 Hello, and welcome to this session in which we will discuss the variable interest entity or VIE. Well, to understand VIE, we have to understand when do we consolidate because VIE is related to consolidation. So variable interest entity. Well, this is what we learned so far. We learned so far that you have to consolidate when you have what's called controlling interests. That's when you consolidate. What does it mean controlling interest? Well, controlling interests usually it's presented through a percentage. This is what we learned so far. If you own between zero to 20% of some company's stock, equity stock, you account for this investment using the fair value method. In other words, you have no saying in the company. You have no significant control. Therefore, you will account for it fair value. What does that mean? It means if the stock of that company goes up, the value of your investment goes up, and if the stock value of that company of your investing goes down, the value of your investment goes down. Now, if we go above 20, up to 50, then you have to account for this investment using the equity method. And the equity method means what? It means your investment is proportionally directly related to the net income, net losses, and dividend from that investment. And we covered the equity method in details. What happened if you own more than 20, more than 50%, here you have what we called control and you consolidate. So this is called the voting model. Voting model means what? It means if you own more than 50%, guess what? You are in control of the company. You have a controlling interest. That's the assumption. Unless we know otherwise, you have a controlling interest. This is the voting model you consolidate. So what is controlling interest? Let's say this one more time. It means you have direct or indirect ability to influence or determine the direction of management and policies. In other words, you are in control of the company. And an easy way to find out whether you have control or not if you have more than 50% interest. Unless, again, there is some sort of an agreement on the side. Now, how do we have control? Again, equity interests more than 50%. However, sometimes you could have control by contract or some sort of a side agreement. So although you may not have 50% plus, you might have 0, 10, 15, any percentage or no percentage at all for that matter and direct equity ownership. But you have some sort of a side agreement or a contract that could give you controlling interest. Under those circumstances, we will disregard the 50% plus requirement. Now, what we have is we have a variable interest model. And really, what happens in the real world is first, if there's no percentage, you would look at the variable interest model. First, you have to see, do we have any contract or side agreement that's given us controlling interest? What is controlling interest? It means you influence management. You can tell the company what to do. If you can tell the company what to do, you are in control. It doesn't matter what the percentage is. So how do we use this variable interest model? Well, guess what? When controlling interests exist through a method other than equity ownership, then you have a variable interest model. In other words, although you don't own more than 50%, but somehow you control the company. Well, if that's the case, we have a variable interest model. Simply put, when you look at an investing, you ask yourself, do I have a variable interest model? If not, then I will go to the voting model. If I have the more than 50%, then I consolidate. Now, the best way to illustrate this is to learn about the company called Enron. So we will use Enron as an excellent case to illustrate the concept of this variable interest model. So after we look at Enron, we're gonna look at the characteristic of the VIE. How do we know we have a VIE? But once we look at Enron, it will make more sense. And how do we know that we have an EIE? We look at the characteristic of a VIE. So let's take a look at Enron. But before we look at Enron, most likely you're watching this because you are either an accounting student or a CPA candidate. Either or, I'm glad you are here. That's why you are watching. You are looking for some additional help. I'm here to help you, farhatlectures.com. My website will have additional resources, lectures, notes, PowerPoint, multiple choice through false. That's gonna help you in your accounting courses. This is a partial list. Or your CPA review course, which is my material is aligned with your Becker, Roger, Wiley, Gleam. I don't replace your CPA review course. I'm just gonna give you additional explanation, additional resources, which in turn will help you with your preparation. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation. If you're watching, please like this recording. If you like it, share it with other. Connect with me on Instagram, Facebook, Twitter, Reddit. And if you're a CPA candidate, I have a group me account called CPA Exam Support Group. You can join there as well. So the best is to look at Enron. Let's take a look at Enron. Well, here's Enron. Enron is a company that existed. Now it's no longer exist. What Enron used to do is something like this. Enron will create what's called, used to be called SPE, Special Purpose Company, which is now we're gonna call it Variable Interest Entity. So they will create some sort of a partnership, some sort of a company, some sort of a joint venture on the side. And that venture is for a well-defined limited purpose. So for example, if they wanted to buy barges or transportation boat from Nigeria, so they will set up a company on the side to do so. The sponsor, which is Enron, provide most