PICPA - Consolidation of Variable Interest Entities


Consolidation of Variable Interest Entities

By Nazzi Zola, CPA


In June 2009, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 167 (SFAS 167), Amendments to FASB Interpretation No. 46(R). As suggested by its title, SFAS 167 amended FASB Interpretation No. 46(R) (FIN 46(R)), Consolidation of Variable Interest Entities. These statements provide guidance for consolidation of an entity when it would not otherwise be required to do so under the control model of ARB No. 51, Consolidated Financial Statements.

This article provides an overview of the major provisions of SFAS 167 and an analysis of some of its primary provisions. As of the writing of this article, SFAS 167 had not yet been codified into the Accounting Standards Codification (ASC), therefore references will be to SFAS 167 itself.

SFAS 167 attempts to close a loophole where certain enterprises can avoid consolidation if they effectively control another entity. Thus, an entity whose investors do not have sufficient equity at risk to finance its activities without additional subordinated financial support—or if the holder of the equity investment at risk lack the power to direct the activities of the entity that most significantly affect its economic performance, the obligation to absorb expected losses, or the right to received expected residual returns—may be subject to consolidation by another enterprise, which is not a majority equity owner.

It is necessary to analyze four elements to determine whether an enterprise must consolidate an entity in which it does not have majority voting control:

  • Determine if the entity potentially controlled meets the definition of an “entity” as defined by FASB in SFAS 167. It is only these organizations that qualify for potential consolidation.
  • If the organization is an entity, determine if it meets one of the seven scope exceptions. If one of the scope exceptions applies, the entity is scoped out of SFAS 167 and consolidation is not required.
  • If the entity is not scoped out, determine if the entity is a variable interest entity (VIE), and whether the enterprise has a variable interest in the VIE.
  • If the entity is a VIE and the enterprise has a variable interest in it, determine which enterprise is the primary beneficiary. The primary beneficiary is the one required to consolidate the VIE.

The remainder of this article will examine a few of the provisions of the SFAS 167 model.

SFAS 167 defines a qualifying entity as “any legal structure used to conduct activities or to hold assets. Some examples are corporations, partnerships, limited liability companies, grantor trusts, and other trusts. Portions of entities or aggregations of assets within an entity shall not be treated as separate entities for purposes of applying this interpretation unless the entire entity is a variable interest entity.” Most organizations will meet the definition of an entity, and will require the analysis to proceed to the subsequent steps.

The statement does not apply to certain scope exceptions, including some not-for-profit organizations, employee pension and benefit plans, certain investment companies, some life and health insurance entities, certain governmental organizations, and enterprises with an interest in a VIE created before Dec. 31, 2003, if it is unable to obtain the information to make the necessary determinations.

There is one additional scope exception that is often misinterpreted. It is referred to as the Business Scope Exception (BSC). In general, the provisions of SFAS 167 do not have to be applied to an entity that meets the definition of a business as provided in the FASB ASC. This exception is often misinterpreted because those making the evaluation of the entity often do not apply all of the provisions of the exception.

The BSC notes that although it does not apply to entities that meet the definition of a business as a general rule, it does apply if the following are met:

  • The enterprise participated in the design or redesign of the entity.
  • The entity is designed so that substantially all of its activities involve or are conducted on behalf of the enterprise.
  • The enterprise provides more than half of the total equity, subordinated debt, and other forms of subordinated financial support based on the fair values of the interests in the entity.
  • The entity is primarily involved in securitizations or similar financing arrangements.

While the first, second, and fourth prohibitions from applying the BSC are relatively straightforward, the third one requires further clarification, especially in understanding “subordinated financial support.” The statement defines this term as referring “to variable interests that will absorb some or all of an entity’s expected losses.” This definition is easy to misinterpret, in that it does not refer to losses reported on the income statement. That is, an entity, which is very profitable, can still have expected losses.

In this regard, the statement explains that expected losses “are the expected negative variability in the fair value of its net assets. Expected variability includes expected variability resulting from operating results of the entity.” This variability is derived from the discounting of expected cash flows of the entity. Specifically, the statement clarifies that “expected losses are computed once the expected cash flows are determined. Estimated cash flows (possible outcomes) are compared with the computed expected cash flows (probability-weighted outcomes). Estimated cash flows that are less than the expected cash flows contribute to expected losses.”

Therefore, if an enterprise other than the equity owners is absorbing more than half of the negative variability in the expected cash flows of the entity, the entity does not qualify for the BSC and SFAS 167 applies to the evaluation of the entity. For example, if an enterprise has a contract with an entity to purchase its output, and the contract is structured in such a way that the enterprise is absorbing the majority of the expected losses, the enterprise may have to consolidate the entity even though it has no ownership interest in the entity.


Nazzi Zola, CPA, is general manager of research and transaction support at Allegheny Energy in Greensburg, Pa. He can be reached at nzola@alleghenyenergy.com

LAST UPDATED 1/5/2010

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