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  • 1. October 2009 Financial Reporting Executive Summary ...................1 Consolidation of Variable Interest Background ...............................2 Entities Statement 167 ............................3 Substance.................................................3 This Financial Reporting letter was prepared and distri- Variable Interests.....................................3 Variable Interest Entities........................4 buted by BDO Seidman, LLP to help our clients anticipate Consolidation Based on Variable and respond to questions that may arise with the implemen- Interests ................................................6 tation of FASB Statement No. 167, Amendments to FASB Shared Power...........................................8 Related Parties ........................................8 Interpretation No. 46(R). Presentation & Disclosure .....................9 Transition .................................................9 Executive Summary SEC Reporting Implications .....10 In June, the FASB published its latest standard on consolidation policy.1 The Internal Control Reporting...................10 result? Many more entities will be consolidated than in the past and “off-bal- Rule 3-05 and Article 11 of ance sheet” accounting will be much less common. Regulation S-X and Form 8-K..........10 The Impact of Retrospective This project comes on the heels of the credit crisis and is intended to Adoption on Incorporating respond to several perceived deficiencies in the current consolidation rules. Financial Statements by Reference For instance, Statement 167 mandates that substance, not form, govern in Registration Statements ..............11 whether variable interest entities2 (VIEs) are consolidated or kept off the Practical Steps..........................11 books. While this may seem obvious, the new standard was designed to more clearly portray business economics in financial reports, which some observers On the Horizon..........................12 believed was lacking under prior GAAP.3 Going forward, so-called “qualifying For More Information ...............12 special purpose entities” will no longer be exempt from consolidation and must be evaluated like all other entities. Similarly, troubled debt restructur- Appendix A: Summary of FIN 46(R), as amended by ings in which creditors grant concessions to debtors must be analyzed, which Statement 167.......................13 wasn’t previously required. On the margin, these two scoping changes will result in more entities being consolidated compared to prior GAAP. Appendix B: Key Changes Statement 167 makes to 1 FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R). This Financial Reporting letter has been FIN 46(R) ...............................14 drafted using legacy GAAP references since Statement 167 was issued in that format. The FASB’s Accounting Standards Codification is the single source of authoritative nongovernmental US GAAP for interim and annual periods ending after September 15, 2009. It supersedes all authoritative literature in Levels A-D of the GAAP hierarchy and new accounting guidance will be issued in the form of Accounting Standards Updates to the Codification. 2 See section titled “Variable Interest Entities” below for a definition of this term. 3 Generally Accepted Accounting Principles
  • 2. Financial Reporting In addition, Statement 167 elim- While these revisions will pull the end to assist with implementa- inated one key reason that was an incremental number of struc- tion efforts for all companies. Two commonly relied upon to avoid tures onto corporate balance appendices are also provided to consolidation. In many structures, sheets, the FASB preserved off-bal- summarize the variable interest one party often managed daily ance sheet treatment for situations consolidation model and highlight operations but wasn’t required to in which none of an entity’s the major changes that Statement consolidate the entity because pas- investors are individually able to 167 makes to FIN 46(R)4 sive investors had the ability to exert control. Said differently, if the remove the manager or block his or power to direct key business activ- ities is shared by two or more par- Background her actions in certain circum- stances. Such rights were rarely ties, consolidation isn’t required. The purpose of consolidated finan- exercised, but they frequently As a result, “true” joint ventures will cial statements is to present the determined the accounting out- continue to be presented in the results of operations and the finan- come. Under the new guidance, financial statements as a single cial position of a parent and all its those situations should be much asset, as well as a single element of subsidiaries as if the consolidated less common. earnings. group were a single economic Most importantly, the funda- The new standard should also entity. A parent consolidates enti- improve transparency for users by ties in which it holds a controlling mental criteria changed for decid- segregating assets and liabilities financial interest. The usual condi- ing whether a VIE should be con- on the balance sheet that are sub- tion for a controlling financial inter- solidated. Previously, companies ject to certain settlement restric- est is ownership of a majority vot- measured who was exposed to a tions and enhancing footnote dis- ing interest. As a general rule, own- majority of a VIE’s “risks and closures about the risks to which an ership by one company of more rewards” to decide which investor investor is exposed. than 50% of the outstanding voting had to consolidate. That is, con- As indicated above, it’s helpful to shares of another company results solidation conclusions turned on understand that Statement 167 was in consolidation (the “voting inter- complex modeling techniques that developed squarely in the context est model”).5 were used to estimate the entity’s of financial institutions and struc- However, there are exceptions to expected cash flows, taking into tured finance. Nevertheless, it the rule. The voting interest model account uncertain market dynam- applies to almost all industries. may not identify the party with a ics. The underlying accounting the- Therefore, companies should begin controlling financial interest ory was that investors who agreed evaluating the new standard now to because control of some entities to take on such exposure only did determine the impact it will have at may be achieved through arrange- so because it also conveyed control adoption—the first fiscal year that ments that do not involve voting over the entity. However, that was- begins after November 15, 2009, interests. As indicated in Statement n’t always borne out in practice. including interim periods within 167, the FASB believes a controlling Now, companies are actually that year. financial interest in these types of required to identify the business This Financial Reporting letter pro- entities should be identified on the activities that significantly impact vides a short background on con- basis of whether an interest gives an entity’s economic performance solidation policy in general and its holder power over the entity’s and decide who has the power to then discusses the specific require- activities and rights to receive its direct them, in addition to consid- ments of Statement 167. In addi- benefits or obligations to absorb its ering possible upside and down- tion, it outlines several important losses. This is known as the “vari- side investment risk. With this implications the new standard has able interest model.” Entities sub- change, situations in which no one for public companies that must ject to this approach are called consolidates should be less fre- comply with the SEC’s rules, and “variable interest entities,” or VIEs. quent. includes practical suggestions at 4 FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities – an interpretation of ARB No. 51 5 Accounting Research Bulletin No. 51, Consolidated Financial Statements COPYRIGHT 2009, BDO SEIDMAN, LLP 2
