Special Purpose Entities or Variable Interest Entities: Lack of Equity Investors
Variable Interest Entities
One topic that has generated much discussion and even some “bad blood” in the accounting profession and business community as a whole is variable interest entities, formerly known as “special purpose entities.” One common definition of a variable interest entity is a legal business structure which does not have enough capital to support itself due to its lack of equity investors. The financial support for the variable interest entity is provided by an outside source, such as another corporation. A variable interest entity is often created by a corporation to serve as a holding company, which will hold assets or debt for the creating corporation. A corporation can use such a vehicle to finance an investment without putting the entire firm at risk. In years past, this has cause considerable controversy because variable interest entities have been used inappropriately by large companies to hide “bad assets” such as subprime mortgage exposure. In general, the creating of a variable interest entity serves three primary purposes for a company.
1. A variable interest entity can be used to reduce the cost of debt financing. For example, when a company securitizes an asset and needs financing to do so it can use a variable interest entity to increase their credit rating. The company seeking financing can sell assets that it has on its balance sheet to a variable interest entity as a temporary transaction. The variable interest entity obtains the funds to purchase the assets from the corporation by issuing securities. This is called an asset backed transaction. Because the variable interest entity owns the assets, which are also the collateral for the securities issued, lenders evaluate the credit quality of the collateral instead of that of the corporation. As a result, lower funding costs are achieved by the corporation. A non-investment grade issuer can obtain funding at investment-grade levels by isolating the assets in
One topic that has generated much discussion and even some “bad blood” in the accounting profession and business community as a whole is variable interest entities, formerly known as “special purpose entities.” One common definition of a variable interest entity is a legal business structure which does not have enough capital to support itself due to its lack of equity investors. The financial support for the variable interest entity is provided by an outside source, such as another corporation. A variable interest entity is often created by a corporation to serve as a holding company, which will hold assets or debt for the creating corporation. A corporation can use such a vehicle to finance an investment without putting the entire firm at risk. In years past, this has cause considerable controversy because variable interest entities have been used inappropriately by large companies to hide “bad assets” such as subprime mortgage exposure. In general, the creating of a variable interest entity serves three primary purposes for a company.
1. A variable interest entity can be used to reduce the cost of debt financing. For example, when a company securitizes an asset and needs financing to do so it can use a variable interest entity to increase their credit rating. The company seeking financing can sell assets that it has on its balance sheet to a variable interest entity as a temporary transaction. The variable interest entity obtains the funds to purchase the assets from the corporation by issuing securities. This is called an asset backed transaction. Because the variable interest entity owns the assets, which are also the collateral for the securities issued, lenders evaluate the credit quality of the collateral instead of that of the corporation. As a result, lower funding costs are achieved by the corporation. A non-investment grade issuer can obtain funding at investment-grade levels by isolating the assets in
Cited: Nikolai, L.A., Bazley, J.D., & Jones, J.P. Current developments in accounting. Mason, OH: Cengage Learning. Deloitte. (2010, March). Consolidation of variable interest entities: a roadmap to applying the variable interest entities consolidation model. Retrieved from http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/AERS/ASC/us_assur_Consolidations_0310 Financial Accounting Standards Board, . (2003). Summary of interpretation no. 46. Retrieved from http://www.fasb.org/summary/finsum46.shtml