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It is important to note that Statement 167 established a more principles-based approach to the determination of the primary beneficiary. In doing so, there are several elements of the standard for which there is not detailed implementation guidance, and the application of professional judgment will be required. Given the lack of detailed implementation guidance, we anticipate that practice will continue to evolve subsequent to the effective date.
FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R) (primarily incorporated into FASB ASC Topic 810-10, ConsolidationOverall, by ASU 2009-17)
One of the industries that might have been most significantly affected by Statement 167 is the asset management industry. As currently written, Statement 167 would have resulted in asset managers consolidating many hedge funds, private equity funds and other investment funds that they manage. However, in February 2010, the FASB issued an Accounting Standards Update (ASU) primarily to address concerns with the application of Statement 167 by reporting enterprises in the asset management industry by deferring the effective date of Statement 167 for certain investment funds. The FASB currently has a project on its agenda that would eliminate the deferral discussed above. In addition, the FASBs tentative decisions would modify the Variable Interest Models provisions for evaluating an enterprise as a principal or an agent and the provisions for evaluating the substance of kick-out rights and participating rights, among other things. Readers should monitor developments in this area closely. In May 2011, the IASB issued new consolidation accounting guidance that establishes a single consolidation model for all entities. The FASB and IASB jointly deliberated much of the IASBs new consolidation guidance. However, after hearing from constituents, the FASB decided in early-2011 not to issue consolidation guidance similar to the IASBs guidance. The FASB disagreed with aspects of the IASBs new consolidation model, but said it plans to amend US GAAP to better align it with the IASBs new guidance related to the principal-agent determination. The new IASB guidance is more similar to the guidance for the consolidation of VIEs than the current guidance, but it creates new differences between US GAAP and IFRS in some areas. Some longstanding differences also remain. We have updated this version of our publication to provide insights from the SEC, updates on recent standard-setting activities and further clarifications and enhancements to our interpretative guidance. Refer to Appendix A for further detail on the updates provided. We will continue to provide updates in the future as consolidation accounting evolves. We hope this publication will help you understand and apply the complex accounting provisions of the Variable Interest Model. We are available to assist you in understanding and complying with these provisions and are prepared to answer your particular concerns and questions.
June 2011
Contents
1 Introduction ................................................................................................................ 13 1.1 Interpretative guidance ........................................................................................................ 15 1.2 IFRS convergence ................................................................................................................ 18 2 Definitions of terms ..................................................................................................... 19 2.1 Interpretative guidance ........................................................................................................ 20
Questions and interpretative responses 2.1 Expected losses and expected residual returns are not GAAP or economic income or loss ....................................................... 20 2.2 Subordinated financial support............................................................ 21
3 Consideration of substantive terms, transactions and arrangements ........................... 22 3.1 Interpretative guidance ........................................................................................................ 22
Questions and interpretative responses 3.1 Evaluation of changes in terms, transactions and arrangements prior to the adoption of Statement 167 .......................... 23 3.2 Consideration of the substance of existing terms, transactions and arrangements upon the adoption of Statement 167 ........................ 24
4.2 4.3
4.4
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4.5
Interpretative guidance Qualifying special-purpose entities ................................................. 37 Questions and interpretative responses 4.14 Impact of the elimination of the QSPE scope exception .......................... 37 4.6 Interpretative guidance Investment companies ................................................................... 38 Questions and interpretative responses 4.15 Variable interests in investment companies .......................................... 38 4.16 Investment company scope exclusion .................................................. 39 4.7 Interpretative guidance Governmental entities ................................................................... 41 Questions and interpretative responses 4.17 Could an enterprise be required to consolidate a governmental entity?... 41 4.18 Could governmental entities consolidate VIEs? ..................................... 41 4.19 Governmental financing vehicles ......................................................... 41 4.8 Interpretative guidance Not-for-profit organizations ........................................................... 42 Questions and interpretative responses 4.20 Not-for-profit organizations used to circumvent consolidation ............... 43 4.21 Not-for-profit organizations as related parties ...................................... 43 4.9 Interpretative guidance Separate accounts of life insurance enterprises............................... 44 4.10 Interpretative guidance Information availability .................................................................. 44 Questions and interpretative responses 4.22 Lack of information necessary to apply the Variable Interest Models provisions ................................................................. 44 4.11 Interpretative guidance Certain businesses......................................................................... 47 Questions and interpretative responses 4.23 Business scope exception ................................................................... 47 4.24 Determining whether a variable interest holder participated significantly in the design or redesign of the entity ............................... 48 4.25 Joint venture scope exception ............................................................ 48 4.26 Franchisee scope exception ................................................................ 49 4.27 Determining whether substantially all of the activities of an entity involve, or are conducted on behalf of, a variable interest holder ........... 51 4.28 Determining the amount of subordinated financial support provided by an enterprise ................................................................... 52 4.29 Applicability of business scope exception for each party to an entity ...... 52 4.30 Business scope exception must be evaluated at each reporting period .... 53
5 Evaluation of variability and the variable interest determination .................................. 54 5.1 Interpretative guidance ........................................................................................................ 56
Questions and interpretative responses 5.1 Trust preferred securities ................................................................... 61 Terms of interests issued ..................................................................................................... 64 Subordination ...................................................................................................................... 64 Questions and interpretative responses 5.2 Determining whether subordination is substantive ................................ 65 Certain interest rate risk....................................................................................................... 66 Interpretative guidance Certain interest rate risk ................................................................ 66 Questions and interpretative responses 5.3 Excluding variability from periodic interest receipts/payments ............... 66 5.4 Evaluating prepayment risk................................................................. 68
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5.4 5.5
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5.6 5.7
5.8
Certain derivative instruments.............................................................................................. 68 Interpretative guidance Certain derivative instruments ....................................................... 70 Questions and interpretative responses 5.5 Application of the Variable Interest Models strongly indicated derivatives guidance ........................................................... 70 5.6 Total return swaps ............................................................................. 73 5.7 Embedded derivatives ........................................................................ 75 5.8 Notional amounts are not specified assets ............................................ 77 5.9 Variable rate liabilities owed to a VIE ................................................... 77 Other arrangements and examples ....................................................................................... 78 Questions and interpretative responses 5.10 Identification of the risks the entity is designed to create is based on underlying economics, not accounting or legal form ................ 78 5.11 Financial guarantees as variable interests ............................................ 79 5.12 Purchase and supply contracts as variable interests .............................. 81 5.13 Operating leases as variable interests .................................................. 82 5.14 Prepaid rent as variable interests ........................................................ 82 5.15 Local marketing agreements and joint service agreements in the broadcasting industry as variable interests ................................. 83 5.16 Purchase and sale contracts for real estate as variable interests ............ 84 5.17 Netting or offsetting contracts ............................................................ 85 5.18 Implicit variable interests.................................................................... 87 5.19 Impact on acquisition date provisions in ASC 805 ................................. 90 5.20 Illustrative example Identification of variable interests commercial real estate ....................................................................... 91
6 Variable interests fees paid to decision makers or service providers ......................... 92 6.1 Interpretative guidance ........................................................................................................ 93
Questions and interpretative responses 6.1 Evaluation of same level of seniority as other operating liabilities of the entity ....................................................................... 95 6.2 Estimating an entitys anticipated economic performance................... 96 6.3 Determination of what level of other interests meets the definition of more than an insignificant amount (ASC 810-10-55-37(c)) ............. 97 6.4 Determination of what meets the definition of more than an insignificant amount (ASC 810-10-55-37(c)) vs. the determination of whether an equity investment is substantive in the VIE assessment......................................................................... 98 6.5 Determination of whether the magnitude of fees meets the definition of insignificant (ASC 810-10-55-37(e) and (f)) .................... 98 6.6 Concept of insignificant in the evaluation of fees paid to a decision maker or service provider vs. could be potentially significant in the determination of the primary beneficiary ................... 99 6.7 Consideration of a decision maker that does not hold a variable interest............................................................................... 100 6.8 Reconsideration of a decision makers or service providers fees as variable interests .................................................................. 101
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Related parties in evaluating fees paid to a decision maker(s) or service provider(s) ......................................................... 102 Employee benefit plans..................................................................... 102 Consideration of quantitative analysis in evaluating fees paid to decision maker(s) or service provider(s) as variable interests ............... 103
8 Variable interests interests in specified assets ....................................................... 114 8.1 Interpretative guidance ...................................................................................................... 114
Questions and interpretative responses 8.1 Interests in specified assets .............................................................. 115 8.2 Illustrative example .......................................................................... 117
9 Determining whether an entity is a variable interest entity ........................................ 119 9.1 Interpretative guidance Equity investment at risk (ASC 810-10-15-14(a)).......................... 121
Questions and interpretative responses 9(a).1 Forms of investments that qualify as an equity investment at risk ........ 125 9(a).2 Sufficiency of equity investment at risk based on fair value ................. 125 9(a).3 Commitments to fund losses, stock subscriptions ............................... 126 9(a).4 Significant participation in profits and losses ...................................... 126 9(a).5 Other investments made by equity owners ......................................... 127 9(a).6 Source of the equity investment ........................................................ 127 9(a).7 Effect of items reported in other comprehensive income ..................... 129 9(a).8 Do profitable entities have expected losses? ...................................... 129 9(a).9 Sweat equity ................................................................................... 129 9(a).10 Effect of variable interests in specified assets and silos ....................... 130 9(a).11 Equity investment financed with nonrecourse debt ............................. 131 9(a).12 Fees received by an equity investor ................................................... 132 9(a).13 At-risk equity group for equity sufficiency test is used to determine if the at-risk equity group has power .................................. 133 9(a).14 Call option premiums received by an equity investor ........................... 134 9(a).15 Entities used to invest in synthetic fuel tax credits .............................. 134 9(a).16 Transactions outside the entity ......................................................... 135 9(a).17 Determining sufficiency of equity through comparison with other entities ................................................................................... 137 9(a).18 Regulatory capital requirements ....................................................... 138
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9.2
9.3
9.4
Illustrative examples Qualitative and quantitative analyses of sufficiency of equity at risk .............................................. 139 9(a).20 Is an equity investment of 10% of the entitys total assets sufficient? ... 141 9(a).21 Illustrative examples Sufficiency of equity at risk ............................. 142 Interpretative guidance Power (ASC 810-10-15-14(b)(1))................................................. 146 Questions and interpretative responses 9(b)(1).1 Holders of the equity investment at risk must make substantive decisions ....................................................................... 147 9(b)(1).2 Must all equity holders participate in decision making? ........................ 148 9(b)(1).3 Participation in decision making by holders of interests that are not equity investments at risk...................................................... 149 9(b)(1).4 Effect of decision makers or service providers when evaluating power under ASC 810-10-15-14(b)(1) ............................... 150 9(b)(1).5 Can interests other than equity investment at risk be considered for purposes of evaluating power under ASC 810-10-15-14(b)(1)? ................................................................ 150 9(b)(1).6 Determining whether a general partners at-risk equity investment is substantive ................................................................. 151 9(b)(1).7 Consideration of kick-out rights and participating rights ...................... 154 9(b)(1).8 Franchise arrangements ................................................................... 155 9(b)(1).9 Illustrative examples ........................................................................ 156 9(b)(1).10 Affordable housing projects .............................................................. 159 Interpretative guidance Obligation to absorb expected losses (ASC 810-10-15-14(b)(2)) ................................................................................................. 161 Questions and interpretative responses 9(b)(2).1 Do customary business arrangements violate ASC 810-10-15-14(b)(2)? ................................................................ 163 9(b)(2).2 Common arrangements that may violate ASC 810-10-15-14(b)(2) ....... 163 9(b)(2).3 Disproportionate sharing of losses ..................................................... 164 9(b)(2).4 Absorption of expected losses by an equity holder through other than an equity investment ........................................................ 164 9(b)(2).5 May other variable interest holders be shielded from risk of loss? ........ 165 9(b)(2).6 Sharing first dollar risk of loss ........................................................... 166 9(b)(2).7 Variable interests in specified assets ................................................. 166 9(b)(2).8 Illustrative examples ........................................................................ 167 Interpretative guidance Right to receive expected residual returns (ASC 810-10-15-14(b)(3)) ................................................................................................. 169 Questions and interpretative responses 9(b)(3).1 Examples of situations that violate the conditions of ASC 810-10-15-14(b)(3) .................................................................. 169 9(b)(3).2 Equity holder receives expected residual returns through other than an equity interest............................................................. 171 9(b)(3).3 Participation of other variable interest holders in expected residual returns ............................................................................... 171 9(b)(3).4 Disproportionate sharing of profits .................................................... 172 9(b)(3).5 Variable interests in specified assets ................................................. 172 9(b)(3).6 Impact of call options on an entitys assets or its equity ....................... 173
9(a).19
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9.5
Interpretative guidance Anti-abuse clause (when the economics do not follow the votes) (ASC 810-10-15-14(c)) ...................................................................................... 175 Questions and interpretative responses 9(c).1 Evaluating the substantially all requirement ....................................... 176 9(c).2 Variable interests to be considered when applying the antiabuse clause .................................................................................... 177 9(c).3 Limited partnerships ........................................................................ 178 9(c).4 Related parties ................................................................................ 179 9(c).5 Do related parties include de facto agents? ........................................ 180 9(c).6 Determining whether voting rights are proportionate to economic rights ............................................................................... 181 9(c).7 Illustrative examples ........................................................................ 182
10 Expected losses and expected residual returns .......................................................... 184 10.1 Interpretative guidance ...................................................................................................... 184
Questions and interpretative responses 10.1 Profitable entities have expected losses ............................................. 187 10.2 Expected losses and expected residual returns are based on design of entity ................................................................................ 188 10.3 Calculation of expected losses and expected residual returns............... 188 10.4 Approaches to calculating expected losses and expected residual returns ............................................................................... 191 10.5 Use of the risk-free rate for discounting ............................................. 191 10.6 Allocation of a VIEs expected losses and expected residual returns...... 192 10.7 Sum of expected losses and expected residual returns of variable interest holders exceed those of the VIE ................................ 195 10.8 Reasonableness checks for an expected loss calculation ...................... 197 10.9 Number of possible outcomes needed ................................................ 199 10.10 Possible outcome projections for an entity with an indeterminate life............................................................................. 200 10.11 Inability to obtain information necessary to calculate expected losses and expected residual returns ................................... 200 10.12 Effect of variable interests in specified assets on an entitys expected losses ............................................................................... 200 10.13 Inclusion of credit risk in an expected loss calculation ......................... 201 10.14 Inclusion of investors tax benefits in an expected loss calculation ........ 202 10.15 Inclusion of interest rate risk in an expected loss calculation ................ 203 10.16 Concepts underlying the application of Fair Value, Cash Flow and Cash Flow Prime Methods ................................................... 203 10.17 Effect of the application of the fair value accounting provisions in ASC 820 ......................................................................................... 205
11 Initial determination of VIE status ............................................................................. 207 11.1 Interpretative guidance ...................................................................................................... 207
Questions and interpretative responses 11.1 Is there a significance threshold in applying the Variable Interest Model? ................................................................... 207 11.2 Consideration of anticipated changes in an entitys design or activities ..................................................................................... 208
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13 Development stage enterprises ................................................................................. 221 13.1 Interpretative guidance ...................................................................................................... 221
Questions and interpretative responses 13.1 Development stage enterprises are not exempt from all VIE provisions .................................................................................. 222 13.2 Assessment of a development stage enterprise as a potential VIE.................................................................................... 222 13.3 Reconsideration of the sufficiency of a development stage enterprises equity investment at risk ................................................ 223 13.4 Analogies to the provisions of the Variable Interest Model for development stage enterprises .................................................... 223
14 Primary beneficiary determination ............................................................................ 224 14.1 Interpretative guidance Power and benefits ...................................................................... 226
Questions and interpretative responses 14.1 Consideration of both the power and benefits criterion........................ 230 14.2 Multiple primary beneficiaries ........................................................... 230 14.3 Effect of the variable interest determination on the primary beneficiary analysis .......................................................................... 231 14.4 Entities with no substantive decision-making ...................................... 231 14.5 Consideration of related parties in the primary beneficiary determination ................................................................. 232 14.6 Relationship of the assessment of power in the VIE determination vs. the primary beneficiary determination ..................... 232 14.7 Reconsideration of which party has the power .................................... 232 14.8 Examples where no party has the power ............................................ 233 14.9 Power under the Variable Interest Model vs. control for voting interest entities ............................................................................... 233
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14.2
14.3
14.4 14.5
Power to significantly impact the entitys economic performance ......... 234 Evaluating rights held by the board of directors and an operations manager in an operating venture ...................................... 234 14.12 Concept of could potentially be significant in the determination of the primary beneficiary ........................................... 236 14.13 Quantitative analysis of benefits........................................................ 236 14.14 Power when circumstances arise or events happen ............................. 236 14.15 Power when circumstances arise or events happen vs. protective rights .............................................................................. 237 14.16 A VIE can be the primary beneficiary of another VIE ........................... 238 14.17 Performing the primary beneficiary assessment prior to the VIE determination ............................................................................ 238 14.18 Consideration of potential voting rights (e.g., call options, convertible instruments) when assessing power.................................. 238 Interpretative guidance Kick-out rights, participating rights and protective rights ............... 239 Questions and interpretative responses 14.19 Consideration of the board of directors when assessing power ............. 240 14.20 Evaluating the substance of kick-out rights in the Variable Interest Model .................................................................... 240 14.21 Consolidation through participating rights .......................................... 241 14.22 Liquidation rights as kick-out rights ................................................... 242 14.23 Call options as kick-out rights ............................................................ 242 14.24 Kick-out right holder as party with the power ..................................... 242 Interpretative guidance Shared power.............................................................................. 243 Questions and interpretative responses 14.25 Different parties with power over the entitys life cycle........................ 244 Interpretative guidance Involvement with the design of the VIE ......................................... 245 Interpretative guidance Disproportionate power and benefits ............................................ 245 Questions and interpretative responses 14.26 Evaluating disproportionate power and benefits ................................. 246 14.27 Effect of VIE determination anti-abuse clause (ASC 810-10-15-14(c)) on the identification of the primary beneficiary .......................................................................... 246
14.10 14.11
15 Related parties and de facto agents........................................................................... 247 15.1 Interpretative guidance ...................................................................................................... 247
Questions and interpretative responses 15.1 Application of the phrase without the prior approval of the reporting entity to common contractual provisions ............................ 249 15.2 Conditions in ASC 810-10-25-43(d) on an agreement that it cannot sell, transfer or encumber its interests in the VIE without the prior approval of the reporting entity are inclusive ................ 250 15.3 Close business relationship condition ................................................. 251 15.4 Substantive sale, transfer or encumbrance restriction that is one-sided ..................................................................................... 251 15.5 Separate accounts of life insurance enterprises as related parties ........ 251
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16 Determining the primary beneficiary from a related party group ................................ 253 16.1 Interpretative guidance ...................................................................................................... 253
Questions and interpretative responses 16.1 Principal-agency relationship ............................................................ 254 16.2 Determining the relationship and significance of a VIEs activities to members of a related party group .................................... 255 16.3 One member of a related party group not clearly identified as primary beneficiary ...................................................................... 256 16.4 Equity interests held by related parties of the primary beneficiary are noncontrolling interests ............................................. 257 16.5 Determining which party within the related party group is primary beneficiary .......................................................................... 257 16.6 Quantitative analysis in determining the primary beneficiary from a related party group ............................................... 258
17 Initial measurement and consolidation ....................................................................... 259 17.1 Interpretative guidance ...................................................................................................... 260
Questions and interpretative responses 17.1 Form 8-K and pro forma reporting requirements................................. 261 17.2 Form 8-K and SEC Regulation S-X Rules 3-05 and 3-14 reporting requirements .................................................................... 261 17.3 Pre-existing hedge relationships under ASC 815 ................................. 261 17.4 Continuation of leveraged lease accounting by an equity investor in a deconsolidated lessor trust ............................................ 266
18 Accounting after initial measurement ........................................................................ 267 18.1 Interpretative guidance ...................................................................................................... 267
Questions and interpretative responses 18.1 Attribution of intercompany eliminations in consolidation .................... 268 18.2 Losses in excess of noncontrolling interests ....................................... 272 18.3 Consolidated versus combined financial statements ............................ 272 18.4 Primary beneficiarys acquisition of noncontrolling interest ................. 272 18.5 Accounting for liabilities after initial consolidation .............................. 273 18.6 Possible embedded derivative contained in certain limited recourse obligations ......................................................................... 273 18.7 Reduction of preferred stock noncontrolling interest after consolidation ........................................................................... 274 18.8 Date to reflect deconsolidation of a VIE.............................................. 275 18.9 Attribution of income/loss in an asset-backed financing entity ............. 275
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21 Effective date and transition ..................................................................................... 286 21.1 Interpretative guidance ...................................................................................................... 289
Questions and interpretative responses 21.1 Effect of prior period VIE reconsideration events on initial measurement ......................................................................... 293 21.2 Transition for an enterprise that is not the primary beneficiary on the adoption date but would have been in prior periods presented if Statement 167 had applied ......................... 294 21.3 Practicability exception for measurement available on an entity-by-entity basis........................................................................ 294 21.4 Practicability exception for measurement when the activities of the entity are primarily related to securitizations or other forms of asset-backed financings .................... 294 21.5 Practicability exception general ...................................................... 295 21.6 Determining fair value in arriving at carrying amounts upon transition.. 295 21.7 Determining initial carrying amounts when involvement precedes the effective date of current accounting standards ............... 296 21.8 Application of accounting standards that require an assessment of managements intent or application of judgment retrospectively .................................................................. 296 21.9 Practicability exception not available for deconsolidation .................... 297 21.10 Retrospective application when an enterprise no longer consolidates a VIE at the date of adoption .......................................... 297 21.11 SEC registration requirements following the adoption of Statement 167 ................................................................................ 298 21.12 Derivatives hedge designation for newly consolidated VIEs upon adoption of Statement 167 ....................................................... 298 21.13 Accumulated other comprehensive income and carrying amounts ........ 298 21.14 Table of selected financial data in Form 10-K ..................................... 299 21.15 Internal control over financial reporting requirements for an entity newly consolidated pursuant to the adoption Statement 167 ............... 299 21.2 Interpretative guidance Statement 167 deferral ............................................................... 300 Questions and interpretative responses 21.16 Consolidation analysis for entities that qualify for the deferral ............. 302 21.17 Disclosures ...................................................................................... 303 21.18 Foreign investment funds ................................................................. 303 21.19 Foreign money market funds............................................................. 303 21.20 Subsequent loss of status to qualify for the deferral Recognition and measurement principle ............................................. 304 21.21 Partnership obligation to fund losses .............................................. 304 21.22 Significance obligation to fund losses .............................................. 305
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Appendix A: Summary of important changes ................................................................... 306 Appendix B: Abbreviations used in this publication .......................................................... 308 Appendix C: Index of ASC references in this publication .................................................. 310 Appendix D: Step-by-step guide to applying the Variable Interest Model .......................... 314 Appendix E: Variable Interest Entity identifier tool ............................................................. 315 Appendix F: Example VIE analysis ................................................................................... 322 Appendix G: Other publications ....................................................................................... 334
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Notice to readers: This publication includes excerpts from and references to the FASB Accounting Standards Codification (the Codification or ASC). The Codification uses a hierarchy that includes Topics, Subtopics, Sections and Paragraphs. Each Topic includes an Overall Subtopic that generally includes pervasive guidance for the topic and additional Subtopics, as needed, with incremental or unique guidance. Each Subtopic includes Sections that in turn include numbered Paragraphs. Thus, a Codification reference includes the Topic (XXX), Subtopic (YY), Section (ZZ) and Paragraph (PP). Throughout this publication references to guidance in the Codification are shown using these reference numbers. References are also made to certain pre-Codification standards (and specific sections or paragraphs of pre-Codification standards) in situations in which the content being discussed is excluded from the Codification. This publication has been carefully prepared but it necessarily contains information in summary form and is therefore intended for general guidance only; it is not intended to be a substitute for detailed research or the exercise of professional judgment. The information presented in this publication should not be construed as legal, tax, accounting, or any other professional advice or service. Ernst & Young LLP can accept no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. You should consult with Ernst & Young LLP or other professional advisors familiar with your particular factual situation for advice concerning specific audit, tax or other matters before making any decisions.
Portions of FASB publications reprinted with permission. Copyright Financial Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk, CT 06856-5116, U.S.A. Copies of complete documents are available from the FASB.
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Excerpt from Accounting Standards Codification
Consolidation Overall Overview and Background Consolidation of VIEs 810-10-05-8 The Variable Interest Entities Subsections clarify the application of the General Subsections to certain legal entities in which equity investors do not have sufficient equity at risk for the legal entity to finance its activities without additional subordinated financial support or, as a group, the holders of the equity investment at risk lack any one of the following three characteristics: a. b. c. The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entitys economic performance The obligation to absorb the expected losses of the legal entity The right to receive the expected residual returns of the legal entity.
Paragraph 810-10-10-1 states that consolidated financial statements are usually necessary for a fair presentation if one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities. Paragraph 810-10-15-8 states that the usual condition for a controlling financial interest is ownership of a majority voting interest. However, application of the majority voting interest requirement in the General Subsections of this Subtopic to certain types of entities may not identify the party with a controlling financial interest because the controlling financial interest may be achieved through arrangements that do not involve voting interests. 810-10-05-8A The reporting entity with a variable interest or interests that provide the reporting entity with a controlling financial interest in a variable interest entity (VIE) will have both of the following characteristics: a. b. The power to direct the activities of a VIE that most significantly impact the VIEs economic performance The obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.
810-10-05-9 The Variable Interest Entities Subsections explain how to identify VIEs and how to determine when a reporting entity should include the assets, liabilities, noncontrolling interests, and results of activities of a VIE in its consolidated financial statements. Transactions involving VIEs are common. 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. At the same time, many reporting entities have used VIEs for valid business purposes and have properly accounted for those VIEs based on guidance and accepted practice.
Financial reporting developments Consolidation of variable interest entities 13
1 Introduction
810-10-05-10 Some relationships between reporting entities and VIEs are similar to relationships established by majority voting interests, but VIEs often are arranged without a governing board or with a governing board that has limited ability to make decisions that affect the VIEs activities. A VIEs activities may be limited or predetermined by the articles of incorporation, bylaws, partnership agreements, trust agreements, other establishing documents, or contractual agreements between the parties involved with the VIE. A reporting entity implicitly chooses at the time of its investment to accept the activities in which the VIE is permitted to engage. That reporting entity may not need the ability to make decisions if the activities are predetermined or limited in ways the reporting entity chooses to accept. Alternatively, the reporting entity may obtain an ability to make decisions that affect a VIEs activities through contracts or the VIEs governing documents. There may be other techniques for protecting a reporting entitys interests. In any case, the reporting entity may receive benefits similar to those received from a controlling financial interest and be exposed to risks similar to those received from a controlling financial interest without holding a majority voting interest (or without holding any voting interest). The power to direct the activities of a VIE that most significantly impact the entitys economic performance and the reporting entitys exposure to the entitys losses or benefits are determinants of consolidation in the Variable Interest Entities Subsections. The Variable Interest Entities Subsections also provide guidance on determining whether fees paid to a decision maker or service provider should be considered a variable interest in a VIE. 810-10-05-11 VIEs often are created for a single specified purpose, for example, to facilitate securitization, leasing, hedging, research and development, reinsurance, or other transactions or arrangements. The activities may be predetermined by the documents that establish the VIEs or by contracts or other arrangements between the parties involved. However, those characteristics do not define the scope of the Variable Interest Entities Subsections because other entities may have those same characteristics. The distinction between VIEs and other entities is based on the nature and amount of the equity investment and the rights and obligations of the equity investors. 810-10-05-12 Because the equity investors in an entity other than a VIE generally absorb losses first, they can be expected to resist arrangements that give other parties the ability to significantly increase their risk or reduce their benefits. Other parties can be expected to align their interests with those of the equity investors, protect their interests contractually, or avoid any involvement with the entity. 810-10-05-13 In contrast, either a VIE does not issue voting interests (or other interests with similar rights) or the total equity investment at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support. If a legal entity does not issue voting or similar interests or if the equity investment is insufficient, that legal entitys activities may be predetermined or decisionmaking ability is determined contractually. If the total equity investment at risk is not sufficient to permit the legal entity to finance its activities, the parties providing the necessary additional subordinated financial support most likely will not permit an equity investor to make decisions that may be counter to their interests. That means that the usual condition for establishing a controlling financial interest as a majority voting interest does not apply to VIEs. Consequently, a standard for consolidation that requires ownership of voting stock or some other form of decision-making ability is not appropriate for such entities.
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1 Introduction
1.1
Interpretative guidance
Note: In February 2010, the FASB issued an Accounting Standards Update (ASU) primarily to address concerns with the application of Statement 167 for reporting enterprises in the asset management industry by deferring the effective date of Statement 167 for certain investment funds. See additional discussion in Chapter 21. The FASB currently has a project on its agenda that would eliminate the deferral discussed above. In addition, the FASBs tentative decisions would modify the Variable Interest Models provisions for evaluating an enterprise as a principal or an agent (see Chapter 6) and the provisions for evaluating the substance of kick-out rights and participating rights (see Chapters 9 and 14), among other things. Readers should monitor developments in this area closely. In many instances, an enterprise will consolidate an entity because the entity is controlled through voting interests. In situations in which the equity investors lack the characteristics of a controlling financial interest, the voting interest approach is not effective in identifying whether an enterprise should consolidate an entity. For example, these situations arise when the equity investors do not bear the residual economic risks or have the rights to the residual economic returns. ASC 810-10 explains how to identify variable interests and variable interest entities (VIEs), and how an enterprise should assess its interest in a VIE to decide whether to consolidate that entity. Only if an entity is determined not to be a VIE (i.e., a voting interest entity), would the traditional voting interest model in ASC 810 be considered. Enterprises1 should apply ASC 810-10s variable interest consolidation model2 (the Variable Interest Model) to transactions with other entities to determine if they have a variable interest in the entity and, if so, whether the entity is a VIE. If the enterprise has a variable interest in a VIE, the enterprise must determine whether consolidation of that VIE is required. In effect, in determining whether to apply the Variable Interest Model, one must consider the following three threshold questions: Does the enterprise have a variable interest in an entity? If so, is the entity a VIE? If the entity is a VIE, should the enterprise consolidate the VIE?
When we use the term enterprise in this publication, we refer to the enterprise that is evaluating its potential variable interest in a potential VIE for purposes of determining whether it must consolidate that entity or to the enterprise that consolidates a VIE. When we use the term entity, we refer to the potential VIE or to the VIE. That is, the purpose of the Variable Interest Model is to determine whether the enterprise is the party that must consolidate an entity that is a VIE. Generally, ASC 810-10 includes guidance with respect to the consolidation considerations for voting interest entities and variable interest entities for each of ASC 810-10s sections. In each of ASC 810-10s sections there is a General subsection with respect to the consolidation model. This guidance applies to voting interest entities and also may apply to variable interest entities in certain circumstances. The Variable Interest Entities subsection within each of ASC 810-10s sections contains considerations with respect to variable interest entities. In referring to the Variable Interest Model in ASC 810-10, we are referring to the guidance applicable to variable interest entities in each of ASC 810-10s sections. 15
1 Introduction
If the enterprise is subject to a scope exception to the Variable Interest Model, does not have a variable interest or the entity is not a VIE, other GAAP should be applied to the transaction (i.e., other GAAP should be applied to account for the interest in or involvement with the entity). If the entity is a VIE, the Variable Interest Model should be followed, and the VIE should be evaluated for consolidation based on whether the enterprise has both: The power to direct the activities of a VIE that most significantly impact the entitys economic performance (power) The obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE (benefits)
Variable interests in an entity are contractual, ownership or other pecuniary interests in an entity that change with changes in the fair value of the entitys net assets exclusive of variable interests (e.g., equity interests, certain management or service contracts). ASC 810-10 describes various types of variable interests and provides considerations for evaluating what meets the definition of a variable interest. In order to determine whether an entity is a VIE, ASC 810-10-15-14 provides criteria for determining whether (a) the entity lacks sufficient equity or (b) the entitys equity holders lack power or the obligation and right as equity holders to absorb the entitys expected losses or to receive its expected residual returns. These entities VIEs are subject to the Variable Interest Model and are to be evaluated for consolidation based on the power and benefits criteria and not based on the ownership of outstanding voting shares. To determine a VIEs primary beneficiary, an enterprise must perform a qualitative assessment to determine which party, if any, has the power and benefits. Therefore, an enterprise must identify which activities most significantly impact the VIEs economic performance and determine whether it, or another party, has the power to direct those activities. Prior to Statement 167s amendments, ASC 810-10 generally required an enterprise to determine the primary beneficiary through the quantification and allocation of potential variability in an entitys returns to its variable interest holders. Estimates of a number of possible future outcomes of the entity, as well as the probability of each outcome occurring, were prepared. The results of each possible outcome were allocated to the parties holding variable interests in the VIE. Based on the allocation of these possible outcomes, the party, if any, that absorbed a majority of the entitys variability was the VIEs primary beneficiary and was required to consolidate the VIE. Statement 167 eliminated the quantitative analysis for purposes of determining the primary beneficiary. However, it should be noted that Statement 167 did not necessarily eliminate the need to perform a quantitative analysis in applying its other provisions, as described elsewhere in this publication (e.g., sufficiency of equity at risk in the VIE determination).
