Understanding variable interest entities (VIEs) in accounting
No, it’s not a medical diagnosis. VIE is an accounting acronym that stands for “variable interest entity.” VIE accounting has become an essential aspect of financial reporting for many companies.
If your company is the primary beneficiary of a VIE, you generally must consolidate that VIE into your financial statements. But to truly understand the accounting for a VIE, it’s important to understand why we have this VIE guidance in the first place.
Before, U.S. GAAP (circa 2000) considered only voting interest entities (i.e., entities with majority voting rights) when determining controlling interest for consolidation purposes. However, after the Enron scandal, the Financial Accounting Standards Board (FASB) took another look at the concept to understand whether controlling interest can be achieved through arrangements that do not involve voting interests.
In a nutshell, Enron used hundreds of special purpose vehicles (SPVs) to avoid reporting their impaired assets and even to report gains on “sales” of those assets from the main company to these SPVs. While Enron didn’t directly own a large portion of these SPVs, they controlled the SPVs and by keeping these SPVs off the company’s financial statements, they were able to inflate profits by billions of dollars.
Due to this, the concept of a VIE was introduced as a consolidation requirement so that stakeholders can now ascertain a fair picture of the true financial status of a VIE company. This led to the development of the VIE model in accounting rules, which is now part of the Accounting Standards Codification.
How do you know if an entity is a VIE?
The simple answer is that the entity itself is not a normal entity. In other words, the entity was not created and does not operate like other entities in the same industry.
To conduct a VIE analysis, the FASB focused on two main features: insufficiency of equity at risk and lack of control by the apparent voting shareholders.
Insufficiency of at-risk capital
Insufficiency of at-risk capital, or being “thinly capitalized,” means that the total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties.What does an “at-risk” equity investment include and not include? Equity at risk, for example, can include equity that participates in profits and losses. But it does not include amounts provided, directly or indirectly, to equity investors by others by way of fees or contributions or amounts financed by loans or guarantees about loans by others.
Equity holders lack control
The second feature of a VIE is that the equity at-risk holders lack controlling financial interest (economics and power). In other words, they are not really running the show and don’t have the power to make key decisions or block other decisions. If the equity holders lack any of the following indicators of financial control, the entity is a VIE:- The power to direct the activities of the entity that most significantly impact the entity’s economic performance
- The obligation to absorb expected losses
- The right to receive expected residual returns
Variable interest entity consolidation
The entity that has a majority of the variable interests will consolidate the VIE. This majority interest holder is called the “primary beneficiary.” Understanding the primary beneficiary definition is crucial for VIE accounting. A reporting entity will be deemed to be a primary beneficiary if it has both of the following characteristics:
- The power to direct the activities of a VIE that most significantly impact the VIE’s economic performance.
- The obligation to absorb losses or receive benefits of the VIE that could potentially be significant to the VIE.
There are some situations where there is no primary beneficiary or when there are multiple beneficiaries. In those instances, we might have to apply a related party tiebreaker to determine which entity consolidates the VIE.
Are there any exceptions to the rules?
Like most rules, there are exceptions. The FASB calls these scope exceptions, and they apply to employee benefit plans, governmental organizations, certain investment companies, money market funds and nonprofit entities. These types of entities are scoped out of the VIE guidance and do not have to apply it.
Additionally, the FASB recognized that privately held companies often have entities under common control and, based on their relationship with the users of the financial statements (typically banks), the resulting consolidation might not make the most economic sense. So, in 2018, the FASB issued an accounting standard (ASU 2018-17) that allowed private companies to make an accounting election to not apply VIE guidance to entities under common control.
To qualify for this exception, all of the following criteria must be met:
- The reporting entity and the VIE are under common control.
- The reporting entity, the legal entity and the entity controlling these entities are not public business entities.
- The reporting entity does not have a majority voting interest in the VIE.
If the reporting entity makes this election, they do not have to consolidate the VIE; however, there are several disclosures the entity must meet in the footnotes to the consolidated financial statements surrounding the relative risk associated with the VIE and the effect on the reporting entity’s financial statements due to its involvement with the VIE (among other disclosures).
VIE considerations: Wipfli can help
The FASB is aware that companies sometimes create additional entities to manage the risk associated with doing business. When creating these entities, management needs to be aware of VIE guidance and how and when it will trigger the consolidation of these VIEs into company financial statements.
If you need assistance determining whether an entity is a VIE, whether exceptions apply or other VIE considerations, contact Wipfli for assistance. Our experienced professionals can help you navigate the complexities of VIE contracts, perform VIE analysis and help ensure the proper treatment of consolidated VIEs in your financial reporting.
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