Variable interest entity accounting came about as a response to the Enron scandal, where special purpose entities that were actually owned by Andy Fastow were not consolidated in Enron’s financial statements because Enron had no direct ownership, even though it was on the hook for the losses in these entities. VIE accounting was designed to force liabilities onto the balance sheet. Chinese companies use the VIE rules in a different way – to put assets (and related income) on the balance sheet (and income statement) for companies that they do not actually own.
Companies and their advisors are clever, and over the years since Enron have found new ways to use VIEs, so the Financial Accounting Standards Boards modified VIE accounting rules in 2009 to tighten them up. The FASB observed:
Some reporting entities have entered into arrangements using VIEs that appear to be designed to avoid reporting assets and liabilities for which they are responsible, to delay reporting losses that have already been incurred, or to report gains that are illusory.
The 2009 VIE accounting rule changes did not have a significant effect on Chinese VIEs. Accountants decided that the existing VIE control agreements for Chinese VIEs fit the new rules and that the VIEs could continue to be consolidated. I have questioned that conclusion in a recent post. I am not convinced that the existing technical service agreements actually give the public company access to the residual profits of the VIE.
The 2009 VIE rule changes also brought in some new disclosure requirements. Fredrick Oqvist and I have gone through the 2010 financial statements for every Chinese company on NASDAQ and the NYSE and examined those disclosures. Here is what we found:
We then looked for the disclosures required by the new VIE accounting rules. The first required disclosure is as follows:
The carrying amounts and classification of the VIE’s assets and liabilities in the statement of financial position that are consolidated in accordance with the Variable Interest Entities Subsections, including qualitative information about the relationship(s) between those assets and liabilities…
That requirement says "give us some balance sheet information about the VIE." Only 59% of the Chinese VIEs disclose any balance sheet information. Clients of the Big Four, which audit 71 of the 107 VIEs, disclose some balance sheet information 72% of the time. Many of the smaller auditing firms involved with Chinese VIEs seem unaware of the new disclosure requirements. When there is disclosure, most of the time only total VIE assets and liabilities are disclosed, rather than disclosing the classified balance sheet information required by the standard. The level of detail provided varies significantly based on the auditing firm, with Deloitte clients generally disclosing more information. For an example of what I consider to be a quality disclosure, look at E-House (China) Holdings annual report (pages F-8-10). With E-House, separate balance sheets are provided for each of the VIEs. Many of the disclosures report only total assets (and 41% report nothing!), which I consider to be inadequate and not in compliance with the accounting standard.
The second important disclosure requirement under the new standards is this:
Qualitative and quantitative information about the reporting entity’s involvement (giving consideration to both explicit arrangements and implicit variable interests) with the VIE, including, but not limited to, the nature, purpose, size, and activities of the VIE, including how the VIE is financed.
In other words, "tell us what the VIE does and how it relates to the public company." Here the disclosures are pathetic. Only 29% of companies with VIEs disclose the revenue and net income of the VIE. Excluding companies audited by Deloitte, which disclose this information 82% of the time, only 4% of companies disclosed the revenue of the VIE. Deloitte audits the most VIEs (34 of 107) and its clients have more consistent and higher quality disclosures than companies audited by the other firms. I do not believe that any of the disclosures, however, rise to the standard set by the rules. More qualitative information is required about VIE activities, including describing payment arrangements between the VIE and the public company.
Disclosures are not required when amounts are immaterial. That may be the reason why some VIEs disclose so little information, since if the VIE is being used only to hold required licenses, it may not have material operations. I would argue that in the case of VIEs, the fact that VIE assets and revenues are immaterial is a material fact that should be disclosed.
Investors need the information required by the FASB standards on VIEs to properly assess the risks of investing in companies that use the VIE structure. I call on companies to improve the quality of disclosures. I suggest that the Big Four get together and agree how to apply the FASB standard in China. I also call on the SEC to get tougher on requiring companies to make these disclosures.