16
1 Introduction
Yes
No
No
Yes
VIE?
Yes
Yes
No
Yes
* Apply other GAAP, which may include other GAAP within ASC 810. If a VIE and the enterprise has a variable interest in the VIE, the Variable Interest Models disclosure requirements may still be applicable.
17
1 Introduction
1.2
IFRS convergence
Under both US GAAP and IFRS, the underlying determination of whether entities are consolidated by a reporting enterprise is based on a controlling financial interest. However, differences do exist. Unlike IFRS, US GAAP distinguishes between VIEs and voting interest entities. Under US GAAP, the determination of whether an entity is a VIE or a voting interest entity is often a critical consideration. If an entity is a VIE, the consolidation analysis is based on the variable interests held the entity. In May 2011, the IASB issued new consolidation accounting guidance3 that establishes a single control model for all entities. The new guidance replaces or amends portions of the existing consolidation guidance under IFRS and is effective for fiscal years beginning on or after 1 January 2013. The FASB and IASB jointly deliberated much of the IASBs new consolidation guidance. However, after hearing from constituents, the FASB decided in early-2011 not to issue consolidation guidance similar to the IASBs guidance. The FASB disagreed with aspects of the IASBs new consolidation model, but said it plans to amend US GAAP to better align it with the IASBs new guidance related to the principalagent determination. The new IASB guidance is more similar to the guidance for the consolidation of VIEs than the current guidance, but it creates new differences between US GAAP and IFRS in some areas. Some longstanding differences also remain. Our To the Point publication, Key differences between IASBs new consolidation guidance and US GAAP, highlights some of the significant differences that exist between current US GAAP and the IASBs new guidance.
Definitions of terms
Excerpt from Accounting Standards Codification
Consolidation Overall Glossary 810-10-20 Expected Losses and Expected Residual Returns Expected losses and expected residual returns refer to amounts derived from expected cash flows as described in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements. However, expected losses and expected residual returns refer to amounts discounted and otherwise adjusted for market factors and assumptions rather than to undiscounted cash flow estimates. The definitions of expected losses and expected residual returns specify which amounts are to be considered in determining expected losses and expected residual returns of a variable interest entity (VIE). Expected Variability Expected variability is the sum of the absolute values of the expected residual return and the expected loss. Expected variability in the fair value of net assets includes expected variability resulting from the operating results of the legal entity. Primary Beneficiary An entity that consolidates a variable interest entity (VIE). See paragraphs 810-10-25-38 through 25-38G for guidance on determining the primary beneficiary. Subordinated Financial Support Variable interests that will absorb some or all of a variable interest entitys (VIEs) expected losses. Variable Interest Entity A legal entity subject to consolidation according to the provisions of the Variable Interest Entities Subsections of Subtopic 810-10. Variable Interests The investments or other interests that will absorb portions of a variable interest entitys (VIEs) expected losses or receive portions of the entitys expected residual returns are called variable interests. Variable interests in a VIE are contractual, ownership, or other pecuniary interests in a VIE that change with changes in the fair value of the VIEs net assets exclusive of variable interests. Equity interests with or without voting rights are considered variable interests if the legal entity is a VIE and to the extent that the investment is at risk as described in paragraph 810-10-15-14. Paragraph 810-10-25-55 explains how to determine whether a variable interest in specified assets of a legal entity is a variable interest in the entity. Paragraphs 810-10-55-16 through 55-41 describe various types of variable interests and explain in general how they may affect the determination of the primary beneficiary of a VIE.
19
2 Definitions of terms
2.1
Interpretative guidance
Following are some important terms relevant to the application of the Variable Interest Model and our observations about them: Expected losses and expected residual returns/expected variability Negative variability in outcomes to be absorbed (expected losses) or positive variability in outcomes to be received (expected residual returns) by holders of variable interests in a variable interest entity. Expected losses and expected residual returns are derived using the techniques described in CON 7. The determination of an entitys expected losses and expected residual returns is discussed in the Interpretative guidance and Questions in Chapter 10 of this publication. Primary beneficiary An enterprise that has (1) the power to direct activities of a VIE that most significantly impact the entitys economic performance and (2) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. A VIE should have only one primary beneficiary. A VIE may not have a primary beneficiary if no party meets the criteria described above. Subordinated financial support Variable interests that absorb some or all of an entitys expected losses. Variable interest entity A VIE is an entity that does not qualify for a scope exception from the Variable Interest Model (see Interpretative guidance and Questions to Chapter 4 for scope exceptions) and is subject to consolidation based on the Variable Interest Model. The Variable Interest Models criteria identify a VIE as an entity (1) which has an insufficient amount of at-risk equity to permit the entity to finance its activities without additional subordinated financial support provided by any parties, (2) whose at-risk equity owners, as a group, do not have power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entitys economic performance or (3) whose atrisk equity owners do not absorb the entitys losses or receive the entitys residual returns. Variable interests Refer to Chapter 5 for a detailed discussion of variable interests. Equity investment Interests reported as equity in the financial statements of the entity being evaluated for consolidation. An equity investment is a variable interest in a VIE only to the extent the investment is considered to be at risk.
Expected losses and expected residual returns are not GAAP or economic income or loss
Question 2.1 Do expected losses and expected residual returns represent the amounts expected to be reported under generally accepted accounting principles (GAAP) or economic losses and income that are expected to be earned by the entity? The concepts of expected losses and expected residual returns are difficult aspects of the Variable Interest Model to understand and to apply. This difficulty arises primarily because expected losses and expected residual returns are neither GAAP nor economic losses expected to be incurred by the entity nor GAAP or economic income expected to be earned by the entity. Instead, expected losses and expected residual returns are defined as amounts derived from techniques described in CON 7. CON 7 requires expected cash flows to be derived by projecting possible outcomes and assigning each possible outcome a probability weight. Under the Variable Interest Model, expected losses and expected residual
Financial reporting developments Consolidation of variable interest entities 20
2 Definitions of terms
returns represent the potential for variability in each outcome from the expected (or mean) outcome. Outcomes that exceed the expected outcome give rise to expected residual returns (overperformance or positive variability), while outcomes that are less than the expected outcome give rise to expected losses (underperformance or negative variability). The Variable Interest Model also provides that expected losses and expected residual returns represent amounts discounted and otherwise adjusted for market factors and assumptions, rather than undiscounted cash flow estimates. The concept of expected losses and expected residual returns is further discussed in the Interpretative guidance and Questions in Chapter 10 of this publication.
21
810-10-15-13B Judgment, based on consideration of all the facts and circumstances, is needed to distinguish substantive terms, transactions, and arrangements from nonsubstantive terms, transactions, and arrangements.
3.1
Interpretative guidance
Statement 167 added language to ASC 810-10 stating that only substantive terms, transactions and arrangements, whether contractual or noncontractual, should be considered in applying the Variable Interest Model. The FASB concluded that this guidance is necessary to avoid situations in which the form of an entity may indicate that an entity is not a VIE or an enterprise is not a primary beneficiary when the substance of the arrangement may indicate otherwise. However, the inclusion of this provision is not meant to imply that nonsubstantive terms should be considered in other areas of accounting. The FASB included this provision in response to concerns regarding the potential for certain enterprises to engage in restructuring in and around their involvement with a VIE in an effort to maintain their consolidation conclusions that otherwise would have changed upon adoption of Statement 167. ASC 810-10 does not provide detailed implementation guidance or examples of the considerations that enterprises should evaluate when determining whether terms, transactions and arrangements are substantive. We believe that, in certain circumstances, significant professional judgment will be required to determine whether terms, transactions and arrangements are substantive and would therefore be considered in applying the Variable Interest Model. In some instances, enterprises previously may not have evaluated whether terms, transactions or arrangements are substantive as there was no explicit requirement to do so. In considering whether terms, transactions and arrangements are substantive, we believe that it is appropriate to consider among other things, the purpose and design of the entity and the business purposes for the particular arrangements or transactions when alternative arrangements or transactions are typically used with respect to involvement in an entity.
Financial reporting developments Consolidation of variable interest entities 22
Given the nature of the considerations in ASC 810-10-15-13A and 15-13B, we believe that it is likely that these provisions will be broadly applied by the SEC staff. As such, we believe that it will be important for an enterprise to contemporaneously document the substance of the terms, transactions and arrangements that it enters into, with particular emphasis on changes to the terms, transactions and arrangements that occur for existing involvement in entities prior to the effective date of Statement 167.
Evaluation of changes in terms, transactions and arrangements prior to the adoption of Statement 167
Question 3.1 How should an enterprise evaluate changes in terms, transactions and arrangements for entities for which they are already involved that occur subsequent to the issuance, but prior to the effective date, of Statement 167? For purposes of evaluating the provisions of ASC 810-10-15-13A and 15-13B, only changes in terms, transactions and arrangements that have a substantive effect on the consolidation analysis (e.g., an entitys status as a VIE, the determination of the primary beneficiary of a VIE) are required to be considered. In evaluating whether changes in terms, transactions and arrangements are substantive, and therefore should have an effect on the Variable Interest Model analysis, careful consideration should be given to changes that occur to existing arrangements prior to Statement 167s effective date. The Variable Interest Model does not provide detailed implementation guidance or examples of the considerations that enterprises should evaluate when determining whether terms, transactions and arrangements are substantive. Thus, we believe that, in certain circumstances, significant professional judgment will be required to determine whether changes to terms, transactions and arrangements are substantive and, therefore, are necessarily considered in applying the provisions of the Variable Interest Model. In evaluating the substance of the changes, we believe that it is appropriate to consider, among other things, the entitys original purpose and design and the business rationale for the changes. In particular, the business purpose of the change to a transaction or arrangement should be analyzed when alternative arrangements or transactions typically are used with respect to involvement in an entity. For example, changes made to the structure of an arrangement to conform the arrangement to other similar arrangements that the enterprise is involved in may be relevant in concluding that a change is substantive. Alternatively, changes made to a particular arrangement that deviate from an enterprises traditional involvement may call into question the substance of the particular change. In many circumstances, the underlying economics that accompany a change will be an important consideration. We generally believe that substantive changes to terms, transactions and arrangements will have an economic consequence to the parties involved. For example, assume that party A has a variable interest and would have the power to direct the activities of a VIE that most significantly impact the entitys economic performance over a VIE under the Variable Interest Model. Assume that leading up to the adoption of Statement 167, the arrangements between the parties involved with the VIE are altered such that party B is provided with the unilateral ability to remove party A as the party with the power. Thus, under the Variable Interest Model, party A would no longer have power. Also, assume that party A received no substantive compensation as part of party B obtaining the kick-out rights. Under this scenario, the arrangements should be carefully analyzed to ensure that the change is substantive. The fact that party A received no compensation for giving up its rights to control the VIE may raise questions as to whether the changes to arrangements were substantive.
Financial reporting developments Consolidation of variable interest entities 23
Consideration of the substance of existing terms, transactions and arrangements upon the adoption of Statement 167
Question 3.2 Is an enterprise required to evaluate the provisions of ASC 810-10-15-13A and 15-13B for an entity that the enterprise previously has been involved with and for which there has not been any changes in the terms, transactions or arrangements? Yes. Under the transition provisions of Statement 167, an enterprise is required to evaluate the effects of Statement 167 on historical consolidation conclusions as if Statement 167s requirements have always been effective. Thus, an enterprise should consider the provisions of ASC 810-10-15-13A and 15-13B on historical terms, transactions and arrangements in making this assessment. The Variable Interest Model does not provide detailed implementation guidance or examples of the evaluation that enterprises should make when determining whether terms, transactions or arrangements are substantive. We believe that enterprises should consider, among other things, the entitys original purpose and design and the business rationale for existing structures. Under the provisions of the Variable Interest Model, we note that the form of a transaction is often an important consideration in arriving at an accounting conclusion. While form is important in the accounting analysis, the form of a transaction and its related attributes often drive the economics attributable to an entitys variable interest holders. One such example is the importance of form in establishing the tax status and related attributes of an interest in an entity. As such, when evaluating the provisions of ASC 810-10-15-13A and 15-13B, we believe that a comparison of the terms, transactions and arrangements to the enterprises involvement in similar entities and a comparison to the typical involvement that other enterprises may have in similar entities may provide an indication as to the substance of an existing arrangement. For example, if a particular arrangement is consistent with an enterprises typical involvement in and structure of an entity (or the traditional form of the arrangement for similar entities), it may provide an indication that the terms, transactions or arrangements are substantive. Significant professional judgment will be required when evaluating whether terms, transactions and arrangements are substantive and would therefore be considered in applying the provisions of Statement 167. Notwithstanding the requirements of ASC 810-10-15-13A and 15-13B, we believe that the primary intent of the FASB in including those provisions in the amendments to the Variable Interest Model was its concern with respect to potential structuring opportunities that certain enterprises may have contemplated to avoid an anticipated accounting consequence upon adoption of Statement 167 (e.g., consolidation of a previously nonconsolidated entity). While the amendments to the Variable Interest Model introduce an explicit requirement to consider the substance of terms, transactions and arrangements in evaluating consolidation conclusions, we believe that a consideration of substance was implicitly required in evaluating the business purpose of an enterprises involvement with a particular entity and, ultimately, the accounting conclusions prior to the amendments to the Variable Interest Model. As a result, we generally would not expect that the provisions of ASC 810-10-15-13A and 15-13B would necessitate a change to a prior consolidation conclusion under the amendments to the Variable Interest Model, as non-substantive terms, transactions or arrangements likely were not determinative in an enterprises previous consolidation conclusion with respect to involvement in an entity.
24
Scope
Excerpt from Accounting Standards Codification
Consolidation Overall Scope and Scope Exceptions General 810-10-15-1 The Scope Section of the Overall Subtopic establishes the pervasive scope for all Subtopics of the Consolidation Topic. Unless explicitly addressed within specific Subtopics, the following scope guidance applies to all Subtopics of the Consolidation Topic. 810-10-15-2 The General Subsection of this Section establishes the pervasive scope for this Subtopic, with specific exceptions noted in the other Subsections of this Section. 810-10-15-3 All reporting entities shall apply the guidance in the Consolidation Topic to determine whether and how to consolidate another entity and apply the applicable Subsection as follows: a. b. If the reporting entity is within the scope of the Variable Interest Entities Subsections, it should first apply the guidance in those Subsections. If the reporting entity has an investment in another entity that is not determined to be a VIE, the reporting entity should use the guidance in the General Subsections to determine whether that interest constitutes a controlling financial interest. Paragraph 810-10-15-8 states that the usual condition for a controlling financial interest is ownership of a majority voting interest, directly or indirectly, of more than 50 percent of the outstanding voting shares. Noncontrolling rights may prevent the owner of more than 50 percent of the voting shares from having a controlling financial interest. If the reporting entity has a contractual management relationship with another entity that is not determined to be a VIE, the reporting entity should use the guidance in the Consolidation of Entities Controlled by Contract Subsections to determine whether the arrangement constitutes a controlling financial interest.
c.
810-10-15-4 All legal entities are subject to this Topics evaluation guidance for consolidation by a reporting entity, with specific qualifications and exceptions noted below. 810-10-20 Legal Entity Any legal structure used to conduct activities or to hold assets. Some examples of such structures are corporations, partnerships, limited liability companies, grantor trusts, and other trusts.
25
4 Scope
Scope and Scope Exceptions General 810-10-15-6 The guidance in this Topic applies to all reporting entities, with specific qualifications and exceptions noted below. 810-10-15-8 The usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule ownership by one reporting entity, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity is a condition pointing toward consolidation. The power to control may also exist with a lesser percentage of ownership, for example, by contract, lease, agreement with other stockholders, or by court decree. 810-10-15-9 A majority-owned subsidiary is an entity separate from its parent and may be a variable interest entity (VIE) that is subject to consolidation in accordance with the Variable Interest Entities Subsections of this Subtopic. Therefore, a reporting entity with an explicit or implicit interest in a legal entity within the scope of the Variable Interest Entities Subsections shall follow the guidance in the Variable Interest Entities Subsections. 810-10-15-11 A difference in fiscal periods of a parent and a subsidiary does not justify the exclusion of the subsidiary from consolidation. Scope and Scope Exceptions Variable Interest Entities 810-10-15-15 Portions of legal entities or aggregations of assets within a legal entity shall not be treated as separate entities for purposes of applying the Variable Interest Entities Subsections unless the entire entity is a VIE. Some examples are divisions, departments, branches, and pools of assets subject to liabilities that give the creditor no recourse to other assets of the entity. Majority-owned subsidiaries are legal entities separate from their parents that are subject to the Variable Interest Entities Subsections and may be VIEs.
4.1
If the entire entity is a VIE, the enterprise must consider whether silos are present. Refer to Chapter 7 of this publication for further details. 26
4 Scope
Determining whether a structure meets the definition of a legal entity requires the consideration of the individual facts and circumstances and may require the assistance of legal counsel. In situations in which this evaluation proves challenging, answering yes to some or all of the following questions may suggest the structure is a legal entity. Can the structure under its own name (i.e., apart from other parties): Enter into contracts? Enter into or become part of court or regulatory proceedings? File a tax return? Open a bank account or obtain financing?
The Variable Interest Models scope is so broad that even a majority-owned (or wholly-owned) subsidiary that is legally separate from its parent is subject to the Variable Interest Model and may be a VIE, notwithstanding the parents apparent control of the entity through its ownership of a majority of the subsidiarys outstanding voting stock. The parent must determine whether the subsidiary is a VIE. If the subsidiary is not a VIE (or qualifies for one of the Variable Interest Models scope exceptions) other GAAP should be followed and presumably the parent should continue to consolidate the subsidiary based on its ownership of a majority of the subsidiarys outstanding voting stock. If, however, the subsidiary is a VIE, the Variable Interest Model must be applied, and the parent should consolidate the subsidiary only if the enterprise has (1) the power to direct activities of a VIE that most significantly impact the entitys economic performance and (2) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE.
4 Scope
Entities used to facilitate leasing arrangements Build-to-suit arrangements Leases including lessee guarantees of asset values Leases including lessee purchase options Sale/Leasebacks Enhanced Equipment Trust Certificates Sale of property subject to operating leases Lot option deposits of homebuilders Land banks used by homebuilders Real estate partnerships Investment partnerships
Securitization vehicles Commercial paper conduits Collateralized Debt Obligations, Collateralized Bond Obligations and Collateralized Loan Obligations
Structures formerly known as qualified special-purpose entities (QSPEs) Entities used for tax-motivated structures Affordable housing partnerships Synthetic fuel partnerships Wind farms Trust preferred securities Grantor trusts Credit card master trusts
Limited-liability companies
Partnerships
Trusts
Joint ventures
Portions of entities
Question 4.2 What does the Variable Interest Model mean when it refers to portions of entities or aggregations of assets within an entity, and what is the conceptual basis for excluding them from the scope of the Variable Interest Model? Prior to the FASBs introduction of the Variable Interest Model, a multi-purpose special-purpose entity (SPE) (e.g., a single SPE with a residual equity investment that owns multiple properties leased to a number of different lessees, each financed with the proceeds from nonrecourse financings that do not contain crosscollateral provisions) was determined to create multiple virtual SPEs because the nonrecourse debt with no cross-collateral provisions effectively segregated the cash flows and assets of the various leases. Each virtual SPE was evaluated for potential consolidation by the individual lessees. Application of this approach could have resulted in the recognition of the same asset and nonrecourse debt by both the lessor (because it has legal title to the asset and is the primary obligor of the debt) and the lessee (because a substantive capital investment was not at risk in the virtual SPE during the lease term). In its deliberations regarding consolidation of VIEs, the FASB decided that the same asset and same debt should not be recognized by multiple parties. Accordingly, the Variable Interest Model provides that a portion of an entity, such as a division, department or branch, is excluded from the Variable Interest Models scope unless the entire entity is a VIE. However, for VIEs in which an enterprise holds a variable interest in specified assets of an entity, an enterprise must treat its portion of the entity as a separate VIE if the specified assets are essentially the only source of payment for specified liabilities or specified other interests. (See the Interpretative guidance and Questions in Chapter 7 for a discussion of the silo provisions.)
28
4 Scope
Portions of entities
Manufacturer X leases a building under an operating lease from Company Y, which is not a VIE. The lease contains a fixed price purchase option and a first dollar risk of loss residual value guarantee. Company Y finances 100% of its purchase of the asset with nonrecourse debt. Example 2 Company Y creates a separate legal entity that is a VIE to acquire an asset to be leased to Manufacturer X under the same terms as Example 1. The asset is financed entirely by nonrecourse debt. In Example 1, the nonrecourse debt effectively segregates the cash flows and the asset associated with the lease and, therefore, in substance creates a silo, or virtual SPE (as it was previously referred to) in Company Ys financial statements. This transaction is economically similar to Example 2, in which the leased asset and the debt are in a separate legal structure. In Example 1, because Company Y is not a VIE, and the Variable Interest Model prohibits a portion of a non-VIE from being treated as a separate entity, Manufacturer X is prohibited from evaluating the assets and liabilities under the lease for potential consolidation under the Variable Interest Models provisions. In contrast, in Example 2, the existence of a separate entity invokes the provisions of the Variable Interest Model. Because that entity is a VIE, Manufacturer X is required to determine whether it is the VIEs primary beneficiary. Because of the difference in legal form between the two transactions above, different accounting may result when the substance of the transaction is very similar.
29
4 Scope
Majority-owned entities
Question 4.4 Should an enterprise evaluate a majority-owned or wholly-owned entity as a potential VIE? All entities (as defined) are subject to the Variable Interests Model, including majority-owned and whollyowned entities. Accordingly, an enterprise should evaluate a majority-owned or wholly-owned entity to determine whether (1) the entity qualifies for one of the Variable Interest Models scope exceptions (see the Interpretative guidance and Questions below), (2) the entity is a VIE and (3) if the entity is a VIE, whether the enterprise is the primary beneficiary.7 Application of the Variable Interest Models provisions could result in an enterprise not consolidating a wholly owned subsidiary. For example, if an enterprise has formed an entity that has an equity investment that is insufficient to absorb its expected losses, the entity could be a VIE. If another variable interest holder in the entity (e.g., a service provider) has (1) the power to direct activities of a VIE that most significantly impact the entitys economic performance and (2) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE, then the enterprise would not be the primary beneficiary. In many cases, however, it will be clear that an enterprise is a majority-owned entitys primary beneficiary (if, in fact, the entity is a VIE), given its capital structure and corresponding rights with respect to decision-making (i.e., power). As a result, an enterprise would likely consolidate the majorityowned entity regardless of whether it is an entity evaluated for consolidation based on the ownership of voting interests or variable interests. While it still may be necessary to determine whether the entity is a voting interest entity or a VIE because of the differing disclosure requirements for each type of entity, the Variable Interest Model provides for relief from certain of its disclosures if (1) an enterprise holds a majority voting interest in an entity, (2) the entity meets the definition of a business in ASC 805 and (3) the entitys assets can be used for purposes other than the settlement of the entitys obligations. For further discussion, see the Interpretative guidance and Questions in Chapter 20 on disclosures.
An enterprise with greater than 50% ownership in an entity will have a variable interest in that entity through its equity interest. 30
4 Scope
Tiered structures
Assume Company B is determined to be a VIE and Company A is its primary beneficiary. Analysis We believe Company B first should be evaluated as a potential VIE. This example assumes that Company A is Company Bs primary beneficiary. Accordingly, Company A should consolidate Company B. In evaluating whether Company A is a VIE, we believe Company As standalone balance sheet without consolidation of Company B should be used. That is, Company A should be evaluated based on its own contractual arrangements without consideration of Company Bs financial position. In this case, Company As variable interest holders are its equity holders. Company Bs variable interest holders remain variable interest holders only in Company B and are not variable interest holders in Company A, even though Company A is required to consolidate Company B.
31
4 Scope
4.2
Scope exceptions
Excerpt from Accounting Standards Codification
Consolidation Overall Scope and Scope Exceptions General 810-10-15-12 The guidance in this Topic does not apply in any of the following circumstances: a. b. c. d. e. An employer shall not consolidate an employee benefit plan subject to the provisions of Topic 712 or 715. [Subparagraph superseded by Accounting Standards Update No. 2009-16] [Subparagraph superseded by Accounting Standards Update No. 2009-16] Investments accounted for at fair value in accordance with the specialized accounting guidance in Topic 946 are not subject to consolidation according to the requirements of this Topic. A reporting entity shall not consolidate a governmental organization and shall not consolidate a financing entity established by a governmental organization unless the financing entity meets both of the following conditions: 1. 2. Is not a governmental organization. Is used by the business entity in a manner similar to a (VIE) in an effort to circumvent the provisions of the Variable Interest Entities Subsections.
Scope and Scope Exceptions Variable Interest Entities 810-10-15-13 The Variable Interest Entities Subsections follow the same Scope and Scope Exceptions as outlined in the General Subsection of this Subtopic, see paragraph 810-10-15-1, with specific transaction qualifications and exceptions noted below. 810-10-15-17 The following exceptions to the Variable Interest Entities Subsections apply to all legal entities in addition to the exceptions listed in paragraph 810-10-15-12: a. Not-for-profit entities (NFPs) are not subject to the Variable Interest Entities Subsections, except that they may be related parties for purposes of applying paragraphs 810-10-25-42 through 2544. In addition, if an NFP is used by business reporting entities in a manner similar to a VIE in an effort to circumvent the provisions of the Variable Interest Entities Subsections, that NFP shall be subject to the guidance in the Variable Interest Entities Subsections. Separate accounts of life insurance entities as described in Topic 944 are not subject to consolidation according to the requirements of the Variable Interest Entities Subsections. A reporting entity with an interest in a VIE or potential VIE created before December 31, 2003, is not required to apply the guidance in the Variable Interest Entities Subsections to that VIE or legal entity if the reporting entity, after making an exhaustive effort, is unable to obtain the information necessary to do any one of the following: 1. 2. 3. Determine whether the legal entity is a VIE Determine whether the reporting entity is the VIEs primary beneficiary Perform the accounting required to consolidate the VIE for which it is determined to be the primary beneficiary.
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b. c.
4 Scope
This inability to obtain the necessary information is expected to be infrequent, especially if the reporting entity participated significantly in the design or redesign of the legal entity. The scope exception in this provision applies only as long as the reporting entity continues to be unable to obtain the necessary information. Paragraph 810-10-50-6 requires certain disclosures to be made about interests in VIEs subject to this provision. Paragraphs 810-10-30-7 through 30-9 provide transition guidance for a reporting entity that subsequently obtains the information necessary to apply the Variable Interest Entities Subsections to a VIE subject to this exception. d. A legal entity that is deemed to be a business need not be evaluated by a reporting entity to determine if the legal entity is a VIE under the requirements of the Variable Interest Entities Subsections unless any of the following conditions exist (however, for legal entities that are excluded by this provision, other generally accepted accounting principles [GAAP] should be applied): 1. The reporting entity, its related parties (all parties identified in paragraph 810-10-25-43, except for de facto agents under paragraph 810-10-25-43(d)), or both participated significantly in the design or redesign of the legal entity. However, this condition does not apply if the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee. The legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties. The reporting entity and its related parties provide more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the legal entity based on an analysis of the fair values of the interests in the legal entity. The activities of the legal entity are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements.
2. 3.
4.
A legal entity that previously was not evaluated to determine if it was a VIE because of this provision need not be evaluated in future periods as long as the legal entity continues to meet the conditions in (d).
4.3
33
4 Scope
Eligibility for scope exceptions in applying the Variable Interest Model upon adoption of Statement 167s amendments to ASC 810-10
Question 4.8 Should an enterprise evaluate its eligibility to apply a scope exception for entities with which it is involved upon the adoption of Statement 167s amendments to the Variable Interest Model (which are effective 1 January 2010 for calendar year-end companies)? Yes. In adopting the amendments to the Variable Interest Model in ASC 810-10, an enterprise should assume that those amendments have always been effective. The determination of whether an entity is a VIE and which enterprise, if any, is the VIEs primary beneficiary should be made as of the date the enterprise first became involved with the entity. That conclusion should then be reevaluated when events requiring reconsideration of the entitys status as a VIE or when a change in the primary beneficiary would have occurred under the Variable Interest Model. Therefore, we believe that making the determination of whether an entity with which the enterprise is involved is a VIE requires the enterprise to evaluate whether any of the Variable Interest Models scope exceptions are applicable. Generally with respect to the scope exceptions, we believe that the historical conclusions reached will be consistent with the conclusions reached upon the adoption of Statement 167s amendments to the Variable Interest Model. That is, aside from the QSPE scope exception, an entity that previously qualified for a scope exception to the Variable Interest Model likely will qualify for a scope exception upon adoption of the amendments. This is because the amendments did not modify the scope exceptions, except with respect to QSPEs. See Question 4.14 for a discussion of QSPEs.
4.4
34
4 Scope
35
4 Scope
A leveraged ESOP issues debt and uses the proceeds to buy shares either from the Sponsor or the market. All the shares are initially unallocated (or are in suspense) but then become released to specific employee accounts as the ESOP makes its debt service payments. Vesting provisions often also are applied. As such, a leveraged ESOP typically has three types of shares at any point in time: unallocated shares in the suspense account, allocated but unvested shares and vested shares. A leveraged ESOP can either borrow externally (e.g., from a bank or other lender) or internally from the Sponsor. In either case, however, the ESOP has no source of funds for debt service other than dividends (if any) on the shares held. It must rely, therefore, on the Sponsors subsequent contributions to provide the necessary funding. The Variable Interest Model provides a scope exception to an employer for its employee benefit plans subject to the provisions of ASC 712 or 715. Nonleveraged ESOPs are defined contribution pension plans covered by ASC 715. ASC 718 includes guidance on nonleveraged ESOPs that is generally consistent with the guidance for defined contribution plans in ASC 715. Accordingly, we believe that nonleveraged ESOPs are excluded from the scope of the Variable Interest Model for their sponsors. The guidance for accounting for leveraged ESOPs in ASC 718 is not consistent with the guidance for defined contribution plans in ASC 715 (because vesting is not a factor in recognizing compensation costs for defined contribution plans under ASC 715, and ASC 718 provides accounting models for when shares are to be credited to unearned ESOP shares and the measurement of compensation). However, because leveraged ESOPs are a form of defined contribution plan and ASC 718 provides detailed clarifying guidance for leveraged ESOPs, we believe an employer should not evaluate a leveraged ESOP for potential consolidation pursuant to the Variable Interest Model.
4 Scope
In most circumstances, we believe that the employer will be the primary beneficiary. The decisions that most significantly impact the economic performance of a rabbi trust will be those involving the funding of the trust and the investment strategy. While the employee may indicate a desired strategy, we generally believe that the investment decisions of a rabbi trust rest with the employer. In addition, decisions involving funding of the trust rest with the employer. As a result, the employer has the power to make decisions that most significantly impact the economic performance of the rabbi trust. In addition, the employer has benefits that could be potentially significant to the economic performance of the trust by virtue of its contingent call option on the rabbi trusts assets in the event of the employers bankruptcy. Because plans and trust agreements vary, careful consideration of the specific terms and conditions is required before applying the Variable Interest Model.
4.5
37
4 Scope
4.6
Additionally, investments accounted for at fair value in accordance with the specialized accounting guidance in ASC 946 are not subject to consolidation according to the requirements of the Variable Interest Model. The FASB currently has a project on its agenda to amend ASC 946 to modify the definition of an investment company (i.e., the scope of ASC 946), which could change which enterprises are eligible to apply investment company accounting. Readers should monitor developments in this area closely.
38
4 Scope
Assume that ABC, Inc., which is not an investment company, has an investment in RIC, a registered investment company subject to SEC Regulation S-X Rule 6-03(c)(1) that accounts for its investments in accordance with ASC 946. RIC is a VIE, and ABC, Inc. is the primary beneficiary. RIC has only three investments, in Company A, Company B and Company C. Although not required, if ABC, Inc. were to evaluate each investee of RIC to determine if it is a VIE, assume ABC, Inc. concludes the following:
VIE? Company A Company B Company C No Yes Yes Is RIC primary beneficiary? Not applicable Yes No
Analysis Although RIC is the primary beneficiary of a VIE (Company B), it would not consolidate Company B. Because RIC applies the guidance in ASC 946, it is exempt from applying the Variable Interest Model provisions. However, RIC should be consolidated by ABC, Inc. because RIC is a VIE and ABC, Inc. is its primary beneficiary. Pursuant to ASC 810-10-25-15, ABC, Inc. would retain in its consolidated financial statements the specialized accounting followed by RIC. That is, because RIC is provided a scope exception from applying the Variable Interest Model, ABC, Inc. would not be required to evaluate RICs investments in Company A, Company B or Company C as potential variable interests requiring consolidation of those companies. Refer to Question 4.16 for further discussion of the status of ASC 810-10-25-15.
