranches of $90 million each – one tranche secured by the first building and the other tranche secured by the second building. Neither tranche has any right to the collateral securing the other tranche.

The venture enters into lease agreements with Company X and Company Y, two unrelated lessees. The terms of the lease agreements require periodic lease payments that will cover the interest on the debt and a return to Investors A and B during the lease term. At the end of the lease term, each lessee is required to 1) exercise a fixed price purchase option or 2) sell the leased asset. If a lessee elects to sell the leased asset and it is sold for less than the venture's acquisition cost, the lessee is obligated to make up the difference, up to a specified amount. If the asset is sold for more than the venture's acquisition cost, the lessee receives the excess as a rent rebate.

Although it appears in substance that the joint venture is comprised of two separate entities (one with the building leased to Company X and one with the building leased to Company Y), the structure does not meet the conditions in paragraph 13 of FIN 46 or the FSP because each owner shares proportionately in the returns or losses of each asset. In other words, to meet the conditions in paragraph 13 and the FSP to be reported as separate entities, each investor would have to have an interest that is targeted to a specified asset of the entity. The result of this interpretation appears to be that an entity need not issue any equity; instead, it could issue a small amount of subordinated debt that has recourse to all of the entity's assets and not trigger a requirement to divide a larger entity into multiple VIEs.

Initial Application

Because the FASB did not elect to “grandfather” the accounting for existing entities, a company with a potentially significant variable interest in an entity would be required to determine if that entity is a VIE subject to FIN 46. FIN 46 specifies that the determination of whether an entity is a VIE should be made as of the date the company became involved with the entity or, if applicable, as of the date that a reassessment event occurs. In certain circumstances, it will be difficult for a company with investments it has owned for a long period of time to make that determination if there have been no recent reassessment events because the information for determining the entity's expected losses for purposes of assessing whether the condition in paragraph 5(a) was met at the time the investment was made may not have been retained or can no longer be found (which may occur if the variable interest was held by a company that has been acquired multiple times).

When it is not practicable for a company to make the determination as to whether the entity is a VIE as of the date it became involved or, if applicable, as of the date of a reassessment event, FSP FIN 46-4, “Transition Requirements for Initial Application of FASB Interpretation No. 46, Consolidation of Variable Interest Entities,” indicates that the determination should be made as of the date the company adopts FIN 46. In that circumstance, if the entity is a VIE, the company would also determine if it was the primary beneficiary as of the date the determination is made, not at the date it originally became involved with the VIE.

Transition and Effective Dates

The guidance in the FSPs related to multipurpose entities and the computation of expected losses was effective immediately on the date of issuance (July 24, 2003) for VIEs to which the requirements of FIN 46 had already been applied, and should be applied to other VIEs as part of FIN 46's adoption.

The expansion of the scope exception for not-for-profit entities that did not follow the guidance in SOP 94-3 became effective on the date the FSP was issued, while the guidance in the FSP on FIN 46's transition requirements was effective on issuance for all interests in VIEs held by companies that elected to adopt FIN 46 before July 24, 2003.

If the guidance in an FSP resulted in a change to previously reported financial information, the impact of that change should be reported by cumulative effect adjustment in the first reporting period ending after July 24, 2003. Alternatively, the FSPs permit restatement of prior periods, with a cumulative-effect adjustment as of the beginning of the first year restated.

What Next?

A number of accountants have been asking themselves that very question. While the FASB's decision to defer FIN 46's effective date(see sidebar, below)has helped alleviate some of the concerns of both preparers and auditors that conclusions reached in adopting the provisions of the Interpretation could change as the FASB issues additional interpretive guidance, the question is still very applicable. On Oct. 31, 2003, the FASB issued a proposed Interpretation that would interpret FIN 46. Some of the more significant provisions of the proposed Interpretation include:

• Defer the application of FIN 46 for companies that are unable to obtain information necessary to (a) determine whether 1) an entity formed prior to Feb. 1, 2003 is a VIE or 2) the company is its primary beneficiary, or (b) consolidate the entity if it is a VIE and the company its primary beneficiary, and require certain disclosures in that circumstance.
• Exclude from FIN 46's scope mutual funds in the form of trusts and trusts managed by a bank trust department.
• Clarify: (i) that rights and obligations from all variable interests in an entity should be considered in determining whether voting rights are disproportionate to the right to receive expected returns or the obligation to absorb expected losses; (ii) that operating losses and modifications of agreements in response to those losses do not require a reassessment of an entity's status as a VIE or the identity of the entity's primary beneficiary unless the losses or modifications impact the characteristics of the controlling equity interest (paragraph 5(b) of FIN 46); (iii) the application of the related party provisions in paragraph 17 to require the holders of variable interests to first consider whether the VIE's activities are more closely associated with the activities of one of the variable interest holders; (iv) that a de facto agency relationship cannot be rebutted such that, if the VIE's activities are not more closely associated with the de facto agent's activities, the “de facto principal” is the primary beneficiary (even if the de facto agent would not be considered an agent under the guidance in EITF Issue No. 96-19, “Debtor's Accounting for a Modification or Exchange of Debt Instruments,” or EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”).
• Require the primary beneficiary to account for goodwill resulting from the initial consolidation of a VIE in accordance with FASB Statement No. 141, Business Combinations, when the VIE meets the definition of a business in EITF Issue No. 98-3, “Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business.”

In addition to the proposed Interpretation, the FASB staff is continuing to work on FSPs addressing the following, both of which could impact conclusions reached by companies that have already adopted FIN 46:

• the computation of expected losses and expected returns, including: (i) the amount of fees to be included under paragraphs 8(c) and 8(d); (ii) the effect of those fees on the determination of the entity's expected losses; (iii) whether the ability of other parties to remove the decision maker is relevant in determining the amount of fees to be included under paragraphs 8(c) and 8(d); (iv) the impact of fees on the computation of expected variability in paragraph 8(a) (the FSP would clarify that the computation of expected variability is before the effects of variable interests, such as fees).
• how to allocate expected losses and expected residual returns to the variable interest holders when the holders' interests are not pro-rata.

Based on the above listing of proposed implementation guidance, it appears that accountants will be struggling to implement the guidance in FIN 46 for a while longer.

(see sidebar)

FASB Defers Effective Date of FIN 46

On Oct. 9, 2003, the FASB staff issued FSP FIN 46-6, “Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities,” which delays FIN 46's effective date for variable interests held by public companies in VIEs or potential VIEs created before Feb. 1, 2003.

Under FIN 46, public companies were required to apply the provisions in FIN 46 to entities created before Feb. 1, 2003 no later than the beginning of the first interim or annual reporting period beginning after June 15, 2003 (the beginning of the third quarter for a calendar year company). FSP FIN 46-6 defers the effective date until the end of the first interim or annual reporting period ending after Dec. 15, 2003 (the end of the fourth quarter for a calendar year company).

The deferral of the effective date did not apply to companies that had already issued financial statements reflecting the application of FIN 46 to VIEs created prior to Feb. 1, 2003.

FIN 46-6 also temporarily extends the scope exclusion for registered investment companies to nonregistered investment companies that follow the guidance in the AICPA Audit and Accounting Guide, Audits of Investment Companies (the Audit Guide). The FASB will revisit the scope exclusion once the Accounting Standards Executive Committee of the AICPA finalizes its project to clarify the scope of the Audit Guide.