Consolidation Of Variable Interest Entities Research Articles

Consolidation of off-balance sheet entities and investment efficiency

PurposeThe purpose of this study is to examine the effect of consolidating off-balance sheet entities on firm-level investment efficiency. Financial Accounting Standards Board Interpretation No. 46, consolidation of variable interest entities – an Interpretation of ARB No. 51 (FIN 46) is used as a quasi-exogenous shock to financial reporting in this study.Design/methodology/approachThe authors empirically test the change of investment efficiency for a sample of firms affected by FIN 46 in the post-FIN 46 periods. In the regression, a group of matched pairs selected from unaffected firms is used as the control sample and firm characteristics are used as control variables.FindingsThe authors find that firms affected by FIN 46 experience improvement in investment efficiency after adopting the standard compared to unaffected firms. The authors also document that FIN 46 firms’ level of investment decreases after FIN 46 compared to unaffected firms. These empirical results suggest that the improvement in investment efficiency is likely to be achieved by the reduction in over-investment. Further analyses show that amongst the affected firms, firms consolidating off-balance sheet special purpose entities (SPEs) improve investment efficiency mainly by reducing over-investment, whereas firms avoiding the consolidation of SPEs do not display such tendency.Originality/valueThis study contributes to the literature on the relation between financial reporting and investment efficiency, as well as the literature on the impact of FIN 46. To the best of the authors’ knowledge, this study is the first to examine the relation between the consolidation of off-balance sheet entities and investment efficiency.

Does Consolidation of Variable Interest Entities Improve the Pricing of Financial Reporting in Bank Holding Companies? Evidence From FAS 166/167

The study examines whether consolidating qualified special-purpose entities (QSPEs) under Statement of Financial Accounting Standards Nos. 166 and 167 (FAS 166/167) improves the market reaction to earnings disclosures. We use a difference-in-difference design to compare the change sample, which is defined as banks that consolidate QSPEs after FAS 166/167, with the no-effect sample, which is defined as financial institutions with no QSPEs or banks that do not consolidate QSPEs after FAS 166/167. The results show that, during a short window around earnings announcements, the change sample experiences higher market reaction to earnings surprises than the no-effect sample after the implementation of FAS 166/167. We also find that the effect is more pronounced in banks that engage in securitization and in financial institutions whose securitized loans originate primarily from consumer loans rather than mortgages. Additional analysis also finds that adopting FAS 166/167 enhances the ability of earnings to predict future earnings and future cash flows in banks. The important implication of the study for regulators is that FAS 166/167 improves bank transparency.

The Impact of Financial Reporting Flexibility on Auditor Risk Judgment – Evidence from a Natural Experiment

This paper investigates how auditors respond, in terms of their pricing and audit work, to a reduction of clients’ financial reporting discretion upon the implementation of FIN 46R “Consolidation of Variable Interest Entities” in year 2003. The accounting standard mandatorily requires firms to consolidate the performance of variable interest entities (VIEs) under their control. These entities can no longer be off-balance sheet and managers’ flexibility in using these entities for manipulating earnings is substantially constrained. Using a difference-in-difference research design, we find that auditors charge relatively fewer audit fees and have shorter audit reporting lags for firms which are significantly affected by FIN 46R after its adoption, compared to a group of controlled firms. This result concurs with the view that auditors react favorably to the reduction of clients’ financial reporting discretion, by reducing their audit pricing and audit work. Our finding is concentrated among those clients with higher accrual earnings management constraints and auditors with less client specific knowledge and also auditors who have no clients conducting severe accounting restatements. Our results are robust to different matched control samples and our conclusion remains valid by using an alternative treatment sample which is not affected by the contemporaneous adoption of SOX Act.

Auditing and Accounting for the Consolidation of Variable Interest Entities

AbstractIn 2009, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. (SFAS) 167 (ASC 810), which broadens the number of entities that will consolidate formerly unconsolidated offbalance sheet assets and liabilities, and otherwise greatly changes the framework for consolidated financial statements. While the literature provides some examples of accounting for Variable Interest Entities (VIEs), little discussion examines how to audit such VIEs, which is important in light of some related audit failures. In this article, the authors summarize the provisions of SFAS 167 and discuss the auditing implications. They also discuss how recent International Financial Reporting Standards affect how entities should account for and audit VIEs. © 2013 Wiley Periodicals, Inc.