39
4 Scope
If the specialized accounting in ASC 946 is not to be retained by a non-investment company parent or equity method investor of an investment company, the parent company or equity method investor must apply the Variable Interest Models provisions to investments held by the investment company in the parents or equity-method investors financial statements. Illustration 4-5: Investment company scope exclusion under SOP 07-1
Example 2
Example 1
Investment company
Investee
Investee
If the reporting entity in Example 1 meets the definition of an investment company pursuant to SOP 07-1 (and is therefore within its scope), it is not required to apply the Variable Interest Models provisions. If the investee was also an investment company, the reporting entity must determine whether to consolidate the investment company investee. However, the Variable Interest Model should not be used in making that determination. In Example 2, the non-investment company reporting entity is required to apply the Variable Interest Models provisions to determine whether it should consolidate the investment company. If consolidation of the investment company were required, a separate evaluation must be made as to whether investment company accounting should be retained by the reporting entity. If investment company accounting is retained by the reporting entity, the reporting entity would not apply the Variable Interest Model to the investment companys investees. However, if investment company accounting is not retained by the reporting entity, the Variable Interest Model must be applied to each of the investees to determine whether they should be consolidated based on their voting or variable interests in the consolidated financial statements of the non-investment company reporting entity. Effective date and transition SOP 07-1s provisions have been deferred indefinitely. However, the above guidance would apply if SOP 07-1 was adopted before its deferral.
40
4 Scope
4.7
4 Scope
Furthermore, entities are presumed to be governmental if they have the ability to issue directly (rather than through a state or municipal authority) debt that pays interest exempt from federal taxation. However, entities possessing only that ability (to issue tax-exempt debt) and none of the other governmental characteristics may rebut the presumption that they are governmental entities if their determination is supported by compelling, relevant evidence. A governmental agency may form a separate entity (such as a municipal bond trust) for the specific purpose of allowing an enterprise to obtain lower cost financing (generally due to tax benefits provided to investors) as an incentive to have the enterprise invest in an economically distressed area, or to serve some specific public purpose. Although governmental entities are not subject to consolidation under the Variable Interest Model, we believe that a separate financing vehicle formed by a governmental agency for the purpose of assisting an enterprise in obtaining lower cost financing will not necessarily be a governmental entity, based on the characteristics above. However, in order to be subject to the Variable Interest Model, a financing vehicle formed by a governmental entity must also be used by the enterprise in a manner similar to a VIE in an effort to circumvent the application of the Variable Interest Model. We believe the SEC staff is applying scope exceptions somewhat literally. Accordingly, we believe that it would be difficult to justify how an entity that issues debt that pays interest exempt from federal taxation could be used to circumvent consolidation provisions. That is, we believe that it would be difficult to assert that a financing vehicle that met the requisite criteria to issue tax-exempt debt was used to circumvent consolidation without calling into question whether the financing vehicle should continue to have the ability to issue debt with preferential tax treatment. Accordingly, while the evaluation as to whether this scope exception is applicable should be based on consideration of all the relevant facts and circumstances, we believe an entity that issues debt that pays interest exempt from federal taxation generally will not be subject to the Variable Interest Models provisions.
4.8
42
4 Scope
43
4 Scope
4.9
4.10
4 Scope
To qualify for this scope exception, the enterprise must have made and must continue to make exhaustive efforts to obtain the information. The scope exception applies to individual variable interest entities or potential variable interest entities, not to a class of entities if information is available for some members of the class. Additionally, the exception applies only until the necessary information is obtained, at which point the Variable Interest Models provisions would apply. Companies utilizing the scope exception have a continuing obligation to attempt to obtain the information necessary to perform the evaluation of whether the entity is a VIE and, if so, whether the enterprise is the primary beneficiary. We understand that the SEC staff believes that when making a determination of when an entity was created, consideration should be given as to whether the entity was created and began substantive operations prior to 31 December 2003. The SEC believes that the exception should not be applied to an entity whose legal structure was merely formed prior to that date, but began substantive operations or was reconfigured after 31 December 2003 in such way that the creation date of the entity is not relevant. We also believe that the scope exception should not be applied to entities that were created prior to 31 December 2003 and had substantive operations, if the entity became dormant and was reactivated at a date subsequent to 31 December 2003. We believe that it is inappropriate for an enterprise to apply this scope exception if a significant amount of information about an entity is known by the enterprise, and reasonable assumptions can be made about the unknown information necessary to apply the provisions. If material, disclosures should be made regarding the assumptions used. The FASB expects that the use of this scope exception will be infrequent, particularly if the enterprise was involved in creating or restructuring the VIE or potential VIE. We understand that the SEC staff also believes that the use of this exception should be infrequent and limited to the aforementioned types of situations. An enterprise holding a variable interest in another entity that exposes it to substantial risks would normally obtain information about that entity to monitor its exposure (even if the exposure is limited). If this scope exception has been applied and the information subsequently becomes available, the Variable Interest Model must be applied at that time. If the enterprise determines that the entity is a VIE and it must consolidate the entity as its primary beneficiary, it initially should consolidate the entity through a cumulative catch-up adjustment (see the Interpretative guidance and Questions in Chapter 21). ASC 810-10 does not provide guidance on what constitutes exhaustive efforts. Determining when exhaustive efforts have occurred without successfully obtaining the required information will be based on the applicable facts and circumstances. Companies wishing to avail themselves of this scope exception should be prepared to document the efforts that have been undertaken to obtain the necessary information. In determining whether an entity has inappropriately applied this scope exception, we understand that the SEC staff intends to consider all relevant facts and circumstances, including whether registrants operating in the same industry with similar types of arrangements were able to obtain the required information. The SEC staff will address whether this scope exception has been inappropriately applied on a case-by-case basis, as discussed in a December 2003 speech. Note that the references to FIN 46 in the following speech equate to the Variable Interest Model in the ASC.
45
4 Scope
46
4 Scope
4.11
47
4 Scope
Determining whether a variable interest holder participated significantly in the design or redesign of the entity
Question 4.24 A holder of a variable interest in an entity that is a business, as defined by ASC 805, is eligible for a scope exception from applying the Variable Interest Model if the variable interest holder and its related parties did not participate significantly in the design or redesign of the entity (among other conditions). How should a variable interest holder determine whether it significantly participated in designing or redesigning the entity? We believe an enterprise holding a variable interest in an entity generally should be deemed to have significantly participated in the design or redesign of the entity, and the business scope exception should not be applied, if any of the following criteria are met: The entity was initially formed as a wholly- or majority-owned subsidiary of the enterprise or its related parties (excluding de facto agents as that term is defined by the Variable Interest Model see Chapter 15 for further discussion). The enterprise or its related parties (excluding de facto agents) held a significant variable interest in the entity at or shortly after the entitys formation or redesign. The entity was formed or restructured by others on behalf of the enterprise or its related parties (excluding de facto agents). If the enterprise or its related parties acquire a significant variable interest in an entity shortly after formation, this may indicate that the entity was formed on its behalf. Determining if the entity was formed on behalf of the enterprise will be based on the applicable facts and circumstances and will require the use of professional judgment.
We believe that the reference to the design or redesign of the entity refers to the legal structure, including ownership of variable interests in the entity, nature of the variable interests and the nature of the entitys activities. If an entitys operations are significantly revised, this should be considered a redesign of the entity, even if the ownership of variable interests or the legal structure of the entity is not substantially changed. The determination of whether a variable interest holder participated significantly in the design or redesign of an entity should be based on consideration of all relevant facts and circumstances.
48
4 Scope
Entities described as joint ventures are organized in a variety of legal forms. In addition to the corporate form, partnerships and individual interests may also be used to organize a joint venture as contemplated by ASC 323-30-15-3. We believe that to conclude an entity is a joint venture under joint control, the following conditions generally should be present: The entity should be under the joint control of the venturers. Joint control of major decisions is one of the most significant characteristics of the class of entities described as joint ventures, which should be assessed without regard to the legal form of ownership or the proportion of voting interest held. Joint control contemplates joint decision making over key decisions such as significant acquisitions and dispositions and issuance or repurchase of equity interests, among others. In ventures with more than two venturers, we believe that joint control exists only if all major decisions are subject to unanimous consent by all venturers. The venturers must be able to exercise control of the venture through their equity investments. If a venturer exercises its decision-making authority through a means other than a voting equity investment (e.g., through a management services contract), the entity should not be evaluated as a joint venture for purposes of applying the business scope exception. In such situations, we believe, by design, the holders of the entitys equity investment at risk do not have the ability to make decisions that have a significant effect on the success of the entity (see the Interpretative guidance and Questions in Chapter 9). Consequently, we believe that it would generally be inappropriate for enterprises holding variable interests in such entities to avail themselves of the joint venture scope exception.
Determining whether an enterprise holds a variable interest in an operating joint venture will be a matter of facts and circumstances and will require the use of professional judgment. For example, the terms of put or call options between or among parties should be carefully evaluated in determining whether the entity is a joint venture that is subject to joint control.
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4 Scope
d.
e.
f.
The payment of an initial franchise fee or continuing royalty fee is not a necessary criterion for an agreement to be considered a franchise agreement. We believe that analogies generally should not be made to the scope exceptions to the Variable Interest Model. Therefore, we believe that the franchise scope exception should only be applied to franchisees (or operating joint ventures see Question 4.25).
50
4 Scope
Determining whether substantially all of the activities of an entity involve, or are conducted on behalf of, a variable interest holder
Question 4.27 In applying the Variable Interest Models business scope exception, how should a variable interest holder determine if substantially all of the activities of an entity either involve it or are conducted on its behalf? The assessment of whether substantially all of the entitys activities either involve, or are conducted on behalf of, a variable interest holder is a judgmental determination that should be based on an assessment of the applicable facts and circumstances. Although the amount of the entitys economics attributable to the variable interest holder is a factor that should be considered, we believe the determination of whether substantially all of the activities of an entity involve or are conducted on behalf of a variable interest holder should not be based primarily on a quantitative analysis. We believe the activities of the entity under evaluation should be compared to those of the variable interest holder. Factors that should be considered in determining if substantially all of the activities of the entity involve or are conducted on behalf of the variable interest holder8 for determining the applicability of the scope exception include: Are the entitys operations substantially similar in nature to the activities of the variable interest holder? Are the majority of the entitys products or services bought from or sold to the variable interest holder? Were substantially all of the entitys assets acquired from the variable interest holder? Are employees of the variable interest holder actively involved in managing the operations of the entity? Do employees of the entity receive compensation tied to the stock or operating results of the variable interest holder? Is the variable interest holder obligated to fund operating losses of the entity, if they occur? Has the variable interest holder outsourced certain of its activities to the entity? If the entity conducts research and development activities, does the variable interest holder have the right to purchase any products or intangible assets resulting from the entitys activities? Has a significant portion of the entitys assets been leased to or from the variable interest holder? Does the variable interest holder have a call option to purchase the interests of the other investors in the entity? Fixed price and in the money call options likely are stronger indicators than fair value call options. Do the other investors in the entity have an option to put their interests to the variable interest holder? Fixed price and in the money put options likely are stronger indicators than fair value put options.
For purposes of evaluating the factors listed, the term variable interest holder should be read to include the holder and its related parties, except its de facto agents under ASC 810-10-25-43(d). 51
4 Scope
Assume an enterprise, Investco, has provided subordinated financial support to a business, Bizco. In determining if it can apply the business scope exception, Investco obtains the following information regarding the capital structure of Bizco:
Fair value basis Subordinated financial support Debt Preferred stock Common stock Book basis $ 500 700 1,000 $ 2,200 Provided by Investco $ 400 500 100 $ 1,000 Provided by others $ $ 200 300 500 $ Total 600 500 400 $ 1,500
Analysis In this example, because Investco has provided more than half of Bizcos subordinated financial support, on a fair value basis (66%, or $1,000 divided by $1,500), it is unable to apply the scope exception to the variable interests it holds in Bizco. In certain circumstances, a variable interest holder may also provide a guarantee on the debt of the entity. In these circumstances, we generally believe that it is appropriate to include the fair value of the underlying debt subject to the guarantee when determining the amount of subordinated financial support provided by the variable interest holder.
4 Scope
need not apply the Variable Interest Models provisions to its variable interests in Business B because it does not provide more than half of the subordinated financial support to the entity. Investor Y, however, must apply the Variable Interest Model to its variable interests in Business B because it provides more than half of the subordinated financial support to the entity.
53
That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. Paragraph 810-10-25-38A provides guidance on the use of a quantitative approach associated with expected losses and expected residual returns in connection with determining which party is the primary beneficiary. 810-10-25-22 The variability to be considered in applying the Variable Interest Entities Subsections shall be based on an analysis of the design of the legal entity as outlined in the following steps: a. b. Step 1: Analyze the nature of the risks in the legal entity (see paragraphs 810-10-25-24 through 25-25). Step 2: Determine the purpose(s) for which the legal entity was created and determine the variability (created by the risks identified in Step 1) the legal entity is designed to create and pass along to its interest holders (see paragraphs 810-10-25-26 through 25-36).
810-10-25-23 For purposes of paragraphs 810-10-25-21 through 25-36, interest holders include all potential variable interest holders (including contractual, ownership, or other pecuniary interests in the legal entity). After determining the variability to consider, the reporting entity can determine which interests are designed to absorb that variability. The cash flow and fair value are methods that can be used to measure the amount of variability (that is, expected losses and expected residual returns) of a legal entity. However, a method that is used to measure the amount of variability does not provide an appropriate basis for determining which variability should be considered in applying the Variable Interest Entities Subsections. 810-10-25-24 The risks to be considered in Step 1 that cause variability include, but are not limited to, the following: a. Credit risk
54
b. c. d. e. f.
Interest rate risk (including prepayment risk) Foreign currency exchange risk Commodity price risk Equity price risk Operations risk.
810-10-25-25 In determining the purpose for which the legal entity was created and the variability the legal entity was designed to create and pass along to its interest holders in Step 2, all relevant facts and circumstances shall be considered, including, but not limited to, the following factors: a. b. c. d. e. The activities of the legal entity The terms of the contracts the legal entity has entered into The nature of the legal entitys interests issued How the legal entitys interests were negotiated with or marketed to potential investors Which parties participated significantly in the design or redesign of the legal entity.
810-10-25-26 Typically, assets and operations of the legal entity create the legal entitys variability (and thus, are not variable interests), and liabilities and equity interests absorb that variability (and thus, are variable interests). Other contracts or arrangements may appear to both create and absorb variability because at times they may represent assets of the legal entity and at other times liabilities (either recorded or unrecorded). The role of a contract or arrangement in the design of the legal entity, regardless of its legal form or accounting classification, shall dictate whether that interest should be treated as creating variability for the entity or absorbing variability. 810-10-25-27 A review of the terms of the contracts that the legal entity has entered into shall include an analysis of the original formation documents, governing documents, marketing materials, and other contractual arrangements entered into by the legal entity and provided to potential investors or other parties associated with the legal entity. 810-10-25-29 A qualitative analysis of the design of the legal entity, as performed in accordance with the guidance in the Variable Interest Entities Subsections, will often be conclusive in determining the variability to consider in applying the guidance in the Variable Interest Entities Subsections, determining which interests are variable interests, and ultimately determining which variable interest holder, if any, is the primary beneficiary.
55
5.1
Interpretative guidance
ASC 810-10-25-22 requires an enterprise to evaluate the design of an entity as the basis for determining the entitys variability in applying the Variable Interest Model. The by design approach is a qualitative approach that considers (1) the nature of the risks in the entity and (2) the purpose for which the entity was created in determining the variability the entity is designed to create and pass along to its interest holders. Once the variability the entity is designed to create and pass along to its interest holders is determined, variable interests are identified. Variable interests absorb or receive the variability created by the entitys assets, liabilities or other contracts. Interests that introduce the risk that the entity is designed to create generally are not variable interests in the entity; variable interests absorb the risk the entity is designed to pass along to its interest holders. After the entitys variable interests are determined, the entitys expected losses and expected residual returns can be evaluated. We are aware of three primary methods used to calculate expected losses and expected residual returns: Fair Value, Cash Flow and Cash Flow Prime. The methods differ based on how the underlying cash flows are projected and discounted. Each of these methods used to calculate expected losses and expected residual returns is described in this chapter and more fully in the Interpretative guidance in Chapter 10 of this publication. Expected losses and expected residual returns should not be computed prior to the identification of the interests that absorb the selected variability. We believe that the provisions of the Variable Interest Model should be applied as follows: Step 1: Determine the variability the entity was designed to create and distribute Consideration 1: Consideration 2: What is the nature of the risks in the entity? What is the purpose for which the entity was created? If the subordination in the entity is substantive, the entity is likely designed to create and distribute credit risk. Consider whether the entity is designed to create and distribute interest rate risk from periodic receipts. Separately consider prepayment risk from interest rate risk.
Step 2:
Identify variable interests Consideration 1: Consideration 2: Variable interests absorb the variability designated in Step 1 without regard to the instruments legal form or accounting classification. While a derivative instrument may absorb variability the entity was designed to create, it is likely not a variable interest if (1) its underlying is a market observable variable and (2) it is senior relative to other interest holders. If changes in the fair value or cash flows of the derivative are expected to offset all, or essentially all, of the risk or return (or both) related to a majority of the assets (excluding the derivative instrument) or the entitys operations, further analysis of entitys design is required to determine whether the derivative instrument is a variable interest (discussed further in this Chapter). Determine whether the variable interest is in a specified asset (discussed further in Chapter 8).
Consideration 3:
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Step 3:
Compute expected losses and expected residual returns9 Consideration 1: Consideration 2: Identify silos and exclude them from the calculation of expected losses and expected residual returns (discussed in Chapter 7). Use the Fair Value Method to measure expected losses and expected residual returns if the entity was designed to create and distribute fair value variability (discussed fully in Chapter 10). Use either the Cash Flow Method or Cash Flow Prime Method to measure expected losses and expected residual returns if the entity is designed to create and distribute cash flow variability.10
Consideration 3:
The remaining discussion in this section describes each of these steps in more detail. Step 1: Determining the variability the entity was designed to create and distribute While the Variable Interest Model indicates all entity risks should be considered, the by design approach does not require that all risks be included in measuring and assigning variability. For example, while an entity may have interest rate risk that is created by periodic interest receipts from its assets, that interest rate risk appropriately should be excluded from applying the provisions of the Variable Interest Model if it is concluded that the entity was not designed to create and distribute interest rate risk. Step 1 Consideration 1: Nature of risks in the entity The nature of the risks of the entity (i.e., the risks the entity is exposed to) should be considered in determining the basis for applying the provisions of the Variable Interest Model. These risks may include, but are not limited to: Credit risk Interest rate risk (including prepayment risk) Foreign currency exchange risk Commodity price risk Equity price risk Operations risk
Step 1 Consideration 2: Purpose for which the entity was created ASC 810-10-25-25 requires an analysis of the entitys activities, including which parties participated significantly in the design or redesign of the entity, the terms of the contracts the entity entered into, the nature of entity interests issued and how the entitys interests were marketed to potential investors. The entitys governing documents, formation documents, marketing materials and all other contractual arrangements should be closely reviewed and combined with the analysis of the entitys activities to determine the variability the entity was designed to create.
10
Subsequent to the adoption of Statement 167, the determination of expected losses and expected residual returns is no longer necessary for determining the primary beneficiary of a variable interest entity. However, the Variable Interest Model still utilizes the concepts of expected losses and expected residual returns for certain provisions, such as the determination of whether or not an entity is a variable interest entity. The difference between the methods is primarily due to the method of measuring interest rate variability on variable rate assets and is discussed fully in Chapter 10. 57
Step 2: Identifying variable interests Instruments that absorb the variability the entity was designed to create and distribute without regard to their accounting or legal forms are variable interests. Accordingly, we believe the entitys underlying economics should be used as the basis for determining the risks the entity was designed to create and distribute to its interest holders. Interests that absorb risks the entity was not designed to create are considered part of the entitys net assets. The method to measure variability should be selected to ensure that the variability associated with the entitys designed risks are appropriately measured and allocated to the entitys variable interest holders. The method selected to measure variability does not necessarily dictate which interests are variable interests (as opposed to creators of variability), as the methods seem to indicate by their title. Rather, it is the design of the entity that drives that distinction. The following excerpt from the Accounting Standards Codification provides implementation guidance for identifying variable interests. Refer to Chapter 6 for the consideration of fees paid to a decision maker or service provider as variable interests.
Finally, these paragraphs do not analyze the relative significance of different variable interests, because the relative significance of a variable interest will be determined by the design of the VIE. The identification and analysis of variable interests must be based on all of the facts and circumstances of each entity. 810-10-55-21 Paragraphs 810-10-55-16 through 55-41 also do not discuss whether the variable interest is a variable interest in a specified asset of a VIE or in the VIE as a whole. Guidance for making that determination is provided in paragraphs 810-10-25-55 through 25-56. Paragraphs 810-10-25-57 through 25-59 provide guidance for when a VIE shall be separated with each part evaluated to determine if it has a primary beneficiary. Equity Investments, Beneficial Interests, and Debt Instruments 810-10-55-22 Equity investments in a VIE are variable interests to the extent they are at risk. (Equity investments at risk are described in paragraph 810-10-15-14.) Some equity investments in a VIE that are determined to be not at risk by the application of that paragraph also may be variable interests if they absorb or receive some of the VIEs variability. If a VIE has a contract with one of its equity investors (including a financial instrument such as a loan receivable), a reporting entity applying this guidance to that VIE shall consider whether that contract causes the equity investors investment not to be at risk. If the contract with the equity investor represents the only asset of the VIE, that equity investment is not at risk. 810-10-55-23 Investments in subordinated beneficial interests or subordinated debt instruments issued by a VIE are likely to be variable interests. The most subordinated interest in a VIE will absorb all or part of the expected losses of the VIE. For a voting interest entity the most subordinated interest is the entitys equity; for a VIE it could be debt, beneficial interests, equity, or some other interest. The return to the most subordinated interest usually is a high rate of return (in relation to the interest rate of an instrument with similar terms that would be considered to be investment grade) or some form of participation in residual returns. 810-10-55-24 Any of a VIEs liabilities may be variable interests because a decrease in the fair value of a VIEs assets could be so great that all of the liabilities would absorb that decrease. However, senior beneficial interests and senior debt instruments with fixed interest rates or other fixed returns normally would absorb little of the VIEs expected variability. By definition, if a senior interest exists, interests subordinated to the senior interests will absorb losses first. The variability of a senior interest with a variable interest rate is usually not caused by changes in the value of the VIEs assets and thus would usually be evaluated in the same way as a fixed-rate senior interest. Senior interests normally are not entitled to any of the residual return. Step 3: Compute expected losses and expected residual returns The Fair Value Method, Cash Flow Method and Cash Flow Prime Method each measure variability resulting from interest rate fluctuations that result in variations in the amount and timing of cash proceeds received upon (1) anticipated sales of entity investments and (2) receipt of principal payments (or prepayments) on entity assets, although they measure them differently. Refer to Chapter 10 for additional discussion.
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After considering all of the relevant facts and circumstances, the variability the entity was designed to create and distribute fair value or cash flow is determined. The Fair Value Method is used to compute expected losses and expected residual returns for entities designed to create fair value risk. Either the Cash Flow Method or the Cash Flow Prime Method is used to compute expected losses and expected residual returns for entities designed to create cash flow risk. In general, the most significant difference between the Cash Flow Method and Cash Flow Prime Method is whether variability from periodic interest receipts from variable-rate financial instruments is measured; while the Cash Flow Method measures that variability by projecting the instruments cash flows under a variety of scenarios and discounts those cash flows using forward interest rates, the Cash Flow Prime Method projects the instruments cash flows using the same forward interest rates at which the cash flows are discounted, thus creating no variability from periodic interest receipts. Variability due to credit risk is measured under both methods. We generally expect the Cash Flow Prime Method will be used to calculate expected losses and expected residual returns in many cases in practice because: The Fair Value and Cash Flow Methods measure interest rate variability arising from periodic interest payments, and many entities are not designed to create and distribute that risk; and The Cash Flow Prime Method is generally the only approach that practically permits variability to be measured for entities that are businesses or that primarily hold or operate real estate or nonfinancial assets.
Because the by design approach is applied after considering all relevant facts and circumstances, certain instruments that may otherwise appear to absorb the entitys risks may not be considered variable interests. For example, ASC 810-10-55-81 through 55-86 illustrate how an entity may be designed to provide financing through a combination of forward contracts both purchases and sales. While one of those contracts may absorb risk under the different methods, by looking at the design of the entity, neither forward is a variable interest. That is, both instruments are considered to be creators of variability. The by design approach requires professional judgment, based on consideration of all relevant facts and circumstances. Illustrative examples The Variable Interest Model provides basic examples (ASC 810-10-55-55 through ASC 810-10-55-86) that illustrate how the nature of risks should be identified, the purpose for which the entity was created and the variability the entity was designed to create. The purpose of the following sections is to illustrate the process for evaluating an entitys variability and determining an entitys variable interest holders. Specifically, the following sections address various considerations including: Terms of interests issued Subordination Certain interest rate risk Certain derivative instruments Other arrangements and examples
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Typically in these arrangements, the trusts preferred investors have the rights of preferred shareholders and do not have creditor rights unless the enterprise directly issues an incremental credit guarantee to the investors. Additionally, the trusts preferred investors generally do not have voting rights in the trust. However, if the enterprise defaults on its issued debentures, the trustee can pursue its rights as a creditor. In some arrangements, however, the trusts preferred investors may have the right to act directly against the enterprise.
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The following diagram summarizes the cash flows for a typical issuance of trust preferred securities. The diagram does not include guarantees and other arrangements between the parties for simplicity.
Offering flows
Sponsor
Sponsor organizes a newly-formed entity, usually in the form of a Delaware business trust, and purchases all of the trusts common equity securities.
Cash proceeds
Subordinated debentures 2
Trust Trust uses proceeds of the sale of the common securities (if any) and the trust preferred securities to purchase deeply subordinated debentures from Sponsor, with terms often identical or similar to those of the trust preferred securities.
Cash proceeds
Investors
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This diagram summarizes the operating cash flows between Sponsor, Trust and Investors.
Operating cash flows Sponsor makes periodic interest payments on its subordinated debentures to Trust.
Sponsor
Trust uses debenture interest payments (received from Sponsor) to pay periodic dividends on trust preferred securities to Investors.
Trust 3
Preferred dividends
Investors
Holders of variable interests in the trust Preferred investors: Each of the trusts preferred investors is exposed to variability in the performance of the trust and, therefore, has a variable interest in the trust. Enterprise: The enterprises common stock investment typically is not a variable interest because an equity investment is a variable interest only to the extent that the investment is considered to be at risk. Because the enterprises investment in the trusts common stock often is funded by the trust (through the loan), it is not considered to be at risk (see ASC 810-10-55-22 for additional guidance). Additionally, the enterprises issued debentures, inclusive of the related call option, create rather than absorb variability of the trust. Finally, any guarantee provided by the enterprise is effectively a guarantee of its own performance (i.e., the trust is only able to pay interest and principal to preferred shareholders if the enterprise pays interest and principal on its debentures issued to the trust).
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Other structures In a variation of the trust preferred securities arrangement discussed above, we are aware of some structures in which an intermediary entity exists between what would otherwise be the typical sponsor and trust as described above. In these structures, the intermediary entity may exist for tax reasons and effectively acts as an additional trust through which securities are issued and proceeds are received. Following the entity by entity approach to consolidation evaluations, the trust that ultimately issues the trust preferred securities to outside investors should carefully consider whether it is the primary beneficiary of the intermediary trust.
5.2
5.3
Subordination
Excerpt from Accounting Standards Codification
Consolidation Overall Recognition Subordination 810-10-25-32 For legal entities that issue both senior interests and subordinated interests, the determination of which variability shall be considered often will be affected by whether the subordination (that is, the priority on claims to the legal entitys cash flows) is substantive. The subordinated interest(s) (as discussed in paragraph 810-10-55-23) generally will absorb expected losses prior to the senior interest(s). As a consequence, the senior interest generally has a higher credit rating and lower interest rate compared with the subordinated interest. The amount of a subordinated interest in relation to the overall expected losses and residual returns of the legal entity often is the primary factor in determining whether such subordination is substantive. The variability that is absorbed by an interest that is substantively subordinated strongly indicates a particular variability that the legal entity was designed to create and pass along to its interest holders. If the subordinated interest is considered equity-at-risk, as that term is used in paragraph 810-10-15-14, that equity can be considered substantive for the purpose of determining the variability to be considered, even if it is not deemed sufficient under paragraphs 810-10-15-14(a) and 810-10-25-45.
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We believe the terms of equity investments that are not at-risk should be carefully evaluated in determining whether they should be included in the determination of whether the entitys subordination is substantive. For example, an entity may issue equity that is puttable by the investor to the entity at its purchase price. In that case, the equity investment would not be at-risk pursuant to ASC 810-10-15-14(a)(1) because it does not participate significantly in losses. Accordingly, we do not believe that equity should be considered in determining whether the subordination is substantive because the investor is not contractually required to absorb the entitys losses. Judgment will be required to determine whether an equity investment that is not at-risk should be included as part of the entitys subordinated interests issued. In determining whether an entitys subordination is substantive, equity that is at-risk but not sufficient to absorb expected losses pursuant to ASC 810-10-15-14(a) may be considered for purposes of determining whether the entitys subordination is substantive. For example, assume an entity has assets ($100) and has issued senior debt ($80), subordinated debt ($10) and equity ($10). If the entitys expected losses are greater than $10, the equity would not be sufficient (and thus would be a VIE), but the subordination from the combination of the subordinated debt and equity may be substantive (and thus the entity is designed to create and distribute credit risk) after considering all of the facts and circumstances.
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5.4
5.5
11
That is based on a market observable index and is equal in priority to at least the most senior interest in the entity. 66
The VIE enters into a fixed to floating (LIBOR) interest rate swap with an $80 notional amount that has at least the same priority of payment as the senior debt. Variability in the value of the VIEs asset will result from changes in market interest rates and the credit risk of the B-rated bond. Analysis In this example, we believe that because LIBOR is a market observable variable and the interest rate swap is pari passu or senior relative to other interest holders in the entity, the interest rate swap is not a variable interest. (Even though economically 80% of the interest rate variability in the fair value of the bond will be absorbed (expected losses) or received (expected residual returns) by the swap counterparty.) Consequently, the interest rate swap would be considered a creator of interest rate variability. If the entity was not designed to create interest rate risk from periodic interest receipts, the only variability in the entity would be from the credit risk of the bond. If the VIE did not enter into an interest rate swap, the variability otherwise absorbed by the interest rate swap counterparty would be absorbed by the equity holder (through its implicit pay-float, receivefixed interest rate swap), and because that exposure is not senior to the debt, we believe interest rate variability from periodic receipts/payments would be included in the variability of the entity. Example 2 Facts Assume a VIE has the following balance sheet
Asset B-Rated Bond Floating rate $ 100 Liabilities Senior debt Fixed rate Equity $ $ 80 20
The VIE enters into a floating (LIBOR) to fixed interest rate swap with an $80 notional amount that has at least the same priority of payment as the senior debt. Analysis In this example, the swap synthetically converts a portion of the floating rate B-rated bond into a fixed rate instrument. Variability in the values of the synthetic fixed rate instrument is created by changes in market interest rates and the credit risk of the B-rated bond. Because the interest rate swap is based on a market observable index and has the same level of seniority as the most senior interest, it is not a variable interest even though economically 80% of the interest rate variability from cash flows of the bond will be absorbed (expected losses) or received (expected residual returns) by the swap counterparty. Consequently, if the entity was not designed to create interest rate risk from periodic interest receipts, the only variability in the entity would be due to the credit risk of the B-rated bond.
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If the VIE did not enter into an interest rate swap, the variability otherwise absorbed by the interest rate swap counterparty would be absorbed by the equity holder (through its implicit pay-float, receivefixed interest rate swap), and because that exposure is not senior to the debt, we believe interest rate variability from periodic receipts/payments would be included in the variability of the entity.
5.6
b.
