Question

Advantage and disadvantage of variable interest entity. please explain it in detail

Answer 1

Accoring to U.S. Financial Accounting Standards Board (FASB), Variable interest entity means, is an entity that an investor has a controlling interest in, but this controlling interest is not based on a majority of voting rights. VIEs are subject to consolidation under certain conditions.

Under Interpretation no. 46(R) a VIE must be consolidated into the financial statements of the primary beneficiary company when either of the following conditions exist:

1) The VIE does not have sufficient equity investment at risk.

2) Equity investors in the VIE lack any of three characteristics of controlling financial interest. Investors with such an interest

a) Participate in decision-making processes by voting their shares.

b) Expect to share in returns generated by the entity.

c) Absorb any losses the entity may incur.

Eg: A company started Z company with the help of a Third party and holds only 10% of ownership even though they contributed most of the capital. And A company is benified by purchasing all the raw matrials they required. However if Z company underperforms A company need to contribute more capital and incur losses.

Advantages.

1) Variable interest entities are used as special purpose vehicles to finance certain investments without putting the parent entity at risk of loss. Eg : VIE is used to invest parent companys interest in some other companys.

2) Even though the capial contributed by Residual entities (Investers), Residual equity holders do not control the VIE. However they are the primary benifitary from VIE.

3) The investor or company have controling interst in VIE, So they can purchase the required raw materials in more competitive prices.

4) Companies typically establish VIEs to maintain financial assets, including those that are actively involved – such as those that conduct research and development (R&D) operations – as well as entities that fill more passive roles

5) Companys establish VIE's beacuse they are relieved from the complex management burden. Residual equity holders are shielded from the gains and losses normally associated with ownership (Investing company or investor mostly having controling interest not voting interests.)

6) Even though the capital is contributed by Invester in VIE, the invester can elimiate Company assets and the related loan on its consolidated financial statements. If a company is not the primary beneficiary of the entity, consolidation is not required.

7) Parent company can enter in to more complex areas of business with minimal risk or they are getting acess to more agressive technologys. Exchange of technical knowledges.

8) Goodwill to the parent company if VIE performs well. And eliminating the risk involved in entry to a new sector.

Disadvantage

1) No Voting Rights for the parent company or Investor..

2) Form 10-K filing, companies must disclose its relationship to variable interest entities. The accounting rules that apply to these business structures are clarified by the Financial Accounting and Standards Board's FIN 46.

3) If the company is the primary beneficiary of the entity, then the holdings of that entity must be disclosed on the company's consolidated balance sheet. A company is considered the primary beneficiary of the entity if it has a majority interest in the VIE.

4) Sometimes VIE need to sacrifice thier inerest for the parent company interest. (Need to sell their final products in low profitable margin. This will affect VIE's financial performance.

5) Parent company need to Absorb any losses the entity may incur. Still financial risk is associated with the parent company.

6) VIE's are working under the rules and regulations of the companys or governmets Act. This will affect the parent companys interest in some times.