diff --git a/lib/ansible/playbook/__init__.py b/lib/ansible/playbook/__init__.py
index 118d5c11f81..f440f58e891 100644
--- a/lib/ansible/playbook/__init__.py
+++ b/lib/ansible/playbook/__init__.py
@@ -284,7 +284,6 @@ class PlayBook(object):
         # let runner template out future commands
         setup_ok = setup_results.get('contacted', {})
         for (host, result) in setup_ok.iteritems():
-            facts = result.get('ansible_facts', {})
             self.SETUP_CACHE[host] = result.get('ansible_facts', {})
         return setup_results
 
@@ -299,14 +298,12 @@ class PlayBook(object):
         self.callbacks.on_play_start(play.name)
 
         # get facts from system
-        rc = self._do_setup_step(play)
+        self._do_setup_step(play)
 
         # now with that data, handle contentional variable file imports!
-        if play.vars_files and len(play.vars_files) > 0:
-            play.update_vars_files(self.inventory.list_hosts(play.hosts))
+        play.update_vars_files(self.inventory.list_hosts(play.hosts))
 
         for task in play.tasks():
-
             # only run the task if the requested tags match
             should_run = False
             for x in self.only_tags:
@@ -323,4 +320,3 @@ class PlayBook(object):
                 self.inventory.restrict_to(handler.notified_by)
                 self._run_task(play, handler, True)
                 self.inventory.lift_restriction()
-
diff --git a/test/TestPlayBook.py b/test/TestPlayBook.py
index ebd8bd7aef9..85ee178fb1f 100644
--- a/test/TestPlayBook.py
+++ b/test/TestPlayBook.py
@@ -25,9 +25,6 @@ class TestCallbacks(object):
     def on_start(self):
         EVENTS.append('start')
 
-    def on_setup(self):
-        EVENTS.append([ 'primary_setup' ])
-
     def on_skipped(self, host, item=None):
         EVENTS.append([ 'skipped', [ host ]])
 
@@ -46,9 +43,6 @@ class TestCallbacks(object):
     def on_task_start(self, name, is_conditional):
         EVENTS.append([ 'task start', [ name, is_conditional ]])
 
-    def on_unreachable(self, host, msg):
-        EVENTS.append([ 'unreachable', [ host, msg ]])
-
     def on_failed(self, host, results, ignore_errors):
         EVENTS.append([ 'failed', [ host, results, ignore_errors ]])
 
@@ -161,6 +155,19 @@ class TestPlaybook(unittest.TestCase):
        print data
        assert data.find("ears") != -1, "template success"
 
+   def test_playbook_vars(self): 
+       test_callbacks = TestCallbacks()
+       playbook = ansible.playbook.PlayBook(
+           playbook=os.path.join(self.test_dir, 'test_playbook_vars', 'playbook.yml'),
+           host_list='test/test_playbook_vars/hosts',
+           stats=ans_callbacks.AggregateStats(),
+           callbacks=test_callbacks,
+           runner_callbacks=test_callbacks
+       )
+       playbook.run()
+       assert playbook.SETUP_CACHE['host1'] == {'attr2': 2, 'attr1': 1}
+       assert playbook.SETUP_CACHE['host2'] == {'attr2': 2}
+
    def test_yaml_hosts_list(self):
        # Make sure playbooks support hosts: [host1, host2]
        # TODO: Actually run the play on more than one host
diff --git a/test/test_playbook_vars/group_vars/group b/test/test_playbook_vars/group_vars/group
new file mode 100644
index 00000000000..6a07468c3bd
--- /dev/null
+++ b/test/test_playbook_vars/group_vars/group
@@ -0,0 +1,2 @@
+---
+attr2: 2
diff --git a/test/test_playbook_vars/host_vars/host1 b/test/test_playbook_vars/host_vars/host1
new file mode 100644
index 00000000000..05a7ccaa5b6
--- /dev/null
+++ b/test/test_playbook_vars/host_vars/host1
@@ -0,0 +1,2 @@
+---
+attr1: 1
diff --git a/test/test_playbook_vars/hosts b/test/test_playbook_vars/hosts
new file mode 100644
index 00000000000..17ecaa85e6c
--- /dev/null
+++ b/test/test_playbook_vars/hosts
@@ -0,0 +1,6 @@
+host1
+host2
+
+[group]
+host1
+host2
diff --git a/test/test_playbook_vars/playbook.yml b/test/test_playbook_vars/playbook.yml
new file mode 100644
index 00000000000..7c3f03bfd09
--- /dev/null
+++ b/test/test_playbook_vars/playbook.yml
@@ -0,0 +1,2 @@
+---
+- hosts: group