  • 3. Financial Reporting BDO Insight: To ensure the proper ests in an entity that change with cant amount of the entity’s model is applied, it is critical to changes in the fair value of the expected residual returns. determine whether the entity entity’s net assets, excluding vari- • The service arrangement being evaluated for consolidation is able interests themselves. That is, includes only terms, conditions, a VIE or not. The consolidation con- variable interests absorb changes or amounts that are customarily clusion will often differ depending in the fair value of an entity’s net present in arrangements for sim- on which model is required—vot- assets (i.e., variability), rather than ilar services negotiated at arm’s ing or variable. create variability. Common exam- length. ples of variable interests include • The total amount of anticipated The rest of this letter describes the subordinated debt and equity fees are insignificant relative to revised variable interest model in instruments issued by the entity, the total amount of the variable greater detail, including a review of certain guarantees, puts, calls and interest entity’s anticipated eco- its scope to help companies pick forwards, marketing arrangements nomic performance. the right path when they come to and leases, as well as other con- • The anticipated fees are expected this fork in the road. tracts such as management and to absorb an insignificant service agreements. Importantly, if amount of the variability associ- a reporting enterprise doesn’t hold ated with the entity’s anticipated Statement 167 a variable interest in a VIE, it is pre- economic performance. Substance – The FASB debated, and cluded from applying the variable Equity interests are generally ultimately concluded, it was nec- interest consolidation model. inconsistent with the fiduciary con- essary to provide a reminder that The FASB provided a narrow cept because they represent an only substantive terms, transac- exception in Statement 167 for obligation to absorb losses and a tions and arrangements should be management or service agreements right to receive benefits. In con- considered when applying State- of a strictly fiduciary nature. Fees trast, fixed fee arrangements, such ment 167. That is, nonsubstantive paid to decision makers and service as 1% of assets under management, items should be ignored—both providers do not require evaluation may qualify for the exception contractual and noncontractual. On as a variable interest if all of the fol- depending on their terms. More- the surface, this seems straightfor- lowing six conditions are satisfied:6 over, determining whether a fee ward. However, it’s important to • The fees are compensation for arrangement meets the scope note that the FASB observed situa- services provided and are com- exception described above will tions in practice where minor fea- mensurate with the level of effort require an understanding of similar tures have been added to or required to provide those serv- contracts used in the VIE’s industry removed from arrangements solely ices. to help ascertain whether it repre- to achieve a desired accounting • Substantially all of the fees are at sents a mere fiduciary relationship. outcome that frustrates the objec- or above the same level of sen- Some variable interests are eas- tive of the variable interest model. iority as other operating liabili- ier to identify than others. The The intent of the substance princi- ties of the entity that arise in the examples above are apparent ple is to prohibit similar structuring normal course of the entity’s because they exist in writing. Other in the future, and does not imply activities, such as trade payables. variable interests are implied by the that nonsubstantive items should • The decision maker or service existence of relationships or trans- be considered in other areas of provider and its related parties, if actions, historical patterns of act- GAAP. As a result, judgment will be any, do not hold other interests ing in a certain capacity or the rep- required to determine whether cer- in the variable interest entity that utational risk of not providing tain terms, transactions and individually, or in the aggregate, financial support to an entity. These arrangements are substantive. would absorb more than an are known as implicit variable inter- insignificant amount of the ests, which must be identified and Variable Interests are contractual, entity’s expected losses or considered when applying the vari- ownership or other monetary inter- receive more than an insignifi- able interest model. 6 Paragraph B22 of FIN 46(R), as amended COPYRIGHT 2009, BDO SEIDMAN, LLP 3
  • 4. Financial Reporting The FASB illustrated an implicit ior and shed light on the presence considered “at risk” under FIN 46R variable interest using the rela- of an implicit variable interest. because he “pays” for it by provid- tionship between a manufacturing ing services. However, the limited company and a leasing company. Variable Interest Entities – An partners who contributed the “at Assume a manufacturing company entity is a VIE if one or more of the risk” equity were deemed to retain is owned by two individuals, one following is true: power of the partnership’s opera- of which also owns a leasing com- • The total equity investment at tions by virtue of kick-out rights or pany. The leasing company has no risk is not sufficient to permit the participating rights. For example, if assets other than a manufacturing entity to finance its activities predefined circumstances occurred, facility that it leases to the manu- without additional subordinated such as a significant deterioration facturer. In this example, the lease financial support provided by any in financial condition, the limited does not contain a residual value parties. partners acting as a group could guarantee related to the manufac- • Equity holders lack (i) the power kick the general partner out. While turing facility or include an option to direct the activities that most latent, this ability meant that the for the lessee to buy the assets. significantly impact the entity’s equity investment at risk (i.e., the Therefore the lease does not repre- economic performance, (ii) the limited partners’ capital) repre- sent a variable interest. However, obligation to absorb expected sented power over the partnership. the manufacturing company would losses or (iii) the right to receive Therefore, it was not considered a be deemed to hold an implicit vari- expected residual returns.7 VIE and the variable interest model able interest in the leasing com- • Expected losses or returns are didn’t apply. pany if the manufacturer effectively not proportionate to voting Under Statement 167, kick-out guarantees the investment of the rights and substantially all of an rights and participating rights are leasing company’s owner. This entity’s activities involve or are no longer relevant to the analysis, would be true if an expectation conducted on behalf of an unless a single party has the uni- exists (or history suggests) that the investor with only a few voting lateral ability to exercise them manufacturer would make funds