What it means
Normally, a company consolidates (adds together line by line) the accounts of businesses in which it owns a majority of the votes. That simple test fails when control comes from contracts, funding or guarantees instead of votes.
A variable interest entity is an entity where this is the case, so a different test is needed. An entity is usually a VIE if its equity investors are not enough to finance its activities, if they lack the power to direct what matters most, or if they do not absorb the entity's expected losses or receive its expected gains.
Typical examples are securitisation vehicles, special purpose entities and some leasing and joint venture structures. A variable interest is any contract or investment that exposes the holder to the entity's ups and downs, such as loans, guarantees, equity or fees linked to performance.
The holder who has both the power to direct the activities that most affect the entity's economic performance, and the obligation to absorb losses or the right to receive benefits that could be significant, is the primary beneficiary. The primary beneficiary consolidates the VIE, bringing its assets and liabilities onto its own balance sheet.
The reporting company also has to disclose its involvement with VIEs it does not consolidate, so readers can see what exposure exists. The rules came about after special purpose entities were used by some companies to keep debt off the balance sheet.
International standards use a broader control model rather than a separate VIE concept, so the answer can differ for a group reporting under another framework. Judgement plays a large part in the assessment.
Management must document why it reached its conclusion, and auditors will challenge any structure where the answer depends on fine contractual detail, so the analysis is usually repeated when the contracts or the funding change.
In practice
Real-world examples
Example 1
A retailer leases its stores from a property company that was set up solely to own them. The retailer guarantees the property company's mortgage and decides which stores to lease. It is the primary beneficiary and consolidates the property company, so the mortgage appears on its balance sheet.
Example 2
A bank sets up a trust that buys car loans and issues bonds to investors. The bank services the loans and keeps the first-loss slice of the risk. Because it directs the trust's key activities and absorbs significant losses, the bank consolidates the trust.
Example 3
A technology company has a minority stake in a start-up that depends on a loan from the company and uses its software exclusively. The start-up cannot operate without that support. The company assesses whether it is the primary beneficiary and, if so, includes the start-up in its group accounts.
Think of it
Imagine leasing a restaurant building where the landlord gives you complete control over the menu, staff, and daily takings, while you take all the profits and cover all losses. Even though you do not own the bricks and mortar, you effectively run the business.
Case study
Seen in the real world
Meridian Freightways is an illustrative, fictional shipping group that wanted to expand its fleet without raising its reported debt. It set up a separate vessel-owning company funded by a bank loan and a very small equity investment from an outside investor.
Meridian agreed to charter every vessel for ten years and guaranteed the loan. Its accountants concluded that the vessel company was a VIE because the equity was too thin to stand alone, and that Meridian, which decided how the ships were used and carried the losses if charter income fell, was the primary beneficiary.
In the illustrative result, the ships and the loan were added to Meridian's balance sheet, and its debt ratios were higher than the board had expected. The lesson is that moving an asset into a separate company does not remove it from the group accounts when the group keeps control.
Watch out
Common mistakes
- Assuming that owning less than half of the votes means a company does not need to include an entity in its accounts.
- Treating a VIE as something improper, when many are used for legitimate purposes such as securitisation and project finance.
- Ignoring disclosure, when even a company that does not consolidate a VIE must explain its involvement and its maximum exposure to loss.
Questions
People also ask
What is a primary beneficiary?
It is the party that has the power to direct the activities that most affect the VIE and the obligation to absorb significant losses or the right to receive significant benefits.
Is a VIE the same as a special purpose entity?
Not exactly, because many special purpose entities are VIEs, but the VIE test applies to any entity that meets the criteria, whatever its purpose.
Why does consolidating a VIE matter to lenders?
It brings the entity's debt onto the balance sheet, which raises reported leverage and can affect loan covenants.