FASB INTERPRETATION NO. 45 AND 46
a.k.a. How to Lose Your Credit Relationships and Confuse Investors (Part 2)

The Financial Accounting Standards Board (FASB) recently issued FASB Interpretation (FIN) No. 46, Consolidation of Variable Interest Entities and Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. In the hierarchy of accounting rules, Interpretations are generally accepted accounting principles (GAAP) which means if you need to issue GAAP basis financial statements, the rules of these Interpretations may apply to you and your company.

In the accounting world, these new rules are often referred to as “Enron response” rules. Both are designed to curb the abuses related to off-balance sheet or “hidden” assets and liabilities. In other words, force the inclusion of assets and liabilities which were found to be hidden during the Enron scandal (off-balance sheet).

What does all this mean to the family owned, privately held company? Well, it could mean a significant change to your financial statements. Let's discuss each interpretation separately.

FIN 46

According to the provisions of FIN 46 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 to hold assets. This means those assets held individually/personally are not within the scope of FIN 46.

What is a VIE?

The first test in determining whether an entity is a VIE is reviewing the capital structure of the entity. A VIE is generally designed with insufficient equity. In general, an equity investment of less than 10% of the entity's total assets is considered insufficient to permit the entity to finance its activities without additional subordinated financial support. In order to avoid the 10% rule, the entity must meet one of the following criteria:

1. The entity must demonstrate that it can finance its activities without additional subordinated financial support.
2 . The equity is at least as much as similar entities with no additional subordinated financial support.
3. The equity invested exceeds the estimated expected losses.

The second test in determining whether an entity is a VIE is reviewing the characteristics of the investors. In general, equity investors of a VIE lack primary decision-making abilities and an obligation to absorb any losses of the entity. For example, if a construction company guarantees the debt of a equipment leasing company and the leasing company owners do not, this may cause the leasing company to be classified as a VIE since the owners lack the obligation to absorb any potential business losses.

So you have a VIE, now what?

After you determine that an entity is a VIE, you need to determine if the related operating company has a variable interest in it and whether it is the primary beneficiary. Didn't we already do that in steps one and two? In general, by defining the entity as a VIE, you just created a variable interest. A primary beneficiary is the entity that receives the most benefit from the VIE. For example, Company A is an operating company and the owners of Company A also own Company B. Company B holds the building Company A leases and Company A is the only tenant of Company B. Company A is the primary beneficiary. Company B will be consolidated with Company A.

FIN 45

FIN 45 elaborates on the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. It also requires a guarantor to recognize, at the inception of certain guarantees, a liability for the fair value of the obligation undertaken in issuing the guarantee.

What guarantees are affected?

FIN 45 applies to any contingently payable guarantee that meets one of the following characteristics:

1. The guarantor pays based on changes in an underlying interest rate, security price, exchange rate, etc., relating to an asset, liability or an equity security of the guaranteed party.
2. The guarantor pays based on another entity's failure to perform.
3. The guarantee contains certain indemnification agreements.
4. The guarantee is an indirect guarantee of the indebtedness to others.

What is the effect on the financial statements?

In general, if a guarantee meets one of the characteristics described above, the guarantor must record a liability for the fair value or market value of the obligation it assumes under the guarantee on its balance sheet.

All guarantors, regardless if their guarantees are recorded as a liability, are required to disclose additional information regarding any outstanding guarantees. This means that your financial statements will disclose information including nature of the guarantee, maximum amount of potential future payments, current carrying amount of the liability, and whether the guarantor has any recourse provisions.

Who is excluded?

Unfortunately, no guarantor is excluded from the additional disclosure requirements. However, guarantees that are issued between certain related parties are not required to be recorded as a liability.

What is the next step?

The impact of these pronouncements will affect financial reporting, loan covenants, operating results, and bonding to name a few. Under both interpretations, you may need to record additional debt on your company's balance sheet. Please keep in mind, we have provided only a summary of the new standards. Please give us a call if you are concerned that your business may be impacted by FIN 45 or 46. Each entity with which you or your business is involved will need to be analyzed to determine if they meet the definition of a VIE. In addition, any guarantees will need to be reviewed to determine if your company needs to record a liability for issuing the guarantee.

Mary F. Actor, CPA
Director of Assurance Services