rights. available to the leasing company While these are essentially the (including its related parties and to avoid its debt being called or to same three concepts that FIN 46(R) de facto agents10). This is because prevent a creditor from invoking a established, the second item – the FASB was troubled that in prac- guarantee that was issued by the power over the entity – has tice, such rights have been consid- leasing company’s owner. changed significantly because of ered substantive for accounting the role that kick-out rights8 and purposes but were rarely exercised. BDO Insight: All of the relevant participating rights9 play under The FASB acknowledged that the facts and circumstances must be Statement 167. new evaluation of kick-out rights considered when determining To illustrate, many partnerships and participating rights under whether an implicit variable inter- consist of a single general partner Statement 167 is different than how est exists. In that regard, it is impor- and many limited partners. These they are currently treated in EITF tant to obtain a thorough under- partnership agreements commonly Issues 96-1611 and 04-5,12 but standing of the economic incen- assign responsibility for operations decided that the inconsistency tives or conflicts of interest that to the general partner, while the would be considered in a separate exist in a particular situation limited partners are passive. Often, project to reconsider consolidation because they may influence behav- the general partner’s equity is not policy more broadly. 7 Expected losses and expected residual returns refer to amounts derived from the entity’s expected cash flows, discounted and otherwise adjusted for market factors and assumptions. 8 For purposes of Statement 167, kick-out rights are the ability to remove the enterprise with the power to direct the activities of a VIE that most significantly impact the entity’s economic performance. 9 For purposes of Statement 167, participating rights are the ability to block the actions through which an enterprise exercises the power to direct the activities of aVIE that most significantly impact the entity’s economic performance. 10 The definitions of related parties and de facto agents are largely unchanged by Statement 167. These include the parties identified by Statement No. 57, Related Party Disclosures, and others specified in paragraph 16 of FIN 46(R), as amended. 11 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 12 Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights COPYRIGHT 2009, BDO SEIDMAN, LLP 4
  • 5. Financial Reporting BDO Insight: In the partnership disincentive for dissolution (liqui- ing activities like provisions to pro- illustration above, the limited part- dation) or removal tect a franchisor’s brand. While pro- ners would now be deemed to lack • The absence of an adequate num- tective rights do not influence the power over the partnership’s activ- ber of qualified replacement gen- consolidation analysis, judgment ities because no single limited part- eral partners or the lack of ade- may be required to differentiate ner could remove the general part- quate compensation to attract a protective rights from other types ner, meaning the partnership qualified replacement of rights, depending on the nature would be considered a VIE. Further, • The absence of an explicit, reason- of the VIE and the terms of its gov- the general partner’s unit would able mechanism in the limited erning documents. embody a controlling financial partnership agreement or in the In Statement 167, the FASB also interest because it represents the applicable laws or regulations, by affirmed that an entity’s classifica- ability to direct the partnership’s which the limited partners holding tion as a VIE can change over time. most significant activities, as well as the rights can call for and conduct The FASB considered requiring an an obligation to absorb losses and a vote to exercise those rights ongoing (i.e., daily) assessment of a right to receive returns.13 • The inability of the limited part- VIE status, but rejected that Consequently, the general partner ners holding the rights to obtain approach because it would have would be the primary beneficiary the information necessary to exer- been too costly. Instead, all of the and consolidate the partnership. cise them. reconsideration events in FIN 46(R) This is a significant change from were retained, and two more were prior GAAP, in which the partner- While there may be other factors added: i) changes that cause the ship was not considered a VIE, nor relevant to a particular fact pattern, equity holders to lose the power to was it typically consolidated by the kick-out rights and participating direct an entity’s significant activi- general partner under the voting rights should be currently exercis- ties, and ii) troubled debt restruc- interest model (generally, EITF 04- able, considering all of the poten- turings under Statement 15.14 5) because the limited partners as tial barriers above, to be consid- The FASB reasoned that an a group could exercise kick-out ered substantive under Statement entity previously considered to be a rights. 167. And, due to the inconsistent voting interest entity could experi- treatment of kick-out rights and ence severe losses, causing share- Note that even if a single limited part- participating rights between the holders to lose their voting power ner could exercise kick-out rights or voting interest model and the over the entity. This might enable a participating rights, they must still be revised variable interest model, guarantor or lender to obtain con- substantive to influence the consoli- more entities will be considered trol of the entity without triggering dation analysis. In practice, compa- VIEs under Statement 167 com- a reconsideration of its VIE status nies should consider whether there pared to prior GAAP. under prior GAAP. The FASB found are any significant barriers to the Kick-out rights and participating such an outcome troubling, and as exercise of these rights, similar to the rights differ from protective rights, a result, added it to the list of examples in EITF 04-5: which are designed to protect their reconsideration events to increase • Kick-out rights subject to condi- interest holder without giving that the scope of entities that may be tions that make it unlikely they will party a controlling financial inter- subject to the variable interest con- be exercisable, for example, con- est. Examples include approval or solidation model. ditions that narrowly limit the tim- veto rights that do not affect a VIE’s ing of the exercise significant activities (e.g., a right Consolidation Based on Variable • Financial penalties or operational that protects a lender by restricting Interests – This element of the vari- barriers associated with dissolving an entity’s ability to sell important able interest model changed more assets), the ability to remove the than any other under Statement (liquidating) the limited partner- enterprise that has a controlling 167. Previously, companies were ship or replacing the general part- financial interest in bankruptcy, or required to consolidate a VIE if they ners that would act as a significant limitations on an entity’s operat- had a variable interest that would 13 See “Consolidation Based on Variable Interests” below for further discussion of what constitutes a controlling financial interest under Statement 167. 14 Accounting by Debtors and Creditors for Troubled Debt Restructurings COPYRIGHT 2009, BDO SEIDMAN, LLP 5