of the resources and all the activities of the SPE. When I say SPE, Special Purpose Entity, it's the same thing as Variable Interest Entity, just because I'm used to saying SPE rather than Variable Interest Entity. So the activities of the Variable Interest Entity is governed largely by contract or agreement that rests with the sponsor. So now, so we created this joint venture or this partnership. What would this joint venture or partnership do? They will go to Bank One or Bank of America, Bank of America, and they will ask for a loan. Well, Bank of America will tell them, look, you're a new company, you're a new joint venture, you really have no assets. What is the purpose of your business to give you a loan? They would say, okay, no problem. They would say, we have actually a guarantor. Enron will guarantee our loan. Well, oh, we know who Enron is, sure. So how much money do you want to borrow for this project? We want to borrow $50 million. Bank of America will lend this SPE $100 million. So that's fine, now they will borrow the money. And Bank of America is not concerned about this loan. Why? Because Enron is guaranteeing this transaction. So if anything happened, Enron will guarantee the transaction. Now what would Enron do? Enron will provide services. For example, Enron, they will do many things, but let's keep it simple for now. They will provide services like management services, consulting services for this SPE. And the SPE will pay Enron $100 million in fees. So simply put, the money will transfer from the SPE books to Enron books. Enron will debit cash $100 million, credit revenue $100 million. This is just to kind of show you the example. Now, you're saying, hold on a second. If this SPE was created by Enron, it doesn't make a difference because this SPE will have to consolidate with Enron. Therefore, the loan will be showing on the Enron books. Well, based on the old rules, and notice I highlighted and I put it in red. Based on the old rules, Enron would not have to consolidate if they can bring 3% equity to this SPE. Simply put, if they can bring 3% equity, independent interest, then this SPE will be considered independent. And as a result, they don't have to consolidate. They don't have to consolidate. So what did Enron do? Enron will create those fictitious third party, which I'm going to show you on the next slide, to make the SPE and Enron as independent companies. So they don't have to consolidate. They would use the executive real estate agent and other individuals. So what is the purpose? So why did Enron do this? Well, you create SPE, the Enron style to do three things. One is to avoid losses. So this is what Enron used to do. Enron will make investments. They will buy investments. And by the way, they were starting a company like Netflix. Netflix, the Netflix that you know now, but with the blockbuster, then the deal did not go through. But simply put, they will buy investments. They did a lot of things, but part of it is they will invest in other companies. And if those investments were bad, it means they didn't do well on those investments. What Enron would do, they would fictitiously sell them to those SPEs, not only one, they did many SPEs, you will see in a moment. So they will sell them to this SPE for a profit to avoid the losses, thus creating illusionary gains. So it's like basically, they will sell it to them. Hold on a second. If they sell it to them, how would the SPE pay for this? Remember, the SPE will go to different banks and get the money, so they will buy the investment from Enron. And Enron will show that they are doing well. They are making good investments, but really they're buying and selling from themselves. Also what Enron would do, they will keep that off the books, off the books, which is called off-balance sheet financing. Simply put, remember that loan that SPE got for 100 million. It's supposed to be on Enron books. We'll turn the loan into revenue and no one will see the loan. Enron committed all three violations by using those SPEs. Now it's worth looking at it, the actual case of Enron. And this is what it looks like. Sorry about the quality of the picture. I looked everywhere and I could not find really a good quality, but I'm gonna try to explain this. So this is Enron. Enron will have a relationship with this Chukko investment LP. Now, for example, Enron would use this Chukko to buy barges from Nigeria for transportation, for freight. Now who owns really Chukko? Well, let's see. Chukko is owned by Michael Copper and William Dotson. So Michael Copper owns 96.5 and Bill Dotson who works at Chukko who's the domestic partner of Michael Copper owns 2.5. So hold on a second. Who are these two individuals? First, Michael Copper is a former SEO of Enron, but he left. Well, he's like now an outsider and Bill Dotson, his domestic partner. In that state, domestic partners were not considered related parties. So what happened is this? Enron will ask them because they control Chukko and they're considered independent and notice they don't control Chukko directly. They control this partnership and this partnership control Chukko. So what they would do, they will deal amongst themselves. They will buy stuff from Enron and show that Enron is making a profit. And again, how do they buy it? They go to Barclay Banks and they will ask Barclay Banks for loans. And this is how they booked illusionary gain by using Michael Copper and Bill Dotson. Simply put, here what we're talking about is this, substance over form. Although Chukko is considered independent, but Chukko is controlled by outside parties. And by the way, Enron executives will pass the money to Michael Copper indirectly and they will ask them to invest in this