Variable Interest (entity)

I am confused by Schweser’s explanation of variable interest/variable interest entity, can someone please clarify? Thanks!!!

Variable interest entity is an accounting term (also known as Special purpose entities). In simple terms, when a company deals with another party (e.g sale transaction) and that the said transaction is qualified per IFRS (accounting standards) to be a variable interest entity, then at the consolidation level (when company issues financial statements), they need to account for the variable interest entity (i.e. account for the entity’s as if it was within the company).

E.g. if A) company X buys coal from a third mining company called Y, B) X owns the majority and owns voting shares of Y, C) X is the sole buyer of coal extracted from Y and so on, it is as if Y is qualified as a variable interest entity .

In conclusion X needs to consolidate in it’s F/S Y (only to the extent of the ownership in Y).

Hope did not confuse you too much.

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The best way to understand SPEs and VIEs is to refer to the core CFA material. They have examples that will help you understand the concept better.

As a side note, SPEs will appear again (although in a different context) when you get to swaps, so understanding them now will do you wonders then.

I agree with Aether in the above, CFA text is great at explaining this… it gives you context and stuff.

SPEs are also essential for securitization in most cases. They won’t be discussed much when you get up to the section on MBS and ABS (at least it wasn’t in Schweser) but they are generally an essential part of the securitization process in order to legally separate the assets being securitized. In the context of securitization, SPEs are often referred to as “bankruptcy-remote entities” because the assets that are being securitized are legally separated from the sponsor and (theoretically) cannot be touched by the sponsor’s creditors in the case of bankruptcy of the sponsor.

When it comes to SPE or VIE, the most tested concept in CFA (in particular FRA) is to:

  1. Identify if an entity is an VIE or not

  2. If yes, what is the accounting treatment.

There are 4 conditions that decide the status as a VIE. 2 most important ones are:

  1. the entity (that is tested for VIE status) will have insufficient total at-risk equity capital from it’s sponsor company, which means it will fund the remaining from a 3rd party capital provider, who’ll in turn seek pro-rata share on the residual benefits.

  2. The sponsor company would be the primary beneficiary and also the absorbs majority of the risk.

If any of these conditions satisfy, the Primary beneficiary should consolidate the VIE in it’s books. Then the effect of securitization (if any) would dissappear.

Good post NitiCFA. If VIE we consolidate. But how does the effect of securitization dissappear?