  • 6. Financial Reporting absorb the majority of the VIE’s the entity that could potentially In addition, kick-out rights and expected losses, receive a majority be significant to the VIE (“eco- participating rights do not affect a of its expected residual returns, or nomics”). company’s assessment of power, both. Expected losses and returns The FASB articulated power in just as they are not relevant for were calculated using sophisticated all-or-nothing terms, meaning a determining whether an entity is a mathematical models that were single party either does or does not VIE, unless they can be exercised often difficult to understand, apply have the ability to direct the activ- unilaterally by a single party and audit. In addition, the ities that are most significant to (including its related parties and approaches and methods used by the VIE. This encompasses situa- de facto agents). different companies to calculate tions in which a party does not cur- With respect to economics, variability were inconsistent, lead- rently exercise its power to direct losses and benefits only need to ing to different accounting conclu- the activities of an entity, but could be potentially significant to meet this sions for VIEs with similar charac- choose to do so in the future—for characteristic of the primary bene- teristics. Lastly, quantitative and example, directing the activities of ficiary test. This differs from expected qualitative approaches often iden- a securitization vehicle if and when losses and residual returns that are tified a different primary beneficiary its assets become troubled. While used to define a VIE. Under this for the same VIE. it is possible different variable approach, companies may not look To address these deficiencies, interest holders acting in good faith solely to what’s probable for pur- the FASB adopted a purely qualita- may place different weight on the poses of the economics test; they tive model for determining the pri- relative importance of each activity, are required to make their deter- mary beneficiary in Statement 167. the FASB intended the revised pri- mination on the basis of what is That is, quantitative models are not mary beneficiary model to identify merely possible. Companies permitted for this purpose, even as a single controlling financial inter- should also note that significance a fallback when the qualitative est holder, and therefore only one is measured with respect to the approach is considered highly judg- party should consolidate a VIE. VIE, not with respect to the vari- mental in the circumstances. Statement 167 does not provide able interest holder. As a result, However, the standard did not a list of factors or other criteria for Statement 167 establishes a very change the approach for determin- determining which of a VIE’s activ- low threshold for determining ing whether an entity has a suffi- ities are significant. Instead, com- whether a variable interest conveys cient amount of equity at risk, panies will have to use judgment to a potentially significant level of which is one of the criteria for determine which activities most losses or benefits. determining whether it is a VIE in significantly impact an entity’s per- The following example is repro- the first place. Therefore, a quanti- formance. Because business activ- duced from Statement 167 to illus- tative approach may still be neces- ities will differ by the type of entity trate the revised variable interest sary for that purpose. being analyzed, the FASB provided model for identifying a controlling Under Statement 167, a variable examples of applying the power financial interest: interest provides its holder with a and economics model in several controlling financial interest in a different settings, including manu- VIE if it represents both: facturing and distribution, leasing • The power to direct the activities arrangements and securitization of a variable interest entity that vehicles.15 This qualitative analysis most significantly impact the includes a consideration of the pur- entity’s economic performance pose and design of the VIE as well (“power”), and as the risks and rewards that it was • The obligation to absorb losses designed to create and pass of the entity that could poten- through to its variable interest tially be significant to the VIE or holders. the right to receive benefits from 15 See Appendix C of Statement 167. COPYRIGHT 2009, BDO SEIDMAN, LLP 6
  • 7. Financial Reporting Facts and Circumstances An entity is created by a furniture manufacturer and a financial investor to manufacture and sell wood furniture to retail customers in a particular geographic region. The entity was created because the furniture manufacturer has no viable distribution channel in that particular geographic region. The entity is established with $100 of equity, contributed by the furniture manufacturer, and $3 million of 10-year fixed-rate debt, provided by a financial investor. The furniture manufacturer establishes the sales and marketing strategy of the entity, manages the day-to-day activities of the entity, and is responsible for preparing and implementing the annual budget for the entity. The entity has a distribution contract with a third party that does not represent a variable interest in the vari- able interest entity. Interest is paid to the fixed-rate debt holder (the financial investor) from operations before funds are available to the equity holder. The furniture manufacturer has guaranteed the fixed-rate debt to the financial investor. The debt agreement includes a clause such that if there is a materially adverse change that materially impairs the ability of the entity and the furniture manufacturer to pay the debt, then the financial investor can take possession of all the assets of the entity. An independent third party must objectively determine whether a materially adverse change has occurred on the basis of the terms of the debt agreement (an example of a materially adverse change under the debt agreement is the bankruptcy of the entity). Evaluation Purpose and Design of the Entity An enterprise must determine the purpose and design of the variable interest entity, including the risks that the entity was designed to create and pass through to its variable interest holders. In making this assessment, the variable interest holders of the entity deter- mined the following: a. The primary purpose for which the entity was created was to enable the furniture manufacturer to extend its existing business line into a particular geographic region that lacked a viable distribution channel. b. The entity was marketed to the financial investor as a fixed-rate investment in a retail operating entity, supported by the furni- ture manufacturer’s expertise and guarantee. c. The furniture manufacturer’s guarantee of the debt effectively transfers all of the operating risk of the entity to the furniture man- ufacturer. Determination of the Primary Beneficiary The furniture manufacturer and the financial investor (debt holder) are the variable interest holders in the variable interest entity. An enterprise must identify which activities most significantly impact the entity’s economic performance and determine whether it has the power to direct those activities. The economic performance of the entity is most significantly impacted by the operations of the entity because the operating cash flows of the entity are used to repay the financial investor. Thus, the activities that most significantly impact the entity’s economic performance are the operating activities of the entity. The furniture manufacturer has the ability to establish the sales and marketing strategy of the entity and manage the