The valuation and reliability implications of FIN 46 for synthetic lease liabilities

We examine whether adoption of FASB Interpretation No. 46/R (FIN 46), Consolidation of Variable Interest Entities–an Interpretation ofARB No. 51, changed the market valuation and related measurement reliability of synthetic lease liabilities. Adopted in 2003, FIN 46 requires financial statement recognition of many previously off-balance sheet structures, including synthetic leases. Synthetic leases are hybrid financing structures that, prior to FIN 46, allowed firms to maximize the benefits of asset ownership for tax purposes while retaining operating lease treatment within the firm’s financial statements. We identify a sample of 125 synthetic leasing firms impacted by FIN 46. Utilizing methodology consistent with Dhaliwal et al. (2011), we constructively capitalize these lease liabilities in the period preceding FIN 46 and compare market valuation of these liabilities with capitalized leases after adoption of the standard. We find that the market places greater weight on synthetic lease obligations recognized within the body of the financial statements than it does liabilities disclosed within the associated notes. Finally, we rely on econometric procedures developed in Barth (1991) and extended in Choi et al. (1997) to examine whether the differential market valuation of lease liabilities post FIN 46 is due in part to perceived differences in measurement reliability. The results indicate there is a post FIN 46 reliability effect for all lease liabilities examined. However, while the synthetic lease amounts are the most unreliable examined, they also experience the greatest increase in reliability post FIN 46, indicating that perceived measurement reliability explains in part differential market valuation associated with FIN 46. Our findings have the potential to inform the ongoing standard setting debate surrounding the possible capitalization of all leases. Further, our study also has economic implications for managers concerned with the potential constraints on asset financing options imposed by accounting regulation.

An Examination of the Cost of Capital Implications of FIN 46

ABSTRACT This study examines whether the adoption in 2003 of FASB Interpretation No. 46/R (FIN 46), Consolidation of Variable Interest Entities—An Interpretation of ARB No. 51, changed the cost of capital for affected firms. Using comparative analysis on a broad sample of 11,719 firm-quarter observations for 1,389 firms during the period 1998 through 2005, we find evidence that FIN 46 significantly increased the cost of equity capital for firms with affected variable interest entities (VIEs), an increase of approximately 50 basis points relative to firms reporting no material effect from the standard. Further, firms consolidating these formerly off-balance sheet structures experienced the largest increase. Taken together, these results suggest that FIN 46 reduced the opportunity for firms to use off-balance sheet structures to artificially reduce their cost of capital, a matter of regulatory concern. Data Availability: All data are available from public sources.

Risk Implications of Increased Off-Balance Sheet Disclosure: The Case of FIN 46 and SOX

This study investigates the impact of increased disclosures required by Financial Accounting Standards Board (FASB) Financial Interpretation No. 46 (FIN 46) Consolidation of Variable Interest Entities and the Sarbanes-Oxley Act of 2002 (SOX). Our results indicate that the maximum risk disclosures required under FIN 46 were only marginally priced, although differences exist across type of VIE and whether the structure was ultimately consolidated. Further, while all firms experienced decreases in idiosyncratic risk around this time of increasing regulatory scrutiny and upon adoption of SOX, only the off-balance sheet disclosures required by FIN 46 appear to have significantly altered firm idiosyncratic risk beyond the general provisions of SOX. Our study has implications for accounting regulators determined to design effective investor protection regulation.

Changes in accounting and auditing for consolidation of variable interest entities

AbstractIn 2009, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 167 (ASC 810), which broadens the number of entities that will consolidate formerly unconsolidated off‐balance‐sheet assets and liabilities and otherwise changes greatly the framework for consolidated financial statements. Many entities had used qualifying special purpose entities and other vehicles to prevent them from applying the consolidation provisions of Financial Interpretation No. 46 (Revised) (FIN 46(R)), Consolidation of Variable Interest Entities. This article summarizes the provisions of the new standard and provides examples of its application in order to help practitioners implement these provisions and provide guidance to companies and clients. © 2012 Wiley Periodicals, Inc.

Altering Investment Decisions to Manage Financial Reporting Outcomes: Asset‐Backed Commercial Paper Conduits and FIN 46

ABSTRACTWe evaluate the manner in which sponsors of highly leveraged asset‐backed commercial paper (ABCP) conduits responded to Financial Accounting Standards Board Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities an Interpretation of ARB No. 51, and its Canadian counterpart Accounting Standards Board of Accounting Guideline 15 (AcG‐15), Consolidation of Variable Interest Entities. By matching commercial paper investors with corporations seeking liquidity, ABCP sponsors facilitate a significant amount of short‐term, securitized financing in the United States. FIN 46 and AcG‐15 require sponsors to consolidate their ABCP conduits with their financial statements. We demonstrate that the volume of ABCP began to decline when FIN 46 was first proposed, and that this decline is primarily attributable to a reduction in North American banks' sponsorship of ABCP. We also demonstrate that North American banks entered into costly restructuring arrangements to avoid having to consolidate their conduits per the new accounting standards. Our results suggest that, in certain settings, accounting standards appear to have real effects on investment activity and product‐market competition.