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810-10-25-36 If the changes in the fair value or cash flows of the derivative instrument are expected to offset all, or essentially all, of the risk or return (or both) related to a majority of the assets (excluding the derivative instrument) or operations of the legal entity, the design of the entity will need to be analyzed further to determine whether that instrument should be considered a creator of variability or a variable interest. For example, if a written call or put option or a total return swap that has the characteristics in (a) and (b) in the preceding paragraph relates to the majority of the assets owned by a legal entity, the design of the entity will need to be analyzed further (see paragraphs 810-10-25-21 through 25-29) to determine whether that instrument should be considered a creator of variability or a variable interest. Implementation Guidance and Illustrations Forward Contracts 810-10-55-27 Forward contracts to buy assets or to sell assets that are not owned by the VIE at a fixed price will usually expose the VIE to risks that will increase the VIEs expected variability. Thus, most forward contracts to buy assets or to sell assets that are not owned by the VIE are not variable interests in the VIE. 810-10-55-28 A forward contract to sell assets that are owned by the VIE at a fixed price will usually absorb the variability in the fair value of the asset that is the subject of the contract. Thus, most forward contracts to sell assets that are owned by the VIE are variable interests with respect to the related assets. Because forward contracts to sell assets that are owned by the VIE relate to specific assets of the VIE, it will be necessary to apply the guidance in paragraphs 810-10-25-55 through 25-56 to determine whether a forward contract to sell an asset owned by a VIE is a variable interest in the VIE as opposed to a variable interest in that specific asset. Other Derivative Instruments 810-10-55-29 Derivative instruments held or written by a VIE shall be analyzed in terms of their option-like, forwardlike, or other variable characteristics. If the instrument creates variability, in the sense that it exposes the VIE to risks that will increase expected variability, the instrument is not a variable interest. If the instrument absorbs or receives variability, in the sense that it reduces the exposure of the VIE to risks that cause variability, the instrument is a variable interest. 810-10-55-30 Derivatives, including total return swaps and similar arrangements, can be used to transfer substantially all of the risk or return (or both) related to certain assets of an VIE without actually transferring the assets. Derivative instruments with this characteristic shall be evaluated carefully. 810-10-55-31 Some assets and liabilities of a VIE have embedded derivatives. For the purpose of identifying variable interests, an embedded derivative that is clearly and closely related economically to its asset or liability host is not to be evaluated separately.
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5.7
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In addition, we believe that in determining whether condition (1) has been met, the underlying must be observable based on market data obtained from sources independent of the reporting entity or its variable interest holders. In addition, as part of that determination, we believe consideration should be given to whether the underlying is readily convertible to cash, as that term is defined in ASC 815, to qualify as a market observable variable. A market price or rate can be estimated or derived from thirdparty sources in many circumstances. However, we believe the mere presence of a market quote, without sufficient liquidity in the derivative market or the market for the underlying, would not qualify as an observable market. Therefore, we believe liquidity of the derivative market or the underlying is an important element with respect to satisfying this criterion. For example, for interest rate swaps, we believe LIBOR is a market observable variable. Similarly, for a foreign currency swap agreement, we believe the spot price for Japanese yen, as a highly liquid currency, would have an underlying that has a market observable rate, but an illiquid currency may not have a market observable rate, even if a quote can be obtained in the marketplace. Judgment will be required to determine whether the underlying is based on a market observable variable. In order for condition (2) to be satisfied, we believe that the derivative instrument must be at least pari passu with the instrument that has the most senior claim on the entitys assets. Illustration 5-2: Derivative instruments
Example 1 Credit linked notes Facts Bank A, seeking to obtain credit protection on an investment in bonds (Investment Y), enters into a credit default swap with a newly-established trust. Investors purchase credit-linked notes, the proceeds from which are invested in US Treasury securities. Bank A pays a specified premium for credit protection, and, if a credit event occurs (as defined), the trust pays Bank A the notional amount and receives Investment Y. The credit-linked notes are satisfied through delivery of the defaulted bonds or by selling them and issuing cash. Analysis While all of the facts and circumstances must be considered, we believe the entity was designed to create and distribute the credit risk of Investment Y. Accordingly, even if the embedded derivative in the credit-linked notes meets conditions (1) and (2) described previously, the value of that embedded derivative is highly correlated with changes in the operations of the entity. That is, the entitys value is based almost exclusively on the credit of Investment Y, which is the underlying for the credit default swap. Accordingly, the credit default swap issued to Bank A would be a creator of variability. The credit linked notes are variable interests as they absorb the risk the entity was designed to create and distribute the credit of Investment Y. We believe that a similar analysis should be performed for financial guarantee contracts.
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Example 2 Total return swap Facts An entity holds one share of common stock of each of the companies listed in the S&P 500, which were purchased by issuing variable-rate debt to Investor Y. The entity enters into a total return swap with Investor X pursuant to which Investor X pays the entity a LIBOR-based rate and receives the total return of the S&P 500. Analysis We believe the entity was designed to create and distribute the price risk of the S&P 500 Index. While the S&P 500 Index is a market observable variable, the change in the value of the total return swap is expected to offset essentially all of the risk or return of all of the entitys assets. Accordingly, we believe Investor X has a variable interest in the entity. That is, we do not believe it would be appropriate to conclude that because the S&P 500 Index is a market observable variable, the derivative is a creator of variability, pursuant to ASC 810-10-25-35 through 25-36. Rather, based upon the design of the entity, which was to create and distribute price risk of the S&P 500, Investor X has a variable interest. Determining whether a derivative instrument is a creator or absorber of an entitys variability is based on individual facts and circumstances and requires the use of professional judgment. The following table lists certain common derivative contracts and provides a general framework for whether economically the contract absorbs fair value or cash flow variability. As described previously, variable interests are identified after the variability the entity was designed to create and distribute has been determined and after application of ASC 810-10-25-35 and 25-36 and consideration of all facts and circumstances (including whether the derivative instrument is a variable interest in specified assets). If the derivative instrument does not absorb variability, it is not a variable interest. If the derivative instrument absorbs variability, it may or may not be a variable interest depending on the application of the guidance in ASC 810-10-25-35 and 25-36 as discussed above:
Absorb variability VIE instrument Written put Written call Purchased put Purchased call Forward to buy Description Counterparty has an option to sell assets to the VIE Counterparty has an option to purchase assets from the VIE VIE has an option to sell assets to the counterparty VIE has an option to purchase assets from the counterparty VIE has entered into an arrangement to buy an asset at a fixed price from the counterparty in the future. The derivative instrument can be bifurcated into a: Written put Purchased call Fair Value No13 Yes Yes No No13 Cash Flow12 No13 Yes Yes No No13
12 13
Under either the Cash Flow Method or Cash Flow Prime Method Credit risk should be considered, however. That is, if there is a significant likelihood that the VIE will be unable to perform according to the terms of the derivative contract due to the nature or amount of its assets, the counterparty may have a variable interest in the VIE. 72
Absorb variability VIE instrument Forward sell Description VIE has entered into an arrangement to sell an asset at a fixed price to the counterparty in the future. The derivative instrument can be bifurcated into a: Purchased put Written call The counterparty absorbs or receives variability in the value of the asset. Accordingly, it is a variable interest.14 VIE has purchased a put, or the option to sell assets, to the counterparty Counterparty has purchased a put, or the option to sell assets, to the VIE VIE makes variable interest rate payments on a notional amount to the counterparty in exchange for fixed interest payments VIE makes fixed interest rate payments on a notional amount to the counterparty in exchange for floating interest payments VIE pays total return relating to a specific asset or group of assets to a counterparty in exchange for a fixed return on a notional amount. Analogous to a forward to sell Counterparty pays total return relating to a specific asset or group of assets to the VIE in exchange for a fixed return on a notional amount. Analogous to a forward to buy Fair Value Yes Cash Flow12 Yes
Purchased guarantee Sold guarantee Floating for fixed interest rate swap Fixed for floating interest rate swap Total return swap out
Yes No13 No
Yes
No
Yes
Yes
No
No
14
A forward to sell an asset to the counterparty in the future at the market price on that future date would not be a variable interest in the entity. 73
liabilities or specified other interests. In applying ASC 810-10-25-35 and 25-36, we believe the changes in the fair value of the total return swap should be compared with the changes in the majority of the siloed assets. If the referenced asset or group of assets is a silo, if the larger host entity is a VIE and if the total return swap is a variable interest in the silo, the swap counterparty should determine if it is the primary beneficiary of the silo (see the Interpretative guidance and Questions to Chapter 7). Illustration 5-3: Facts An entity, Finco, makes an investment of $100 in marketable debt securities maturing in three years. To finance the acquisition of the marketable debt securities, Finco borrows $100 on a nonrecourse basis. The fair value of Fincos total assets is $500. Finco enters into a total return swap with a counterparty, Investco, such that the total returns on the marketable debt securities are received by Investco. In exchange, Investco pays Finco LIBOR plus 50 basis points on a $100 notional for a three-year term. The total return swap is senior relative to the other interest holders in the entity. Analysis Because the marketable debt securities held by the entity are essentially the only source of payment for the lender, and essentially all of the expected residual returns of the referenced asset have been transferred from the holders of other variable interests in Finco to Investco, Investco has a variable interest in a silo. Because the changes in the value of the total return swap are expected to offset essentially all of the risk or return of a majority of the silos assets, we believe Investco has a variable interest in the silo. Accordingly, if Finco is a VIE (after exclusion of the silo see the Interpretative guidance and Questions to Chapter 7), Investco would be required to determine if it is the primary beneficiary of the silo and therefore should consolidate the marketable debt securities and the related nonrecourse debt. If the entity holds the referenced asset or group of assets, but the swap is not a variable interest in a silo, is the swap a variable interest in the entity as a whole? If the fair value of the referenced asset or group of assets that is held by the entity represents greater than one-half of the total fair value of the entitys assets, the swap counterparty should evaluate whether the total return swap is a variable interest in the entity. If the total return swap (1) does not have an underlying that is a market observable variable or (2) is not senior relative to other interest holders, it is a variable interest. Additionally, if those conditions are not met, it may still be a variable interest if it is expected to change in fair value in a manner that is expected to offset all or essentially all of the risk or return (or both) related to a majority of the entitys assets. If the total return swap is a variable interest, it must be determined if the entity is a VIE and, if so, whether it should consolidate the entity as the primary beneficiary. If the fair value of the referenced asset or group of assets that is held by the entity is less than half of the fair value of the entitys total assets, the total return swap is an interest in specified assets and is not a variable interest in the entity as a whole. Accordingly, the swap counterparty is not required to apply the provisions of the Variable Interest Model to determine whether it should consolidate the entity (see Question 8.1) nor is it required to provide disclosures relating to variable interests in VIEs. Total return swaps
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An entity, Finco, has a note receivable from a third party due in three years and bearing interest at 8% per annum. The fair value of the note receivable is $300. The fair value of Fincos assets, in total, is $500. No silo is assumed to exist. Finco enters into a total return swap with a counterparty, Investco, such that the total return on the loan is received by Investco. In exchange, Investco pays Finco LIBOR plus 50 basis points on a $300 notional for a three-year term. Analysis Because the total return swap references assets held by Finco that have a fair value greater than onehalf of Fincos total assets, Investco has a variable interest in Finco.
Embedded derivatives
Question 5.7 Should the rights and obligations of an embedded derivative (whether or not it is bifurcated) be considered a variable interest? ASC 810-10-55-31 states that [f]or the purpose of identifying variable interests, an embedded derivative that is clearly and closely related economically to its asset or liability host is not to be evaluated separately. Determining whether an embedded derivative is clearly and closely related economically to the host instrument will be based on the applicable facts and circumstances. The evaluation should be based on a comparison of the nature of the underlying in the embedded derivative to the host instrument. We believe that if the underlying that causes the value of the derivative to fluctuate is inherently related to the host instrument, it should be considered clearly and closely related and should not be bifurcated from the host instrument and separately evaluated to determine if it is a variable interest. For purposes of applying the provisions of the Variable Interest Model, an embedded derivative generally should be considered clearly and closely related economically to the host instrument if the value of the embedded derivative reacts in a similar and proportionate (i.e., the derivative is not leveraged or deleveraged) manner (either in direct or inverse correlation) as the host instrument to the effects of changes in external factors. ASC 815 requires that in certain circumstances embedded derivatives be bifurcated from the host contract and accounted for in the same manner as freestanding derivatives. ASC 815 also focuses on whether the economic characteristics and risks of the embedded derivative are clearly and closely related to economic characteristics and risks of the host contract for purposes of making the determination as to whether an embedded derivative should be bifurcated from the host instrument. Based on discussions with the FASB staff, we understand, however, that the determination as to whether an embedded derivative is a variable interest is not to be based solely on ASC 815s bifurcation guidance (e.g., an embedded derivative may not require bifurcation under ASC 815 for reasons other than the clearly and closely related test). However, we do believe that ASC 815s clearly and closely related provisions should be viewed as similar to the guidance in ASC 810-10-55-31 in the Variable Interest Model. The following describes common host instruments and embedded derivatives contained therein and whether such embedded derivatives generally should be bifurcated and evaluated separately to determine if the embedded derivative is a variable interest. This guidance primarily is based on that found in ASC 815.
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Host debt instruments: Interest-rate indices An interest rate or interest-rate index generally should be considered clearly and closely related to the host debt instrument provided (1) a significant leverage factor is not involved or (2) the instrument cannot be settled in such a way that the investor would not recover substantially all of its recorded investment. Inflation-indexed provisions Interest rates and the rate of inflation in the economic environment for the currency in which a debt instrument is denominated are clearly and closely related provided a significant leverage factor is not involved. Credit sensitive payments The creditworthiness of a debtor and the interest rate on a debt instrument issued by that debtor are clearly and closely related. Thus, interest rates that reset on an event of default, upon a change in the debtors credit rating, or on a change in the debtors credit spread over treasury bonds all would be considered clearly and closely related. However, a reset based on a change in another entitys credit rating or its default would not be considered clearly and closely related. Calls and puts on debt instruments Call or put options are generally clearly and closely related unless the debt involves a substantial premium or discount (such as found in zero-coupon bonds), and the option is only contingently exercisable. Interest-rate floors, caps and collars Interest rate floors, caps, and collars (i.e., a combination of a floor and cap) within a host debt instrument are generally clearly and closely related provided the floor is at or below the current market rate at issuance and the cap is at or above the current market rate at issuance, and there is no leverage. Equity-indexed interest payments Changes in the fair value of a specific common stock or on an index based on a basket of equities are not clearly and closely related to the interest return on a debt instrument. Commodity-indexed interest or principal payments Changes in the fair value of a commodity are not clearly and closely related to the interest return on a debt instrument. Conversions to equity features The changes in fair value of an equity interest and the interest rates on a debt instrument are not clearly and closely related. Thus, conversion to equity features embedded in a host debt instrument issued by a VIE should be accounted for as a variable interest.
Host equity instruments: Calls and puts on equity instruments Put and call options that require the VIE to reacquire the instrument or give the holder the right to require repurchase of the instrument are not clearly and closely related to the equity instrument. An equity instrument host is characterized by a claim to the residual ownership interest in an entity, and put and call features are not considered to possess that same economic characteristic. Additionally, an equity instrument issued by a VIE subject to puts and calls may not qualify as an equity investment at risk for purposes of applying the provisions of the Variable Interest Model (see the Interpretative guidance and Questions to Chapter 9).
Host lease instruments: Inflation-indexed rentals Rentals for the use of leased assets and adjustments for inflation on similar property are considered to be clearly and closely related. Thus, unless a significant leverage factor is involved, an inflation-related derivative embedded in an inflation-indexed lease contract should not be separated from the host contract and separately evaluated as a potential variable interest.
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Term-extending options An option that allows either the lessee or lessor to extend the term of the lease at a fixed rate is not clearly and closely economically related to changes in the value of the leased asset and is a variable interest. However, options to extend the lease term at the then current market rental for the asset are clearly and closely economically related. Contingent rentals based on lessee sales Lease contracts that include contingent rentals based on certain sales of the lessee generally would be clearly and closely related to the value of the leased asset. Contingent rentals based on a variable interest rate The obligation to make future payments for the use of leased assets and the adjustment of those payments to reflect changes in a variable market interest rate index (e.g., prime or LIBOR) generally would be considered clearly and closely related. Residual value guarantees An obligation of the lessee to make a payment to the lessor if the value of the leased asset is below a pre-determined amount at a future date. Because residual value guarantees are commonly used to transfer substantial risk of decreases in values of assets from a lessor to a lessee in a manner similar to a purchased put (see Question 5.5), they should be considered a variable interest. Purchase options A right of the lessee to acquire the leased asset from the lessor at a future date. Because fixed price purchase options are commonly used to transfer the right to receive appreciation in values of leased assets from a lessor to a lessee in a manner similar to a written call (see Question 5.5), they should be considered a variable interest. However, options allowing the lessee to acquire the leased asset at the assets fair value at the date the option is exercised are not variable interests.
5.8
Identification of the risks the entity is designed to create is based on underlying economics, not accounting or legal form
Question 5.10 Should the risks the entity is designed to create be identified based on the entitys underlying economics? How should the transactions legal form or their accounting be considered in that identification? ASC 810-10-25-26 states that the role of a contract or arrangement in the design of an entity regardless of its legal form or accounting classification dictates whether that contract or arrangement is a variable interest. We believe the economics underlying the entitys transactions, and not their accounting or legal forms, should be used in identifying the entitys risks. Illustration 5-5: Identification of risks based on underlying economics
Transfer to a VIE accounted for as a secured borrowing Company A transfers financial assets ($500) to a newly-created VIE that will pay for the transferred assets by issuing senior beneficial interests ($400) to unrelated third parties. Company A retains a subordinated interest ($100) in the transferred financial assets. Assume the transfer legally isolates the transferred assets from the transferor but is to be accounted for as a secured borrowing pursuant to ASC 860. We believe the provisions of the Variable Interest Model should be applied based on the VIEs underlying economics, not how the transferor accounted for the transfer. We believe in this example the VIE was designed to be exposed to the credit risk of the transferred assets. While for accounting purposes the VIEs asset is a receivable from the transferor, the VIE is not exposed to the transferors credit risk. Indeed, while the VIE does not recognize the transferred assets for accounting purposes, economically, the senior beneficial interest holders are exposed to variability in the transferred assets, and not the transferors credit risk. Legally, the VIE holds title to the transferred assets. We do not believe it would be appropriate to conclude that the transferor does not have a variable interest in the entity because it accounted for the transfer as a secured borrowing. Assuming the subordination is substantive, we believe the VIE was designed to create and distribute credit risk from the transferred assets. The transferor (through its retained interest) and senior beneficial interest holders would each have variable interests in the entity.
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Product financing arrangements (modified from Case F in ASC 810-10-55-75 through 55-77) Assume an entity is created by a furniture manufacturer and a financial investor to sell furniture to retail customers in a particular geographic region. The entity is created with $100 and $200, contributed by the furniture manufacturer and financial investor, respectively. The entity has entered into a fixed price purchase agreement for inventory with the furniture manufacturer, but any purchased inventory can be sold back to the furniture manufacturer for cost at any time. We believe that although the furniture manufacturer is not able to record the sale of the inventory to the entity for accounting purposes through application of ASC 470-40, the entity has economic exposure to price declines of the inventory through the fixed price purchase agreement. Accordingly, inventory price risk is a risk the entity was designed to create and distribute to its interest holders. (The furniture manufacturer absorbs the inventory price risk through the put option written to the entity and, accordingly, has a variable interest in the entity.) In this example, the entity generally is also exposed to sales volume and price risk, operating cost risk and credit risk of the furniture manufacturer.
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While a determination must be made of the nature of the risks in the entity, the purpose for which the entity was created and the variability the entity was designed to create and distribute, we generally believe a third-party financial guarantee, by design, absorbs the credit risk associated with the possible default on the entitys assets or liabilities. Accordingly, we generally believe it would not be appropriate to conclude that the entity was designed to create and distribute the financial guarantors credit risk to the entitys variable interest holders. That is, we generally believe the financial guarantee would, by design, absorb the credit risk of the entitys assets or liabilities, and consequently, the financial guarantor would have a variable interest in the entity. Illustration 5-6: Facts An entity holds a portfolio of fixed rate BBB-rated bonds, which it acquired in the market by issuing debt to unrelated investors. The bonds will be held to their maturities. The entity obtains a financial guarantee from ABC Co., which guarantees the timely collection of principal and interest payments due on the bonds. ABC Co.s credit rating is AAA. The entity markets the debt as an investment in AAA-rated securities. Analysis The entity has (1) credit risk from the BBB-rated bonds, (2) fair value interest rate risk related to the BBB-rated bonds periodic interest payments and (3) credit risk related to the AAA-rated financial guarantor. We generally do not believe that variability arising from the periodic interest payments on the fixed rate bonds would be considered in applying the provisions of the Variable Interest Model because the bonds are to be held to their maturities, and the entity was not designed to create and distribute fair value variability to the individual debt holders. While the entity was marketed to the investors as an investment in AAA-rated bonds, we believe that, by design, the entity was designed to create and distribute the risk related to the BBB-rated bonds, which is absorbed by ABC Co., through its financial guarantee. As ABC Co.s interest is considered to be an interest in the entity as a whole pursuant to ASC 810-10-25-55, ABC Co. has a variable interest in the entity. In some cases, the reporting entity that has received the proceeds from the borrowing issues the guarantee. In those cases, we generally do not believe the reporting entity has a variable interest because it is, in effect, guaranteeing its own performance. Financial guarantees
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Financial guarantees
Company A establishes a trust that issues debt to unrelated third parties and, in turn, loans the funds to Company A. The terms of the debt owed by Company A mirror those of the trust to its creditors. Company A also separately guarantees the trusts debt. Analysis We believe the trust was designated to create and distribute Company As credit risk to the trusts debt holders. Accordingly, Company A does not have a variable interest in the entity. Moreover, Company As guarantee of the trusts debt is, in effect, a guarantee of its own performance because the trusts only asset is a receivable from Company A.
Reporting enterprise sells product to entity Not a variable interest; creates entitys variability
Determining whether a purchase or supply contract is a variable interest should be based on careful consideration of all facts and circumstances and requires the use of professional judgment.
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Except when the supply contract is a derivative instrument that is determined not to be a variable interest in accordance with ASC 810-10-25-35 through 25-36 81
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Local marketing agreements and joint service agreements in the broadcasting industry as variable interests
Question 5.15 How should the provisions of the Variable Interest Model be applied to local marketing agreements (LMAs) and joint service agreements (JSAs) that are used in the broadcasting industry? LMAs and JSAs are used regularly in the broadcasting industry to enable enterprises to achieve economies of scale by combining the operations of stations in certain markets where FCC regulations would otherwise prohibit an acquisition. Because FCC licenses and the related broadcasting assets generally are held in a separate legal entity, the provisions of the Variable Interest Model generally are applicable to arrangements relating to the stations. Local marketing agreements Although LMAs may take many forms, generally an enterprise will obtain the right to operate the broadcast assets of a station. The licensee (operator) will operate the station as a leased asset, making all programming and employment decisions, selling advertising and controlling substantially all operating cash inflows and outflows, subject to FCC-mandated limitations. Generally, enterprises operating a station pursuant to an LMA pay a fixed monthly fee to the licensor (seller). LMAs commonly are entered into because: Station owners may realize the efficiencies of operating multiple stations in a single market without actually acquiring additional broadcast licenses. FCC approval of the sale of the broadcast license is pending. The pending sale of a broadcast license is public information, which may lead to decreased ratings, advertising sales and the loss of employees prior to the acquirer assuming control of the station. LMAs allow the buyer to begin operating the station prior to approval of the license transfer, thereby minimizing some potential negative economic effects.
Under the terms of an LMA, the licensor and operator both maintain responsibility for the compliance of the stations programming with FCC rules and regulations, among other requirements. Accordingly, an LMA must give the licensor (1) the ability to terminate the agreement or (2) veto power over programming that it believes would not comply with FCC standards. We believe that an LMA may represent a variable interest in the entity that owns the station assets. In order to make this determination, we believe the terms of the LMA should be evaluated to determine whether the agreement is analogous to the lease of property, plant and equipment subject to the provisions of ASC 840. While ASC 840 specifically excludes intangible assets from its scope, we believe that the operator of an LMA should determine if, by analogy to ASC 840, the arrangement is similar to an operating lease for the use of property, plant and equipment. As discussed in Question 5.13, operating leases with lease terms that are consistent with market terms at the inception of the lease and do not include a residual value guarantee, fixed price purchase option or similar feature generally will not represent a variable interest in an entity. Accordingly, if an enterprise is operating a broadcast station pursuant to an LMA that is analogous to an operating lease, we believe the LMA generally would not be deemed a variable interest in the entity holding the license and related broadcasting assets. Conversely, if an LMA is not determined to be analogous to an operating lease, generally we believe the contract represents a variable interest, and the provisions of the Variable Interest Model should be applied accordingly.
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Joint service agreements Generally, pursuant to a JSA, an enterprise that owns a station in a given market will act as a service provider to an enterprise that owns the FCC license and related station, tower and broadcasting equipment of a second station in the same market, combining the stations selling, marketing and bookkeeping functions. The enterprises each retain ownership of their respective assets. The enterprise acting as the service provider is responsible for the sale of advertising for both stations, administrative, operational and business functions, maintenance, repair and replacement of equipment and facilities. The service provider generally is required to obtain the second enterprises approval of annual budgets and any capital expenditures. The enterprise acting as the service provider retains control over the programming and all other operations of the station it owns. It also consults with the second enterprise relating to the programming that is aired on the second station, but that enterprise, as the FCC license holder, retains the exclusive control over the programming, as well as employment decisions and financing of the second station. The enterprise acting as the service provider collects and retains the operating revenues of both stations and remits a portion of the second stations cash flows to the second enterprise. The terms of a JSA should be evaluated by the service provider to determine whether the arrangement is a variable interest in the entity that owns the broadcast station. Pursuant to ASC 810-10-55-37, fees paid to an entitys decision maker(s) or service providers are not a variable interest if certain conditions are met. Refer to Chapter 6 for discussion of those conditions. It is important that all of the relevant terms and conditions of an LMA or JSA are understood before applying the provisions of the Variable Interest Model. LMAs and JSAs may contain provisions (or may be entered into in conjunction with other agreements) for certain put and (or) call options on the stations assets at a future date. Additionally, other contractual provisions may provide protection against a decrease in the fair value of the station assets (e.g., a nonrefundable deposit received by the station owner that may be applied against the exercise price of a call option, if and when exercised, by the option purchaser). These terms should be evaluated carefully against the provisions of the Variable Interest Model because (1) the entity owning the station may be a VIE, and (2) the operator or service provider may be that entitys primary beneficiary.
Generally, we believe the following conditions, among others, should be considered in determining whether the conditions precedent to the purchasers obligation to close are substantive: Must the existing lender consent to the transfer of the property and the assumption of the existing loan? Has that consent been obtained? Do title requirements exist that the seller is required to comply with? Are there any specified violations that must be cured prior to the closing date? What is the nature of those violations? Is the seller required to obtain estoppel certificates? Is the contract terminable upon the event of a material casualty to the property prior to closing? Who bears the risk of loss on the property? What are the sellers representations and warranties? For example, could the termination of a tenant lease or a material default by a tenant permit the purchaser to terminate the contract and receive a refund of the escrow deposit?
In contrast, generally we believe that a purchase and sale contract that, by design, provides the purchaser with no rights or nonsubstantive rights to terminate the contract and has passed the risks and rewards of the real estate to the buyer would be a variable interest in the entity. Additionally, we generally believe a lot option contract to control a supply of land to be used in future construction by homebuilders is subject to the Variable Interest Models provisions.
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Bank A, seeking to obtain protection for Investment Y, enters into a credit default swap with a newlyestablished trust. Investors purchase credit-linked notes, the proceeds from which are invested in US Treasury securities. Bank A pays a specified premium for credit protection, and if a credit event (as defined) occurs, the trust pays Bank A the notional amount and receives Investment Y. The credit linked notes are satisfied through delivery of the defaulted bonds or by selling them and paying cash. Bank A also contributes cash to the entity in exchange for equity. That equity investment absorbs the first dollar risk of loss created by the credit default swap. The arrangement is depicted as follows:
Protection Premium
Cash
BankA
Cash Cash Equity
Issuer
CLNs Bondyield
CLNholder
US Treasury Bond
Analysis We believe the trust was designed to create and distribute the credit risk of Investment Y. Accordingly, the credit default swap issued to Bank A would be a creator of variability. The credit linked notes are variable interests as they absorb the risk the entity was designed to create and distribute, the credit of Investment Y. We do not believe Bank As equity investment is a variable interest because, by design, Bank A absorbs losses that it created through its credit default swap. That is, on a net basis by design Bank A has no risk for this equity investment. Any loss absorbed by Bank A in its equity is, by design, equal to its gain on the credit default swap, leaving it neutral to the credit risk of Investment Y for the amount of the equity investment. Economically, we believe Bank A effectively has created a deductible to its credit protection. That is, Bank A effectively has obtained an insurance policy from the credit linked note holders, and that policy provides protection for losses only in excess of Bank As equity investment. We believe Bank A could have structured the transaction similarly by having the credit default swaps terms state that Bank A was entitled to payment only after losses exceeded a deductible amount. Under either alternative, we believe the accounting should be the same; the trust was designed to create and distribute credit risk that is absorbed only by the credit linked note holders. The basic terms of this structure may be used in different arrangements including financial guarantees and insurance/reinsurance. We believe there may be other views in the accounting for these arrangements. Accordingly, readers are cautioned to carefully evaluate the structures design considering all of the individual facts and circumstances in applying the provisions of the Variable Interest Model.
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Thus, identifying whether a reporting entity holds a variable interest in a VIE or potential VIE is necessary to apply the provisions of the guidance in the Variable Interest Entities Subsections. 810-10-25-51 An implicit variable interest is an implied pecuniary interest in a VIE that changes with changes in the fair value of the VIEs net assets exclusive of variable interests. Implicit variable interests may arise from transactions with related parties, as well as from transactions with unrelated parties. 810-10-25-52 The identification of explicit variable interests involves determining which contractual, ownership, or other pecuniary interests in a legal entity directly absorb or receive the variability of the legal entity. An implicit variable interest acts the same as an explicit variable interest except it involves the absorbing and (or) receiving of variability indirectly from the legal entity, rather than directly from the legal entity. Therefore, the identification of an implicit variable interest involves determining whether a reporting entity may be indirectly absorbing or receiving the variability of the legal entity. The determination of whether an implicit variable interest exists is a matter of judgment that depends on the relevant facts and circumstances. For example, an implicit variable interest may exist if the reporting entity can be required to protect a variable interest holder in a legal entity from absorbing losses incurred by the legal entity. See Example 4 (paragraph 810-10-55-87) for an illustration of this guidance. 810-10-25-53 The significance of a reporting entitys involvement or interest shall not be considered in determining whether the reporting entity holds an implicit variable interest in the legal entity. There are transactions in which a reporting entity has an interest in, or other involvement with, a VIE or potential VIE that is not considered a variable interest, and the reporting entitys related party holds a variable
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interest in the same VIE or potential VIE. A reporting entitys interest in, or other pecuniary involvement with, a VIE may take many different forms such as a lessee under a leasing arrangement or a party to a supply contract, service contract, or derivative contract. 810-10-25-54 The reporting entity shall consider whether it holds an implicit variable interest in the VIE or potential VIE. The determination of whether an implicit variable interest exists shall be based on all facts and circumstances in determining whether the reporting entity may absorb variability of the VIE or potential VIE. A reporting entity that holds an implicit variable interest in a VIE and is a related party to other variable interest holders shall apply the guidance in paragraph 810-10-25-44 to determine whether it is the primary beneficiary of the VIE. That is, if the aggregate variable interests held by the reporting entity (both implicit and explicit variable interests) and its related parties would, if held by a single party, identify that party as the primary beneficiary, then the party within the related party group that is most closely associated with the VIE is the primary beneficiary. The guidance in paragraphs 810-10-25-48 through 25-54 applies to related parties as defined in paragraph 810-10-25-43. For example, the guidance in paragraphs 810-10-25-48 through 25-54 applies to any of the following situations: a. b. c. A reporting entity and a VIE are under common control. A reporting entity has an interest in, or other involvement with, a VIE and an officer of that reporting entity has a variable interest in the same VIE. A reporting entity enters into a contractual arrangement with an unrelated third party that has a variable interest in a VIE and that arrangement establishes a related party relationship.
ASC 810-10-55-25 states that [g]uarantees of the value of the assets or liabilities of a VIE (explicit or implicit) are variable interests if they protect holders of other interests from suffering losses. Although ASC 810-25-55-25 refers to guarantees as one type of implicit variable interest, there are other types. Implicit variable interests should be considered in applying all of the provisions of the Variable Interest Model. Implicit variable interests may cause an entity to be a VIE (e.g., an implicit variable interest could protect the holders of the entitys equity investment at risk). Implicit variable interests are the same as explicit variable interests in that they both absorb the entitys variability. Implicit variable interests, however, indirectly (as opposed to directly) absorb the entitys variability. Implicit variable interests may arise from transactions with both related and unrelated parties. While the determination of whether an implicit variable interest exists is based on the facts and circumstances, transactions in which (1) the reporting enterprise has an explicit variable interest in, or other involvement with, an entity and (2) a related party has a variable interest with the same entity, should be closely examined in determining whether there are any implicit variable interests. Factors that should be considered in determining whether the reporting enterprise has an implicit variable interest in entities involving related parties include: What is the nature of the related party relationship? An implicit variable interest may exist when a related party has the ability to control or significantly influence the reporting enterprise. For example, assume the Chief Executive Officer (CEO) of a reporting enterprise is also the CEO and sole owner of an entity that provides services to the reporting enterprise. The nature of the related party relationship may indicate that the CEO may require the reporting enterprise to reimburse the entity for losses incurred (losses that otherwise would be absorbed by the CEO). What is the economic impact, if any, to the reporting enterprise or related party? For example, if the reporting enterprise and related party were wholly-owned subsidiaries of the same parent, there would be no net economic benefit to the parent from the implicit guarantee. However, an economic
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incentive may exist if the reporting enterprise was not wholly-owned and a portion of the losses, for example, on a guarantee, could be allocated to the reporting enterprises noncontrolling owners. Under what constraints do the reporting enterprise and related party operate? Are all related party transactions separately evaluated by senior management? Is the reporting enterprise or related party subject to regulation? Do other parties involved with the reporting enterprise or the related party believe implicit variable interests exist? For example, in setting the interest rate on the reporting enterprises newly issued debt, did the financial institution believe there were any guarantees or other forms of credit support that were not reflected in the reporting enterprises financial statements? Have any transactions occurred that should have contemplated implicit variable interests, but did not? Why werent the implicit variable interests considered in applying the provisions of the Variable Interest Model to the prior transactions?
