Jacob Myers
Deloitte & Touche, LLP
Agenda
• Introduction
• Background - FIN 46(R), FAS 140, FAS 167
• Comparisons to newly issued FAS 167
guidance
• Research tools
• Case study
• Audit issues
• Questions & Comments
Introduction
• Jacob Myers
– Deloitte Senior Manager – Assurance Services
– Service clients in various industries
• Financial Services, Software, Agriculture
– St. Louis University
• Majors - Accounting and Finance
– Other organizations
• St. Louis Variety Club – Finance Committee
• St. Louis University Business School Alumni Board
Why Consolidation Guidance
• Add transparency and consistency to the financial
statements
– Many firms were avoiding reporting debt and losses
from special purpose entity (SPE) deals
• Enron
• Recent credit crisis
• Impact of consolidation in marketplace
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Financial ratios
Loan covenants
Regulatory capital
Cost to implement guidance, processes
FIN 46(R)
• Variable Interest Entities – VIEs
• Special Purpose Entities – SPEs, off balance sheet
– Form & Purpose of VIEs
• Trust, Partnership, joint ventures, or Corporation
• Facilitate transactions – Transfer of Assets, leasing, hedging, R&D
• Low-cost financing structure
– Characteristics of VIEs
• Activities are limited
• Equity investor role minor – less than 10%
• Sponsoring firm’s involvement
– Guarantees
– Contribution of Capital
– Risks and rewards
FIN46(R)
• Consolidation of VIEs
– Prior GAAP - ARB 51
• Consolidated based on voting rights
– Identifying if a VIE exists
• Equity at risk not sufficient to permit the potential VIE
to finance its activities
• Equity investors lack one of the following:
– Direct or indirect ability to make decisions about entity
through voting or similar rights
– An obligation to absorb the expected losses of the entity
– Rights to receive the expected residual returns of the entity
FIN46(R)
– Identification of the Primary Beneficiary of the VIE
• Requires the primary beneficiary to consolidate
• Characteristics include (mirror equity investors in a VIE):
– The direct or indirect ability to make decisions about the VIEs
activities
– The obligation to absorb the entity’s expected losses
– The right to receive the entity’s expected residual returns
• Assessment of control
– Entity that bears the majority of the risk
FIN46(R)
– Disclosure Requirements
• For Primary Beneficiaries
– VIE’s nature, purpose, size and activities
– Carrying amount and classification of consolidated assets
– Lack of Recourse (if any)
• Significant Variable Interest (Not Primary Beneficiary)
– Nature of involvement with VIE
– Nature, purpose and size of VIE
– Exposure to losses
FAS 140
• Transfers of financial assets
– Mortgage loans, accounts receivable, credit card
receivables
• Qualifying Special-Purpose Entities - QSPE’s
– Indicated that financial assets transferred to a QSPE
are typically derecognized by the transferor
– Legal isolation concept
• Permits derecognition of a portion or a
component of a financial asset
• Relates to FIN 46(R) because QSPE’s are exempt
from consolidation requirements
Potential Primary Beneficiary
Potential VIEs
Guarantees Debt
Max Return 6% 95% Debt owed by
Leases Data Center
JP Morgan
ABC Data Center, LLC
5% Equity
Microsoft
Unrelated
Shareholders
& Debt
holders
Facebook
Investment
of 1%
Outstanding
70% Equity
Shares of Intel
30% Debt
Leases Office Space
95% of Debt owed
by Goldman Sachs
XYZ Office Leasing
5% Equity Non
Voting Metlife
FAS 167
• Recently issued guidance for consolidations
• Why FAS 167
– Needed to expand disclosure requirements of FIN 46R
and address elimination of QSPEs
• Broader Scope:
– Includes Entities covered under FIN46R and QSPE’s
• FAS 166 eliminated the concept of a QSPE
– Amends derecognition guidance in FAS 140
– Expands the Consolidation and Disclosure
Requirements associated with VIE’s
Comparison
FIN 46(R)
FAS 167
1. QSPE’s are generally exempt
1. Transferors, sponsors, and
2. Primary BeneficiaryQuantitative Reasoning:
2. Primary BeneficiaryQualitative Reasoning:
–
Based on Risks and Rewards
3. Shared Power:
–
Focus is on absorbing
expected losses or receiving
expected returns
investors in QSPE’s need to
consider consolidation and
disclosure
– Power and economics model
– Power to direct activities
– Obligation to absorb losses
3. Shared Power:
– Power to direct activities
– Do decisions require the
consent of both parties
Comparison
FIN 46(R)
4. Reconsideration of
Primary Beneficiary:
–
–
Changes in contractual
agreement
Addition or disposal of
interest
5. Reconsideration of VIE:
–
Interest holders reconsider
whether entity is a VIE if
certain events occur
FAS 167
4. Reconsideration of
Primary Beneficiary
–
Continuous reconsideration
5. Reconsideration of VIE:
– An additional event requires
reconsideration
Comparison
FIN 46(R)
FAS 167
6. Presentation Requirements:
6. Presentation Requirements:
– Not required to present
consolidated VIE separately
on Balance Sheet
– Must present separately on
the face of Balance Sheet the:
• Assets used to settle
obligations
• Liabilities for which creditors
do not have recourse against
primary beneficiary
FAS 167 Disclosure Requirements
• Financial preparers must disclose method for
determining whether they are the primary beneficiary
of a VIE
– Disclose significant judgments and assumptions made
• Must disclose the details of any financial or other
support provided to a VIE
– Disclose reasons for providing the support
– Disclose all terms of arrangements and agreements with
VIE
• If Shared Power between multiple parties
– Disclose Significant Factors and Judgments made in
determination
Research Tools
• Orginal FASB pronouncements
• Third party service providers
– Lawyers, accountants, etc.