day-to-day activities of the entity. The debt holder has the power to take possession of all of the assets of the entity if there is a materially adverse change under the debt agreement. However, the debt holder’s rights under the materially adverse change clause represent protective rights. Protective rights held by other parties do not preclude an enterprise from having the power to direct the activities of a variable inter- est entity that most significantly impact the entity’s economic performance. Protective rights are designed to protect the interests of the party holding those rights without giving that party a controlling financial interest in the entity to which they relate. The debt holder’s rights protect the interests of the debt holder; however, the entity’s economic performance is most significantly impacted by the activities over which the furniture manufacturer has power. The debt holder’s protective rights do not prevent the furniture manufacturer from having the power to direct the activities of the entity that most significantly impact the entity’s economic per- formance. If an enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity’s eco- nomic performance, then that enterprise also is required to determine whether it has the obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits that could potentially be signifi- cant to the variable interest entity. The furniture manufacturer has the obligation to absorb losses that could potentially be signif- icant through its equity interest and debt guarantee and the right to receive benefits that could potentially be significant through its equity interest. On the basis of the specific facts and circumstances presented above and the analysis performed, the furniture manufacturer would be the primary beneficiary of the variable interest entity because: a.) It is the variable interest holder with the power to direct the activities of the variable interest entity that most significantly impact the entity’s economic performance. b.) Through its equity interest and debt guarantee, it has the obligation to absorb losses of the entity that could potentially be significant to the variable interest entity and the right to receive benefits from the entity that could potentially be significant to the variable interest entity. COPYRIGHT 2009, BDO SEIDMAN, LLP 7
  • 8. Financial Reporting Lastly, the FASB decided to BDO Insight: Conclusions about holder does not consolidate the require an ongoing assessment of shared power should also consider VIE, other GAAP applies. For primary beneficiary status. In the whether the written requirement instance, an investor in a true joint past, variable interest holders has substance. For example, regard- venture would likely apply the reconsidered whether they were the less of the agreement in place, does equity method of accounting.16 But primary beneficiary only when cer- history indicate one party acts uni- in those circumstances, Statement tain triggering events occurred. laterally? If not, what sort of conse- 167 still requires certain disclo- Statement 167 eliminated this ele- quences would stem from individual sures about variable interests that ment of the variable interest model action in the future? This line of are not held by the primary benefi- to align it with the voting interest questioning may be particularly rel- ciary.17 approach. Now variable interest evant to previously non-consoli- holders must monitor changing cir- dated joint ventures that are VIEs Related Parties – Statement 167 cumstances that influence whether during the implementation of changed the role of related parties the holder has either obtained or Statement 167. (including de facto agents18) in the lost a controlling financial interest consolidation analysis. Previously, in the VIE, such as amendments to If power over a VIE is not shared, a company was required to con- its governing documents or the consolidation is required by one sider whether its variable interest, issuance of new debt and equity party. When an entity’s significant when combined with the variable securities. Decisions to consolidate activities are directed by multiple interests of its related parties, or deconsolidate an entity should unrelated parties and the nature of would identify the company as the be reflected in the financial state- the activities that each party directs primary beneficiary. If so, the indi- ments on the date circumstances is not the same (for example, man- vidual within the related party change, and prior periods are not ufacturing, distribution and retail- group that was judged to be the recast to conform to the current ing), then the party who can direct most closely associated with the presentation. the subset of activities that most VIE consolidated. This was known significantly impact the entity’s as the related party “tie-breaker” Shared Power exists when a com- economic performance is deemed test and judgment was required to pany determines that power is, in to have power. determine the “winner” based on fact, shared among unrelated par- If power is not shared but the any principal-agency relationships ties such that no individual has the entity’s significant activities are that exist between the parties, the power to direct the VIE’s most sig- directed by multiple unrelated par- relationship and significance of the nificant activities. In that case, no ties and the nature of the activities VIE’s activities to the various par- one meets the definition of a pri- that each party directs is the same, ties, exposure to variability and the mary beneficiary and the VIE isn’t then the party with power over the entity’s original design. consolidated. Shared power is majority of those activities is the Under the revised approach, present when unrelated parties primary beneficiary. This might be each individual within the related require mutual consent for deci- true for a securitization vehicle in party group is now required to first sions about the VIE’s most signifi- which multiple parties service the apply the “power and economics” cant activities. An entity’s govern- loans that it holds, but one party test described above. The related ing documents will usually indicate services a majority of the loans. party tie-breaker test only applies if whether a mutual consent require- If, after considering all available no individual has both power and ment exists. information, a variable interest economics, but the group as a 16 Statement 167 provides an illustration in which a VIE does not have a primary beneficiary due to the presence of shared power. See example 8 in Appendix C. 17 See paragraphs 22B – 22E of FIN 46(R), as amended. 18 Paragraph 16 of FIN 46(R), as amended, defines de facto agents of an enterprise as: (a) A party that cannot finance its operations without subordinated financial sup- port from the enterprise, for example, another variable interest entity of which the enterprise is the primary beneficiary (b) A party that received its interests as a con- tribution or a loan from the enterprise (c) An officer, employee, or member of the governing board of the enterprise (d) A party that has an agreement that it cannot sell, transfer, or encumber its interests in the entity without the prior approval of the enterprise. The right of prior approval creates a de facto agency relationship only if that right could constrain the other party’s ability to manage the economic risks or realize the economic rewards from its interests in a variable interest entity through the sale, transfer, or encumbrance of those interests. However, a de facto agency relationship does not exist if both the enterprise and the party have right of prior approval and the rights are based on mutually agreed terms by willing, independent parties. (e) A party that has a close business relationship like the relationship between a pro- fessional service provider and one of its significant clients. COPYRIGHT 2009, BDO SEIDMAN, LLP 8