Implicit variable interests may also arise in situations in which an enterprise, by design, enters into contracts with variable interest holders outside the entity that effectively protect those holders from absorbing a significant amount of the entitys variability. Factors that should be considered in determining whether the reporting enterprise has an implicit variable interest in entities in these situations include: Was the arrangement entered into in contemplation of the entitys formation? Was the arrangement entered into contemporaneously with the issuance of a variable interest? Why was the arrangement entered into with a variable interest holder instead of with the entity? Did the arrangement reference specified assets of the variable interest entity?
The determination of whether an implicit variable interest exists is a matter based on facts and circumstances, requiring the use of professional judgment. The following example provides an illustration of implicit variable interests:
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810-10-55-89 Manufacturing Entity should consider whether it holds an implicit variable interest in Leasing Entity. Although the lease agreement itself does not contain a contractual guarantee, Manufacturing Entity should consider whether it holds an implicit variable interest in Leasing Entity as a result of the leasing arrangement and the relationship between it and the owner of Leasing Entity. For example, Manufacturing Entity would be considered to hold an implicit variable interest in Leasing Entity if Manufacturing Entity effectively guaranteed the owners investment in Leasing Entity. The guidance in paragraphs 810-10-25-48 through 25-54 shall be used only to evaluate whether a variable interest exists under the Variable Interest Entities Subsections and shall not be used in the evaluation of lease classification in accordance with Topic 840. Paragraph 840-10-25-26 addresses leases between related parties. Manufacturing Entity may be expected to make funds available to Leasing Entity to prevent the owners guarantee of Leasing Entitys debt from being called on, or Manufacturing Entity may be expected to make funds available to the owner to fund all or a portion of the call on Leasing Entitys debt guarantee. The determination as to whether Manufacturing Entity is effectively guaranteeing all or a portion of the owners investment or would be expected to make funds available and, therefore, an implicit variable interest exists, shall take into consideration all the relevant facts and circumstances. Those facts and circumstances include, but are not limited to, whether there is an economic incentive for Manufacturing Entity to act as a guarantor or to make funds available, whether such actions have happened in similar situations in the past, and whether Manufacturing Entity acting as a guarantor or making funds available would be considered a conflict of interest or illegal.
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d. e. f.
810-10-55-37A For purposes of evaluating the conditions in the preceding paragraph, the quantitative approach described in the definitions of the terms expected losses, expected residual returns, and expected variability is not required and should not be the sole determinant as to whether a reporting entity meets such conditions. In addition, for purposes of evaluating the conditions in the preceding paragraph, any interest in the entity that is held by a related party of the entitys decision maker(s) or service provider(s) should be treated as though it is the decision makers or service providers own interest. For that purpose, a related party includes any party identified in paragraph 810-10-25-43 other than: a. An employee of the decision maker or service provider (and its other related parties), except if the employee is used in an effort to circumvent the provisions of the Variable Interest Entities Subsections of this Subtopic An employee benefit plan of the decision maker or service provider (and its other related parties), except if the employee benefit plan is used in an effort to circumvent the provisions of the Variable Interest Entities Subsections of this Subtopic.
b.
810-10-55-38 Fees paid to decision makers or service providers that do not meet all of the conditions in the preceding paragraph are variable interests.
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6.1
Interpretative guidance
Note: In February 2010, the FASB issued an Accounting Standards Update (ASU) primarily to address concerns with the application of Statement 167 for reporting enterprises in the asset management industry by deferring the effective date of Statement 167 for certain investment funds. As currently written, Statement 167 would have resulted in asset managers consolidating many hedge funds, private equity funds and other investment funds that they manage. Additionally, the ASU deferred the effective date of Statement 167 for money market funds (MMFs) that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940. For further discussion of this ASU, refer to Chapter 21. The FASB currently has a project on its agenda that would eliminate the deferral discussed above. In addition, the FASBs tentative decisions would modify the Variable Interest Models provisions for evaluating an enterprise as a principal or an agent (discussed in this Chapter) and the provisions for evaluating the substance of kick-out rights and participating rights (see Chapters 9 and 14), among other things. Readers should monitor developments in this area closely. The Variable Interest Model defines variable interests as contractual, ownership, or other pecuniary interests in an entity that change with changes in the fair value of the VIEs net assets in ASC 810-1020. In applying the provisions of the Variable Interest Model, an enterprise first must determine whether it has a variable interest in the entity being evaluated for consolidation. An enterprise should consider the purpose of the entity and the risks that the entity was designed to create and pass along to its interest holders in making that determination. Refer to the Interpretative guidance to Chapter 5 for a more detailed discussion of general considerations with respect to the identification of variable interests. The Variable Interest Model provides specific guidance for evaluating whether fees paid to a decision maker or service provider are variable interests. Statement 167 amended this guidance. The most significant change is that a decision maker or service provider no longer need be subject to removal through substantive kick-out rights to conclude that it does not hold a variable interest. The FASB has indicated that the amendment to remove the kick-out rights criterion was to promote consistency between the determination of whether an enterprise has a variable interest in a VIE and whether an enterprise is the primary beneficiary of a VIE. As described in detail in Chapter 14, the FASB concluded that kick-out rights should not be considered in the primary beneficiary determination unless a single enterprise (including its related parties and de facto agents) has the unilateral ability to exercise such rights. Additionally, Statement 167 replaced the quantitative thresholds of trivial and not large with the term insignificant for purposes of assessing the magnitude of a decision makers or service providers fees or the amount of variability that could be absorbed by the fees or its other variable interests. This change was made to provide a consistent threshold throughout the analysis of a decision makers or service providers fees. The other amendments primarily consolidate the criteria included in the Variable Interest Model into two paragraphs as reproduced above. The conditions in ASC 810-10-55-37 focus on the nature of the services and the amount of the fees (including the decision maker or service provider and its related parties). Specific items to note are: Criteria (a) and (d) may require a decision maker or service provider to analyze similar arrangements among parties outside of the relationship being analyzed to assess whether it meets these criteria
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Criteria (c), (e) and (f) may include elements of a quantitative assessment, in certain circumstances, and will require an assessment of what meets the definition of insignificant. While fee percentages (e.g., 2% of assets under management, 20% of profits) often are stated in contractual arrangements, a decision maker or service provider may be required to perform a quantitative analysis, in certain cases, to determine the magnitude and variability of fees that may be earned. It is important to note that with criteria (e) and (f), the fees and economic performance being evaluated are what are anticipated. Therefore, this may require an enterprise to consider probabilistic outcomes over time, rather than what could potentially occur if probability was ignored. It should be noted that the FASB has provided no bright-lines for the quantitative thresholds contained in these criteria Criterion (c) requires an enterprise to evaluate its other interests in the entity. These interests could include implicit variable interests. Refer to Question 5.18 for further discussion of implicit variable interests When evaluating fees paid to a decision maker or service provider, interests held by related parties, (except for certain employees and employee benefits plans discussed in ASC 810-10-55-37A) should be treated as though they are the decision makers or service providers own interest. Refer to ASC 810-10-25-43 (see Chapter 15) for the Variable Interest Models definition of related parties When giving consideration to interests held by separate accounts of an insurance enterprise as possible related parties of the decision maker or service provider, refer to Question 15.5 In assessing significance pursuant to ASC 810-10-55-37, the quantitative approach described in the definitions of the terms expected losses, expected residual returns and expected variability in the ASC Master Glossary is not required and should not be the sole determinant
The revised guidance for determining whether fees paid to a decision maker or service provider (and its related parties) represent a variable interest in a VIE is fundamentally attempting to determine whether an enterprise is acting in a fiduciary capacity as an agent to the VIE or whether the enterprise is a principal. The FASB expects that an enterprise that acts solely as a fiduciary or agent typically would not have a variable interest in a VIE as its fees and variable interests, if any, would typically meet the criteria in ASC 810-10-55-37. If an enterprises fees or other variable interests do not meet these criteria, the FASB believes that an enterprise is a principal to the transaction. To illustrate, a general partner in a partnership arrangement may receive a carried interest that allows the general partner to participate significantly in the profits of the partnership (e.g., 20%). In these situations, a general partner likely will conclude that their equity interest does provide them with a variable interest. If an enterprise concludes that it does not have a variable interest in an entity after evaluating the provisions of ASC 810-10-55-37 and considering any other interests in the entity, we believe that the enterprise is not required to evaluate the provisions of the Variable Interest Model further to account for its interest. This includes determining whether the enterprise is the primary beneficiary of the entity and whether the enterprise is subject to the disclosure provisions of the Variable Interest Model. If an enterprise does have a variable interest in an entity, the next step is to evaluate whether the entity is a VIE. Several changes to the Variable Interest Model will increase the emphasis on the analysis of fees paid to decision makers. The determination of the primary beneficiary of a VIE is based upon a qualitative analysis, which requires an enterprise to determine whether it has (1) the power to direct the activities of a VIE that most significantly impact the entitys economic performance (power) and (2) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE (benefits). As a result, an arrangement with a decision maker that constitutes a variable interest takes on greater importance in
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the application of the Variable Interest Model, as amended by Statement 167. If a decision maker has a variable interest, it may have power and benefits and, therefore, be the primary beneficiary. Refer to Chapter 14 for Interpretative guidance and related Questions with respect to the determination of the primary beneficiary. Frequently, decision maker and service provider arrangements do not include provisions whereby the decision maker or service provider can be removed. Prior to Statement 167s amendments, those arrangements were considered variable interests. In addition, prior to Statement 167s amendments, some enterprises in practice may have considered whether such arrangements, in combination with other variable interests, would have caused the enterprise to be the primary beneficiary of the VIE through absorption of a majority of the expected losses and expected residual returns. If the arrangement could not have caused the enterprise to be the primary beneficiary, those enterprises may not have performed a formal evaluation of whether the arrangement was a variable interest. Specifically, the enterprise may not have evaluated all of the conditions included in ASC 810-10-55-33 through 5538 prior to Statement 167s amendments to determine whether the arrangement is a variable interest. Additionally, some may find that interpretations of the quantitative thresholds of trivial and not large are different from insignificant. As noted in certain comment letters on the Exposure Draft, some practitioners had interpreted more than trivial as anything more than zero. Therefore, as a result of the discussed changes to these provisions, previous consolidation conclusions should be revisited upon the adoption of Statement 167. A decision makers or service providers evaluation of whether an arrangement is a variable interest under the provisions of ASC 810-10-55-37 will require a careful examination of the facts and circumstances and the use of professional judgment. By virtue of the rights to make decisions in the service contract, a decision maker that holds a variable interest could be deemed the primary beneficiary of a VIE.
To further illustrate, assume that a decision maker of an operating entity receives a performance fee that is calculated as a percentage of operating income (prior to consideration of the performance fee). In arriving at operating income, the entity deducts all operating expenses including salaries, utility expenses and repairs and maintenance. While the performance fee is calculated after all operating expenses have been deducted from sales, the calculated performance fee ranks pari passu with other operating payables in the entity with respect to priority of claim. As a result, the performance fee does not violate the provision of ASC 810-10-55-37(b).
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Determination of what level of other interests meets the definition of more than an insignificant amount (ASC 810-10-55-37(c))
Question 6.3 How should an enterprise determine what is considered a more than an insignificant amount for purposes of assessing whether fees paid to a decision maker or service provider represent a variable interest (ASC 810-10-55-37(c))? In making the determination of whether fees paid to an entitys decision maker(s) or service provider(s) (and its related parties) represent a variable interest, ASC 810-10-55-37(c) indicates that the decision maker or service provider and its related parties cannot hold other interests that would absorb more than an insignificant amount of the entities expected losses or residual returns. This threshold is used for purposes of evaluating the magnitude of the other interest(s) held by an entitys decision maker or service provider. The FASB has not provided any detailed implementation guidance or bright-lines for considering the quantitative thresholds contained in these criteria. We believe the provisions of ASC 810-10-55-37 are based upon the objective of determining whether an enterprise is acting as a fiduciary (or agent) or a principal in its role as a decision maker or service provider. The FASB believes that the larger the other variable interest(s) held by the decision maker or service provider become, then the more likely the decision maker or service provider is acting as a principal. Therefore, the FASB provided the threshold of more than an insignificant amount for making this assessment. We believe that more than insignificant should be interpreted to mean the same as significant. We also believe that an evaluation of the threshold of more than insignificant will require a careful evaluation of the purpose and design of each entity in which the enterprise has involvement and will require significant professional judgment. In addition, qualitative factors may be relevant in making this threshold determination. In particular, we believe that it is relevant to consider the nature of the other variable interests held (e.g., senior vs. subordinated interests) rather than the pure magnitude of those interests. The following are some additional considerations: We believe that an enterprise may determine that it can hold a higher dollar amount of senior interests and still meet the more than an insignificant amount threshold than if the interests held were subordinated or residual interests. That is, if the senior interest is not expected to absorb a significant amount of expected losses or expected residual returns, a relative high ownership level of such interests would not necessarily cause the service providers fees to be considered a variable interest. It may be relevant to compare the significance of the interests held by the enterprise to other similar arrangements in an evaluation of commonality across structures. That is, if the enterprises other interests are significantly higher than those of others providing similar services, then the other interests are more likely to be viewed as significant.
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Determination of what meets the definition of more than an insignificant amount (ASC 810-10-55-37(c)) vs. the determination of whether an equity investment is substantive in the VIE assessment
Question 6.4 Does the determination that an equity investment is substantive for purposes of the VIE determination mean that the equity interest should be viewed as absorbing more than an insignificant amount of the entitys expected losses or receiving more than an insignificant amount of the entitys residual returns? Not necessarily. We generally believe there is a rebuttable presumption that an equity investment is substantive if it is at least 1% or more of the entitys assets (or equity) (refer to Question 9(b)(1).-6 for complete discussion of this view). This threshold relates to the determination of whether an equity holder should be viewed as an at-risk equity holder for purposes of assessing whether the entity is a VIE (i.e., whether the at-risk equity holders (as a group) have power). However, it should be noted that the Variable Interest Model does not introduce a threshold definition (e.g., more than insignificant amount) for purposes of this assessment. We do not believe that the FASB intended for all at-risk equity investments to satisfy the criteria for absorbing more than an insignificant amount of expected losses or receiving more than an insignificant amount of expected returns. Therefore, we do not believe that there is symmetry between what would be considered an at-risk equity holder and an equity investment that would absorb more than an insignificant amount of variability. Thus, we believe that it is possible for a decision maker or service provider to conclude that it holds a substantive equity investment that does not absorb more than an insignificant amount of variability. For example, a 2% interest in the equity at risk would be substantive for purposes of determining whether the investor should be included in group of at-risk equity holders, but likely would not absorb more than an insignificant amount of expected losses or receive more than an insignificant amount of expected returns.
Determination of whether the magnitude of fees meets the definition of insignificant (ASC 810-10-55-37(e) and (f))
Question 6.5 How should an enterprise determine what is considered insignificant for purposes of assessing whether fees paid to decision maker or service provider represent a variable interest (ASC 810-1055-37(e) and (f))? In making the determination of whether fees paid to an entitys decision maker(s) or service provider(s) (and its related parties) represent a variable interest, ASC 810-10-55-37 (e) and (f) incorporate a threshold of insignificant. This threshold is used for purposes of evaluating the magnitude of the fees received by an entitys decision maker or service provider. For the fees not to be considered a variable interest, they must be insignificant to the total anticipated economic performance of the entity and must absorb an insignificant amount of variability of the entitys anticipated economic performance. The FASB has not provided any detailed implementation guidance or bright-lines for considering the quantitative thresholds contained in these criteria. We believe the provisions of ASC 810-10-55-37 are based upon the objective of determining whether an enterprise is acting as a fiduciary (or agent) or a principal in its role as a decision maker or service provider. The criteria in this paragraph imply that the larger the fees become, then the more likely the decision maker or service provider is acting as a principal.
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We believe that an evaluation of the threshold of insignificant will require a careful evaluation of the purpose and design for each entity in which the enterprise has involvement and will require significant professional judgment. Given variations in structures and arrangements across industries and entities within those industries, we generally do not believe that a bright-line for determining what is insignificant should be established. Rather, we believe that, in many cases, qualitative factors may be relevant in making this threshold determination. We believe that it is relevant to consider, among other things, the manner in which the fees are computed (e.g., fixed fees vs. performance-based fees). The following are some additional considerations: Performance fees may require a careful analysis. Many management arrangements contain a performance fee that could cause a fee arrangement to not meet the insignificant threshold. For example, a servicer in an arrangement may receive a performance fee that allows the servicer to participate significantly in the profits of the entity. In these situations, the servicer may conclude that their fee arrangement provides them with a variable interest. It may be relevant to consider the nature of the fee relationship in relation to other similar arrangements. For example, it may be viewed as common for a servicer to earn a fixed fee of 50 basis points on the assets that they service. However, it may be viewed as uncommon for a servicer to receive a 5% incentive fee associated with servicing the same assets.
Concept of insignificant in the evaluation of fees paid to a decision maker or service provider vs. could be potentially significant in the determination of the primary beneficiary
Question 6.6 Is the concept of insignificant in the evaluation of whether an enterprises fees represent a variable interest under ASC 810-10-55-37 the same as could be potentially significant in the determination of whether an enterprise has benefits in the primary beneficiary assessment? No. We believe that they are different thresholds. In ASC 810-10-55-37, we believe that the assessment of significance considers expected or probabilistic outcomes. The FASBs use of the phrases anticipated economic performance (ASC 810-10-55-37(e) and (f)) and would absorb (ASC 810-10-55-37(c)) imply that expected outcomes are the barometer by which the fees or other variable interests are measured against. In contrast, we believe that the assessment of significance as part of the primary beneficiary determination contemplates possible outcomes. In other words, we believe that a consideration of the likelihood or probability of the outcome generally is not relevant for this assessment. The FASBs use of the phrase could potentially be significant implies that the threshold is not what would happen, but what could happen. Accordingly, an enterprise would meet the benefits criterion if it could absorb significant losses or benefits, even if the events that would lead to such losses or benefits are not expected. As a result of these differences, we believe that it would be rare that an enterprise would conclude that a decision makers or service providers fees meet the definition of a variable interest by virtue of provisions (c), (e) or (f), but the fees do not meet the benefits criterion for the purposes of determining the primary beneficiary of a VIE.
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should not be considered in the evaluation of whether the enterprise is the primary beneficiary of the VIE. Of course, if the other variable interest were significant, the requirements of ASC 810-10-55-37(c) would not be satisfied and the decision-maker would be the primary beneficiary.
market fluctuations. We believe that the rationale for this position is similar to that for reconsidering whether an entity is a VIE. The FASB concluded for purposes of ASC 810-10-35-4 that the status of an entity as a VIE should be reconsidered only upon specified events, in part to avoid situations in which changes in the entitys anticipated economic performance would change the entitys status as a VIE. However, there may be certain limited circumstances in which an enterprise determines that its investment (through interests other than its fee) in an entity is worthless. For example, an enterprise may conclude that there is only a de minimis potential for an investment (through interests other than its fee) to provide future cash flows to the enterprise. In the event that an enterprise makes this determination, we believe that the enterprise may reconsider the provisions of ASC 810-10-55-37(c) and reconsider whether its fees are variable interests (i.e., whether the enterprise is no longer a principal to the transaction). In evaluating whether an investment is considered worthless, an enterprise carefully should consider all facts and circumstances. One important element to consider may include whether there is a potential scenario (based on consideration of realistic assumptions) that the enterprise will receive cash flows associated with its investment or otherwise receive some future return. Such a scenario may suggest that an investment is not worthless. We would expect that an enterprise would develop a consistent policy and approach for determining whether an interest is considered to be worthless for purposes of the ASC 810-10-55-37 assessment. Additionally, we expect the scenarios in which an investment is deemed worthless will be infrequent. It is important to note that upon reconsideration, an enterprise may or may not conclude that its role as a principal or agent has changed based upon a qualitative assessment of the conditions in ASC 810-10-55-37 (e.g., fees may remain subordinate).
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Consideration of quantitative analysis in evaluating fees paid to decision maker(s) or service provider(s) as variable interests
Question 6.11 Is a reporting enterprise required to utilize a quantitative analysis to determine whether fees paid to a decision maker(s) or service provider(s) represent variable interests pursuant to ASC 810-10-5537(c) and 55-37(f)? No. ASC 810-10-55-37A indicates that the quantitative approach described in the Master Glossary definitions of the terms expected losses, expected residual returns and expected variability is not required to determine (1) whether fees are insignificant relative to the entitys anticipated economic performance and (2) whether other variable interests held by the reporting enterprise and its related parties would absorb or receive more than an insignificant amount of the entitys expected losses or residual returns, respectively. If the quantitative approach is used, the results should not be the sole determinant when concluding whether a service providers or decision makers fees represent variable interests in the entity. The FASB believes this provision aligns the qualitative assessment of power with determinations of whether a decision maker or service provider is acting in the role as a principal or agent.
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Excerpt from Accounting Standards Codification
Consolidation Overall Recognition Variable Interest and Interests in Specific Assets of a VIE 810-10-25-57 A reporting entity with a variable interest in specified assets of a VIE shall treat a portion of the VIE as a separate VIE if the specified assets (and related credit enhancements, if any) are essentially the only source of payment for specified liabilities or specified other interests. (The portions of a VIE referred to in this paragraph are sometimes called silos.) That requirement does not apply unless the legal entity has been determined to be a VIE. If one reporting entity is required to consolidate a discrete portion of a VIE, other variable interest holders shall not consider that portion to be part of the larger VIE. 810-10-25-58 A specified asset (or group of assets) of a VIE and a related liability secured only by the specified asset or group shall not be treated as a separate VIE (as discussed in the preceding paragraph) if other parties have rights or obligations related to the specified asset or to residual cash flows from the specified asset. A separate VIE is deemed to exist for accounting purposes only if essentially all of the assets, liabilities, and equity of the deemed VIE are separate from the overall VIE and specifically identifiable. In other words, essentially none of the returns of the assets of the deemed VIE can be used by the remaining VIE, and essentially none of the liabilities of the deemed VIE are payable from the assets of the remaining VIE.
7.1
Interpretative guidance
Portions of entities such as divisions, departments and branches of an entity generally are not considered separate entities for purposes of applying the provisions of the Variable Interest Model (see Interpretative guidance and Questions in Chapter 4). However, as noted above, the Variable Interest Model does provide that an enterprise with a variable interest in specified assets of a VIE should consider those assets, and related liabilities, as a distinct VIE (known as a silo) that is separate from the larger host VIE, if the specified assets (and related credit enhancements, if any) are essentially the only source of payment for specified liabilities or other specified variable interests (e.g., fixed price purchase options, residual value guarantees). Determining whether a silo exists directly affects the conclusion as to (1) whether the entity is a VIE and (2) who should consolidate which portion of the VIE. When a silo exists, the expected losses and expected residual returns of the silo are not considered in the calculation of expected losses of the host entity for purposes of determining the sufficiency of the hosts equity investment at risk, even if that silo has no primary beneficiary (see Interpretative guidance and Questions in Chapter 9). Although this is a similar concept to the provisions of the Variable Interest Model related to variable interests in specified assets (see Interpretative guidance and Questions in Chapter 8), all of the expected losses and expected residual returns absorbed or received by the variable interests in the silo are excluded from the host entitys expected losses and expected residual returns.
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If it is determined that after excluding expected losses absorbed by variable interests in one or more silos (and specified assets, if applicable), the host entitys equity investment at risk is sufficient to absorb the remaining expected losses so that the entity is not a VIE (assuming the other criteria also have been met see the Interpretative guidance and Questions in Chapter 9), the entity as a whole would be considered a voting interest entity, and no variable interest holder should separately consolidate the silo. Conversely, a silo can be consolidated separately from the host entity when the host entity is a VIE. If the host entity is a VIE (VIE host), a silo should not be evaluated for consolidation by the VIE hosts variable interest holders. Without requiring a silo to be separated from the VIE host, the same assets and liabilities would be consolidated by two parties, which the FASB believes is an undesirable outcome. If it is determined that the host entity is a VIE, then each portion (i.e., the VIE host and the silo) should be evaluated separately for consolidation. In considering whether an enterprise should consolidate a silo, the variable interest holder should determine whether it has (1) the power to direct activities of a silo that most significantly impact the economic performance of the silo and (2) the obligation to absorb losses of the silo that could potentially be significant to the silo or the right to receive benefits from the silo that could potentially be significant to the silo. That party (if any) should consolidate the silo as its primary beneficiary. A silo is not required to have a primary beneficiary in order to be excluded from the VIE host entity.
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For example, assume an asset is financed with nonrecourse debt representing 95% or more of the assets fair value, and the asset is leased to a lessee under a lease containing a fixed price purchase option (such that the lessee receives essentially all returns associated with increases in the value of the leased asset). In this example, we believe that asset would represent a silo. However, consider the same example (inclusive of the fixed price purchase option), except the asset is financed with nonrecourse debt representing 94% of the assets fair value. In that circumstance, we do not believe that essentially all of the leased asset and related obligations would be economically separate from the host entity. Therefore, no silo exists. A silo is present, and variable interest holders in the silo must consider if they should consolidate the silo as its primary beneficiary, only when the host entity (after all assets, liabilities and equity of the silo are excluded from the analysis) is determined to be a VIE. If only a shell entity remains after all silos are removed, then careful consideration of criteria for determining whether an entity is a VIE is required to determine whether the shell entity, exclusive of the activity in the silos, is a VIE. If the remaining entity is not a VIE, then neither the host entity nor the silo should be evaluated for potential consolidation pursuant to the Variable Interest Model. Illustration 7-1: Example 1 Facts Company A, Company B and Company C each lease separate buildings that are owned by an entity. Each lessee provides a first dollar risk of loss residual value guarantee on the building it leases, and the entity has debt that is cross-collateralized by the three buildings (i.e., all three of the buildings support repayment of the debt). Analysis In this example, no silos exist. Each asset is not essentially the only source of payment for the entitys debt (all three buildings are), and other variable interest holders (outside of Company A, Company B and Company C) of the entity will receive returns associated with increases in the value of the buildings. Example 2 Facts Assume a lessor entitys balance sheet is as follows (on a fair value basis):
Assets Cash Building A (leased to Company A) Building B (leased to Company B) Total assets $ $ 20 120 100 240 Liabilities and equity Debt (recourse only to Building A) Debt (recourse only to Building B) Equity Total liabilities and equity $ $ 120 50 70 240
Silo identification
Additionally, Company A has a fixed price purchase option that allows it to purchase Building A for $120. No such option exists for Building B.
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Analysis In this example, a silo exists for Building A. The building has been wholly financed with nonrecourse debt such that all losses associated with decreases in the value of the building are attributable to the lender (i.e., none of the liabilities of silo are payable from the assets of the remaining entity). Additionally, all returns created by an increase in the value of the building will inure to Company A through the exercise of the fixed price purchase option (i.e., if the building appreciates in value, Company A, and not the host lessor entitys variable interest holders, will receive this benefit). No silo exists for Building B because, although there is debt that is recourse only to the building, the debt constitutes only 50% of the buildings fair value, with the remaining fair value supported by equity that also supports the host entitys other assets. Additionally, the equity holders receive any returns resulting from an increase in the value of Building B. Example 3 Facts Assume a lessor entity owns three buildings. Each building is separately leased to an unrelated third party (Company A, Company B and Company C, respectively). Each lease contains a $100 fixed-price purchase option and provides a first dollar risk of loss residual value guarantee of $85 to the lessor. The lessors balance sheet looks as follows at the inception of the leasing arrangements (on a fair value basis):
Assets Building A (leased to Company A) Building B (leased to Company B) Building C (leased to Company C) Total assets $ $ 100 100 100 300 Equity Total liabilities and equity $ 10 300 Liabilities and equity Debt (Recourse to the Entity) $ 290
Analysis In this example, no silos exist. Although the lease agreements of Company A, Company B and Company C each contain a residual value guarantee and fixed price purchase option that result in losses being absorbed by, and returns received by, each lessee, each asset is not essentially the only source of payment for the VIEs debt (the debt is cross-collateralized by all three buildings). Accordingly, essentially all of the assets and liabilities of any potential silo are not economically separate from the host entity. Example 4 Facts Assume a lessor entity owns three buildings. Each building is separately leased to an unrelated third party (Company A, Company B and Company C, respectively). Each lease contains a $100 fixed price purchase option and provides a first dollar risk of loss residual value guarantee of $85 to the lessor. The lessors balance sheet is as follows at the inception of the leasing arrangements (on a fair value basis):
Assets Building A (leased to Company A) Building B (leased to Company B) Building C (leased to Company C) Total assets $ $ 100 100 100 300 Liabilities and equity Nonrecourse Debt Building A Nonrecourse Debt Building B Nonrecourse Debt Building C Equity (non-targeted) Total liabilities and equity $ $ 96 96 96 12 300
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Analysis In this example, three separate silos exist. Each silo consists of a building, its related nonrecourse debt and a pro rata allocation of the lessors equity because essentially all of each specified asset (the building) and its related specified liability (the nonrecourse debt) or other variable interests (the lessees residual value guarantees and fixed price purchase options) are economically separate from the remaining entity. Additionally, essentially none of the returns of each building can be used by the remaining entity and essentially none of each debt interest is payable from the assets of the remaining entity. Although the non-targeted equity has losses and returns from all three buildings and looks to all three assets for its return, the amount of the interest is not deemed significant enough to prevent the entity from being carved up into three separate silos. The same conclusion would be reached even if no equity existed and instead the $12 was financed with recourse debt. Example 5 Facts Assume a lessor entity owns three buildings. Each building is separately leased to an unrelated third party (Company A, Company B and Company C, respectively). Each lease contains a $100 fixed price purchase option and provides a first dollar risk of loss residual value guarantee of $85 to the lessor. Additionally, the lessee of Building A made a $6 pre-payment of rent at inception of the leasing arrangement. The lessors balance sheet looks as follows at the inception of the leasing arrangements (on a fair value basis):
Assets Cash Building A (leased to Company A) Building B (leased to Company B) Building C (leased to Company C) Total assets $ $ 6 100 100 100 306 Liabilities and equity Nonrecourse Debt Building A Nonrecourse Debt Building B Nonrecourse Debt Building C Deferred Revenue Building A Equity (non-targeted) Total liabilities and equity $ $ 94 94 94 6 18 306
Analysis In this example, no silo exists for Building B or Building C because less than essentially all of the fair value of the specified assets (the buildings) is economically separate from the remaining entity. Rather, each building has been financed partially on a nonrecourse basis, and a sufficient amount of losses inure to the entitys equity interest holder, whose interest is not targeted to specific assets of the entity (i.e., the specified liabilities for Building B and Building C are less than 95%). However, Company A would evaluate Building A as a separate silo. The $6 rent prepayment made by Company A represents a liability of the lessor entity that can be recovered by Company A only through the use of the leased asset. Accordingly, essentially all (nonrecourse debt holder that financed Building A and the deferred revenue relating to the rent prepayment) of the losses and returns of Building A relate to or inure to a specified liability or other variable interest of the lessor entity. In other words, none of the returns of Building A can be used by the remaining entity and essentially none of the nonrecourse debt and deferred revenue for Building A is payable from the assets of the remaining host entity). We believe structuring fees paid to the lessor entity or directly to the lessor entitys equity holder should be evaluated similarly to prepaid rent.
