FASB under the provisions of FIN 46 (R) has prescribed three basic condition which when met by an entity makes it to be considered as a variable interest entity for the purposes of these provisions. These conditions are: 1. The entity should have a thin capital base. This implies that the entity should have insufficient equity to meet its financial obligations or the entity can meet the requirements for its activities through additional subordinated financial support.
Similarly when the equity holders as a group do not have sufficient funds in the equity, or do not have adequate rights to decide on various issues, or do not possess adequate voting rights, or may not be in a position to absorb the pro-rated losses or to receive the pro-rated residual returns of the entity, the entity becomes a VIE. 2. There exist variable interests in the variable interest entities. 3. The entity becomes the primary beneficiary of the VIE. (FASB) Provisions of FIN 46 (R) as applied to San Diego Technology Holdings Inc
The provisions of FIN 46(R) as applied to the transactions of San Diego presents the following circumstances: $ 103 million guarantee given on behalf of EOTT Tech Partners L. P and $ 538 million relating to the trade obligations of EOTT: These transactions do not attract the provisions of FIN 46 (R) as these guarantees are secured by the assets of EOTT. Since EOTT does not seem to be thinly capitalized and has sufficient capital to finance its activities without additional subordinated financial support the entity cannot be characterized as a VIE.
But still it needs to be clarified whether the company meets the equity threshold requirement of 10% to meet its financial obligations so that it does not become the VIE of San Diego. (PWC) $ 386 million in lease obligations: As the obligation here is covered by an indemnity from an investment grade company this transaction need not be consolidated under San Diego accounts. This transaction may be considered as an exception allowed by the provisions. Transactions with limited partnerships in which the general partner’s managing member is presumably Michael Monus the CEO of San Diego Tech Holding:
These transactions fall under the provisions of FIN 46 (R). It is quite transparent that the entity is formed just to keep the obligations of San Diego off its balance sheet. This can obviously be inferred from two issues as exhibited in the balance sheet of San Diego. It is to be seen that the company San Diego is highly leveraged with debts to assets ratio of 80%. When the liabilities of the VIE are consolidated the debts to assets ratio will change to a higher figure of 95%. There is the obvious likelihood of the consolidation hitting the covenants in respect of some of the debts contracted by San Diego.
It is quite likely therefore the CEO decided to keep some off-balance sheet transactions. This might be the reason to create the limited partnership with major shareholding by Michael Monus. Secondly it is the transaction relating to transfer of inventory to the limited partnership. In this transaction San Diego declares the earning of a gross margin of $ 67 million. This transaction appears to be a bogus one just to push up the financial position of San Diego. Ethical Issues to Consider Mr.
Michael Monus CEO of San Diego seems to be adamant in continuing the off-balance sheet transactions and does not want any of the associated debts to appear in the balance sheet of San Diego. When the provisions of FIN 46 (R) are clearly attracted to the transactions of the limited partnership in which he holds a majority share such transaction needs consolidation. It is necessary that Mr. Michael Monus needs to be consulted on the implications of the provisions of FIN 46 (R) before our firm decides to bid for the account of San Diego as there may be serious ethical issues.
Things that need to be ascertained The capital structure of EOTT and its financial standing need to be ascertained to ensure that the company does not attract the provisions of FIN 46 (R) relating to VIE. There is also the need to test the 10% equity threshold limit. The capital structure of the limited partnership in which the CEO of San Diego holds a majority shareholding needs to be checked. It is also necessary to examine the transactions entered into between these two companies.
The true value of the inventory transferred to the limited partnership and the real profits earned by San Diego needs to be studied to ensure the genuineness of the transaction. References 1. Accountantsoffice online ‘Consolidation under the variable interest entity model (FIN 46R) – http://accountantsofficeonline. lsc-cpa. com/Shared/ShowNewsletter. aspx? FirmID=918476A418E4F5FEFB22CA308BE0A070&NewsletterID=0045E89DAEBCFB38D2B3C97F6BA6F6A8&NSType=1 2. FASB Summary of interpretation No 46 – http://www. fasb. org/st/summary/finsum46. shtml 3. PWC structured finance group http://www. securitization. net/pdf/content/PWC_CMADA_30May08. pdf.