  • 9. Financial Reporting whole does. Because power and financial statements until the beneficiary. While retrospective economics must be assessed restriction is satisfied. application isn’t required upon before the related party tie-breaker adoption of Statement 167, com- can be applied, consolidation con- In addition, if a company consoli- panies who choose retrospective clusions based on which related dates more than one VIE, the application and companies who party is most closely associated assets and liabilities of multiple don’t will generally apply the same with the VIE should be less fre- VIEs can be aggregated on the bal- procedures with respect to prior quent than prior to Statement 167. ance sheet. In those circumstances, periods to determine the proper companies are encouraged to pro- carrying amounts to record. Presentation and Disclosure – vide clear footnote disclosures Any difference between the net Generally, a primary beneficiary’s explaining the criteria for aggregat- amounts recognized in the balance consolidated financial statements ing entities with different risk expo- sheet and any previously recog- are presented on the same basis sures. nized interest in the newly consol- as traditional voting entities. The Statement 167 also requires idated entity would be recognized assets, liabilities and noncontrol- additional disclosures that are as a cumulative effect adjustment ling interests of a VIE are treated designed to illustrate a company’s to retained earnings. If it is not the same as if they were consoli- involvement with VIEs and any sig- practicable to determine the carry- dated based on holding a voting nificant changes in risk exposure ing amounts of the assets, liabili- interest greater than 50%. Never- due to that involvement. This ties, and noncontrolling interests theless, companies are required to includes describing any significant of newly-consolidated VIEs, com- present the assets and liabilities of judgments and assumptions made panies are permitted to use fair consolidated VIEs separately if cer- in the consolidation analysis. The value at date of adoption. Further, tain restrictions exist.19 A VIE’s disclosures are mostly consistent for VIEs that engage principally in assets must be separated if they with those required under FSP FAS securitizations or other forms of can only be used to settle its own 140-4 and FIN 46(R)-8, which was asset-backed financing, if certain obligations, as opposed to obliga- issued in December 2008 and is conditions are met the standard tions of the consolidated group. superseded by Statement 167. permits a company to measure the Similarly, liabilities have to be sep- assets and liabilities at their arated if the related creditors do Transition – Statement 167 is effec- not have recourse to the general unpaid principal balances as an tive as of the beginning of the first credit of the primary beneficiary. fiscal year beginning after alternative to fair value. BDO Insight: Statement 167 does November 15, 2009 and for interim BDO Insight: These circumstances not define the term “practicable.” periods in those years. Voluntary are most prevalent in securitiza- As a result, companies will need to adoption prior to that date is not tion vehicles, but the separate determine what level of effort is allowed, although the new stan- presentation requirements are not required to reach this threshold, dard does provide a choice limited to entities in the financial and apply it consistently as an between prospective and retro- services area. For example, in the accounting policy election. Some spective adoption. manufacturing example above, companies may wish to consider If a company consolidates an assume the financial investor the factors in Statement 15420 for entity as a result of the initial appli- imposed a covenant restriction on this purpose, but are not required cation of the standard, it should the VIE’s assets, such that assets to do so: measure and recognize the assets, cannot be distributed to any other • After making every reasonable liabilities, and noncontrolling inter- lender, equity investor or affiliate effort to do so, the entity is unable ests of the newly-consolidated VIE until the 10-year fixed-rate debt is at their carrying amounts as if repaid. In that case, the VIE’s assets Statement 167 had been applied to apply the requirement. would be separately presented in from the time the enterprise first • Retrospective application requires the manufacturer’s consolidated met the conditions to be a primary assumptions about management’s 19 While consolidated subsidiaries that are not VIEs may be subject to similar restrictions, the separate presentation requirement in Statement 167 is unique to VIEs. 20 Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3 COPYRIGHT 2009, BDO SEIDMAN, LLP 9
  • 10. Financial Reporting intent in a prior period that cannot a cumulative effect adjustment to registrant does not have the right be independently substantiated. retained earnings of the first year or authority to assess the internal • Retrospective application requires restated. In any event, companies controls of the consolidated entity significant estimates of amounts, should disclose their chosen tran- and also lacks the ability, in prac- and it is impossible to distinguish sition method. tice, to make that assessment….” objectively information about those Since under Statement 167 VIEs estimates that: will be consolidated by entities – Provides evidence of circum- SEC Reporting with the power to direct the activi- stances that existed on the Implications ties of the VIE that most signifi- date(s) at which those amounts cantly affect its economic perform- would be recognized, measured, Statement 167 may require an SEC ance, it appears there will be few or disclosed under retrospective registrant to consolidate or decon- situations where the FAQ’s condi- application, and solidate an entity. It may require tions for relief will apply. Therefore – Would have been available this either (a) as a result of the in most cases, an evaluation of the when the financial statements change in accounting that occurs consolidated VIE’s internal controls for that prior period were when an entity adopts Statement will be required if the results of the issued. 