When Enron’s house of cards tumbled, among its many accounting abuses was the use of off-balance-sheet entities to hide significant amounts of debt. As a result, a new accounting pronouncement (FASB Interpretation No. 46, Consolidation of Variable Interest Entities) was issued in January 2003 and was later revised in December 2003. The effective date of the new FIN 46 rules for calendar year, non-public companies is no later than December 31, 2005.
The new rules change the way entities become subject to consolidation. In the past, the usual condition for consolidation was when one enterprise owned a majority voting interest in another entity (51%). The new rules no longer consider just a majority interest. In fact, for a variable interest entity (VIE), there may be no voting interest of one entity in another, yet consolidation may be required if certain criteria are met.
A typical example would be an operating enterprise that leases real estate from a related entity. One reason a real estate entity is set up is to insulate the real property from potential claims arising from the operating entity. Let’s assume the operating entity has loans outstanding with a financial institution. Let’s also assume there are loan covenants based on the financial condition of the operating enterprise. If the operating enterprise has to consolidate the leasing entity under the new rules, some of the loan covenants’ financial ratios may not be met.
For non-public companies, a single lender typically is aware of the operating enterprise and any related companies. Therefore, unlike the Enrons of the world, in most cases, all the information about an entity and its related parties is known. In fact, financial institutions normally would participate in lending to each entity. However, the new standards do not differentiate between large public companies and non-public companies.
Using the previous example, let’s assume the leasing entity (lessor) has a large amount of debt and little equity existing from the formation of the leasing entity. If the operating entity (lessee) guarantees the debt of the lessor, this creates a variable interest. Then the operating entity has to follow the steps in FIN 46 to determine whether it needs to consolidate the lessor.
There are instances where someone other than the operating entity would be the one to consolidate and, in certain circumstances, no one may end up consolidating the VIE. If there is a related-party group associated with the operating entity, the member of that group who is determined to be the one to consolidate the VIE is called the Primary Beneficiary. To make matters more confusing, if the real estate is owned by an individual (not in a partnership, S corp., LLC, etc.), then FIN 46 does not apply, and the real estate entity is not consolidated.
To consolidate or not to consolidate
The rules are complex, and each situation is based on its own facts and circumstances. For CPAs, arriving at a conclusion as to whether or not a client should consolidate a VIE requires considerable judgment.
Some enterprises may choose not to consolidate a VIE, even though under the new generally accepted accounting principles (GAAP), they are required to do so. If an accountant audits these statements, a qualified or adverse opinion may result. On a review or compilation report, additional paragraphs would be added to the usual report indicating GAAP is not being followed.
It’s possible that an entity may choose to prepare its financial statements on an Other Comprehensive Basis of Accounting (OCBOA), such as on the income tax basis or cash basis, thereby avoiding the GAAP requirements, which include the FIN 46 consolidation rules.
Lender alert
When working with customers and their CPAs, lenders should be aware of the various scenarios, including qualified GAAP reports or unqualified OCBOA reports. In fact, you may find your customers more reluctant to be guarantors of related-party debts.
You could also be asked to accept various types of accountant’s reports from your customers. And you may be asked to rewrite the loan covenants or begin drafting loan documents indicating that the loan covenants are based on GAAP effective on a certain date (i.e., before FIN 46 became effective).