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Focus on Home Builders: New Reporting Requirement

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The Financial Accounting Standards Board (FASB) issued a new financial reporting requirement that may have a farreaching impact on home builders. Home builders often enter into lot option contracts and joint ventures as a normal course of business.
January 1, 2005

FASB Interpretation No. (FIN) 46R for Home Builders

The Financial Accounting Standards Board (FASB) issued a new financial reporting requirement that may have a farreaching impact on home builders. Home builders often enter into lot option contracts and joint ventures as a normal course of business. Under FASB Interpretation No. (FIN) 46R, Consolidation of Variable Interest Entities, these contracts or joint ventures, depending on their structure, could require consolidation by the home builder. Following is a brief summary of the standard.

Background
In December 2003, the FASB issued FIN 46R, Consolidation of Variable Interest Entities. FIN 46R is a principles-based standard that introduces an accounting model that bases consolidation of an entity on the sharing of economic risk and rewards rather than equity ownership and voting rights.

Transactions involving Variable Interest Entities (VIEs) have become increasingly common. Previous accounting rules require consolidation of subsidiaries in which the reporting company has a controlling financial interest. This has historically been based on whether the reporting company has a majority voting interest. FIN 46R creates a model requiring companies to consider consolidation of the VIE, regardless of whether the company has majority voting interest.

The FASB defines a VIE as having one or more of the following characteristics:

  1. The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity.
  2. The equity investors lack one or more of the following essential characteristics of a controlling financial interest:
    1. The direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights.
    2. The obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities.
    3. The right to receive the expected residual returns of the entity if they occur, which are the compensation for the risk of absorbing the expected losses.
  3. The equity investors have voting rights that are not proportionate to their economic interests, and the activities of the entity involve or are conducted on the behalf of an investor with a disproportionately small voting interest.

Common relationships and transactions entered into by home builders, primarily land development joint ventures and lot option contracts, could trigger variable interest and consolidation of the joint venture or entity that owns the lots under contract.

Potential transactions, relationships or structures that may qualify as a VIE include, but are not limited to, certain leasing entities, the transfer or sale of assets to an entity owned by a single employee or by members of an entity's management, management of an unconsolidated asset or business by a company or its officers.

The Interpretation requires existing unconsolidated VIEs to be consolidated by their primary beneficiaries (as defined below) if the entities do not effectively disperse risks among parties involved. VIEs that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed.

The primary beneficiary of the VIE is the party that absorbs a majority of the entity's expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests which are the ownership, contractual, or other financial interests in an entity that change with the changes in the fair value of the entity's net assets excluding variable interests. Companies must also consider variable interests held by related parties and de facto agents as their own when determining.

 

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