167 or (b) due to events or changes in circumstances that occur after VIE are significant to the company. an entity has adopted Statement If initial application results in 167. Some of the SEC reporting After Adoption – Question 3 of the deconsolidation of a VIE, a com- implications of these events are FAQs noted above addresses a sit- pany should measure any retained discussed below. uation where a registrant acquires interest in the deconsolidated sub- a business during a year but it is sidiary at its carrying value at the Internal Control Reporting not possible to conduct an assess- date of adoption. Any difference Entities consolidated under State- ment of an acquired business’ between the net amounts removed ment 167 should be included in a internal controls during the period from the balance sheet and the company’s assessment of its inter- between the consummation date amount of any retained interest in nal controls. Question 1 of the SEC and year end. The SEC staff allows the newly deconsolidated entity staff’s Frequently Asked Questions a registrant to exclude a business should be recognized as a cumula- related to Management’s Report on from the scope of its internal con- tive effect adjustment to retained Internal Control over Financial Report- trol assessment in this situation. earnings. ing22 addressed the internal control Accordingly, an SEC registrant may If a company consolidates an reporting requirements when a reg- exclude a VIE that is newly consol- entity as a result of the initial appli- istrant consolidated an entity as a idated due to events or changes in cation of the standard, it may result of adopting FIN 46. It states circumstances from the scope of its choose to apply fair value under that the SEC staff “would typically internal control assessment in the Statement 159.21 This option must expect management’s report on year consolidation occurs if an be elected on an entity by entity internal control over financial assessment is not possible. basis and must be applied to all reporting to include controls at all eligible financial assets and finan- consolidated entities, irrespective Rule 3-05 and Article 11 cial liabilities of that entity. A com- of the basis for consolidation.” of Regulation S-X and pany must disclose its rationale for Form 8-K electing the option and the impact Upon Adoption – In FAQ 1 referred to Upon Adoption – In the past, the it has on the cumulative effect above, the SEC staff provided con- adoption of a new accounting stan- adjustment. ditional relief from evaluating the dard (e.g., FIN 46 and FIN(R)) that Finally, Statement 167 permits, internal controls of certain consol- resulted in a registrant consolidat- but does not require, a company idated VIEs that existed prior to ing an entity that is a business for to retrospectively apply the new December 15, 2003. The relief was the first time has not been consid- guidance for one or more years with available for situations “where the ered the type of extraordinary cor- 21 The Fair Value Option for Financial Assets and Financial Liabilities 22 See COPYRIGHT 2009, BDO SEIDMAN, LLP 10
  • 11. Financial Reporting porate event that triggers the need cance (under Rule 1-02(w) of Conversely, if a registrant elects for acquired business financial Regulation S-X). These rules could to adopt Statement 167 only on a statements under Rule 3-05 of require a description of the event, prospective basis, or if the retro- Regulation S-X and Item 9.01(a) of audited pre-consolidation financial spective application of Statement Form 8-K. The adoption of statements of a newly consolidated 167 is not material, its registration Statement 167 also should not trig- VIE (if the VIE is a significant busi- statement may incorporate by ref- ger the need for historical financial ness), and/or pro forma informa- erence its most recent Form 10-K statements of newly-consolidated tion. (assuming the prior financial state- VIEs that are businesses. The SEC ments don’t require revision for staff has not provided guidance on The Impact of Retrospective other purposes). This would whether the consolidation or Adoption on Incorporating include its historical annual finan- deconsolidation of a VIE resulting Financial Statements by cial statements for periods prior to from adopting a new accounting Reference in Registration the adoption of Statement 167. standard is a reportable event Statements under Item 2.01 of Form 8-K. The As noted above, companies have staff has, however, informally indi- the option to adopt Statement 167 Practical Steps cated that pro forma information retrospectively or prospectively. The implementation of any new may be appropriate. If adopting Companies will need to consider major accounting standard can Statement 167 requires a registrant the consequences of the method require a significant amount of to consolidate or deconsolidate a they choose as they evaluate the resources. With respect to VIE, the effect is material, and the financial statement requirements Statement 167, affected companies registrant is not adopting of registration statements that are should start their efforts soon if Statement 167 retrospectively, it filed or become effective (or are they haven’t already done so to may wish to consider providing pro post-effectively amended) after avoid a financial reporting crunch forma information. their first Form 10-Q is filed that in 2010 (including the impact on reflects the adoption of Statement 167. loan covenants), particularly with After Adoption – In contrast, when events or changes in circumstances This could be important because first quarter 10-Qs. The following require a registrant to consolidate if the effect of adopting Statement suggestions should help in that or deconsolidate a VIE, this is an 167 is material and a registrant has regard: event that may require reporting (a) retrospectively adopted State- • Identify involvement with and pursuant to Rule 3-05 and Article ment 167 and (b) filed interim investments in other entities – 11 of Regulation S-X and/or Items financial statements for a period Companies should begin by tak- 2.01 and 9.01 of Form 8-K, even if a that includes the date of adoption, ing an inventory of their invest- registrant did not issue or receive the SEC staff will expect the regis- ments in and arrangements with any consideration. Under these trant to revise its prior period other entities. Remember, this rules, the need to report and nature annual financial statements, list should include written and of the reporting required depend selected financial data and man- unwritten contracts, oral agree- on whether the VIE is a business agement’s discussion and analysis ments and reputational consid- (under Rule 11-01(d) of Regulation before incorporating them by refer- erations to capture explicit as S-X) or a collection of assets, ence or presenting them in a new well as implicit variable interests whether it is consolidated or registration statement (other than (recall the leasing example deconsolidated, and its signifi- one filed on Form S-8).23,24 above). 23 We understand that a registrant usually does not need to file revised annual financial statements in order to file a new registration statement on Form S-8. The instructions to Form S-8 require a registrant to disclose material changes in a filing that is incorporated by reference in the Form S-8. The manner in which material changes may be disclosed is a matter of judgment. In that regard, even though a change would require revising the annual financial statements if the offering was registered using a different registration statement form, it is usually possible to adequately disclose the change in a Form S-8 without revising the financial statements. 24 We understand that a registrant usually does not need to file revised annual financial statements in order to conduct or continue an offering using an already effec- tive registration statement. We understand that a registrant may continue to offer securities pursuant to an effective registration statement unless the revision to the financial statements would constitute a fundamental change. Determining whether a change is so significant that it constitutes a fundamental change is a legal ques- tion. In practice, fundamental changes are rare. However, an underwriter might request an issuer to voluntarily file revised financial statements or present them in a prospec- tus supplement. COPYRIGHT 2009, BDO SEIDMAN, LLP 11
