Aggressive corporate financial officers are always looking for sneaky ways to keep liabilities off the balance sheet. When the FASB issued interpretation FIN 46R, one such loophole was effectively cut off – the variable interest entity.

1. Off-balance sheet financing schemes

Debt and other liabilities can raise a lot of red flags with current and potential investors, so it is desirable for company management to keep them off the balance sheet as much as possible. Liabilities are often the target of aggressive accounting tactics – in the past, before the big Enron and WorldCom scandals, the popular schemes involved improper lease classifications and expense capitalizations. Another common arrangement was the establishment of special purpose entities whose sole purpose was to limit liabilities and losses on financial statements due to a technicality in the consolidation rules.

Under the old rules, a company was only required to consolidate a partially-owned subsidiary if owned a controlling interest – generally accepted to mean 50% or greater ownership and voting rights. Certain organizational structures, such as an LLC, are flexible when it comes to ownership and voting, so they could previously be used to hide liabilities. Here’s an example of what that means.

2. What is a variable interest entity?

Let’s say Friends Company establishes Little Company with a third party and takes a small 5% ownership interest, even though it provided 90% of Little’s capital. This new company gets a loan to construct a manufacturing facility, and because it is so small and so new, Friends Company is required to guarantee the loan. The facility produces a small metal part used in Friends Company’s manufacturing process, and Friends purchases every unit produced by Little Company. If Little Company loses money, Friends Company provides more capital to keep Little Company afloat. In this example, Friends Company clearly benefits the most from Little Company’s operations, and it is clearly responsible for covering Little’s losses. Under normal consolidation rules, however, Friends Company does not have to report the Little Company assets and the related loan on its consolidated financial statements.

FIN 46R established a two-step test to determine whether a subsidiary needs to be consolidated based on the alternative variable interest rules. First, a variable interest must exist, which means cash flows to and from the entity could change based on the makeup of its assets and liabilities. In the above example, Friends might lose a lot of money if Little Company can’t control production costs or has to default on its loan. If it is determined that a variable interest exists, the primary beneficiary of the entity must consolidate the entity’s assets and liabilities as if it holds a 50% ownership interest.

Variable interest entities can be complex organizations, so a deeper discussion about them is beyond the scope of this article. In addition, specifics about the consolidation process are not relevant to your understanding of what a variable interest entity is and how it should be accounted for, so we’ll leave that discussion alone for now.

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