• Online research tools
• Other company disclosures
• Other publications
– AICPA, SEC, public accounting firms, state societies
Case Study
XYZ Oil is an established oil drilling company that wants to expand
its operations to offshore drilling platforms in the Gulf of
Mexico. XYZ determines that it can obtain the $350 million
needed to lease the platform by issuing debt at an annual
interest rate of 5%.
Instead of leasing the platform itself, XYZ decides to establish a
separate legal entity, Saltwater Drilling Co., to lease the drilling
platform. In doing so it can obtain the $350 million needed at an
annual rate of 4%.
An outside investor contributes $30 million for 100% of the
nonvoting shares in Saltwater Drilling Co. The remaining $320
million is raised through a debt offering, of which XYZ is the
guarantor. XYZ must also pay the investor for any losses incurred
if the asset is sold at the end of the lease term.
Questions
• Would Saltwater Drilling Co. qualify as a VIE under FIN 46?
Under FAS 167?
– Could Saltwater Drilling have obtained financing without XYZ
guaranteeing the debt?
– Does the equity investor have the ability to make decisions about the
entities’ activities?
– Does the equity investor bear the risk of loss?
– Does the equity investor receive the expected residual returns?
• Would XYZ qualify as a primary beneficiary?
– Does XYZ have the power to direct the activities of Saltwater?
– Does it bear the risk of loss or have the right to receive benefits?
– Would it qualify as a primary beneficiary under FIN 46? FAS 167?
Questions
• What documents would you need to examine to
determine that Saltwater is a VIE with XYZ as its
primary beneficiary?
• Should Saltwater be consolidated into XYZ?
– How should this be presented on the Financial
Statements?
Answers
• Would Saltwater Drilling Co. qualify as a VIE under FIN 46(R)? Under
FAS 167?
– The answer is probably ‘Yes’ under both. The equity investor has an
insignificant (less than 10% ownership) and the entity probably
couldn’t finance the operations without XYZ’s support.
– The investor also bears little risk as they are guaranteed their money
back if the asset is sold at a loss at the end of the lease.
• Would XYZ Qualify as a Primary Beneficiary?
– Probably ‘Yes’ under both FIN 46(R) and FAS 167
– The investor doesn’t appear to bear much risk and since they own
non-voting stock their influence may not be significant.
– XYZ appears to bear the risk of loss since they are guaranteeing the
debt.
– Examination of the agreements would be needed to see who has the
power to direct activities and the obligation to absorb losses and
receive benefits.
Answers
• So, should Saltwater Drilling Co. be
consolidated into XYZ?
– If it is determined that Saltwater Drilling Co. is
both a VIE and XYZ Oil is its primary beneficiary
then it should be consolidated into the Financial
Statements
– Under FAS 167, certain assets and liabilities would
be required to be presented separately on the
face of the financial statements and additional
disclosures would be required
Audit Issues
• Audit evidence
– Company’s accounting memo
– Entity documents
• By laws
• Security holder agreements
• Legal Opinions
• Consideration of an effective control environment
– Timing of closing process for the SPE
• Use of specialist/expert
• International coordination
– Language barriers and translation issues
– Legal environment
Questions or Comments?
[email protected]
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Agenda - Saint Louis University