  • 12. Financial Reporting • Determine whether such involve- ments are designed to provide and variable. Many observers ment and investments are vari- financial statement users with an believe the FASB will simply expose able interests – If these invest- insight into a company’s risk the IASB’s final standard in the US ments and arrangements do not exposures, even those that are at a later date, which if adopted meet the definition of a variable considered remote. would converge the two bodies of interest, no further consideration • Determine informational needs GAAP. Therefore, companies should is required under Statement 167. for VIEs to be consolidated – If a expect more changes to consolida- For instance, an operating lease VIE is consolidated for the first tion policy in the not too distant without purchase options and time, the primary beneficiary will future. guarantees of an asset’s residual need access to the VIE’s finan- value may not represent a vari- cial statements and supporting able interest in the lessor. data. Practical challenges may For More Information • Determine whether entities are exist in gaining access to the If you would like further informa- VIEs – If an entity has all of the appropriate information and tion or to discuss the implications required characteristics of a vot- require time and effort to resolve. of the matters discussed in this ing interest entity—for instance, • Consider system updates and Financial Reporting letter, please con- a sufficient amount of equity period-end close procedures – tact the BDO Seidman engagement exists, power and economics rest The primary beneficiary’s infor- partner serving you or one of the with the equity holders and so mation system may need to be following partners: on—then other GAAP applies. modified to capture and inter- • Start the analysis early – Because face with the VIE’s accounting Adam Brown of the judgment required to system. apply the new standard, compa- • Establish monitoring controls – (214) 665-0673 nies will need plenty of time to Changing facts and circum- identify, document and consider stances may impact whether an Leland Graul all of the relevant facts and reach entity is a VIE, and if so, who its an appropriate conclusion, which primary beneficiary is. Therefore, (312) 616-4667 may involve senior management, companies will need to establish the audit committee and the mechanisms alerting manage- Reva Steinberg independent auditor. ment to these events so they can • Don’t forget disclosures for vari- be considered on a timely basis. (312) 616-4658 able interests in VIEs that are not consolidated – This is a common oversight when another variable On the Horizon interest holder is the primary The FASB developed Statement 167 beneficiary. Given recent finan- as a response to the credit crisis. cial institution failures during the The IASB currently has a separate course of Statement 167’s devel- project to revise its consolidation opment, its disclosure require- model for all entities, both voting Material discussed in this Financial Reporting letter is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual circumstances. COPYRIGHT 2009, BDO SEIDMAN, LLP 12
  • 13. Financial Reporting Appendix A: Summary of FIN 46(R), as amended by Statement 167 Step 1 – Does the variable interest model apply? The variable interest model applies if the answer to all three questions is “yes.” • Is the entity a legal entity? (par 3) • Is the entity or reporting enterprise within the scope of FIN 46R? (par 4) • Does the reporting enterprise have a variable interest in the entity? (par 2) Step 2 – Is the entity a VIE? The entity is a VIE if the answer to any of the questions is “yes.” • Is the total equity at risk insufficient to finance the entity’s activities without additional subordinated financial support? (par 5a) • Do the equity holders, as a group, lack characteristics of a controlling financial interest? (par 5b) • Do the equity holders have disproportionate voting rights when compared with their obligations to absorb expected losses? If so, do substantially all of the entity’s activities either involve or are conducted on behalf of the investor with disproportionately few voting rights? (par 5c) Step 3 – Who is the primary beneficiary? • Identify all other parties that hold variable interests in the VIE. (par 14) • Determine if any variable interest holder has a controlling financial interest based on both: – the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance (par 14A(a)) – the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE (par 14A(b)) • Determine whether power is shared among the variable interest holders. (par 14D) • If variable interest holders are related parties, does any individual in the related party group have the characteris- tics of a controlling financial interest? (par 17) • If no individual related party has a controlling financial interest, but the group as a whole does, then determine which related party is most closely associated with the VIE. (par 17) Step 4 – Consolidation, Presentation and Disclosure • Determine the initial measurement and accounting for consolidation of the VIE. (par 18-21) • Ensure appropriate accounting after initial measurement. (par 22) • Present restricted assets and liabilities separately on the balance sheet. (par 22A) • Comply with disclosure requirements. (par 22B-26) Step 5 – Reassessments • Evaluate whether specified events have occurred that could change the status of the VIE. (par 7) • Evaluate whether changing circumstances affect the status of the VIE’s primary beneficiary. (par A25) COPYRIGHT 2009, BDO SEIDMAN, LLP 13
  • 14. Financial Reporting Appendix B: Key Changes Statement 167 makes to FIN 46(R) Topic FIN 46(R) Statement 167 Substance vs. Form No explicit guidance. Only substantive terms and arrange- ments are considered. This avoids form-driven conclusions that frus- trate the objectives of the variable interest model. Primary Beneficiary Identified as the party that absorbs a Identified as the party with power to majority of the VIE’s expected losses direct a VIE’s significant activities and/or returns, often measured with and an obligation to absorb losses or mathematical models. a right to receive benefits that could be significant. Mathematical models are not used. Kick-out Rights and Participating Considered in the VIE determination Ignored unless they can be exercised Rights as to whether the holders of equity at by a single party, including its related risk are able to direct an entity’s parties and de facto agents. activities. Reconsideration Events An entity’s VIE status and the pri- An entity’s VIE’s status is reassessed mary beneficiary were only reass- based on revised triggering events. essed based on certain triggering The primary beneficiary assessment events. is ongoing. Shared Power No explicit guidance. Variable inter- Variable interest holders do not con- est holders did not consolidate VIEs solidate a VIE when power is shared if expected losses and returns were because no single party has the char- widely dispersed. acteristics of a primary beneficiary. Related Parties If a variable interest holder and its Variable interest holder and its related parties as a group had the related parties must individually characteristics of a primary benefici- determine whether they have the ary, then the individual in the group characteristics of a primary benefici- most closely associated with the VIE ary. If none do, but the group does, consolidated. then the party who is most closely associated with the VIE is the pri- mary beneficiary. Scope exception for qualifying No consolidation analysis was The scope exception was removed special purpose entities (QSPEs) required. and all QSPEs must be evaluated for consolidation. COPYRIGHT 2009, BDO SEIDMAN, LLP 14