What is a Variable Interest Entity?
Variable interest entity (VIE) generally refers to an entity in which a public company has a controlling interest even though it doesn’t own majority shares and therefore, the public company has the ability to direct the VIE’s significant activities and control the flow of profits/losses. Common activities of a VIE are generally a transfer of assets, leases, hedging of financial instruments, R&D, etc.
Example of Variable Interest Entity
‘A,’ an Electric company, creates ‘B,’ a power finance co. B issues 100% non-voting stock for $ 16 Million to an outsider investor and issues debt securities to A for $ 384 million. B then purchases an electric generating plant for $400 million and leasesLeasesLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.” it to A for $ 12 million per year for 5 years.
At the end of the lease term, A must either renew the lease for 5 years or purchase the generator for $ 400 million or sell the electric generator plant to the third party. Also, if B is unable to repay the equity investor, then A pays $ 16 million to an equity investor.
In the above example, the below factors point that company B is a VIE, and company A is the primary beneficiary.
- Equity owners do not have the power to direct the operations of the entity.
- A has bought debt securities of B, which constitutes a majority of the investment.
- A has the power to direct the activities of B, which is to lease the electric generating plant to A.
- A is exposed to the variable returns as A has an obligation to absorb the losses or receive returns from the lease agreement, which is the significant activity of B.
- B receives only a fixed fee.
Hence here, A has to consolidate the Financials of B along with itself.
Prior to the Enron scam, US GAAP considered only voting interest entities (i.e., entities with majority voting power) for determining controlling financial interest for consolidation purposes. However, Controlling financial interestControlling Financial InterestA controlling interest is the shareholder's power to speak in the corporate actions or decisions derived from possessing a considerable chunk of the company's voting stock. However, such a stakeholder may or may not hold a significant portion of the company's common stocks. may be achieved through arrangements that do not involve voting interests.
Let’s see the example of Enron, which used certain arrangements to avoid consolidation of financial statements, thereby deprive the users of financial statements to have a true and fair view of the state of affairs at Enron.
Let’s say Enron wants to build a factory for which it needs to invest capital, say $ 10 Million. Now Instead of borrowing money and building a factory through the legal entity of Enron, it created another entity called special purpose entitySpecial Purpose EntityA special-purpose entity is created to fulfill particular objectives, including devising measures to appropriate financial and legal risk profiles. It has a predefined purpose and a limited scope in terms of activity and is sometimes used as a short term solution to a current or potential problem. (SPE) to build the factory.
Now, SPE will go to a bank and ask for a loan of $ 10 million. Enron will guarantee the loan for the SPE. Bank will lend $ 9.7 million to SPE (net of equity investment) based on the guarantee of Enron, and for balance equity investment, Enron would request third parties who would be interested in the project or affiliates of Enron to invest $ 0.3 million.
In this arrangement, an Equity investment of $ 0.3 million is 100% outside of Enron and thus would make SPE independent of Enron, and hence it would no longer have to consolidate the SPE in their books. But the value of Equity investmentEquity InvestmentEquity investment is the amount pooled in by the investors in the shares of the companies listed on the stock exchange for trading. The shareholders make gain from such holdings in the form of returns or increase in stock value. is minuscule compared to the project cost (3% of $ 10 million), and Enron is financing 97% of the deal by guaranteeing the debt. Hence Enron is practically controlling the SPE.
In this way, Enron could move bad assets out of their balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. into the SPE and even book gains on the sale of assets to SPE (which is essentially its own company).
By such arrangements entered, some companies were avoiding reporting bad assets and liabilities for which they are responsible and to delay reporting losses that are incurred or report gains, which were illusionary.
Thus, due to the above, the concept of the variable interest entity was introduced as a consolidation requirement so that stakeholders can see the fair picture of the financials of the company.
It is important to determine control in order to prepare consolidated financial statementsConsolidated Financial StatementsConsolidated Financial Statements are the financial statements of the overall group, which include all three key financial statements – income statement, cash flow statement, and balance sheet – and represent the sum total of its parents and all of its subsidiaries.. US GAAP provides for two models for consolidation of controlling financial interests while IFRS provides a single consolidation model.
Change in Variable Interest Entity Status
The status of Variable Interest Entity(VIE) is to be reviewed at the end of each reporting year orEdit date and time on happening of specific reconsideration events. The following events are to be reviewed for ascertaining the status of VIE:
- Change in the structure of VIE through a change in arrangements/ contracts, resulting in a change in the quantum of equity investment at risk.
- Change in the proportion of risk faced by investors by way of change in equity and debt structure of the entity resulting in a change in the exposure of gains/losses flowing to the primary beneficiary.
- Change in variable return received by the primary beneficiary from the VIE due to additional activities undertaken by VIE subsequent to the initial set up of the structure of VIE.
- Change in profits/losses of VIE due to the change in investment structure or change in business activities of VIE, leading to an insignificant proportion of return flowing to the primary beneficiary.
For the purpose of consolidation, Variable interest must be identified, determine whether the entity is a VIE, Identify the primary beneficiary of the VIE which will consolidate the transactions of VIE in its books and thereby present the consolidated financials of all different legal entities which are under common control so that stakeholders can get the correct view of the financial position of the company as a holistic economic entity.
This has been a guide to what is Variable Interest Entity (VIE) and its definition. Here we discuss the conceptual examples of the variable interest entity. You can learn more from the following articles –