VIEs: Why should you care?

By Randy Bonnecaze

Do you have a variable interest entity (VIE)? You may not know the answer to this question. But if your construction company's financial statements are prepared according to generally accepted accounting principles (GAAP), and they probably are, you need to find out - fast.

Understanding the term. Generally, VIEs are standalone companies that either don't have equity investors with voting rights or whose equity investors don't provide sufficient financial resources to support the VIE's activities.

Under a new GAAP rule, VIEs are no longer considered separate business units and must be consolidated into the financial statements of their primary beneficiaries. The primary beneficiary is the entity that receives or incurs most of a VIE's returns or losses.

For privately held companies, this consolidation requirement is effective for VIEs created after Dec. 31, 2003. But it will not apply to existing VIEs until the first annual period beginning after Dec. 15 (calendar year 2005).

Assessing your vulnerability. You may be thinking, "But I don't have a VIE." You may not. But, then again, you just might. Determining whether you do is a question only your financial advisor can answer. Nonetheless, the following general characteristics may indicate you have a VIE:

• Your construction company significantly participated in the design of a separate entity.
  
• You designed the entity so most of its activities either involve your business or are conducted on your company's behalf.
  
• Your business provides more than half of the total equity, subordinated debt and other forms of subordinated financial support to the entity, based on an analysis of the fair values of the entity's interests.
  
• The entity's activities are primarily related to securitizations or other forms of asset-backed financings or single-lessee lease arrangements.

One typical VIE situation occurs when construction company owners rent real estate or facilities from a separate limited liability company they own. These real estate entities often lack the equity investment or controlling financial interest to circumvent the consolidation requirement.

Protecting your interests. Now you may ask, "Why should I care that I have to consolidate a VIE?" Aside from worrying about where you'll find the time and resources to carry out this process, perhaps you shouldn't care. But your banker and bonding agents may see things differently.

Here's an example: Your well-capitalized, wholly owned construction company has total assets of $8 million, total liabilities of $5 million (of which only $1 million are bank debt) and equity of $3 million. Thus, your current ratio and debt-to-equity ratio are likely quite favorable.

Now assume you must consolidate (add to your balance sheet) your facility, which has a net book value of $500,000 and an $800,000 mortgage since you refinanced it and took distributions to reinvest in your business. (The building's fair market value actually exceeds $1 million.)

By consolidating this VIE, your current ratio diminishes while your debt-to-equity ratio doubles - a result that could violate bank covenants and lessen your bonding capacity. You could, however, restructure the entity to avoid consolidation or at least alert your banker and bonding agent of your revised financial position. But consolidation still presents a risk.

Bracing for the impact. As this is a new reporting requirement, the accounting community is continuing to analyze and interpret its parameters. But that doesn't mean you should take a wait-and-see approach. The time is now to determine whether a VIE consolidation will affect your construction business and how to best proceed.

Editor's Note: Randy J. Bonnecaze is a Certified Public Accountant (CPA) with Hannis T. Bourgeois LLP, Baton Rouge.