Chapter Six Variable Interest Entities Intra Entity Debt

Chapter Six Variable Interest Entities, Intra. Entity Debt, Consolidated Cash Flows, and Other Issues Copyright © 2015 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Variable Interest Entities (VIE’s) 1. Known as Special Purpose Entities (SPE) 2. Established as a separate business structure 1. 2. 3. 4. Trust Joint Venture Partnership Corporation 3. Frequently has neither independent management nor employees 4. Typical purposes – help finance their operations at favorable rates – Transfers of financial assets – Leasing – Hedging financial instruments – Research and development Ø Off-balance sheet financing 6 -2

Variable Interest Entities (VIE’s) Examples of Variable Interests 6 -3

Variable Interest Entities Characteristics of VIEs: Most established for legitimate business purposes Some created to avoid consolidated disclosure Generally have assets, liabilities, and investors with equity interests Role of equity investors can be minor if VIE’s activities are strictly limited Equity investors may serve simply to allow the VIE to function as a legal entity 6 -4

Variable Interest Entities Characteristics continued. . . VIEs bear relatively low economic risk, therefore equity investors are provided a small rate of return. Another party (often the sponsoring firm that benefits from the VIE’s activities) contributes substantial resources – loans and/or guarantees – to enable a VIE to secure financing needed to accomplish its purpose. The sponsoring firm may guarantee the VIE’s debt, assuming the risk of default. 6 -5

Variable Interest Entities Characteristics continued. . . Contractual arrangements limit returns to equity holders yet participation rights provide increased profit potential and risks to sponsor. Risks and rewards are not distributed according to stock ownership but by other variable interests. Sponsor’s economic interest vary depending on the VIE’s success – Hence the term variable interest entity. 6 -6

Variable Interest Entities FASB standard FIN 46 R 3 requires the primary beneficiary (regardless of their ownership) to consolidate the VIE. Who is the “primary beneficiary”? The firm that has the: –Power to direct the activities of the VIE that significantly impact the entity’s economic performance. –Obligation to absorb significant losses of the entity. –Right to receive significant benefits of the entity. 6 -7

Benefit of VIE’s A business sponsors a VIE to purchase and finance asset acquisition. – The VIE leases the asset to the sponsor. – VIE is often eligible for lower interest rate. The VIE has limited assets. This “asset isolation” and limited activity separates the VIE’s creditor(s) from the overall risk of the sponsor. 6 -8

Disclosure Requirements – In Footnotes of ALL VIE Interests Nature, purpose, size, & activities of the VIE Significant judgments made in determining the need to consolidate a VIE or disclose any involvement Nature of restrictions on assets and settlement of liabilities, and the related carrying value Nature of risks, and how a VIE affects the financial position, performance and cash flows of a Primary Beneficiary 6 -9