Accounting scandals in the late 1990's and early 2000's, especially the Enron scandal, caused a new requirement to be fast tracked to approval and added to the existing accounting policies under US GAAP. To fully comply with the increases requirements, companies now need to account for and report on all entities in which they have an interest.

The new requirement that companies have to apply to financial reports is FASB Interpretation No.46 (R) (FIN46R). This interpretation covers the accounting treatment of any entity in which, although not a subsidiary by virtue of shared ownership, the company has an interest in (referred to as a variable interest entity or VIE) and bears some of the risks and rewards of future gains and losses arising in the entity.

FIN46R was designed to address the issue of off balance sheet entities, but its scope is very wide reaching and its application is complex and confusing.  The interpretation requires companies to undertake detailed tests to determine the value of assets in which they have a variable interest as a percentage of the total assets of the entity, and also who enjoys a majority of the risks and rewards of future gains and losses.  In certain circumstances, companies are required to consolidate such entities or account for the assets in which they have an interest, as investments.

There are two tests that may be conducted to see if a transaction must conform to FIN46R requirements, the 50% asset test and the primary beneficiary test. The 50% asset test is generally performed based on the fair value of all assets of the entity and their impact on future cash flows. Where the percentage of assets attributable are substantially more than 50%, a conclusion on a primary beneficiary test for that entity can be reached on a qualitative basis. When it is not substantially clear, a primary beneficiary test is required.

The primary beneficiary test is carried out to determine which entity is the primary beneficiary, that is, which will suffer a majority of expected losses or receive a majority of benefits from expected returns. Expected losses are not real losses but are the amount by which these losses are less than the ‘expected return' that has been projected over a future period for the entity. These numbers measure the variability of the entity's assets' fair value. There may always be expected losses if the cash flows do not meet the projected expected returns, even if the entity is doing well and has a positive cash flow. Thus, the primary beneficiary is determined by the entity that is exposed to the greatest share of the expected losses. The primary beneficiary must then consolidate the entity onto its books.

FIN46R was designed to make it easier for investors to compare companies that have similar interests and invest in similar entities, especially those which occur through variable interest entities. This is to enable a transparent view of where the resources, obligations, and risks lie for the beneficiary companies of the variable interest entities. This leads to achieving the ultimate goal of accounting standards, a more accurate representation of a company for the public and investors to examine and trust.

At Intangible Business, we have experience in applying FIN 46R to complex international groups involving hundreds of legal entities. We have successfully created a logical, transparent step-by-step process for its application to ensure and demonstrate compliance.

FIN46R is a complicated process and can be daunting for companies that have not had to deal with it before. An experienced partner can guide a company through the process with confidence and make the new reporting requirements much easier to deal with.