Copyright 2005 © Deloitte Development LLC All Rights Reserved. Case 06-1 Am I In or Am I Out? Part 1 - Identifying Variable Interests Assume Company A has the following involvements in Entity X. Entity X potentially is a variable interest entity (VIE). In each example, assume that the involvement identified is the only involvement Company A has with Entity X. Required: • Identify whether Company A holds a variable interest in Entity X in each scenario. Involvement Does Company A’s Involvement Represent a Variable Interest? 1 Company A holds debt that was issued by Entity X. 2 Company A is a 40 percent partner in Entity X, a partnership. This entitles Company A to 40 percent of the distributable profits of Entity X. 3 Company A leases an asset from Entity X under an operating lease that represents a majority of the fair value of Entity X’s total assets. The lease contains no residual value guarantee or fixed price purchase option. 4 Company A has provided Entity X a guarantee that Entity X’s sole asset will be worth at least $1 million at the end of five years. 5 Company A, a real estate developer, provides property maintenance services to Entity X (a partnership) under a service contract. The service contract is cancelable only upon the dissolution of Entity X. The fees for the maintenance services are based on the net income of Entity X, at rates that are 30 percent more than market rates, and are paid after payments on trade payables.Case 06-1: Am I In or Am I Out? Page 2 Part 2: Determining Whether an Entity Is a Variable Interest Entity Required: • Review the following examples and determine whether each entity is considered a VIE under FIN 46(R). IMPORTANT!! Each example is meant to illustrate only one of the five VIE criteria. Assume, for the purpose of the examples, that none of the other criteria indicate that the entity is a VIE. Also, assume that the entities in the examples are unable to use the paragraph 4(h) scope exception (commonly known as the “business scope exception”), and, therefore, are within the scope of FIN 46(R). Is the Entity a VIE? Which view do you support? Entity Structure View A View B 1 Entity M is formed to manufacture widgets. Entity M has $100M in equity and is able to secure $200M of high investment-grade financing. There is no other subordinate financing or guarantees. Maybe, the evidence cited here is not enough to make a qualitative determination of whether the entity is a VIE. If a qualitative analysis is not conclusive to determine that this entity’s equity is sufficient, paragraph 9 indicates that the determination should be based on both a qualitative and quantitative analysis. The expected losses of Entity M must be calculated to determine whether this entity is a VIE. No, the entity is not a VIE. Paragraph 9 of FIN 46(R) provides two examples of qualitative factors that indicate an entity’s equity is sufficient. This entity meets factor 9(a) and demonstrates that the entity can finance its activities without additional subordinated financial support, because it has secured high investment grade financing and there is no other subordinate financing or guarantees. Copyright 2005 © Deloitte Development LLC All Rights Reserved.Case 06-1: Am I In or Am I Out? Page 3 Entity Structure View A View B 2 Entity R is formed to produce movies. Entity R is financed with $100M of common stock, $50M of fixed rate non-participating puttable preferred stock (puttable back to the entity at a fixed price), and $500 million of additional subordinated debt. A qualitative analysis of whether Entity R has sufficient equity has been inconclusive. Entity R’s expected losses are $115M. Yes, the entity is a VIE. First, because a fixed-rate preferred stock (that does not participate with common equity in dividends or liquidation) generally does not participate significantly in the profits or losses of the entity, it is not considered equity at risk. Second, because the instrument is puttable back to the entity at a fixed price, the holder can put its instrument back to the entity to protect it from incurring losses. Thus, the interest does not participate significantly in the entity’s losses, and is not considered equity at risk. Therefore, the $115M in expected losses of Entity R exceeds the $100M of equity investment at risk. No, the entity is not a VIE. The preferred stock is considered mezzanine equity, which qualifies as equity investment at risk. 3 Entity X is formed by issuing equity and convertible debt, and both instruments have voting rights equal to the amount invested. Investor 1 invests $20 in return for equity with a 20 percent vote. Investor 2 invests $80 — $20 for equity with a 20 percent vote and $60 for debt with a 60 percent vote. Assume that the equity at risk is sufficient under paragraph 5(a). Decisions are based on a simple majority of all voting rights. Yes, the entity is a VIE. Although the at-risk equity participants in the aggregate appear to meet the characteristics of paragraph 5(b)(1), the ability to make decisions about the entity’s activities is not lodged solely in the equity instruments issued by the VIE. Equity instruments only have a 40 percent interest in total, not sufficient to control the entity. No, the entity is not a VIE. The holders of the equity investment at risk, as a group, have the ability to make decisions about the entity’s activities that have a significant effect on the success of the entity. Copyright 2005 © Deloitte Development LLC All Rights Reserved.Case 06-1: Am I In or Am I Out? Page 4 Entity Structure View A View B 4 Enterprises A and B form a joint venture (JV). The JV is funded entirely by equity. Enterprises A and B invested the same amounts, share equally in profits and losses, and have an equal vote. The JV holds primarily three assets (all real estate assets), each with a fair value representing 33 percent of the entity's total assets. Each of the real estate assets has been guaranteed by different third parties, each unrelated to Enterprise A and B. Each guarantor is required to absorb the expected losses up to a stipulated amount related to the decrease in the value of the real estate asset specific to their respective guarantee. The guarantors absorb losses prior to any absorption by the equity holders. Yes, the JV is a VIE