As described in Section 1.3, the FASB introduced FIN 46 in 2003, expanding the requirements for consolidation of variable interest entities (VIEs) and requiring additional supplementary disclosure by firms with interests in VIEs. Many firms affected by FIN 46 avoided the new consolidation requirements through the creation of Expected Loss Notes (ELNs), under which an outside party became the primary VIE beneficiary.
Callahan, Smith, and Spencer (2012) studied firms affected by FIN 46 during the period 1998– 2005. After controlling for other factors affecting cost of capital, they found that the cost of capital of firms affected by FIN 46 ( and which thus had to either consolidate their VIEs or issue ELNs to avoid consolidation) increased on average after 2003, relative to a control sample of firms that were unaffected by FIN 46.
For those firms affected by FIN 46 that avoided consolidation through ELNs, the authors also found that their increase in cost of capital was less than the increase for those affected firms that did consolidate.

a. Give an explanation for these results that is consistent with securities market efficiency.
b. Give an explanation that is consistent with behaviourially biased investors.
c. How did the FASB and IASB respond to the consolidation loophole of ELNs in FIN 46?

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