Financial Accounting Standard #150,
FASB Interpretation No. 46R
A.K.A. How to Lose Your Credit
Relationships and Confuse Investors (Part 3)
The Financial Accounting Standards Board (FASB) has recently amended Financial Accounting Standard #150, Accounting for Certain Instruments with Characteristics of Both Liabilities and Equity and FASB Interpretation No. 46, Consolidation of Variable Interest Entities. These changes provide additional time and clarity on how to implement these standards, as well as relief to some financial statement users.
FAS 150
FAS 150 was originally issued in May 2003 and covers financial instruments. A financial instrument can be stock, membership interests in a limited liability company or partnership interests. A mandatorily redeemable financial instrument (MRFI) is classified as a liability on the balance sheet unless the redemption is required to occur only upon the liquidation or termination of a reporting entity. A financial instrument issued in the form of shares is mandatorily redeemable if it embodies an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date or upon an event certain to occur. Since death is an “event certain to occur,” a stock redemption agreement that obligates the company to redeem a stockholder’s stock upon the death of a stockholder makes the stock an MRFI. As a result, the entire equity section of the balance sheet (if the redemption price equals or is greater than total equity) is reclassified to a liability on the balance sheet.
For mandatorily redeemable financial instruments of a nonpublic entity, FAS 150 was effective for existing or new contracts for fiscal years beginning after December 15, 2003. As a result of both public and private industry comments, the FASB has amended the pronouncement for nonpublic entities as follows:
- For financial instruments that are mandatorily redeemable on fixed dates for amounts that are either fixed or determinable, the provisions of FAS 150 are effective for fiscal periods beginning after December 15, 2004.
- For all other mandatorily redeemable financial instruments, the provisions of FAS 150 are deferred indefinitely.
In other words, if the redemption price is based on a calculation of fair value of the stock at the time of death, no liability is recorded as a result of this amendment. Conversely, if the redemption price is based upon historical net book value, a liability may be recorded for the redemption liability since the redemption price is determinable.
FIN 46R
FIN 46 was originally issued in December 2002. Just in time for its first anniversary and after numerous updates, the FASB re-issued FIN 46 in its entirety replacing the original version. The revised version is known as FIN 46R. By now you may have heard of bankers, accountants, bonding agents and business owners scratching their heads in confusion at having to determine how to implement this new standard. FIN 46R is meant to eliminate some of that confusion as well as provide more time for the small business owner to determine if they have a variable interest entity.
Most provisions of FIN 46R remain the same as its predecessor. According to FIN 46R, a variable interest entity (VIE) is defined as an entity subject to consolidation. An entity is defined as any legal structure used to conduct activities or hold assets. Assets held individually/personally are not within the scope of FIN 46R.
In general, to determine whether an entity is a VIE, you must perform three tests. By meeting one of these criteria, the entity in question is determined to be a VIE.
- The total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated support provided by any parties, including the equity holders.
- The investors lack the direct or indirect ability to make decisions about the entity’s activities, lack the obligation to absorb the expected losses of the entity or lack the right to receive the expected residual returns of the entity.
- The investors’ right to receive or absorb the expected residual returns or losses of the entity is not in proportion to their voting rights.
After determining that an entity is a VIE, you need to determine if the reporting entity has a variable interest in it and whether or not it is the primary beneficiary. In general, by defining the VIE, you have created a variable interest in it. A primary beneficiary is the entity that receives the most benefit from the VIE and is required to consolidate the VIE.
The consolidation provisions under FIN 46 were effective immediately for all newly created entities after January 31, 2003. Existing entities were not subject to consolidation until the fiscal period beginning after June 15, 2003. FIN 46R extends the immediate consolidation provisions to entities created after December 31, 2003 and for entities in existence at December 31, 2003, the consolidation date is extended until the fiscal periods beginning after December 15, 2004.
While the amendments to both FAS 150 and FIN 46R have provided additional time to implement and respond to these standards, business owners will still need to be prepared for the impact these statements will have on their businesses. The impact of these pronouncements will affect financial reporting, banking relationships, operating results, and bonding. Please keep in mind that we have provided only a summary of the changes and the related standards as currently amended. If you are concerned that your business may be impacted by these changes please give us a call.
Mary F. Actor, CPA
Director of Assurance Services