It all started back in 2001 when the energy giant Enron collapsed. After the dust settled , the results were dramatic: shareholders lost an unprecedented $60 billion in investments and 49,000 employees of Enron and Arthur Anderson, Enron’s accounting firm, lost their jobs and pensions. One of the main reasons behind the collapse was the way Enron used its Special Purpose Entities (SPEs) to borrow money, park bad assets and enter complex derivative arrangements. At that time, Accounting Standards didn’t require Enron to report SPE’s operations on their financial statements as long as at least 3% of SPEs were owned by an outside investor. In accordance with the Accounting Standards, Enron’s financial statements were excluding SPE’s operations and failed to show all its debt, bad assets and losses.
To combat the issue of SPEs encountered in Enron’s case, a new accounting rule came out in 2003 to outline tests that a company must perform to determine if it had variable interest and was the primary beneficiary of an entity. If both tests were positive, such an entity was required to be consolidated into company’s financial statements. Since then, the ruling has gone through few amendments but the intention of the rule has stayed the same – companies must consolidate entities they control whether they own them or not.
The question of variable interest entity VIE is important for companies involved in M&A activities and complicates accounting when the acquirer is buying the company’s assets instead of the company’s stock. The complication arises from the contradiction in accounting standards for recording assets at cost under assets acquisition rules and, at the same time, requiring fair market valuations under the VIE rules with no goodwill allowed under both scenarios. With no goodwill allowed, the difference between the fair market value and the cost may result in gain or loss being recognized upon purchase. Imagine completing an acquisition of a company. The transaction makes good sense and accountants record the assets at acquisition cost. Later that year, the VIE test was performed and at that time you realize that the purchase would have to be recorded at fair market value. And what if the fair market value of assets purchased appeared to be lower than what was initially paid for those assets? With no goodwill allowed, now you have to realize a loss – and believe me – the loss won’t go well with the Board of Directors who initially had approved the acquisition on the premises that it was a good buy. Some companies have been successful in arguing that what they paid for the assets was equal to their fair market value, therefore no gain or loss needs to be recorded. To make such an argument successful may take some conversations with your technical accountants, auditors, and, in some cases, Securities and Exchange Commission.
VIE and Asset Acquisition accounting guidance is not clear on how to deal with the situation described above. With changing accounting rules and differences between International and US Accounting Standards, it is imperative to talk through your acquisitions with corporate technical accounting group and seek technical accountants’ expertise for your transactions. As accounting rules can complicate things, ask the technical accounting group to write up an accounting memo for your transaction before it occurs.