Since the introduction of new rules for variable interest entities (VIE’s) after the Enron debacle, many companies have faced somewhat complex and often times undesirable accounting results. The rules revolved around the concept of a primary beneficiary. This party was deemed to have the most at risk while potentially having an ownership interest that was disproportionate to the control it actually exercised. Under the initial standard, primary beneficiary determination was extremely complex and driven largely by residual return calculations. The standard was amended to take a more subjective approach and evolved away from a computational methodology. However, this approach has also resulted in an increasing number of entities requiring consolidation than under the computational methodology. The new standard uses a subjective approach to determine which parties involved with an entity have the power to direct the activities that are most significant to the entities economics and receives returns or incurs losses that may be significant.
Companies with real estate typically experience issues with variable interest entities. Many times, small business owners will own a building and lease it back to the Company. There is often a loan on the building and that loan is often times guaranteed by the operating company. This guaranty creates a variable interest in the rental property for the operating company that generally will require consolidation of the rental property into the operating company. This can be troublesome because the operating company lender may only wish to see the results of the operating company and including a real estate entity can lessen the usefulness of the information provided to the operating company’s lender. From a financial statement reporting perspective, the company could choose to take a gaap exception and not consolidate the rental entity or they could choose to use tax basis statements which do not require consideration of variable interest entities. Before selecting either of these alternatives, a company should receive approval from the lender to ensure all parties are getting the information they require.
Loan guaranties, advances to joint ventures and waterfall provisions that skew risk and reward of ownership can all lead to potential VIE situations that may require consolidation. Home builders and developers often times set up new projects in separate legal entities, especially in joint venture arrangements. Sometimes the developer may guarantee loans or have waterfall provisions that significantly weight the risk to the homebuilder. Either of these scenarios could require the homebuilder to consolidate the joint venture. Mezzanine lenders providing bridge financing that are taking on significant risk and receive profit interests could also find themselves in the unexpected position of having to consolidate an entity they have no ownership interest in. The VIE rules are designed to ensure the party bearing the majority of economic risk will consolidate the entity.
Generally, consolidation rules have historically required the party that controls an entity to consolidate that entity. VIE standards generally take the position that the party that has the majority of the risk and rewards will also be the party controlling the entity as no prudent business is going to accept the majority of the risk in something without also obtaining the majority of control. So when setting up a joint venture or other legal entities, be sure to carefully evaluate the design and purpose of the entity as this ultimately dictates the potential reporting for that entity. Percentage ownership is not the sole factor in control given the more complex designs and functions of entities in today’s business environment. Consult with your accounting and financial advisers to determine the best options for the design of your legal and economic deal structures so that you can make the decisions that most benefit your business.