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Effect of silos on the host entitys expected losses and expected residual returns
Question 7.2 How does a silo affect the calculation of the larger host entitys expected losses and expected residual returns? All of the expected losses and expected residual returns attributable to variable interest holders in the silo should be excluded from the expected losses and expected residual returns of the host entity, even if that silo has no primary beneficiary. If it is determined that, after excluding expected losses from variable interests in specified assets (see the Interpretative guidance and Questions in Chapter 8) and silos, the host entitys equity investment at risk is sufficient to absorb the entitys remaining expected losses, and the entity is not otherwise a VIE, then a silo does need not to be evaluated separately for consolidation by a variable interest holder in the silo. A silo can be consolidated separately only when the host entity is a VIE. Illustration 7-2: Facts Lease Co.s balance sheet is as follows (on a fair value basis):
Assets Cash Building A (leased to Company A) Building B (leased to Company B) Total assets $ $ 5 120 100 225 Liabilities and equity Debt (recourse only to Building A) Debt (recourse only to Building B) Equity Total liabilities and equity $ $ 100 97 28 225
Effect of silos on the host entitys expected losses and expected residual returns
Building A is leased under an operating lease that does not include a residual value guarantee, fixed price purchase option or other features. Building Bs lease terms include a fixed price purchase option whereby Company B can acquire the building from Lease Co. for $100. Assume expected losses of the entity are $65. Further assume that expected losses relating to Building A are $20, of which $4 are absorbed by the lender and $16 by Lease Co.s equity holder. Expected losses relating to Building B are $45, of which $43 are absorbed by the lender and $2 are absorbed by Lease Co.s equity holder. Analysis Building A is not a silo because nonrecourse debt represents less than essentially all of Building As financing ($100 debt/$120 asset value = 83%, which is less than 95%), and its returns inure to Lease Co.s equity holder. That is, essentially all of Building A, its specified liabilities and its other specified interests are not economically separate from the overall entity. Building B is a silo because nonrecourse debt represents essentially all of Building Bs financing ($97 debt/$100 asset value = 97%, which is 95% or more), and all of the returns associated with the building inure to the lessee, Company B, due to the fixed-price purchase option in the lease. In other words, none of the returns of Building B can be used by the remaining entity and essentially none of the nonrecourse debt for Building B is payable from the assets of the remaining entity. The amount of Lease Co.s equity investment at-risk equity for purposes of determining if the entity is a VIE is $25. The amount of equity at risk excludes equity amounts relating to the Building B silo of $3. This amount is subtracted from the equity of the host entity to arrive at the amount of equity investment at risk.
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Expected losses of the entity for purposes of determining the sufficiency of Lease Co.s equity investment at risk are $20. This amount is derived from the total expected losses of the entity of $65. All expected losses relating to the Building B silo ($45) are subtracted from this amount. Accordingly, Lease Co.s equity investment at risk of $25 is sufficient.
Company A has a fixed price purchase option to acquire Building A from Lease Co. for $120. Building Bs lease terms do not include a residual value guarantee, fixed price purchase option or other features. Building Cs lease terms include a fixed price purchase option whereby Company C can acquire the building from Lease Co. for $100.
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Analysis In this example, Building A is not a silo, because the specified assets and liabilities are not economically separate. To illustrate, even though all returns inure to Company A due to the fixed price purchase option in the lease, the building has been financed less than 95% with nonrecourse debt ($100 debt/$120 asset value = 83%). Additionally, Building B is not a silo even though it has been financed in its entirety with nonrecourse financing, because its returns inure to Lease Co.s equity holder. However, Building C does represent a silo, because it and its specified liabilities are economically separate from the remaining entitys assets, liabilities and equity. To illustrate, Building C has been financed with 97% nonrecourse financing ($97 debt divided by $100 asset value = 97%), and all of the returns associated with the building inure to the lessee, Company C, because of the fixed price purchase option in the lease. In other words, none of the returns of Building C can be used by the remaining entity and essentially none of the nonrecourse debt for Building C is payable from the assets of the remaining entity. Total assets of the entity, less the fair value of Building C (the silo asset), are $225 ($325 less the $100 fair value of Building C). As Building B represents less than half of these assets ($100 of $225), the Building B lender has a variable interest in Building B, only, and not a variable interest in the Lease Co. host entity as a whole. However, since Building A represents more than half of the fair value of the assets of the entity (excluding Building C), Company As and the lenders variable interests in Building A (based on the fixed price purchase option and the nonrecourse loan, respectively) are variable interests in the Lease Co. host entity as a whole. If Lease Co. is a VIE, each should consider whether it should consolidate the entity (exclusive of Building C, the related $97 nonrecourse debt and $3 of equity that comprise the silo) as the primary beneficiary.
Can silo assets be greater than 50% of the fair value of a VIEs total assets?
Question 7.5 Assume a variable interest in specified assets is a variable interest in the entity as a whole (because the fair value of the specified assets of a VIE are greater than 50% of the fair value of the entitys total assets). Can such assets also represent a silo? How should the provisions of the Variable Interest Model be applied in this example? When evaluating an entity to determine if it is a VIE, an enterprise first should determine whether any silos are present. If silos exist, these should be evaluated for consolidation separately from the host entity (if the host entity itself is determined to be a VIE), regardless of their size. A portion of a VIE should be treated as a silo if the specified assets (and related credit enhancements) are essentially the only source of payment for specified liabilities or other variable interests of the VIE, and essentially none of the returns of the assets are available to other variable interest holders in the entity (see Question 7.1). Because the Variable Interest Models provisions treat such assets (and the related liabilities and equity) as a separate entity distinct from the host entity, when such situations exist, it should be evaluated for consolidation as a silo even if the fair value of the silos assets exceed 50% of the fair value of the VIEs total assets.
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Silo asssets greater than 50% of the fair value of the VIEs total assets
Company A has a fixed price purchase option to acquire Building A from Lease Co. for $120. Building Bs lease terms do not include a residual value guarantee, fixed price purchase option or other features. Building Cs lease terms include a fixed price purchase option whereby Company C can acquire the building from Lease Co. for $400. Analysis A determination should be made first as to whether any silos exist in Lease Co. In this example, Building A is not a silo, because while all returns inure to Company A due to the fixed price purchase option in the lease, the building has been financed less than 95% with nonrecourse debt ($100 debt/$120 asset value = 83%). Additionally, Building B is not a silo even though it has been financed in its entirety with nonrecourse financing, because its returns inure to Lease Co.s equity holder. While Company C has a variable interest in specified assets that qualifies as a variable interest in Lease Co. (Building C represents approximately two-thirds of Lease Co.s assets), it is a silo because it has been financed with 97% nonrecourse financing ($388 debt divided by $400 asset value = 97%), and all of the returns associated with the building inure to the lessee, Company C, because of the fixed price purchase option in the lease. In other words, the specified assets and liabilities are economically separate as none of the returns of Building B can be used by the remaining entity and essentially none of the nonrecourse debt for Building B is payable from the assets of the remaining entity. A determination should then be made whether any variable interest holders with interests in specified assets have variable interests in the entity as a whole. The entitys total assets, less the fair value of Building C (because silos are excluded first), are $225 ($625 less the $400 fair value of Building C). As Building B represents less than half of these assets ($100 of $225), the Building B lender has a variable interest in Building B only, and not a variable interest in the Lease Co. host entity as a whole. However, because Building A represents more than half of the fair value of the assets of the entity (excluding Building C), Company As and the lenders variable interests in Building A (based on the fixed price purchase option and the nonrecourse loan, respectively) are variable interests in the Lease Co. host entity as a whole. If Lease Co. is a VIE, Company A, the lender with recourse only to Building A, and the equity holder each should consider whether it should consolidate the entity (exclusive of Building C, the related $388 nonrecourse debt and $12 of equity that comprise the silo) as the primary beneficiary. Additionally, if Lease Co. is a VIE, the Building C silo should be evaluated separately for consolidation by those parties holding variable interests in the silo (Company C, the related lender and the equity holder of Lease Co.).
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Silo not required to have a primary beneficiary to be excluded from host entity
Question 7.6 Must a silo have a primary beneficiary in order for the silos expected losses and expected residual returns to be excluded from the host entity in determining whether the host entity is a VIE? As background, ASC 810-10-25-57 states [i]f one reporting entity is required to consolidate a discrete portion of a VIE, other variable interest holders shall not consider that portion to be part of the larger VIE. That provision was included to preclude two parties from consolidating the same assets, liabilities and equity of a silo. We do not believe that ASC 810-10-25-57 indicates that in determining whether an entity is a VIE, a silo should be excluded from the entity only if the silo has a primary beneficiary. That is, once a silo is determined to exist, the assets, liabilities and equity of the silo and its corresponding expected losses and expected residual returns should be excluded from the larger host entity in applying the Variable Interest Model irrespective of whether there is a primary beneficiary of the silo. Illustration 7-5: Excluding a silos assets, liabilities and equity from the host entity
To illustrate this concept, assume that in addition to other assets it holds, an entity owns a building and leases it to Company A. Company As lease contains a $100 fixed price purchase option. The building leased to Company A was financed entirely through nonrecourse debt funded equally by Lender A and Lender B. Assume the entitys balance sheet at the inception of the leasing arrangement is as follows (on a fair value basis):
Assets Building (leased to Company A) Other assets $ 100 300 Liabilities and equity Nonrecourse Debt Lender A Nonrecourse Debt Lender B Other liabilities Equity Total assets $ 400 Total liabilities and equity $ $ 50 50 280 20 400
In this example, a silo exists because the losses and returns of the building leased to Company A inure to specified liabilities (the nonrecourse debt) or other variable interests (the lessees fixed price purchase option). In other words, the specified assets and liabilities are economically separate as none of the returns of the building can be used by the remaining entity and none of the nonrecourse debt for the building is payable from the assets of the remaining entity. Regardless of whether the silo has a primary beneficiary, the expected losses and expected residual returns related to the silo should be excluded from the larger entity in determining whether the entity is a VIE. If the entity is determined to be a VIE and that entity has a primary beneficiary, we do not believe that primary beneficiary is required to consolidate any silos in the entity (even if those silos do not have a primary beneficiary). Otherwise, the primary beneficiary of the entity would be required to consolidate assets and liabilities in which it may have no economic interest.
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8.1
Interpretative guidance
Situations will exist in which an enterprise holds a variable interest, but the variable interest is related to a specific asset or group of assets of an entity (as opposed to a variable interest in all of the assets of the entity, which is characteristic of an equity holder), and does not have a variable interest in the entity as a whole. For example, assume a VIE has total assets of $1,000,000, $300,000 of which is a machine that is financed with debt. To protect itself against a decline in the value of the equipment, the entity obtains a residual value guarantee on the machine from Company ABC, which guarantees that the machine will be worth at least $200,000 when the debt is due. In this case, Company ABC has a variable interest in a specified asset of the entity, but not in the entity. The Variable Interest Model has special provisions to determine whether an enterprise with a variable interest in specified assets of an entity has a variable interest in the entity as a whole. This determination is important because if a variable interest in specified assets is not considered a variable interest in the entity as a whole, then expected losses related to the variable interests in these specified assets are not considered part of the expected losses of the entity for purposes of determining the adequacy of the equity investment at risk of the entity in the VIE analysis (i.e., any expected losses absorbed by an
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enterprise holding an interest only in specified assets of the entity do not have to be supported by the atrisk equity holders of the entity). If a party has only a variable interest in specified assets of a VIE but does not have a variable interest in the VIE as a whole, it cannot be required to consolidate the VIE. A variable interest in specified assets of an entity is a variable interest in the entity as a whole only if the fair value of the specified assets is more than half of the total fair value of the entitys assets, or if the holder has another variable interest in the entity as a whole. Using the previous example, Company ABC would not have a variable interest in the entity as a whole because it has an interest in a specified asset (i.e., the machine that has a value of $300,000) that is less than half of the total fair value of the VIEs assets ($1 million). With no variable interest in the VIE, Company ABC cannot be required to consolidate it. Additionally, expected losses and expected residual returns related to the variable interest in the machine should not be considered part of the expected losses and expected residual returns of the entity for purposes of determining the sufficiency of the equity investment at risk. We believe that in determining whether the asset with a specified interest in it is worth more or less than one-half of the assets in the entity, the entire fair value of the asset ($300,000) that the interest relates to, and not the amount of the specific exposure ($200,000), should be used in performing this calculation. ASC 810-10-15-14(a) refers to expected losses of an entity for purposes of determining the sufficiency of the equity investment at risk for the entire entity. The provisions of ASC 810-10-25-55 and 25-56 determine whether expected losses that will be absorbed by guarantees or other variable interests in specified assets of the entity are expected losses of the entity for purposes of determining whether an entity has sufficient equity investment at risk. The guidance in ASC 810-10-25-55 and 25-56, therefore, always should be applied before determining whether an entity has a sufficient at-risk equity investment. It should be noted that this provision of the Variable Interest Model is different from the provision relating to silos (see the Interpretative guidance and Questions in Chapter 7 for a discussion of silos). When a silo exists, all of the expected losses and the expected residual returns of the silo are excluded from the calculation of the entitys expected losses and expected residual returns. Additionally, if a silo exists in a larger host entity, we believe the fair value of the silos assets should first be deducted from the fair value of the host entitys total assets before determining whether an enterprise with a variable interest in specified assets of the entity has a variable interest in the host entity as a whole (see Question 7.4).
entity do not have to be supported by the at-risk equity holders of the entity). If a party has only a variable interest in specified assets of an entity, but does not have a variable interest in the entity as a whole, it cannot be required to consolidate the entity under the Variable Interest Model. Illustration 8-1: Facts Assume that an entity with a $50 equity investment at risk acquires two assets, Asset A and Asset B, for use in its operations. The fair value of Asset A is $100. The fair value of Asset B is $300. The fair value of all of the entitys assets is $500. The entity finances the costs of Asset A and Asset B in their entirety with debt from Lender A and Lender B, respectively. The lenders have recourse only to the cash flows generated by Asset A and B, respectively, for payment of the loans and do not have access to the general credit of the entity (i.e., the borrowings are nonrecourse). The expected losses of the entity are $100. The expected losses associated with Asset A are $60. The expected losses associated with Asset B are $30. All expected losses associated with Asset A and Asset B will be absorbed by the lenders. Analysis In this example, Lender A does not have a variable interest in the entity, because the fair value of the asset (Asset A) in which it has a variable interest is less than half of the fair value of the total assets of the entity ($100/$500 = 20%). However, Lender B does have a variable interest in the entity because the fair value of the asset (Asset B) in which it has a variable interest is more than half of the fair value of the total assets of the entity ($300/$500 = 60%). The expected losses of the entity for purposes of evaluating the sufficiency of the entitys equity investment at risk equity are $40 ($100 expected losses of the entity as a whole, less expected losses of $60 relating to Asset A which will be absorbed by Lender A). Accordingly, this entity would have sufficient equity because its $50 equity investment at risk exceeds its expected losses of $40. When determining whether an asset with a specified interest in it is worth more or less than one-half of the total fair value of the entitys assets, the entire fair value of the asset should be used (and not the amount of the specific exposure) in performing this calculation. For example, if an enterprise guaranteed that an entitys asset with a fair value of $500,000 would be worth at least $250,000 at a future date, when determining if the guarantor has an interest in the entity as a whole, the entire fair value of the asset (i.e., $500,000) should be used and not the value of the guarantee. Additionally, we believe that it is appropriate for enterprises holding variable interests in an entitys assets to determine whether the variable interests represent a variable interest in the entity as a whole, or only in the specified assets, based on the aggregate value of the assets in which it holds a variable interest. For example, if a VIE holds four assets that are valued at a total of approximately $20 million and one enterprise has three separate interests in three of the four assets, the enterprise should aggregate those three assets for purposes of determining if the assets in which it holds variable interests comprise greater than half of the fair value of the entitys total assets. If the aggregate fair value of the three assets is less than $10 million, the enterprise would not have a variable interest in the entity. However, if the aggregate fair value of the three assets exceeds $10 million, the enterprise would be deemed to have a variable interest in the entity as a whole. Interests in specified assets
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The provisions of ASC 810-10-25-55 and 25-56 should be applied to determine whether expected losses that will be absorbed by variable interests in specified assets of the entity are expected losses of the entity for purposes of determining whether an entity has sufficient equity investment at risk. The guidance in ASC 810-10-25-55 and 25-56, therefore, should always be applied before evaluating whether an entity has a sufficient at-risk equity investment when determining whether the entity is a VIE.
Illustrative example
Question 8.2 Illustrative example The following illustrates how an interest in specified assets of an entity affects the calculation of an entitys expected losses: Illustration 8-2: Facts Company A guarantees the collection of $750 of a $1,000 receivable held by an entity. The entitys total assets are $2,200. Company A has a variable interest in a specified asset of the entity (the receivable), and that asset is less than half of the total fair value of the entitys assets. Because Company A has no other interests in the entity as a whole, the expected losses related to the guarantee are not considered part of the expected losses of the entity for purposes of determining the sufficiency of the equity at risk in the entity. The expected losses and expected residual returns on that $1,000 receivable are as follows (assume all amounts are at present value):
Possible outcome 1 2 3 Estimated cash flows (a) $ 1,000 800 400 Probability (b) 50% 35% 15% $ Expected cash flows (a)*(b)=c $ 500 280 60 840 $ Expected losses (((a)-$840)*b) $ 14 66 80 $ Expected residual returns (($840-a)*b) $ 80 80
Analysis In this example, the guarantee absorbs a portion of the expected loss generated by the potential outcome in which the cash flow to be received is less than $750 (assume that the guarantee absorbs $45 of the $66 expected loss when the outcome is $400). Expected losses from all possible outcomes and the difference between $45 (expected losses absorbed by the guarantor associated with possible outcome 3) and the risk that the guarantor does not perform when called upon should be included in the entitys expected losses. For example, if based on the guarantors credit risk, it was determined that the guarantor could absorb only $43 of the expected losses, only $43 would be excluded in computing the entitys expected losses (see Question 10.12). Assume that the expected losses on the other assets in the entity are $250. The determination of the adequacy of the equity investment at risk would be performed as follows:
Total entity expected losses Less: Expected losses on variable interest in specified asset Entitys expected losses $ $ 33016 43 287
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Expected losses on receivables ($80) plus expected losses assumed on other assets ($250). 117
If the equity investment at risk exceeds $287, the equity investment would be deemed sufficient and, assuming the other criteria are met, the entity would not be considered a VIE. Conversely, if the equity investment at risk is less than $287, the entity is a VIE. The expected losses actually absorbed by the guarantors variable interest should be computed based on its allocated cash flows and the fair value of its variable interest, and that amount should be excluded from the entitys total expected losses (see Interpretative guidance and Questions to Chapter 10). It should be noted that the provisions relating to interests in specified assets are different from the provisions relating to silos (see the Interpretative guidance and Questions to Chapter 7 for a discussion of silos). When a silo exists, all of the expected losses and the expected residual returns of the silo are excluded from the analysis of the entitys expected losses and expected residual returns.
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4.
Paragraphs 810-10-25-45 through 25-47 discuss the amount of the total equity investment at risk that is necessary to permit a legal entity to finance its activities without additional subordinated financial support. b. As a group the holders of the equity investment at risk lack any one of the following three characteristics: 1. The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entitys economic performance. The investors do not have that power through voting rights or similar rights if no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation or a general partner in a
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partnership). Legal entities that are not controlled by the holder of a majority voting interest because of noncontrolling shareholder veto rights as discussed in paragraphs 810-10-25-2 through 25-14 are not VIEs if the shareholders as a group have the power to control the entity and the equity investment meets the other requirements of the Variable Interest Entities Subsections. Kick-out rights or participating rights held by the holders of the equity investment at risk shall not prevent interests other than the equity investment from having this characteristic unless a single equity holder (including its related parties and de facto agents) has the unilateral ability to exercise such rights. Alternatively, interests other than the equity investment at risk that provide the holders of those interests with kick-out rights or participating rights shall not prevent the equity holders from having this characteristic unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those rights. A decision maker also shall not prevent the equity holders from having this characteristic unless the fees paid to the decision maker represent a variable interest based on paragraphs 810-10-55-37 through 55-38. 2. The obligation to absorb the expected losses of the legal entity. The investor or investors do not have that obligation if they are directly or indirectly protected from the expected losses or are guaranteed a return by the legal entity itself or by other parties involved with the legal entity. See paragraphs 810-10-25-55 through 25-56 and Example 1 (see paragraph 81010-55-42) for a discussion of expected losses. The right to receive the expected residual returns of the legal entity. The investors do not have that right if their return is capped by the legal entitys governing documents or arrangements with other variable interest holders or the legal entity. For this purpose, the return to equity investors is not considered to be capped by the existence of outstanding stock options, convertible debt, or similar interests because if the options in those instruments are exercised, the holders will become additional equity investors.
3.
If interests other than the equity investment at risk provide the holders of that investment with these characteristics or if interests other than the equity investment at risk prevent the equity holders from having these characteristics, the entity is a VIE. c. The equity investors as a group also are considered to lack the characteristic in (b)(1) if both of the following conditions are present: 1. The voting rights of some investors are not proportional to their obligations to absorb the expected losses of the legal entity, their rights to receive the expected residual returns of the legal entity, or both. Substantially all of the legal entitys activities (for example, providing financing or buying assets) either involve or are conducted on behalf of an investor that has disproportionately few voting rights. This provision is necessary to prevent a primary beneficiary from avoiding consolidation of a VIE by organizing the legal entity with nonsubstantive voting interests. Activities that involve or are conducted on behalf of the related parties of an investor with disproportionately few voting rights shall be treated as if they involve or are conducted on behalf of that investor. The term related parties in this paragraph refers to all parties identified in paragraph 810-10-25-43, except for de facto agents under paragraph 810-10-25-43(d).
2.
For purposes of applying this requirement, reporting entities shall consider each partys obligations to absorb expected losses and rights to receive expected residual returns related to all of that partys interests in the legal entity and not only to its equity investment at risk.
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Enterprises should apply the Variable Interest Model to involvements with other entities to determine if they have a variable interest in an entity. (Refer to Chapters 5-8 for Interpretative guidance and Questions.) If so, the Variable Interest Model is applied to determine whether the entity with which it is involved is a VIE or a voting interest entity. The Variable Interest Model provides the criteria for determining whether an entity with which an enterprise is involved is a VIE. If an entity is a VIE, then an enterprise will evaluate the entity for consolidation using the provisions of the Variable Interest Model. If an enterprise does not have a variable interest in an entity, the enterprise should account for its interest in accordance with other literature.
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While there may not be substantive economic differences between an entity that is capitalized with equity and an entity that is capitalized solely with subordinated debt (because in both situations the residual holder absorbs the first dollar risk of loss), the Variable Interest Model indicates the form of the instrument is determinative, and to be an equity investment, the interest must be recorded as GAAP equity in that entitys financial statements, even if all of the entitys expected losses will be absorbed by the equity holders through other instruments. For purposes of the sufficiency test, an equity investment at risk does not include amounts provided to the equity investor directly or indirectly by the entity or by other parties involved with the entity, unless the provider is a parent, subsidiary or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor. An equity investment obtained directly or indirectly through fees or charitable contributions should not be included in the equity sufficiency test because it is not considered at risk. For example, in a lease transaction, fees paid by the lessee to the owners of an entity (e.g., structuring or administrative fees) are considered a return of the owners equity investment at risk for purposes of evaluating the sufficiency of equity in the entity. The application of this criteria could have a significant impact in determining whether an entity is a VIE. For example, assume Company C and Developer B form a partnership by contributing $80 and $20, respectively. Company C and Developer B have voting and economic interests of 80% and 20%, respectively. Further assume that Developer B receives a development fee of $25 from the partnership. Expected losses of the entity are determined to be $50. In this case, the developers equity investment at risk ($20) should be reduced by the fee ($25) it received and thus Developer B does not have an equity investment at risk. Determining whether a party to the transaction has an equity investment at risk directly impacts whether the entity is a VIE. Using the previous example, while the resulting equity investment at risk is greater than the entitys expected losses, we believe the entity likely will be a VIE. Although the entity has sufficient equity, the Variable Interest Model requires the holders of the equity investments at risk to absorb the expected losses of the entity. Those equity holders cannot be indirectly protected from absorbing the first dollar risk of loss in the entity. In this example, we believe Company C, the holder of the equity investment at risk, will not absorb all of the expected losses of the entity as they occur, because 20% of losses are allocable to Developer B, and for purposes of evaluating whether the entity is a VIE, Developer B is not a holder of an equity investment at risk because its capital account should be reduced by the development fee paid to it. As such, the entity is a VIE. The Variable Interest Model provides that the equity investment at risk cannot be financed for the equity investor directly by the entity or by parties involved with the entity, unless that party is a parent, subsidiary or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor. We believe that, in general, an equity holder may finance its equity investment or enter into other risk management arrangements provided such arrangements are with parties that have no involvement with the entity. In these situations, however, the transactions structure should be evaluated to ensure the equity investor is not merely acting as an agent for another party (the principal lender, guarantor, etc.), in which case, the equity interest should be attributed to the principal.
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c.
810-10-25-46 Some legal entities may require an equity investment at risk greater than 10 percent of their assets to finance their activities, especially if they engage in high-risk activities, hold high-risk assets, or have exposure to risks that are not reflected in the reported amounts of the legal entities assets or liabilities. The presumption in the preceding paragraph does not relieve a reporting entity of its responsibility to determine whether a particular legal entity with which the reporting entity is involved needs an equity investment at risk greater than 10 percent of its assets in order to finance its activities without subordinated financial support in addition to the equity investment. 810-10-25-47 The design of the legal entity (for example, its capital structure) and the apparent intentions of the parties that created the legal entity are important qualitative considerations, as are ratings of its outstanding debt (if any), the interest rates, and other terms of its financing arrangements. Often, no single factor will be conclusive and the determination will be based on the preponderance of evidence. For example, if a legal entity does not have a limited life and tightly constrained activities, if there are no unusual arrangements that appear designed to provide subordinated financial support, if its equity interests do not appear designed to require other subordinated financial support, and if the entity has been able to obtain commercial financing arrangements on customary terms, the equity would be expected to be sufficient. In contrast, if a legal entity has a very small equity investment relative to other entities with similar activities and has outstanding subordinated debt that obviously is effectively a replacement for an additional equity investment, the equity would not be expected to be sufficient.
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Because precisely estimating expected losses may be difficult, and an entity may need an equity investment at risk greater than its expected losses, the FASB established a presumption that an equity investment is insufficient to allow an entity to finance its activities unless the investment is equal to at least 10% of the fair value of the entitys total assets. We believe that the main reason for this presumption was to emphasize that the consolidation principles prior to the development of the Variable Interest Model, which focused on a 3% equity presumption, were superseded. Under the Variable Interest Model, an equity investment as small as 3% may be insufficient for many variable interest entities. The FASBs preferred methods of overcoming the 10% presumption are to demonstrate the sufficiency of the invested equity at risk by (a) obtaining financing without additional subordinated financial support or (b) referring to the equity invested in another similar entity with similar assets, liabilities and other interests that has financed itself without additional subordinated financial support. It may be difficult for any entity that does not have a relatively simple capital structure to objectively demonstrate that it can finance its activities without additional subordinated financial support. That is, an entity capitalized with multiple classes of debt having different priorities generally would not be able to demonstrate it can finance its activities without additional subordinated financial support because it generally would be unclear that the equity investment at risk is sufficient to absorb the entitys expected losses. Additionally, we believe that it generally will be difficult for most entities to find comparably sized entities that have similar assets, liabilities and other interests that have financed their operations without additional subordinated financial support, and thus meet the ASC 810-10-25-45(b) criterion, because in many cases enterprises will not have enough detailed information about other entities to assess comparability. Accordingly, we believe that many enterprises will default to assessing the sufficiency of at-risk equity through the ASC 810-10-25-45(c) quantitative analysis. To illustrate how an equity investment can be demonstrated to be sufficient, consider a real estate partnership that operates a property. The partnerships initial equity investment is 30% of the assets value. If the partnership was able to obtain market rate, nonrecourse financing for 70% of the propertys value, we believe that, in general, the entity would be able to demonstrate that it can finance its activities without additional financial support (and satisfy the ASC 810-10-25-45(a) criterion). If, however, the entity was able to obtain nonrecourse financing for only 60% of the propertys value, and the partnership obtained subordinated financing from a separate lender for 10% of the propertys value, we do not believe that the entity would have demonstrated that it has sufficient equity by showing that it can finance its activities without additional financial support. Because it was required to issue subordinated debt in order to obtain the senior financing that was used to carry out its principal activities, it is unclear whether the subordinated debt is absorbing expected losses. In that case, if it was unable to find a comparable entity that operates with no additional financial support (the criterion in ASC 810-10-25-45(b)), the partnerships expected losses could be calculated (see the Questions in Chapter 10 for a discussion of how to compute expected losses) based on reasonable quantitative evidence and compared to the amount of the equity investment at risk to demonstrate the equitys sufficiency (ASC 810-10-25-45(c) criterion). The FASB intends the 10% presumption to apply in one direction only. That is, an equity investment of less than 10% is presumed to be insufficient, but an equity investment of 10% or more is not presumed to be sufficient. Because less than a 10% equity investment at risk is presumed to be insufficient, and the Variable Interest model specifies that an equity investment of 10% or greater does not relieve an enterprise of its responsibility to determine whether it requires a greater equity investment, we do not believe that the 10% presumption is relevant. Rather, we believe that the sufficiency of an enterprises equity investment at risk must be demonstrated in all cases through one of the three methods specified in ASC 810-10-25-45.
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Certain forms of perpetual preferred stock, if they significantly participate in the profits and losses of the entity Voting and nonvoting Participating and nonparticipating Convertible and nonconvertible
Preferred stock classified in temporary equity (e.g., because the preferred stock is redeemable upon the occurrence of an event that is not solely under the entitys control, such as a change in control provision) pursuant to ASR 268 Warrants to purchase equity interests LLC member interests General partnership interests Limited partnership interests Certain trust beneficial interests
Although all of the interests noted previously may be reported as equity in the GAAP equity section of the entitys balance sheet, the features of each equity interest must be carefully evaluated to ensure that that they do not include those features that may indicate the equity interest is not at risk, as described in ASC 810-10-15-14(a).
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Determining the fair value of an entitys equity for purposes of assessing the sufficiency of its equity investment at risk may require the use of valuation techniques and the assistance of a valuation professional.
Judgment will be required to determine whether a potential loss in value or participation in the entitys profits is significant. The determination should take into account all relevant facts and circumstances, including the nature of the instrument (e.g., preferred or common stock), the size of the potential losses relative to its fair value when acquired, and the nature of the entitys assets, among other items. Many entities are capitalized with preferred stock bearing a stated dividend rate. The stocks dividend rate should be evaluated to determine whether it permits significant participation in the entitys profits. Determining whether preferred stockholders significantly participate in profits will be based on the facts and circumstances and require the use of professional judgment, but if the fixed coupon of a preferred stock provides a debt-like return, then the preferred stock would not be considered an equity investment at risk. However, if the return is equity-like, then it would be considered to participate significantly in the entitys profits. For example, if the operations of the entity are anticipated to generate a return of 15% in total on amounts invested, and a preferred investor is entitled to a yield of 10% on its investment, that return generally would be deemed to participate significantly in profits. However, if the total return is anticipated to be 40% and a preferred investor is entitled to a yield of only 6% on its investment, that return generally would be more characteristic of a debt-like return, and the preferred stock would not be deemed to participate significantly in profits.
An enterprise makes an equity investment of $10 million in a VIE. It forms a second entity and contributes the investment in the first VIE in exchange for all of the second entitys equity interests. The second entitys expected losses are $8 million. Analysis In this example, the $10 million equity investment in the second entity is not at risk because it has been issued in exchange for a subordinated interest in a VIE. Accordingly, the second entity is a VIE because it has no equity investment at risk. The equity interest has been provided to the equity investor directly or indirectly by the entity or others involved with the entity (e.g., by fees, charitable contributions or other payments). This criterion is not violated, however, if the provider is a related party of the investor and is included in the same set of consolidated financial statements as the investor. Illustration 9-3: Facts Realco, a real estate developer, forms a limited partnership with Investco, a third party investment company. Realco contributes $5 million to the partnership in exchange for a 5% general partnership interest. Investco contributes $95 million in exchange for a 95% limited partnership interest. At its inception, the partnership acquires a plot of land for the development of commercial real estate for $95 million. Additionally, as compensation for certain efforts related to the identification and acquisition of the land and structuring of the partnership, Investco pays a $5 million fee to Realco. Analysis In this example, Realco does not have an equity investment at risk in the partnership because the fees received from Investco must be netted against its investment in the partnership. The equity interest has been financed (e.g., by loans or guarantees of loans) directly by the entity or others involved with the entity, unless financed by a related party included in the same set of consolidated financial statements as the equity investor. Illustration 9-4: Facts Parent forms an entity and capitalizes it with equity of $10 million, which is financed by a third party, Creditco, with debt that has recourse only to Parents investment in the entity. The entity borrows an additional $40 million from Bankco, which is not a related party of Creditco. Analysis Because Parents investment has been financed by a party not involved with the entity, its equity investment is considered at risk. Creditco does not have a variable interest in the entity because Parent was not acting as its agent. Equity investment financed by the entity or others involved with the entity Equity investment provided by the entity or others involved with the entity
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Sweat equity
Question 9(a).9 Are equity interests provided in exchange for services provided or to be provided by an investor (commonly referred to as sweat equity) considered an equity investment at risk? We do not believe that equity interests provided in exchange for services may be considered an equity investment at risk because the entity has provided the investors equity investment through the fees paid in exchange for the services provided, which violates the criterion established in ASC 810-10-15-14. Illustration 9-5: Facts Two oil and gas exploration companies, Oilco and Gasco, form a venture and contribute certain unproven and proven producing oil and gas properties. The two companies agree to provide an interest in the venture to an oilfield services company, Drillco, in exchange for engineering and drilling services provided to the venture. At formation of the venture, the enterprises fair value is $100 million. The equity interests and related fair values of those interests at formation of the venture are as follows:
Ownership% Oilco Gasco Drillco 33.3% 33.3% 33.3% Fair value ($ millions) $ 33.3 33.3 33.3
Sweat equity
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Analysis In this example, the ventures equity investment at risk is $66.6 million (the sum of the equity investments of Oilco and Gasco). Drillcos equity investment is not at risk because it has been provided to Drillco in exchange for services provided to the partnership. Accordingly, the partnership is a VIE because its equity investment at risk ($66.6 million) is insufficient to absorb its expected losses ($70 million). We generally believe equity interests provided in exchange for the contribution of an intangible asset that meets the criteria for the recognition as an asset separate from goodwill pursuant to the provisions of ASC 805 may be considered an equity investment at risk. Illustration 9-6: Facts Two software companies form a partnership and contribute software that each has internally developed for licensing to third parties and cash of $2 million. The software products of each partner, which have complimentary functionality, will be integrated into one product for licensing to third parties. Each software product meets the criteria as an identified intangible asset that could be accounted for separately from goodwill in a purchase business combination pursuant to ASC 805. The carrying value of each partner in its respective software product is minimal. The fair value of each software product contributed is approximately $20 million. The expected losses of the partnership are $30 million. Analysis In this example, the partnerships equity investment at risk is $44 million (the sum of the cash contributed by the partners plus the fair value of the contributed software). Accordingly, the partnership has a sufficient equity investment at risk ($44 million) to absorb its expected losses ($30 million). Equity investment received from the contribution of an intangible asset
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Factors that may indicate that the equity investor is acting as an agent on behalf of another variable interest holder in the entity include: The investor has acted previously as an agent of the lender. Substantially all returns (both profits and losses) inuring to the equity investor are passed through the investor to the lender.