The Valuation and Disclosure Implications of FIN 46 for Synthetic Leases: Off-Balance Sheet Financing of Real Property

We examine whether adoption of FASB Interpretation No. 46/R (FIN 46), Consolidation of Variable Interest Entities–an Interpretation of ARB No. 51, changed the market valuation and related measurement reliability of synthetic lease liabilities. Adopted in 2003, FIN 46 requires financial statement recognition of many previously off-balance sheet structures, including synthetic leases. Synthetic leases are hybrid financing structures that, prior to FIN 46, allowed firms to maximize the benefits of asset ownership for tax purposes while retaining operating lease treatment within the firm’s financial statements. We identify a sample of 125 synthetic leasing firms impacted by FIN 46. Utilizing methodology consistent with Dhaliwal et al. (2011), we constructively capitalize these lease liabilities in the period preceding FIN 46 and compare market valuation of these liabilities with capitalized leases after adoption of the standard. We find that the market places greater weight on synthetic lease obligations recognized within the body of the financial statements than it does liabilities disclosed within the associated notes. Finally, we rely on econometric procedures developed in Barth (1991) and extended in Choi et al. (1997) to examine whether the differential market valuation of lease liabilities post FIN 46 is due in part to perceived differences in measurement reliability. The results indicate there is a post FIN 46 reliability effect for all lease liabilities examined. However, while the synthetic lease amounts are the most unreliable examined, they also experience the greatest increase in reliability post FIN 46, indicating that perceived measurement reliability explains in part differential market valuation associated with FIN 46. Our findings have the potential to inform the ongoing standard setting debate surrounding the possible capitalization of all leases. Further, our study also has economic implications for managers concerned with the potential constraints on asset financing options imposed by accounting regulation.

Economic Consequences of Recognizing Off-Balance Sheet Activities*

This study investigates the economic impact of FASB Interpretation No. 46, Consolidation of Variable Interest Entities (VIEs) - an Interpretation of ARB No. 51 (FIN 46). FIN 46 requires firms to consolidate VIEs, often referred to as special purpose entities (SPEs), if certain criteria are met. I find that the adoption of FIN 46 is associated with both a decline in the use of VIEs and an effort by firms to decrease book leverage by substituting conventional debt with equity. This evidence indicates that the new rule affects firms' capital structure decisions. Moreover, I demonstrate that Standard & Poor's credit ratings for VIE firms have significantly worsened since the adoption of FIN 46. The change in credit rating indicates that FIN 46 conveys new information that was not previously incorporated into credit ratings. I also find that the pricing of information risk decreased for non-VIE firms, but not for the VIE firms. Taken together, the evidence is consistent with the stated goal of FIN 46, which is to enhance the representational faithfulness of financial statements in circumstances where the risk and benefits of ownership are retained.

Altering Investment Decisions to Manage Financial Reporting Outcomes: Asset-Backed Commercial Paper Conduits and FIN 46

We evaluate the manner in which sponsors of highly leveraged asset-backed commercial paper (ABCP) conduits responded to FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities an Interpretation of ARB No. 51, and its Canadian counterpart Accounting Standards Board of Accounting Guideline 15 (AcG-15), Consolidation of Variable Interest Entities. By matching commercial paper investors with corporations seeking liquidity, ABCP sponsors facilitate a significant amount of short-term, securitized financing in the U.S. FIN 46 and AcG-15 require sponsors to consolidate their ABCP conduits with their GAAP financial statements. We demonstrate that the volume of ABCP began to decline when FIN 46 was first proposed, and that this decline is primarily attributable to a reduction in North American banks' sponsorship of ABCP. We also demonstrate that North American banks entered into costly restructuring arrangements to avoid having to consolidate their conduits per the new accounting standards. Our results suggest that in certain settings, accounting standards appear to have real effects on investment activity and product-market competition.

An Examination of the Cost of Capital Implications of Financial Interpretation 46

This study examines whether adoption in 2003 of FASB Interpretation No. 46/R (FIN 46), Consolidation of Variable Interest Entities – an Interpretation of ARB No. 51, changes the cost of capital for affected firms. Using comparative analysis on a broad sample of 11,719 firm-quarter observations for 1,389 firms during the period 1998 through 2005, we find evidence FIN 46 significantly increased the cost of equity capital for firms with affected variable interest entities (VIEs), an increase of approximately 50 basis points relative to firms reporting no material effect from the standard. Further, firms consolidating these formerly off-balance sheet structures experienced the largest increase. Taken together, these results suggest that FIN 46 reduced the opportunity for firms to use off-balance sheet structures to artificially reduce their cost of capital, a matter of regulatory concern.

