Consolidating variable interest entities – Overview of FAS 167

 

Banks will not have to consolidate their off-balance sheet variable interest entities under Financial Accounting Standard 167, Amendments to Interpretation 46(R), Consolidation of Variable Interest Entities, thanks to a ruling from the Federal Deposit Insurance Corporation (FDIC), but all other companies will be required to perform the analyses required by the Statement for each reporting entity's first annual reporting period that begins after November 15, 2009.
 
On December 15, 2009 the Board of Directors of the FDIC finalized the regulatory capital rule related to the FASB's adoption of Standards Nos. 166 and 167. It had concluded that banks affected by the new accounting standards generally would be subject to higher minimum regulatory capital requirements. The final rule provides an optional delay and phase-in for a maximum of one year. Banks will be required to rebuild capital and repair balance sheets to accommodate the new accounting standards by the middle of 2011.
 
FAS 167 replaces the quantitative risks and rewards approach of FIN 46(R) with a qualitative approach that will identify which enterprise has a controlling financial interest in a variable interest entity and has the power to direct the activities of that entity. FAS 167 also addresses the potential impacts on the provisions and application of Interpretation 46(R) from the elimination of the qualifying special-purpose entity concept in Statement 166. Those entities are now subject to FAS 167 as variable purpose entities.
 
An enterprise will be required by Statement 167 to perform an analysis to determine whether the enterprise's variable interest or interests give it a controlling financial interest in a variable interest entity. This analysis identifies the primary beneficiary of a variable interest entity as the enterprise that has both
 
  1. The power to direct the activities of a variable interest entity that most significantly impact the entity's economic performance
  2. The obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.
 
Additionally the Statement amends Interpretation 46(R) to require ongoing reassessments of whether an enterprise is the primary beneficiary of a variable interest entity. Before this Statement, Interpretation 46(R) required reconsideration of whether an enterprise is the primary beneficiary of a variable interest entity only when specific events occurred.
 
 
Tourism, Leisure and Hospitality Industry Illustrates Impacts of FAS 167
 
Tourism Leisure and Hospitality (THL) companies may be considerably affected by Statement 167, say Deloitte TLH leaders in a recent publication. THL companies "typically enter into arrangements that share economic interests and decision powers between numerous entities, (e.g., with management agreements between a management company and a hotel owner, joint ventures between real estate developers and attraction operators)." Implementation of FAS 167 will have significant impact on THL companies both from a financial reporting standpoint and the level of effort required to comply, the authors say.
 
Four areas where FAS 167 will affect the THL industry as it currently operates, according to the Deloitte study are:
 
1.                  Consideration of decision-making rights.
 
Previously, under FIN 46(R) a primary beneficiary analysis focused on which party absorbed the majority of the entity's losses and returns. Under FAS 167, that has been changed to a joint consideration of decision-making rights (power) and obligation to absorb losses or right to receive benefits from a variable purpose entity. For example, in a management agreement for a hotel property, does the manager or the property owner hold the rights to make the decisions over the activities that most significantly impact the economics of the hotel. Or in the case of a joint venture, decision making power may be divided.
 
2.                  "Kick-out" rights
 
Statement 167 will change the way management contracts are considered. Under FAS 167 a single party must be able to exercise their right to remove the decision maker for the "kick-out" rights to be considered substantive.
 
3.                  Consideration of fees paid to decision makers or service providers
 
For THL companies, variable interests in an investment vehicle often include management and incentive fees as well as direct equity investments. Under FAS 167 the fees are considered to be variable interests unless they meet all of a set of criteria.
 
4.                  Transfer restrictions
 
FIN 46(R) specified that mutual transfer restrictions (where one joint venture partner may not sell its stake without the permission of the other party) created a de facto agency relationship. Statement 167 amended this guidance to say that mutual transfer restrictions do not create a de facto agency relationship. This will affect the framework in which THL companies evaluate these arrangements.
 
THL companies operate under a variety of business models with multiple implications under Statement 167. Companies will need to devote considerable thought to how they present the variable interest entities on their financial statements, the writers of the Deloitte report say.
 
When a company is identified as having a controlling financial interest in a variable interest entity, for example, it may be required to consolidate all of the variable interest entity's assets and liabilities, with third party investors reflected as noncontrolling interest holders.
 
Other amendments to FIN 46(R) in Statement 167
 
FASB cited the following as other significant amendments to FIN 46(R) in FAS 167:
 
  • An enterprise is required to assess whether it has an implicit financial responsibility to ensure that a variable interest entity operates as designed, when determining whether it has the power to direct the activities of the variable interest entity that most significantly impact the entity's economic performance.
 
  • This Statement amends certain guidance in Interpretation 46(R) for determining whether an entity is a variable interest entity. It is possible that application of this revised guidance will change an enterprise's assessment of which entities with which it is involved are variable interest entities.
 
  • This Statement amends Interpretation 46(R) to add an additional reconsideration event for determining whether an entity is a variable interest entity when any changes in facts and circumstances occur such that the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity's economic performance.
 
  • Under Interpretation 46(R), a troubled debt restructuring as defined in paragraph 2 of FASB Statement No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, was not an event that required reconsideration of whether an entity is a variable interest entity and whether an enterprise is the primary beneficiary of a variable interest entity. This Statement eliminates that exception for a troubled debt restructuring as defined in Statement.
 
  • This Statement amends Interpretation 46(R) to require enhanced disclosures that will provide users of financial statements with more transparent information about an enterprise's involvement in a variable interest entity. The enhanced disclosures are required for any enterprise that holds a variable interest in a variable interest entity. The content of the enhanced disclosures required by this Statement is generally consistent with that previously required by FASB Staff Position FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities..
 
FDIC Proposes Changes in Safe Harbor Protection
 
Since 2000 and the adoption of 12 C.F.R. Part 360.6, the FDIC has provided important safe harbor protections to securitizations by confirming that in the event of a bank failure, the FDIC would not try to reclaim loans transferred into a securitization so long as an accounting sale had occurred. However, with the FASB's June 2009 changes in FAS 166 and 167, most securitizations will no longer meet the off-balance sheet standards for sale treatment when they take effect on January 1, 2010.
 
On November 12, 2009, the FDIC Board approved a transitional safe harbor that permanently grandfathered securitization or participations in process through March 31, 2010. The Advance Notice of Proposed Rulemaking will seek public comment on what standards should be applied to safe harbor treatment for transactions created after March 31.
 
In an appearance on January 14 before the Financial Crisis Inquiry Commission, FDIC Chair Sheila Bair reasserted her support for recent accounting standard changes that will force companies, and banks in particular, to bring securitized assets on their balance sheet
 
Noting the need for higher capital and liquidity requirements for the largest financial firms, Bair said in prepared remarks, "Off-balance-sheet assets and conduits, which turned out to be not-so-remote from their parent organizations in the crisis, should be counted and capitalized on the balance sheet."
 
She added, "We fully support the changes that the Financial Accounting Standards Board (FASB) has implemented in FAS 166 and 167, which would accomplish the goals of bringing the off-balance-sheet assets and conduits back on institutions balance sheets."
 
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