Academic journal article Journal of Accountancy

To Consolidate or Not: For Some Companies, That Is the Question

Academic journal article Journal of Accountancy

To Consolidate or Not: For Some Companies, That Is the Question

Article excerpt

EXECUTIVE SUMMARY

* AMONG ENRON'S PROBLEMS WAS ITS USE of variable interest entities, which allowed it to leave significant amounts of debt off its balance sheet. In response to concern about this practice, FASB issued interpretation no. 46 in January 2003 and a revised version in December 2003 to help companies decide whether to consolidate VIEs into their financial statements.

* A VIE MUST BE CONSOLIDATED INTO THE FINANCIAL statements of the primary beneficiary company when it does not have enough equity at risk or its equity investors lack any of three characteristics of controlling financial interest. The equity at risk should be sufficient for the VIE to finance its activities without additional support.

* A VIE'S PRIMARY BENEFICIARY TYPICALLY IS ABLE to make decisions about the entity and share in profits and losses. The primary beneficiary is the reporting entity, if any, that receives the majority of expected returns or absorbs the majority of expected losses.

* CPAs SHOULD RECONSIDER A DECISION ABOUT WHETHER an entity is a VIE if its situation changes so its equity investment at risk is no longer adequate, some or all of the equity investment is returned to investors or the entity undertakes additional activities, acquires additional assets or receives an additional equity Investment that is at risk.

* THE GUIDANCE IN INTERPRETATION NO. 46(R) is causing reporting entities to make new decisions about whether affiliated entities need to be consolidated into their financial statements. The practical result of the new rules is that many reporting entities are adding significant assets and liabilities to their balance sheets.

Among myriad accounting problems that led to the downfall of Enron was its use of variable interest entities (VIEs), allowing it to leave significant amounts of debt off its balance sheet. In response to widespread concerns about this business practice, FASB issued Interpretation no. 46, Consolidation of Variable Interest Entities, in January 2003 and Interpretation no. 46 (Revised) with the same name in December 2003. Both interpret Accounting Research Bulletin (ARB) no. 51, Consolidated Financial Statements, to address consolidation requirements for businesses that are affiliated with VIEs.

Interpretation no. 46(R) addresses the consolidation of business enterprises where the usual consolidation condition--ownership of a majority voting interest--does not apply. It focuses on controlling financial interests achieved by means other than voting. Where there is no voting interest, a company's exposure to the assets' risks and rewards represent the best evidence of control. When a company holds a majority of variable interests in another entity, it is considered the primary beneficiary and must consolidate that entity into its financial statements.

The purpose of this article is to explain the substantive provisions of Interpretation no. 46(K) and provide CPAs with practical guidance on the ongoing process of deciding whether a VIE needs to be consolidated, the measurements the primary reporting entity should use in consolidation and the required disclosures.

Public companies were required to implement the consolidation provisions in Interpretation no. 46(R) in 2003 and 2004. Private companies with an interest in a VIE that was created after December 31, 2003, should have consolidated those entities immediately. Most private Companies with VIEs that existed on December 31, 2003, made transition disclosures during calendar year 2004 and were required to consolidate those VIEs no later than calendar year 2005.

WHO SHOULD CONSOLIDATE?

Under Interpretation no. 46(R) a VIE must be consolidated into the financial statements of the primary beneficiary company when either of the following conditions exist:

* The VIE does not have sufficient equity investment at risk.

* Equity investors in the VIE lack any of three characteristics of controlling financial interest. …

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