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Analysis At inception of the entity, the developer has an equity investment at risk of $20,000 (the $50,000 it contributed, less the $20,000 received at inception of the entity and the $10,000 present value17 of the $10,500 to be received upon the first anniversary of the entity). The developers equity investment is not reduced by the additional $30,000 that it may receive if the entity realizes an IRR in excess of 15% over five years, because there is substantial uncertainty as to whether such returns will be realized. Additionally, the fees that the developer will receive as the property manager do not reduce its equity investment, because the fees are received in exchange for the provisions of substantive services and reflect a market rate for such services.
At-risk equity group for equity sufficiency test is used to determine if the at-risk equity group has power
Question 9(a).13 Are the investors identified as having an equity investment at risk for purposes of applying ASC 81010-15-14(a) the same equity investors that should be used for purposes of applying ASC 810-10-1514(b)? Yes. Holders of equity investments not determined to be at risk for the purposes of evaluating the sufficiency of equity should not be considered holders of an equity investment for purposes of determining if the equity holders have the power to direct the activities of the entity that most significantly impact the entitys economic performance. This could result in an entity being a VIE. Illustration 9-10: Facts A real estate developer forms a limited partnership for the development of commercial real estate. Independent investors contribute at-risk equity equal to 95% of the entitys capitalization in exchange for limited partnership interests. The real estate developer contributes equity equal to 5% of the entitys capitalization in exchange for the general partnership interest. At formation of the limited partnership, the developer is paid a development fee equal to 6% of the entitys total capitalization. The fee is netted against the developers equity investment, reducing it to zero. Accordingly, the developer does not have an equity investment at risk. Analysis Assuming that the remaining equity contributions of the limited partners are deemed to be at risk, it is likely that the partnership has a sufficient equity investment at risk to absorb its expected losses. However, the entity is a VIE because the holders of the equity investment at risk (i.e., the limited partners) lack the power to direct the activities of the entity that most significantly impact the entitys economic performance, violating the provisions of ASC 810-10-15-14(b)(1). That is, the general partner makes all substantive decisions for the partnership, and the general partner does not have an equity investment at risk. Accordingly, the partnership would be a VIE. At-risk equity group for equity sufficiency test and group for power test
17
Although Option 2s premium is at fair value, it includes a financing element of $20, representing the amount that the option is in-the-money at its inception. Consequently, we believe the equity investor that wrote the call option should reduce its equity investment at risk by at least $20 (the facts and circumstances may indicate a higher amount may be warranted). A consequence of such a reduction is that the entity may be a VIE because a portion of the investors equity investment that is not at risk will absorb the entitys expected losses, thus violating the requirement that an entitys equity investment at risk absorb the first dollar risk of loss (see the Interpretative guidance and Questions regarding this concept later in this chapter). Additionally, such a reduction could affect the sufficiency of equity test. All of the relevant facts and circumstances should be considered in determining whether a portion of an investors equity investment is at risk, particularly when other transactions among the variable interest holders have occurred.
18
Although Section 29 credits also subsidize other alternative energy sources, this Question focuses on structures used to invest in tax credits arising from the production and sale of coal-based synthetic fuel. Section 29 credits are available for coal-based synthetic fuels produced and sold through 31 December 2007. Generally, this is demonstrated through testing performed by independent laboratories and chemists. 134
19 20
Investors in a synthetic fuel tax credit facility generally receive their returns from a combination of (1) realization of tax credits, (2) deductions for operating losses and (3) depreciation of the synthetic fuel production equipment. Structures used to facilitate investments in synthetic fuel tax credit facilities are usually established as limited partnerships or limited liability companies that pass the tax benefits associated with the entitys production of synthetic fuel directly to the investors. This structure enables a taxpayer to receive credits in proportion to its ownership in the facility while providing some limitation on liability, particularly if the taxpayer is a limited partner or a non-managing member of an LLC. Investors in a synthetic fuel facility may purchase an interest in the entity from a co-investor for a relatively small initial cash payment and contingent consideration based on the amount of tax credits generated by the facility (an earn-out). Operations of synthetic fuel production facilities usually result in operating losses that the investors must fund through ongoing capital contributions, regardless of their ability to utilize the tax credits. We believe that, qualitatively, a typical synthetic fuel structure will be a VIE because the investors generally fund operating losses through ongoing capital contributions. As discussed in the response to Question 9(a).3, a commitment to fund losses is not reported as equity in the GAAP balance sheet of the entity under evaluation. Consequently, the commitment to fund losses cannot be considered an equity investment at risk for purposes of determining whether the entity has sufficient equity. We believe that a synthetic fuel structure that has an insufficient amount of equity at the evaluation date to fund its future operating losses will be a VIE even if, quantitatively, the fair value of the entitys equity investment at risk exceeds the entitys expected losses (see Question 10.14 for our views on including the investors tax benefits in the calculation of expected losses). We understand the SEC staff shares this view.
135
Manufacturer X sells a product to Entity 1 for $100. Entity 1 was capitalized by issuing equity ($10) and debt ($90) to Equity Provider and Lender, respectively. Manufacturer X writes a put option so that Entity 1 may put the equity to Manufacturer X for $10 at a future date. The transaction is demonstrated pictorially as follows:
Lender
$90 Entity1
Analysis We believe the equity investment is not at risk because it does not participate significantly in losses of the entity. Accordingly, because there is no equity investment at risk, the entity would be a VIE. Additional Facts Further assume Manufacturer X entered into the same guarantee arrangement at inception of the arrangement with Equity Provider (instead of Entity 1) as follows:
ManufacturerX
Equity guarantee
Lender
Saleof product
Analysis
We believe the equity investment in this structure also would not be at risk (and the entity would be a VIE) because the substance of guarantee (provided by a party involved with Entity 1) prevents the Equity Provider from being exposed to potential losses of Entity 1. We do not believe that a transaction between two parties may be ignored merely because the entity under evaluation is not a direct party to the transaction. We believe all of the relevant facts and circumstances should be considered in applying the Variable Interest Model.
Financial reporting developments Consolidation of variable interest entities 136
The SEC staff shares this view, as discussed in a December 2004 speech. Note that while this speech was intended to address accounting under FIN 46(R) (prior to the Statement 167 amendments), we believe that the concepts remain relevant to the Variable Interest Model in ASC 810-10.
137
The following are examples of characteristics that should be comparable between the entities (this list is not all-inclusive): Size and composition of assets Amount Exposure to interest rate risk Type and duration Concentration Credit quality Liquidity
Capitalization Type and amount of debt/equity Terms of instruments Priority and liquidation preferences Maturities of debt
Nature of operations Geographic area(s) Scale Product line(s) Service line(s) Cash flows
138
$7.5 million of the bank loan bears a fixed interest rate of 6%, is due in five years and is secured only by combines, hay hauling and other equipment and, therefore, has no recourse to the equity holders. The remaining $1.5 million of the bank loan is unsecured, bears a fixed interest rate of 8%, is guaranteed by the partners and is due in seven years. Older Brother contributed $600,000 and Younger Brother contributed $500,000 in exchange for equity interests. Although each brother has equal voting control, profits and losses are shared in accordance with the respective capital contributions. DAX Partners is unable to demonstrate the sufficiency of its equity investment at risk by comparison to another entity (i.e., through the ASC 810-10-25-45(b) method). Analysis In this example, the sufficiency of equity can be demonstrated only through the method specified in ASC 810-10-25-45(c) (i.e., an expected loss calculation would be required). DAX Partners has not reasonably demonstrated that it can finance its activities without additional subordinated financial support because the unsecured debt has recourse to the partners. Accordingly, an expected loss calculation would be required to demonstrate whether the partners capital exceeds expected losses. Note that the relative size of the equity investment compared with the entitys assets is not determinative (i.e., it cannot be presumed that the equity investment at risk is sufficient even if it were greater than 10% of assets). In this specific circumstance, if the unsecured debt was not guaranteed by the partners and bore a reasonable interest rate, then DAX Partners may be able to demonstrate that it has sufficient equity to finance its activities without additional subordinated financial support. Example 2 Facts Assume the same facts as assumed in Example 1, except the $1.5 million unsecured loan is not guaranteed by the partners, bears a fixed interest rate of 10%, is due in 10 years and is entitled to 30% of all GAAP profits above a stated threshold.
Financial reporting developments Consolidation of variable interest entities 139
Analysis An expected loss calculation is required. The unsecured loan has characteristics of an equity-like return, calling into question the sufficiency of the partners capital. As a result of lacking the partners guarantee of repayment, the subordinate investor demanded a higher interest rate along with a significant participation in GAAP profits, indicating that DAX Partners may not have sufficient equity to support itself without additional subordinated financial support. Example 2.1 Facts Assume the same facts as Example 2, except that the entitys expected losses are computed to be $1 million. However, allocation of the entitys expected losses indicates that in certain possible outcomes of the entity, both the equity investment at risk and the subordinated debt will absorb expected losses. Analysis In this fact pattern, expected losses are less than the partners capital. Accordingly, the equity of the partnership would be considered sufficient even though there are certain scenarios that would show expected losses inuring to the subordinated debt holder. The Variable Interest Model requires only the amount of equity to exceed expected losses of the entity as a whole. It does not require the equity to be sufficient to bear all losses that could occur and not be absorbed by other variable interest holders. It should be noted, however, that if expected losses were calculated to be $1.1 million or higher, the equity of DAX Partners would not be sufficient. Example 3 Facts Assume the same facts as assumed in Example 1, except the unsecured debt is not guaranteed by the partners and the balance sheet of the entity, at its formation, is as follows:
Total assets Bank loan Partner loans Other liabilities Partners capital $12.0 million 6.0 million 3.6 million 1.9 million 0.5 million
Additional facts (different from Example 1): The $6 million bank loan bears a fixed interest rate of 6%, is due in five years and is secured only by combines, hay hauling and other equipment and therefore has no recourse to the equity holders. The partner loans (Big Brother, 60%, and Little Brother, 40%) bear a fixed coupon of 15% and are due in 10 years. Big Brother contributed $300,000 and Little Brother contributed $200,000 in exchange for an equity interest. DAX Partners believes that the entity has sufficient equity to carry on its activities without additional financial support because the total amount of partners capital and partner loans is $4.1 million (33% of total assets). An expected loss calculation shows that the entitys expected losses are $2 million.
140
Analysis Subordinate loans made to the entity by the equity holders or commitments to fund future losses are not equity because an equity investment is defined as amounts that are included within equity in the entitys financial statements. Accordingly, the brothers are required to determine whether the entity has sufficient equity to support its activities without additional financial support. Because of the capital structure, it is not clear that the entity can operate without additional subordinated financial support. Accordingly, an expected loss calculation would need to be performed. DAX Partners does not have sufficient equity, because total partners capital is only $500,000. Although the partner loans could absorb the remaining $1.5 million of expected losses, because that investment is not an equity investment at risk, the entity has insufficient equity to absorb its expected losses. Accordingly, DAX Partners is a VIE.
It cannot be assumed that an equity investment at risk that is based on some percentage of the entitys total assets is either sufficient or insufficient. We believe the 10% presumption, for all intents and purposes, is irrelevant in determining the sufficiency of the equity investment at risk and should not be used in making this determination. That is, an equity investment of at least 10% of the fair value of an entitys total assets is not a safe harbor. Even an equity investment at that level, or higher, requires a demonstration that an enterprises equity investment at risk is sufficient.
141
142
Analysis
At-risk factor 1. Do the equity holders significantly participate in profits and losses of the entity? Example 1 Example 1.1 Example 1.2 No. Investor XYZ does not participate significantly in the losses of the partnership due to the existence of the put option. The put option protects Investor XYZ from all future losses. Accordingly, the equity investment is not at risk. Possibly. As long as the See Example 1. 15% internal rate of return to Investor XYZ makes up a significant amount of the entitys expected GAAP profits, its equity interest would significantly participate in profits and losses of the entity. ABCs equity investment significantly participates in profits and losses. Yes. ABC Enterprises No. equity investment meets this criterion. Accordingly, its equity investment is not at risk No.
2. Does equity include equity interests issued in exchange for subordinated interests in other VIEs?
No.
3. Has any amount of No. equity been provided to the equity investor directly by the entity or by other parties involved with the entity? 4. Has any amount of No. equity been financed directly by the entity or by other parties involved with the entity?
No.
No. Although ABC See Example 1.1. Enterprises financed its equity investment on a nonrecourse basis with Bank A, Bank A has no involvement with the entity. However, it should be noted that if ABC Enterprises were acting in the capacity of an agent for Bank A, Bank A may need to evaluate the entity for consolidation. Yes. Assuming XYZs equity investment is at risk, the $200 million at-risk equity investment exceeds the expected losses of the partnership of $120 million. No. As XYZs equity investment is not at risk, the $100 million at-risk equity investment of ABC Enterprises does not exceed the expected losses of the partnership of $120 million.
5. Is the equity investment sufficient to permit the entity to finance its activities without additional subordinated financial support?
No. As ABC Enterprises equity investment is not at risk, the $100 million atrisk equity investment of XYZ does not exceed the expected losses of the partnership of $120 million.
143
Example 2 Facts Assume Company A and Developer B form a partnership by contributing $80 and $20, respectively. Company A and Developer B have voting and economic interests of 80% and 20%, respectively. The partnership purchased undeveloped property costing $1,000 that was funded by partner contributions, $600 of nonrecourse debt and $325 of unsecured debt. Developer B receives a development fee of $25 from the partnership at inception of the entity. Company A and Developer B calculate expected losses to be $85 based on reasonable quantitative evidence. Analysis The partnership is a VIE because it does not have sufficient equity at risk to permit it to absorb its expected losses. Developer B does not have an equity investment at risk because the $25 of development fees it received at inception of the entity eliminates its equity investment of $20. Accordingly, the partnerships equity investment at risk ($80) is less than expected losses ($85). Example 3 Facts Assume Company B and Developer C form LandDevelopers, Inc. to buy undeveloped land, develop it and sell it to unrelated homebuilders. Each enterprise contributes $5 million in exchange for all of the common stock of the corporation. Profits, losses and decision making are shared pro rata. LandDevelopers, Inc., purchases undeveloped property costing $40 million that was funded by the equity contributions; $20 million of nonrecourse debt; and $12 million of non-voting cumulative preferred stock bearing a fixed coupon of 5% that is puttable at 95% of par in five years. Developer C receives $2 million in development fees at the entitys inception. Expected losses of the entity are $9 million. Analysis The total amount of equity at risk is $8 million ($5 million pertaining to Company Bs investment and $3 million pertaining to Developer Cs investment). Of the $5 million contributed by Developer C, $2 million does not meet the criteria to be considered at risk because it represents fees received from the entity. The preferred stock investment of $12 million would not be considered to participate significantly in profits and losses of the entity because of the put right held by the preferred investor, which prevents it from participating significantly in the entitys losses, and the 5% coupon does not significantly participate in profits. The entity is a VIE because its at-risk equity investment of $8 million is insufficient to absorb the entitys expected losses of $9 million.
144
Example 3.1 Facts Assume the same facts as Example 3, except that instead of receiving a $2 million fee at inception, Developer C receives only $1 million at inception. However, Developer C is unconditionally entitled to receive an additional $1 million to be paid at the end of two years. Analysis The timing of receipt of the vested development fees does not affect the assessment as to whether the equity is at risk. Accordingly, the present value of the fee should reduce the equity investment at risk. Regardless of the discount rate reflected, the deduction of any amount resulting from the present value calculation would reduce the equity investment at risk below $9 million and, therefore, the entity is a VIE. If the development fees were contingent on the entitys performance or other meaningful factors such that Developer C was not vested in the fees at inception, then the deferred development fees may not reduce the Developers equity investment. The determination as to whether the contingency is substantive should be based on the applicable facts and circumstances. Example 3.2 Facts Assume the same facts as Example 3, except that the preferred stock is not puttable or cumulative, bears a fixed coupon of 12% and expected losses of the entity are $15 million. Analysis In this example, the provisions of ASC 810-10-15-14(a) are not violated because the at-risk equity is sufficient to absorb the entitys expected losses. In this fact pattern, at-risk equity is $20 million ($5 million for Company Bs investment, $3 million for Developer Cs investment and $12 million for the preferred stock investment). The $12 million of preferred stock is included as an at-risk equity investment as it will likely participate significantly in the profits of the entity because of the relatively higher rate of return (assuming that the 12% return is a significant portion of the entitys GAAP profits), and, without the put, a significant portion of the investment could be lost if the entity were to incur losses.
145
9.2
146
This change may result in entities becoming VIEs upon the adoption of Statement 167 in certain circumstances. For example, if decision making ability is held by a non-equity holder, an enterprise previously may have concluded that the entity was not a VIE by giving consideration to substantive kickout rights held by the equity holders as a group (as opposed to a single equity holder). This is often a consideration for partnerships or LLCs in which the general partner or managing member does not have a substantive equity investment at risk but can be removed by a majority of the LP or member interests. Thus, the amendments to the determination of whether an entity is a VIE may result in more partnerships and LLCs becoming VIEs. Upon adoption of Statement 167s amendments, limited partnerships that are VIEs likely will be consolidated by the general partner. Alternatively, interests other than the equity investment at risk that provide the holders of those interests with kick-out rights or participating rights do not prevent the equity holders from having power unless a single enterprise (including its related parties and de facto agents) has the unilateral ability to exercise such rights. However, few structures provide for non-equity interests to hold unilateral kick-out rights or participating rights. If an interest other than the equity investment at risk provides the holder of that interest with decisionmaking ability, but the interest does not represent a variable interest based on the guidance in ASC 81010-55-37 and 55-38, that interest does not make the entity a VIE. The FASB reasoned that such a decision maker would never be the primary beneficiary of the VIE because it would not hold a variable interest. Additionally, such an interest typically would indicate that the decision maker was acting as a fiduciary, and the FASB observed that this fact alone should not lead to a conclusion that entity is a VIE. The FASB observed that this guidance was intended to prevent many traditional voting interest entities and certain investment funds from becoming VIEs. For example, if a property manager that is considered to have power over the entity concludes that it does not have a variable interest in the entity after evaluating ASC 810-10-55-37 and 55-38, the property managers decision-making does not make the entity a VIE under the Variable Interest Model. In this instance, the property manager is acting as an agent on behalf of the equity holders, which does not indicate that the entity is a VIE. The determination of whether the holders of an entitys equity investment at risk have the power to direct the activities of an entity that most significantly impact the entitys economic performance should be made after considering all of the facts and circumstances and will often require the use of professional judgment. Refer to the Interpretative guidance in Chapter 14 for additional considerations as to what would constitute power to direct the activities of an entity that most significantly impact the entitys economic performance.
147
Decisions are substantive when they most significantly affect the economic performance of the entity (e.g., revenues, expenses, gains and losses or financial position of the entity). Examples of substantive decisions that affect economic performance may include the ability to purchase or sell significant assets, enter into new lines of business, incur significant additional indebtedness, etc. We believe that the assessment of power in evaluating whether an entity is a VIE generally should be consistent with the assessment of power when determining the primary beneficiary of a VIE. That is, we believe that the identified activities that most significantly impact an entitys economic performance would be the same for the purposes of the VIE determination (ASC 810-10-15-14(b)(1)) and the determination of the primary beneficiary. Additionally, when considering all facts and circumstances, enterprises should consider the extent to which the holders of an entitys at-risk equity investment absorb expected losses and receive expected residual returns of the entity. Generally, the ability to make decisions that have a significant impact on the success of the entity becomes increasingly important to the at-risk equity group as the amount of their investment increases. The greater the amount of the at-risk equity investment as compared to the expected losses of the entity, the less likely it is that the holders of the investment would be willing to give up the ability to make decisions consistent with their interests or permit others to make decisions counter to their interests. Determining whether, as a group, the holders of the equity investment at risk have the power will be based on the applicable facts and circumstances and will require the use of professional judgment.
148
Analysis Because the general partner holds a substantive equity investment at risk, and the equity holders, as a group, have the power, the provisions of ASC 810-10-15-14(b)(1) are not violated. It is not necessary for the 99% limited partner interests to have participating rights for the criterion of ASC 810-10-15-14(b)(1) to be met. It is important to note that any time the voting rights of an equity investor are not proportional to its obligation to absorb the expected losses of the entity, to receive the expected residual returns of the entity, or both, the anti-abuse provision in ASC 810-10-15-14(c) should be evaluated (see further discussion of the anti-abuse provision below).
Participation in decision making by holders of interests that are not equity investments at risk
Question 9(b)(1).3 Is an entity a VIE pursuant to ASC 810-10-15-14(b)(1) if a holder of a variable interest that is not an equity investment at risk substantively participates in decision-making? Yes. The requirement for the equity investors, as a group, to have the ability to make decisions would not be met if a party (including its related parties and de facto agents) other than a holder of an equity investment at risk has participating rights (as defined in the ASC). In situations in which a single party other than at-risk equity holders has the right to make or participate in decisions, emphasis should be placed on the ability of the participating party to block the actions through which at-risk equity holders may exercise power. ASC 810-10-15-14(b)(1) may not be violated, however, if the participating rights are held collectively by multiple, unrelated parties that are not at-risk equity holders. Refer to Question 9(b)(1).7 for further discussion of participating rights. A holder of an interest that is not an equity investment at risk may hold protective rights (such as a lender through debt covenants) without ASC 810-10-15-14(b)(1) being violated. Illustration 9-15: Example 1 Facts Assume that three unrelated enterprises (Enterprises A, B and C) form an LLC. Enterprise A has a 60% equity ownership in the venture, and Enterprises B and C each hold a 20% equity ownership. However, Enterprises B and C can both put their equity interests to Enterprise A at the end of five years for an amount equal to their original equity investment. Enterprise A makes all decisions. However, Enterprise B has the ability to block Enterprise As decisions. Analysis In this fact pattern, Enterprises B and C are not holders of an equity investment at risk because their ability to put their interests to Enterprise A at the end of five years protects them from having to significantly participate in the losses of the LLC. Enterprise A cannot unilaterally make decisions about the entitys activities because Enterprise B has participating rights. Because Enterprise B (holder of an equity investment that is not at risk) has the unilateral ability to exercise the participating rights, the entity is a VIE. Participating rights held by holders of interests that are not equity investments at risk
149
Example 2 Facts Assume the same facts as Example 1. However, in order to block Enterprise As decisions, Enterprises B and C must both agree to do so. Analysis Because two parties must agree to exercise the participating rights, the entity is not a VIE pursuant to ASC 810-10-15-14(b)(1).
Effect of decision makers or service providers when evaluating power under ASC 810-10-15-14(b)(1)
Question 9(b)(1).4 If a decision maker or service provider holds a variable interest in an entity separate from an equity investment at risk, do the holders of the equity investment at risk have the power to direct the activities of the entity that most significantly impact the entitys economic performance (power)? What if the holders of the equity investment at risk have kick-out rights or other rights that allow them to make decisions affecting the entity? Determining whether an entity is a VIE because it has a decision maker or service provider with power or participating rights through an interest separate from an equity investment at risk should be based on the applicable facts and circumstances. In particular, it is important to determine whether the decision maker or service provider has a variable interest based upon an evaluation of the criteria in ASC 810-10-55-37. This analysis focuses on whether the decision maker or service provider is acting in a fiduciary capacity (i.e., as an agent of the equity holders) or as a principal to the transaction. The Variable Interest Model indicates if an interest other than an equity investment at risk provides the holder of that interest with decision-making ability, but the interest does not represent a variable interest (e.g., the decision makers or service providers fee does not constitute a variable interest based on the guidance in ASC 810-10-55-37), then the criterion in ASC 810-10-15-14(b)(1) is not violated. The FASB believed that such a decision maker or service provider could never be the primary beneficiary of a VIE as it does not hold a variable interest. Often in the circumstances in which it is determined that a decision maker has a variable interest, the entity will be a VIE as a result of the decision maker receiving power or participating rights through their fee arrangements (rather than through an equity investment at risk). In making this determination, the nature of the rights held by the holders of the equity investment at risk (i.e., kick-out rights or liquidation rights) should be considered when a single enterprise (including its related parties and de facto agents) has the unilateral ability to exercise those rights. Refer to Question 9(b)(1).7 for further discussion on kick-out rights and liquidation rights.
Can interests other than equity investment at risk be considered for purposes of evaluating power under ASC 810-10-15-14(b)(1)?
Question 9(b)(1).5 Does the power to direct the activities of an entity that most significantly impact the entitys economic performance (power) have to be demonstrated through the ability to vote an equity investment at risk? Yes. Other interests held by holders of an equity investment at risk may not be combined with equity interests in determining whether power is held by the holders of an entitys equity investment at risk. The FASB believes that ASC 810-10-15-14(b) describes the characteristics of a controlling financial interest, and if the rights and obligations provided by the total equity investment at risk lack any of those characteristics, then the ownership of a majority of the equity investment would not be an appropriate basis for determining consolidation of the entity.
Financial reporting developments Consolidation of variable interest entities 150
Assume a partnership is created to develop commercial real estate. None of the partnership interests have voting rights, but one partner, a real estate developer, makes all significant decisions for the partnership under the terms of a service agreement entered into at inception of the entity. The developer is required to have a substantive equity investment at risk as long as it provides services pursuant to the service agreement. Assume the service agreement is a variable interest. Analysis In this example, the power rests with the real estate developer by virtue of the service agreement rather than through its equity interest. Therefore, the entity would be a VIE because there is no decision making for the entity embodied in the equity interests. Example 2 Facts In contrast to the structure above, assume the entity is instead formed as a limited partnership with the real estate developer as the general partner, who makes all significant decisions for the entity. The equity holders agree to a disproportionate sharing of profits within the equity group to compensate the general partner for service performed as the general partner. Analysis Although economically the rights and obligations of the equity holders of both entities are the same, the form of the instrument through which decisions are made for the entity is determinative as to whether the entity is or is not in violation of ASC 810-10-15-14(b)(1). Accordingly, in this case, because the decision making for the entity is embodied in an equity interest, the entity is not a VIE (assuming that none of the other criteria are violated).
In evaluating whether a general partners equity investment is substantive, generally we believe that the general partners other equity (but not debt) investments at risk should be considered. A general partners non-equity investments or equity investments that are not at risk should not be considered in making this determination. A party that is related to the general partner may make an equity investment in the partnership, and that investment may be attributed to the general partner in certain situations in determining whether the condition in ASC 810-10-15-14(b)(1) is met. The nature of the related party relationship should be evaluated based on the individual facts and circumstances to determine whether the related partys equity investment at risk should be attributed to the general partner. We believe that the substance of the entire arrangement even if different from the legal form should be considered in evaluating whether the general partner has a substantive equity investment at risk. For example, if a general and a limited partner are under common control or the general partner controls the limited partner, the limited partners equity investment may be attributed to the general partner in certain situations. However, if the limited partner and the general partner are not under common control, attribution of the limited partners investment to the general partner may not be appropriate. In addition, the Variable Interest Models anti-abuse provisions should be considered where applicable. The SEC staff has indicated that it shares this view, as highlighted in the speech below. Note that the references to FIN 46(R) in the following speech equate to the Variable Interest Model in the ASC. Also note that the discussion of the primary beneficiary determination in the excerpt below has been superseded by the current application of the Variable Interest Model. Refer to the Interpretative guidance and Questions to Chapter 14 for further discussion of the primary beneficiary determination.
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A general partner and group of limited partners invest $1,000 and $1 million, respectively, to form a partnership. The partnership does not issue debt. The general partner may be removed only for cause, and there is no individual limited partner that possesses kick-out rights, as that term is defined in the ASC. Analysis The partnership is a VIE because the group of holders of the equity investment at risk lack the power, as the general partners investment ($1,000, or .1%) is not substantive, and there is no individual limited partner that can remove the general partner. Example 2 Facts Assume the same facts as Example 1, except the general partner also has a limited partnership interest of $100,000. Analysis The group of holders of the equity investment at risk has the power as the general partners aggregate equity investment is considered substantive. (The general partners aggregate at-risk equity investment is at least 1% of the partnerships assets, and there is no evidence to rebut the presumption that it is substantive.) Example 3 Facts Assume the same facts as Example 1, except the limited partnership issued debt of $100,000 to the general partner. Analysis The partnership is a VIE because the group of holders of the equity investment at risk lack the power, as the general partners equity investment at-risk is not substantive, and there is no individual limited partner that can remove the general partner. While the general partner has another investment in the partnership, because that investment is not at-risk equity (it is debt), it cannot be considered in determining whether the general partners equity investment is substantive.
153
Refer to the Interpretative guidance and Questions in Chapter 14 for additional guidance on kick-out and participating rights.
21
Consistent with the guidance in ASC 810-20, we believe that, for the purpose of applying the provisions of Statement 167, kickout rights encompass liquidation rights. Refer to Question 14.22 for further discussion on liquidation rights. 154
Franchise arrangements
Question 9(b)(1).8 Franchise arrangements generally stipulate many specific business practices that the franchisee must follow. Do franchise agreements result in a violation of ASC 810-10-15-14(b)(1)? A typical franchise agreement has as its purpose the distribution of a product, service or establishment of an entire business concept within a particular market area. Both the franchisor and the investors in the franchise contribute resources for establishing and maintaining the franchise. The franchisors contribution may be a trademark, a company reputation, products, procedures, manpower, equipment or a process. The franchisees investors usually contribute operating capital as well as the managerial and other resources required to open and operate the franchise. The franchise agreement generally describes the specific marketing practices to be followed, specifies the contribution of each party to the operation of the business, and sets forth certain operating procedures that both parties agree to comply with. The franchise agreement may establish certain protocols relating to the management or operating policies of the franchises by, among other items: (1) specifying goods and services produced and sold by the franchise, (2) providing training of the franchises employees, (3) establishing standards for the appearance of the franchises place of business and (4) requiring that the franchises purchase raw materials or goods directly from the franchisor. Although many of these decisions are important to the success of the franchise, the fact that certain of these decisions may be stipulated by the franchisor does not necessarily result in the entity being a VIE. By entering into a franchise agreement, at-risk equity investors in a franchise have decided to operate the business in a specific location under a common trademark and system and comply with the franchisors business standards. A key consideration is whether the decisions stipulated through the franchise agreement are meant to protect the franchisors brand, or allow the franchisor to participate in ongoing substantive decision making relating to the franchises operations. The ability of the franchisor to enforce business standards that protect the value of its brand, and the value of other investors franchise entities, does not result in an entity being a VIE. To be considered a voting interest entity, the at-risk equity investor(s) in the franchisee, as a group, should have the power to direct the activities of the franchise that most significantly impact the franchises economic performance through voting or similar rights. The decisions must be substantive (i.e., decisions that may significantly affect the revenues, expenses, gains and losses or financial position of the entity) and not ministerial, in nature. In addition, the equity investors must have the ability to make whatever decisions are not pre-determined through the franchise agreement. These typically would include control over the day-to-day operations of the franchise, including, but not limited to, hiring, firing and supervising of management and employees, establishing what prices to charge for products or services and making capital decisions of the franchise. Also, control over such fundamental decisions as the form (corporate, LLC, LLP, partnership, etc.) of the franchise entity, its charter and how it is capitalized may be important to the success of the franchise. In some situations a franchisor may invest directly in the franchise through an equity position, loan or other means of subordinated financial support. In such cases, or if the franchise investors obligation to absorb expected losses or receive expected residual returns of the franchise is otherwise limited by the franchisor, holding the power to direct the activities of the franchise that most significantly impact the franchises economic performance becomes increasingly important to the franchisor because of the additional risk borne by the franchisor. Although the amount of equity investment as compared to expected losses may mitigate the franchisors risk, in some instances the franchisor will require the franchisee to provide the franchisor with the power to direct the activities of the franchise that most significantly impact the franchises economic performance. In those instances, the equity group would lack the characteristic in ASC 810-10-15-14(b)(1), and, as a result, the franchise would be considered a VIE. In other situations, the franchisor may require the franchisee to relinquish some, but not all, of its
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power to direct the activities of the franchise that most significantly impact the franchises economic performance. Determining whether, as a group, the holders of a franchises equity investment at risk have the ability to make substantive decisions about the entitys activities will be based on the applicable facts and circumstances and will require the use of professional judgment. Additionally, the extent to which the franchisees at-risk equity investors absorb expected losses and receive expected residual returns of the entity should be considered in determining whether, as a group, such holders lack the ability to make decisions about its activities. The greater the amount of their at-risk equity investment as compared to the expected losses of the entity, the less likely it is that the investors would be willing to give up the ability to make decisions consistent with their interests or permit others to make decisions counter to their interests. It should be noted that Statement 167 nullified FSP FIN 46(R)3. FSP FIN 46(R)-3 provided Interpretative guidance on the application of ASC 810-10-15-14(b)(1), including its application to franchise arrangements. Under FSP FIN 46(R)-3, the rights of a franchisor in a franchise arrangement generally were considered protective rights. By including the rights of a franchisor as an example of a protective right in the amendments to the Variable Interest Model, the FASB believes that the same objectives are achieved. Therefore, the FASB does not expect or intend for the nullification of FSP FIN 46(R)-3 to result in a significant change in practice to franchisors evaluations of the criteria in ASC 810-10-15-14(b)(1).