partnership. So these partnerships are in essence, and not in essence, artificially independent, but they're not really independent. So that's the case. The case is to not allow Chukko to be an independent party from Enron. So let's now dive into the characteristic of VIE. When do we have a VIE, Variable Interest Entity? Well, of course we have to disregard the 3% ownership level, okay? Actually, we have to disregard any percentage ownership level. You don't have to own anything. If you have any of the following four, you have a VIE. So those are the important criteria on looking whether there's a VIE or not. One, the entity cannot finance its activities without additional financial help. What does that mean? It means the company is thinly capitalized. There's not enough equity in the company. Therefore, they cannot really borrow. So shareholders cannot borrow without a guarantor. Someone is guaranteeing them. And remember, Enron guaranteed the loan for those SPEs. That's one. So if that's the case, you have a VIE. So you have to know if this is a VIE, who really controls the VIE? Who really owns that VIE? Definitely not the shareholders. Although on the books, there are shareholders. So Michael Copper is not really the true owner of Chukko, nor Bill Datsun, although they own the stocks, but they're not really the true owners. Two, shareholders lack any of the following. And what I mean by any is any. First, voting power. Sometimes they might give you stocks, but those stocks don't have voting power. They have a certain characteristic. Then you're not really a true owner if you cannot vote. You cannot make a decision. Well, although you are the owner, but you are not really in control of the company, management trust somewhere else. You are basically kind of, you know, just a fake owner. Okay? You cannot enjoy the game. You don't enjoy the game. Even if the company make the profit, the game go to somewhere else and you don't absorb the losses. Simply put, you have no skin in the game. You're just simply put artificially an owner in the company. If any of those exist, we have a VIE. Also, if the expected losses exceeds the equity investment at risk, if this partnership is expected to incur losses and those losses are going to be larger than the amount of money invested. Well, guess what? This company is not really a true company because the losses are large enough to wipe out all the shareholders. Also, if there's any disproportionate large voting power relative to the investment, simply put, for example, one party invested 20%, but that party has 90% of the voting power. Well, guess what? This is not really a true ownership. Why? Because if you invested 20%, you're supposed to have 20% of the voting power. Here, what we're saying is the remaining, the party that invested 80% only will have a 10% voting power. Well, that's a disproportionate relationship. Well, if that exists too in any relationship, you have a VIE. Again, any of those four will give you a VIE. They don't have to be all four, any of those four. So what are the forms of VIE? Usually it's either a partnership, joint venture, legal trust, or a corporation. Enron relied heavily on partnership and some joint ventures. VIE cannot be a person. You cannot consolidate with a person. It cannot be a registered investment company. It cannot be an employee benefit plan. It cannot be a government organization. Why am I mentioning all of those? Because on the CPA exam, you might see a multiple choice. All the following are form of VIEs accept. So you wanna make sure you know what accept or they will give you three of those and a joint venture. So you know the answer is joint venture. So simply put, what are we talking about here? We're talking about who consolidate? Who would consolidate those VIEs? Well, the primary beneficiary or the sponsor, okay? So how do we know who's the sponsor? Who's the primary beneficiary? Only we can have one primary beneficiary. So that's the party that have skin in the game. That's the party of the SBE failed. They're gonna have to carry the losses. They're responsible for the losses. So they must meet two criteria. Two criteria is one of them is called the power criteria. What is the power criteria? It means if they direct the activities of the VIE, then they are the primary beneficiary. That's what it is. Enron controlled everything. Also Enron did not really control the ownership percentage, but they controlled everything that the SBE is conducted. Then they meet the power criteria two, the risk reward. Basically the same thing. If they're gonna enjoy the game or absorb the losses or get the residual value of those entities, then they are in control. They're the primary beneficiary. So Enron really controlled all of those. And that's why they were considered the primary beneficiary. Therefore those SBEs should have consolidated with Enron. And when they consolidated, well, Enron would not show profit. They will show losses and they could not hide the debt. And that was the purpose of those SBEs. So what we did is change the rules. So rather than the 3% outside ownership set, forget about any percentages. Let's look at substance over form. Who controls this entity? And whoever's control the entity is the primary beneficiary. And the primary beneficiary will consolidate. At the end of this recording, I'm gonna remind you whether to go to farhaplectures.com and look at additional resources, multiple choice through false. Don't shortchange yourself, invest in yourself, invest in your career. The reason you're watching me is because you need some additional help. I can help you more. Go to farhaplectures, subscribe, invest in yourself. 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