Clandestine Accounting: Variable Interest Entity Consolidation, Financial Leverage and Tax Shelter Participation

We use event study techniques to investigate market participants’ ex ante perceptions regarding the benefits and burdens of Interpretation Nos. 46 and 46R, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 (FIN 46/R). The evidence suggests investors believed the costs of complying with FIN 46/R would significantly outweigh any purported improvements in the quality of accounting information. However, investors also appear to have recognized that the standard would improve information quality for highly levered firms and appropriately limit managerial rent extraction through the use of tax shelters.

Consolidation of Variable Interest Entities: Applying the Provisions of FIN 46 (R)

Financial Accounting Standards Interpretation [FIN] No. 46 (R) provides guidance for investors, sponsors and transferors in ascertaining which variable interest entities should form part of relevant parties' financial statements. Given the complexity of this authoritative pronouncement, we show how a consultant, using an organized approach, helped a CPA firm adhere to this new pronouncement. The appended exhibits and associated explanations should help CPAs implement these provisions and provide guidance for helping companies and clients conform to these complex accounting pronouncements.

Teaching variable interest entities under FIN 46: Untangling risks, expected losses, and expected residual returns

FASB Interpretation No. 46 (FIN 46), as revised, addresses consolidation of variable interest entities. FIN 46 has been described as complex, hard to understand, and difficult to apply. This paper presents a conceptual approach that explains the rationale for consolidation of variable interest entities. A brief discussion of “special purpose entities” (SPEs), including a comparison of an SPE with a parent and a majority-owned subsidiary, is presented first, followed by a summary of the primary consolidation requirements of FIN 46. The main part of this paper uses two hypothetical companies to illustrate and explain what the requirements of FIN 46 are designed to accomplish. The conceptual approach presented in this paper should be a useful pedagogical tool for instructors teaching consolidations and for students attempting to understand the complexities of FIN 46.

The dilemma of bright line accounting rules and professional judgment: Insights from special purpose entity consolidation rules

Special purpose entities (SPEs) gained popularity during the 1990s when they were used as a building block in structured financial transactions. The failure of Enron in late 2001, however, revealed that the accounting for these transactions was based on detailed accounting guidance that often yielded a financial reporting picture that did not reflect the substance of the underlying transaction. In December 2003 the Financial Accounting Standards Board (FASB) issued FIN 46R ‘Consolidation of Variable Interest Entities’, which corrected many of the financial reporting inconsistencies generated by patchwork guidance on consolidation that evolved during the 1990s. This study uses the previous consolidation rules for SPEs to evaluate the impact that bright line accounting rules have on financial reporting decisions. Review of SPE consolidation rules suggests that detailed rules and bright line tests have overshadowed professional judgment, resulting in decisions that were consistent with established rules, but inconsistent with the social policy goal of providing the most useful financial information. In essence, it appears that the detailed rules-based structure of GAAP has squeezed judgment out of the financial reporting system, atrophying the accounting profession's ability to apply sound professional judgment. As a result, the solution to the financial reporting system's current problems may not lie in adding layers of complexity to the existing rule structure, but in developing broader-based principles that encourage and demand individual responsibility and the application of professional judgment.

Is My SPE a VIE Under FIN46 and, If So, So What?

Special purpose entities (SPEs) are widely used in a variety of project and other structured financings as they generally facilitate the isolation of risk and the assignment of responsibility therefor under definitive transaction agreements and other documents and instruments. In addition, if the SPE is not consolidated with a transaction sponsor, this may allow the sponsor to participate in more transactions than it could if the SPE had to be consolidated in the sponsor9s financial statements. Recently, under substantial political and other pressure to act following the alleged abuses of special purpose entities (SPEs) by Enron and others, the U.S. Financial Accounting Standards Board (FASB) issued new guidance on consolidation—FASB Interpretation No. 46 (FIN46), Consolidation of Variable Interest Entities. Many existing SPEs that were not consolidated under prior guidance likely will be consolidated by their sponsors under FIN46, unless they are substantially restructured. Similarly, sponsors entering new structured financing transactions likely will need to structure them differently than in the past to avoid consolidation. The two key determinations in FIN 46 are whether an entity is a variable interest entity (VIE) and, if so, whether an interest holder is a primary beneficiary (PB). The PB of a VIE is required to consolidate the VIE.