Variable Interest Entities and Repo 105

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Variable Interest Entities

One topic that has generated much discussion and even some “bad blood” in the accounting profession and business community as a whole is variable interest entities, formerly known as “special purpose entities.” One common definition of a variable interest entity is a legal business structure which does not have enough capital to support itself due to its lack of equity investors. The financial support for the variable interest entity is provided by an outside source, such as another corporation. A variable interest entity is often created by a corporation to serve as a holding company, which will hold assets or debt for the creating corporation. A corporation can use such a vehicle to finance an investment without putting the entire firm at risk. In years past, this has cause considerable controversy because variable interest entities have been used inappropriately by large companies to hide “bad assets” such as subprime mortgage exposure. In general, the creating of a variable interest entity serves three primary purposes for a company.

1. A variable interest entity can be used to reduce the cost of debt financing. For example, when a company securitizes an asset and needs financing to do so it can use a variable interest entity to increase their credit rating. The company seeking financing can sell assets that it has on its balance sheet to a variable interest entity as a temporary transaction. The variable interest entity obtains the funds to purchase the assets from the corporation by issuing securities. This is called an asset backed transaction. Because the variable interest entity owns the assets, which are also the collateral for the securities issued, lenders evaluate the credit quality of the collateral instead of that of the corporation. As a result, lower funding costs are achieved by the corporation. A non-investment grade issuer can obtain funding at investment-grade levels by isolating the assets in the variable interest entity.

2. The second primary purpose for creating a variable interest entity is that it can be used by a corporation to shift risk from itself to parties willing to accept it. This often occurs when a corporation is seeking funding for a major project. When a corporation uses a variable interest entity for this purpose, it is referred to as project financing. In a transaction such as this, the lenders to the project evaluate the cash flows from the project rather than that of the corporation seeking financing.

3. The third primary purpose of a variable interest entity is that it can be used to accomplish the transfer of tax benefits. This is done by implementing the use of a lease arrangement in which the lessor is entitled to the tax benefits associated with the ownership of the equipment if the lease qualifies as a true lease for tax purposes. In so doing, a corporation that cannot use the tax benefits associated with ownership can transfer those benefits to another party by leasing the equipment to them. In exchange for the tax benefits, the lessor provides a lower-than-market leasing rate that is essentially less than the cost of borrowing funds in order to purchase the equipment.

Variable interest entities are not always easy to identify, especially if the corporation is trying to hide something. This is because they can be very complex. The complexity of issues surrounding the accounting treatment of variable interest entities is confirmed by the massive amounts of regulations and clarifications issued by standard setters and the interpretations of such regulations. The most infamous is FIN 46, followed by FASB Staff Position No. FIN 46(R)-6, “Determining the Variability to Be Considered In Applying FASB Interpretation No. 46(R).” As defined in these documents, a variable interest entity can be formed by a simple relationship. A relationship that forms a variable interest entity is referred to as a...
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