Illustrative examples
Question 9(b)(1).9 Illustrative examples The following examples illustrate the application of the provisions of ASC 810-10-15-14(b)(1) that require the holders of the equity investment at risk, as a group, to have the power to direct the activities of an entity that most significantly impact the entitys economic performance through voting rights or similar rights: Illustration 9-18: Application of the provisions of ASC 810-10-15-14(b)(1) Example 1 Facts High-Tech Enterprises, Investor ABC and Investor XYZ form a joint venture. The venture is formed to acquire a division of High-Tech Enterprises. High-Tech Enterprises will retain a 40% equity ownership in the venture. The fair value of the divisions net assets and liabilities is $300 million. Investor ABC and Investor XYZ each contribute $90 million to the venture in exchange for equity interests. Investor XYZ can put its interest to High-Tech Enterprises for $90 million in Year 5. The corporate charter of the JV provides that decisions will be determined based on a voting majority. The votes are shared as follows:
Voting Allocation High-Tech Enterprises Investor ABC Investor XYZ 40% 30% 30%
Example 1.1 Facts Assume the same facts assumed in Example 1, except that Investor XYZ can vote only on decisions that are determined to be insignificant. Investor XYZs rights are consistent with protective rights as defined in the Variable Interest Model (see ASC Master Glossary or guidance in Chapter 14).
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Example 1.2 Facts Assume the same facts assumed in Example 1, except that Investor XYZ cannot put its investment to High-Tech Enterprises, but High-Tech Enterprises has the right to call Investor ABCs equity interest for $110 million in Year 5. Analysis
Question Do the holders of the equity investment at risk, as group, have the power to direct the activities of an entity that most significantly impact the entitys economic performance? Example 1 Example 1.1 Yes. In this scenario, Investor XYZ does not have participating rights in the entitys decision making. Unlike Example 1, Investor XYZ does not have the same voting rights as the other equity investors, and because those rights provide Investor XYZ with protective rights as defined in the Variable Interest Model (see ASC Master Glossary or guidance in Chapter 14), the holders of the equity investment at risk, as a group, have the power to direct the activities of an entity that most significantly impact the entitys economic performance. Example 1.2 Possibly. If the call option is determined to prevent Investor ABC from significantly participating in the profits of the entity, then Investor ABC would not be considered a holder of an equity investment at risk. In that case, the answer would be the same as in Example 1, except that it would be Investor ABC who would have participating rights in the entitys decision maker as an investor holding an interest other than an equity investment at risk. If the call option were determined not to keep Investor ABC from participating significantly in profits of the entity, then the holders of the equity investment at risk, as a group, would control the entity. It depends on whether Investor ABC participates significantly in the profits of the entity. Assuming that it does not, the entity is a VIE because Investor ABCs equity investment would not be considered to be at risk. However, if it were considered to participate significantly in the profits of the entity, then the entity has not violated the provisions of ASC 810-10-15-14(b)(1). No. Only High-Tech Enterprises and Investor ABC hold equity investments at risk. Investor XYZ does not significantly participate in the losses of the entity due to the put option, and, therefore, its equity investment is not considered to be at risk. High-Tech and Investor ABC cannot unilaterally make decisions about the entitys activities because Investor XYZ has 30% of the voting rights, and if the at-risk equity holders do not agree about an action, Investor XYZ is the tiebreaker, giving an investor other than the holder of an equity investment at risk significant participating rights in the entitys decision making. Has the design of the entity Yes. The entity is a VIE violated the provisions of because the holder of an ASC 810-10-15-14(b)(1)? interest (Investor XYZ) other than an equity investment at risk has the ability to participate in the activities of an entity that most significantly impact the entitys economic performance.
No. The entity has not violated the provisions of ASC 810-10-1514(b)(1) because the holders of the equity investment at risk, as a group (Investor ABC and High-Tech Enterprises), have the power to direct the activities of an entity that most significantly impact the entitys economic performance.
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Example 2 Facts Assume that a transferor transfers $80 of marketable debt securities and $20 of passive equity investments to a special purpose vehicle (SPV). The SPV funds the acquisition of the financial assets by issuing $40 of senior certificates to Company A, $40 of subordinate certificates to Company B, a $10 residual equity interest to Company C and a $10 residual equity interest to the transferor. The residual equity interests purchased by Company C and retained by the transferor are pari passu and are subordinate to the certificates issued to Company A and Company B. SPV has hired an unrelated investment manager (Asset Management, Inc.) to manage its activities. Under the arrangement, Asset Management, Inc. is paid a fee equal to 15% of the residual profits. The agreements specify that any one of the holders of the residual equity interests has the ability to remove Asset Management, Inc. for cause (which is defined as illegal acts, fraud, etc.). Example 2.1 Facts Assume the same facts assumed in Example 2, except that upon majority approval by the holders of the residual equity interests, Asset Management, Inc. can be removed at any time without cause. Example 2.2 Facts Assume the same facts assumed in Example 2.1, except that any one of the holders of the residual equity interests has the ability to remove Asset Management, Inc. at any time without cause. Analysis
Question Do the equity holders, as a group, have the power to direct the activities of an entity that most significantly impact the entitys economic performance? Example 2 No. We believe that the holders of the equity investment at risk do not have substantive kick-out rights providing the ability to remove the asset manager. As the asset manager is not a holder of an equity investment at risk, the equity holders, as a group, do not have the power to direct the activities of an entity that most significantly impact the entitys economic performance. Yes. Example 2.1 No. No party has the unilateral ability to exercise the kick-out rights as exercise can only occur with majority approval by the holders of the residual equity interests. As the asset manager is not a holder of an equity investment at risk, the equity holders, as a group, do not have the power to direct the activities of an entity that most significantly impact the entitys economic performance. Yes. Example 2.2 Yes. One of the holders of the residual equity has the ability to exercise the kick-out rights. Therefore, the equity holders, as a group, have the power to direct the activities of an entity that most significantly impact the entitys economic performance.
Has the design of the entity violated the provisions of ASC 81010-15-14(b)(1)?
No.
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partnership to the general partners, except for excess cash flow generated on the sale of the property. Cash flows from the sale of property, which are generally not expected to be significant, may be allocated partially to the limited partners. In summary, the limited partners receive their investment return through tax credits and tax benefits from allocated losses of the partnership and also may receive a modest level of proceeds from the eventual disposition of the property. The general partner (or in some cases, a related party of the general partner) may make certain guarantees to the limited partners, which could include: Construction guaranty the general partner guarantees that it will fund any amounts necessary to complete the projects construction if the partnership does not have sufficient funds to do so Guaranty against operating deficits the general partner guarantees that it will advance the partnership funds, typically structured as loans, to pay any operating deficits of the partnership for a period of years (commonly three to five years) Guaranty against reduction of credit amount the general partner guarantees that if the amount of the actual tax credits allocated to investors is less than the projected tax credits, the general partner will pay to the partnership for distribution to the limited partners an amount equal to the credit adjustment grossed up by any resulting tax liability of the limited partner
VIE considerations Amounts provided to an equity investor directly, or indirectly, through fees are not considered an equity investment (see Question 9(a).6 for additional discussion). Often the general partners investment is de minimus (it can be as low as 0.01%), and when the fees that the general partner earns are deducted from its contributed capital, the general partner typically will not be considered to have an equity investment at risk in the partnership. Even if the general partner has an equity investment at risk, that investment may not be considered substantive (see Question 9(b)(1).6). In the circumstances in which the general partner does not have an equity investment at risk (or substantive investment), the general partner is excluded from the group of equity holders in evaluating whether the equity holders as a group have power to direct the activities of an entity that most significantly affect the economic performance of the entity (e.g., sale of the property, financing decisions and day-to-day property operating decisions). Limited partners may have protective rights with respect to these significant activities but they usually do not have the unilateral ability to make decisions over such activities. Additionally, an individual limited partner may not have the ability to remove the general partner for reasons other than for cause. Because the general partner typically can make significant decisions and does not have an equity investment at risk (or substantive investment), the limited partners that hold the equity investment at risk do not have the power to direct the activities of an entity that most significantly affect the entitys economic performance. Accordingly, an affordable housing partnership with the terms described above will be a VIE. Furthermore, when the general partner is not considered to have an equity investment at risk but provides one or more of the guarantees described above, the partnership may be a VIE if the guarantee(s) protect the at-risk equity investors (i.e., the limited partners) from the first dollar risk of loss. Thus, the at-risk equity investors do not have the obligation to absorb the expected losses of the entity (see ASC 810-10-15-14(b)(2) and Question 9(b)(2).6 for additional discussion). The affordable housing partnership also should be evaluated pursuant to the anti-abuse test to determine if it is a VIE (see Section 9.5). In the circumstance where the limited partner has up to 99.99% of the affordable housing partnerships economics and no significant voting rights, it initially may appear that substantially all of the entitys activities are conducted on behalf of the limited partner (i.e., because it has up to a 99.99% investment in the partnership) resulting in the partnership being a VIE. However, we
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do not believe the size of the investment alone is determinative in assessing whether substantially all of the entitys activities are conducted on behalf of the investor with disproportionately few voting rights. Instead, we believe the nature of the activities being performed by the entity also should be compared to the activities performed by the investor as part of its ongoing operations to make this determination. In this case, because the partnership is providing affordable housing, and in typical affordable housing partnerships, the limited partners generally are not engaged in that same activity, we do not believe that substantially all of the entitys activities are conducted on behalf of the limited partner. Conversely, if the limited partner is engaged in developing or providing housing, then its activities would be similar to that of the entity, and the entity generally would be considered a VIE pursuant to the Variable Interest Models anti-abuse clause. In evaluating whether the affordable housing partnership has sufficient equity in accordance with ASC 810-10-15-14(a), we believe that the tax benefits provided to the limited partners of an affordable housing partnership should be included in the evaluation of the partnerships expected losses and expected residual returns (see Question 10.14 for additional discussion). The accounting analysis discussed above is of a typical affordable housing partnership. The terms of each entity should be evaluated carefully against the Variable Interest Models VIE criteria before making that determination. Primary beneficiary considerations An enterprise with a variable interest in a VIE is required to consolidate that VIE if it has both power and benefits (see Chapter 14 for additional discussion). As discussed above, typically the general partner has the power to direct the most significant activities of the entity. The general partner typically also receives benefits from the development and operating fees it earns. Therefore, in these typical affordable housing partnerships, the general partner would be identified as the primary beneficiary. However, the terms of each entity should be evaluated carefully against the Variable Interest Models primary beneficiary provisions before making that determination. A structure may provide for a kick-out right that can be exercised unilaterally (without cause) by a single limited partner (inclusive of its related parties and de facto agents). In this case, the general partner would not be the primary beneficiary, and the limited partner should evaluate whether it is the primary beneficiary.
9.3
counterparty fails to perform and there is insufficient collateral. If, however, the put options exercise price was set at $96, the equity holders, as a group, would absorb the first dollar risk of loss of the entity, and the put option would protect only the lenders after the holders of the equity investment at risk suffered a total loss of their investment. Because the holders of the equity investment at risk must bear the exposure to the first dollar risk of loss in the entity, we believe that by design, sharing exposure with non-equity holders or with instruments other than equity investments at risk (e.g., put options or guarantees held or written by a member of the at-risk equity group) is not permitted. Certain arrangements including total return swaps, which pay the total return (i.e., interest, dividends, fees and capital gains/losses) in exchange for floating rate interest payments, by design, may cause an entity to be a VIE. For example, assume an entity issues debt ($90) and common stock ($10), and that amount of equity is determined to be sufficient. The entity initially holds a fixed income instrument with a fair value of $100. Further assume the entity enters into a 90% total return swap with Investment Bank A, pursuant to which the entity will pay 90% of the total return of that fixed income instrument in exchange for a LIBOR-based return. In this situation, the holders of the equity investment at risk are protected from 90% of the assets losses. That is, as the fixed income instruments value declines by $1, the Investment Bank pays the entity $.90 and, in effect, shields the holders of the equity investment at risk from $.90 of the assets losses. Consequently, the equity investment, by design, does not absorb all of the first dollar risk of loss in the entity and, thus, the entity is a VIE. Guarantees on a portion of an entitys assets may be permitted. As discussed in the Interpretative guidance and Questions in Chapter 8, when a variable interest holder has a variable interest in a specific asset, and that asset is less than half of the total fair value of the entitys assets, that variable interest is not a variable interest in the entity. Additionally, guarantees of the values of assets in silos (see the Interpretative guidance and Questions in Chapter 7) are not variable interests in the entity as a whole, as silos are treated as separate entities when applying the Variable Interest Model. If it is not a variable interest in the entity, that variable interest should not be considered in evaluating whether the equity holders in the entity have the obligation to absorb expected losses. Because the holders of the equity investment at risk, as a group, must absorb the entitys expected losses, we believe a disproportionate allocation of losses among the equity owners through their equity interests would not violate this criterion as long as the holders of the equity investment at risk, as a group, are exposed to the first dollar risk of loss in the entity. For example, we believe that allocation formulae that distribute losses among the equity holders (through the equity instruments) generally are consistent with this requirement. However, in situations in which the allocation of profits and losses to the equity holders are disproportionate to their voting interests, the Variable Interest Models anti-abuse provisions (see the Interpretative guidance and Questions later in this Chapter) should be evaluated carefully.
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Absorption of expected losses by an equity holder through other than an equity investment
Question 9(b)(2).4 Is an entity a VIE if certain equity holders are protected from risk of loss by instruments other than equity instruments held or issued by other equity holders? Yes. The obligation of variable interests other than equity interests to absorb expected losses of an entity may not be considered in determining if the entitys at-risk equity holders have the obligation to absorb the entitys expected losses, even if the other variable interests are held or issued by an equity investor.
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Absorption of expected losses by an equity holder through other than an equity investment
A partnership is formed by three investors: A, B, and C. Each partner funds $1 million into the partnership for an equal partnership interest (all considered at risk). The partnership uses the funds to acquire an office building for $1.8 million. Additionally, Investor A agrees to guarantee that the value of the building will be at least $1.8 million if sold during the 10 years following its purchase by the partnership, in exchange for a premium of $200,000. The partnership agreement requires that the partnership liquidate no later than the tenth anniversary of its formation. Analysis In this example, an equity holder is obligated to absorb any expected losses of the partnership upon the disposal of the building for less than $1.8 million because of the guarantee. However, because the obligation to absorb expected losses is embodied in an instrument other than an at-risk equity instrument, the partnership is a VIE.
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Analysis Although the guarantee may shield the holders of the equity investment at risk from risk of loss relating to Building Two, because the fair value of the building is less than half of the total fair value of the entitys assets, the residual value guarantee is not considered a variable interest in the entity. As such, expected losses of Building Two absorbed by the tenant are not considered in evaluating whether the equity holders as a group have the obligation to absorb losses. Accordingly, ASC 810-10-15-14(b)(2) is not violated. However, if the guarantee were for $60 million on Building One instead of Building Two, then the guarantee would be a variable interest in the entity because Building One comprises more than onehalf of the fair value of the entitys assets. The tenant of Building One would have a variable interest in the entity. Because that variable interest would protect the equity holders from risk of loss, the entity would be a VIE. We believe the variability created by each building, as well as the overall design and purpose of the structure, should be evaluated in determining whether the entity is a VIE.
Illustrative examples
Question 9(b)(2).8 Illustrative examples The following illustrates the evaluation of whether the holders of an entitys equity investment at risk, as a group, are protected directly or indirectly from expected losses or are guaranteed a return by the entity itself or by other parties involved with the entity (other than an equity holder): Illustration 9-24: Example 1 Facts Lessor XYZ operates a building to be leased by Company ABC. The building is financed with 80% debt ($400 million), with all of the principal due at maturity, and 20% equity ($100 million). The lease term is 10 years. The equity holders are not constrained from selling their interest in Lessor XYZ, make all decisions about the operations of the building and may at any time expand the building and lease space to other lessees. Lessor XYZ has the right to put the building to Company ABC at the end of 10 years for 90% of the buildings fair value at inception or $450 million. Analysis In this example, the put option limits the losses that will be absorbed by the equity holders resulting from decreases in the fair value of the building to $50 million, or from $500 million to $450 million. Because the holders of the entitys equity investment at risk are protected from risk of loss of their investment through the existence of the put option, the entity is a VIE. Obligation to absorb expected losses
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Example 2 Facts Assume the same facts as in Example 1, except that the put option does not exist. Instead, Company ABC guarantees that at the end of 10 years, the building will be worth at least 10% of its fair value at inception, or $50 million. Analysis In this example, the guarantee does not protect the equity investors from risk of loss but rather prevents the lenders from losing more than $350 million if Lessor XYZ defaults on the loan and the building is worth less than $50 million upon foreclosure. If Company ABC is called upon to perform pursuant to the guarantee, the value of the building will have decreased by at least $450 million, and the equity investors will have suffered a complete loss of their investment. Accordingly, the provisions of ASC 810-10-15-14(b)(2) are not violated. Example 3 Facts Assume the same facts as in Example 2, except that instead of guaranteeing the value of the building, Company ABC writes an option giving the debt holders the ability to put the building to it for $250 million at the end of 10 years if the debt holders foreclose on the building. Analysis Similar to Example 2, the put option provided by Company ABC provides protection only to the lenders. The fixed price put option provided to the debt holders would be effective only when the equity investment at risk has been eliminated. As the holder of the entitys equity investment at risk absorbs 100% of the first dollar of expected losses, the provisions of ASC 810-10-15-14(b)(2) are not violated. Example 4 Facts Fortune 500 Company owns and operates ten crude oil refineries in the United States and has been operating in the crude oil refining and marketing business since it first went public in 1956. To manage certain of its business risks, Fortune 500 Company purchases business interruption insurance, and property and casualty insurance, and locks in the difference between the cost of crude and the sales price of refined products on 60% of its future expected processing runs using total return swaps and other derivative financial instruments. Analysis In this example, Fortune 500 Company is not a VIE simply because of the existence of risk management programs. The criterion in ASC 810-10-15-14(b)(2) is meant to identify entities that, by design, protect the holders of the entitys equity investment at risk from losses arising from the primary economic risks of the entity. While certain normal and customary business practices, such as the acquisition of insurance or hedging activities, protect the equity holders from risk of loss, they do not result in the entitys being a VIE. Judgment is required to determine whether, by design, the holders of the equity investment at risk are protected from first dollar risk of loss.
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9.4
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Predetermined distribution arrangements that limit the residual returns of the entity inuring to the equity holders to either a nominal portion of the entitys net cash flows or an amount that lacks significant variability. Illustration 9-25: Example 1 Facts Lessor XYZ operates a building to be leased by Company ABC. The building was financed with 80% debt ($400 million) and 20% equity ($100 million). The lease term is 10 years. At the end of Year 10, the lessee has an option to buy the building for a fixed price (assume $500 million). The equity holder is not constrained from selling its interest in Lessor XYZ, makes all decisions about the operations of the building and may at any time expand the building and lease space to other lessees. Analysis In this example, the entity is a VIE because the fixed price purchase option caps the expected residual returns of the at-risk equity holders. Example 2 Facts Fortune 500 Company owns and operates ten crude oil refineries in the United States and has been operating in the crude oil refining and marketing business since it first went public in 1956. Fortune 500 Company also has a profit sharing plan that provides its employees with up to 10% of its annual operating profit. Analysis In this example, the provisions of ASC 810-10-15-14(b)(3) are not violated simply because of the existence of the employee profit sharing plan. Sharing of an entitys profits with parties other than holders of the equity investment at risk is permitted as long as that sharing does not cap the at-risk equity holders returns. Judgment is required to determine whether, by design, the at-risk equity holders returns are capped. Example 3 Facts A transferor transfers $80 of marketable debt securities and $20 of passive equity investments to a special purpose vehicle (SPV). SPV funds the acquisition of the financial assets by issuing $40 of senior certificates to Company A, $40 of subordinate certificates to Company B, a $10 residual equity interest to Company C and a $10 residual equity interest to the transferor. Both the residual equity interests purchased by Company C and retained by the transferor are pari passu and subordinate to the certificates issued to Company A and Company B. SPV hires C Management Fund (CMF) to be the asset manager. The asset management agreement provides CMF with the ability to buy and sell securities for profit and stipulates that CMF will receive a fixed fee of $5,000 per month, plus any residual profits after the residual equity interest holders receive a 15% IRR. Analysis In this example, the return to the at-risk equity holders is capped at a 15% IRR. Because the return to the residual equity interest holders is capped, the SPV is a VIE. Right to receive expected residual returns
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Equity holder receives expected residual returns through other than an equity interest
Question 9(b)(3).2 Would the provisions of ASC 810-10-15-14(b)(3) be violated if the right to receive an entitys expected residual returns is provided to an equity holder through an instrument other than an equity interest? The right to receive expected residual returns embodied in a variable interest other than an equity interest held by an at-risk equity holder may not be considered when determining whether the entitys atrisk equity holders have the right to receive the entitys expected residual returns. Illustration 9-26: Facts A partnership is formed by three investors: A, B and C. Each partner funds $1 million into the partnership in exchange for a 33% ownership interest. The partnership uses the funds to acquire an office building for $3 million. Additionally, the partnership writes a call option allowing Investor A to purchase the office building from the partnership for $3.5 million upon the fifth anniversary of the partnerships formation. Analysis In this example, the expected residual returns associated with the building will inure to the at-risk equity holders. However, because the call option caps the return provided to the equity holders through their equity interests, the provisions of ASC 810-10-15-14(b)(3) are violated, and the partnership is a VIE (even though the call option merely reallocates the partnerships returns between the partners). Equity holder receives expected residual returns through other than an equity interest
Analysis In this example, the returns to the holders of the entitys equity investment at risk are not capped, because they will continue to receive one-half of all amounts exceeding a 15% IRR. Accordingly, the provisions of ASC 810-10-15-14(b)(3) are not violated.
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Even if a cap on the return of an asset is considered to be a variable interest in the entity as a whole, judgment should be applied based on the facts and circumstances to determine whether the cap, by design, caps the returns of the group of at-risk equity investors. Illustration 9-29: Facts An LLC is formed and issues debt of $90 million and equity of $10 million. The LLC acquires Building One for $60 million and Building Two for $40 million. Each building is leased to separate third party tenants. The lease terms for Building Two allow the tenant to purchase the building for $40 million at the end of five years. Analysis Although the fixed price purchase option caps the returns to the equity holders for Building Two, because the fair value of the building is less than half of the total fair value of the entitys assets, the purchase option is not considered a variable interest in the entity and the expected residual returns allocable to it should not be considered in evaluating whether the return to the equity holders as a group is capped. Conversely, if the lease terms for Building One allowed the tenant to purchase that building at the end of five years for $60 million, the purchase option would give the tenant a variable interest in the entity because Building One comprises more than one-half of the total fair value of the entitys assets. Because the purchase option would cap the returns inuring to the equity holders from Building One, further analysis would be required to determine whether, by design, the equity investors returns are capped. We believe the variability created by each building, as well as the overall design and purpose of the structure, should be evaluated in determining whether the entity is a VIE. Interests in specified assets
We believe the provisions of ASC 810-10-15-14(b) should also be considered in determining whether the group of the at-risk equity investors have the necessary characteristics of a controlling financial interest. ASC 810-10-15-14(b) indicates that if interests other than the equity investment at risk prevent the equity holders from having the characteristics in ASC 810-10-15-14(b), the entity is a VIE. We believe a determination also should be made about whether the call options are part of the entitys design. We do not believe the Variable Interest Model requires each of an entitys variable interest holders to perform an exhaustive analysis to determine all of the other holders rights and obligations. Instead, we believe an interest holder should assess whether the call option is a key element of the overall structure and design of the entity of which the holders are aware (or should be through the transaction documents themselves or inquiry). Illustration 9-30: Effect of call options on an entitys assets or its equity
Example 1 Call option to acquire 100% of entitys assets Facts Assume an entity owns Asset 1 and Asset 2, which have fair values of $51 and $49, respectively. The entity has equity of $100, contributed by a limited number of stockholders. The entity has written a call option to an unrelated party to acquire both assets for $110 at a future date. Analysis We believe the entity is a VIE because the expected residual returns to the holders of the equity investment at risk are capped through the call option on all of the entitys assets. Further, the entity is a VIE because the call option (i.e., an instrument other than the equity investment at risk) prevents the holders of the equity investment from having the characteristics of a controlling financial interest. Example 2 Call option to acquire 100% of entitys outstanding stock Facts Same facts as Example 1, but the stockholders, by design, have written a call option to an unrelated party to acquire 100% of the entitys outstanding voting stock for $110 at a future date. Analysis We believe the entity is a VIE. The substance of Example 1 and Example 2 are identical. In each case, the returns of the current group of the holders of the at-risk equity investment are capped. For the entity to be a voting interest entity, no interests can prevent the equity holders from having the necessary characteristics described in ASC 810-10-15-14(b). The call option is a separate instrument that caps the returns of the current group of equity holders. Thus, the entity is a VIE. Example 3 Call option to acquire a percentage of entitys assets Facts Same facts as Example 1, but the entity has written a call option to an unrelated party to acquire Asset 1 (51% of the entitys assets) for $55 at a future date.
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Analysis We believe the classification of the entity as a VIE is dependent on the facts and circumstances. Although the entity has written an option to buy a majority of the entitys assets at a fixed price, the stockholders returns are not capped as they continue to have a right to the entitys residual rewards on its remaining assets (49% of the total). By design, the equity holders returns are not capped. Rather, the equity holders have diluted their interest in the entitys returns and limited their upside but have not capped their returns. Indeed, they participate fully in the returns on 49% of the assets, which could be significantly more volatile than the majority of its assets. We believe the variability of the respective assets should be determined and compared, and then the design and purpose for which the entity was created should be evaluated, to determine whether the call option on the majority of the entitys assets results in the entitys classification as a VIE pursuant to ASC 810-10-15-14(b).
9.5
Interpretative guidance Anti-abuse clause (when the economics do not follow the votes) (ASC 810-10-15-14(c))
To prevent an entity from avoiding consolidation of a VIE by structuring it with non-substantive voting rights, the Variable Interest Model provides that an entity is a VIE when (1) the voting rights of some investors are not proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected residual returns of the entity, or both and (2) substantially all of the entitys activities (e.g., providing financing or buying assets) either involve or are conducted on behalf of an investor (including the investors related parties (as defined in ASC 810-10-25-43), except its de facto agents under ASC 810-10-25-43(d)) that has disproportionately few voting rights (which could be indicated in some circumstances by disproportional representation on the board of directors). The intent of this provision is to prevent an equity interest from being analyzed under the voting interests model in those instances in which the features of the entitys structure, or the contractual arrangements among the entitys investors, indicate the voting arrangements are not useful in identifying who truly controls the entity. To illustrate how this provision should be applied, assume Company A, a manufacturer, and Company B, a financier, establish a joint venture. The joint venture agreement states that the venture may purchase only Company As products. Company As and Company Bs economic interests are 70% and 30%, respectively. Further assume that Company B has 51% of the outstanding voting rights. In this case, we believe that the entity is a VIE because substantially all of the entitys activities (i.e., buying Company As products) are conducted on behalf of Company A, which has disproportionately few voting rights as compared with its economic interest. The Variable Interest Model does not provide guidance to determine what constitutes substantially all of an entitys activities. We believe this determination will be based on the individual facts and circumstances and will require the use of professional judgment. We do not believe that the holders of the equity interests of an entity that meets the criterion of ASC 81010-15-14(c) should be presumed to have non-substantive voting rights. As such, determining the primary beneficiary of an entity that is a VIE pursuant to ASC 810-10-15-14(c) will require a careful examination of the facts and circumstances. In particular, the provisions of ASC 810-10-25-38G addressing situations in which a reporting entitys economic interest in a VIE, including its obligation to absorb losses or its right to receive benefits, is disproportionately greater than its stated power to direct the activities of a VIE should be carefully considered. Additionally, the provisions of ASC 810-10-15-13A and 15-13B addressing substantive terms, transactions and arrangements should be considered carefully.
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Under the Variable Interest Model prior to Statement 167s amendments, the primary beneficiary of an entity that was a VIE as a result of ASC 810-10-15-14(c)s provisions was often the party with disproportionally few voting rights. This outcome was due to the previous Variable Interest Models quantitative approach for assessing which party was the primary beneficiary. Subsequent to the amendments, the primary beneficiary of a VIE is the party that has (1) the power to direct activities of a VIE that most significantly impact the entitys economic performance and (2) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. Therefore, the party with disproportionally few voting rights may or may not be the primary beneficiary.
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For purposes of evaluating the factors listed, the term investor should be read to include the investor and the investors related parties, except its de facto agents under ASC 810-10-25-43(d). 176
Were substantially all of the entitys assets acquired from the investor with disproportionately few voting rights? Are employees of the investor with disproportionately few voting rights actively involved in managing the operations of the entity? What roles do the variable interest holders play in conducting the entitys operations? Do employees of the entity receive compensation tied to the stock or operating results of the investor with disproportionately few voting rights? Is the investor with disproportionately few voting rights obligated to fund operating losses of the entity, or is the entity economically dependent on the investor? Has the investor with disproportionately few voting rights outsourced certain of its activities to the entity, or vice versa? If the entity conducts research and development activities, does the investor with disproportionately few voting rights have the right to purchase any products or intangible assets resulting from the entitys activities? Has a significant portion of the entitys assets been leased to or from the investor with disproportionately few voting rights? Does the investor with disproportionately few voting rights have a call option to purchase the interests of the other investors in the entity? Fixed price and in the money call options likely are stronger indicators than fair value call options. Do the other investors in the entity have an option to put their interests to the investor with disproportionately few voting rights? Fixed price and in the money put options likely are stronger indicators than fair value put options.
Not all of these conditions must be present to conclude that the activities of the entity are conducted principally on behalf of the investor with disproportionately few voting rights. Determining whether substantially all of a potential VIEs activities involve or are conducted on behalf of an investor (including the investors related parties, except its de facto agents under ASC 810-10-25-43(d)) with disproportionately few voting rights requires the use of professional judgment after considering all of the relevant facts and circumstances.
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An enterprise holds a 10% equity ownership interest in an entity and also has provided subordinated debt financing to the entity such that, in the aggregate, it has provided 70% of the entitys total capitalization. The enterprises voting rights in the entity are proportionate to its 10% equity ownership interest. Substantially all of the entitys activities are conducted on behalf of the enterprise. Analysis Because the enterprise has an overall economic position in the entity equal to 70% of its capitalization (based on the aggregate of its combined debt and equity position), but has only a 10% voting interest, its obligation to absorb expected losses is disproportionate to its voting interest. As substantially all of the entitys activities are conducted on behalf of the enterprise, the provisions of the anti-abuse clause are applicable, and the entity is a VIE.
Limited partnerships
Question 9(c).3 A limited partnership may have a general partner that maintains a relatively minor partnership interest. If the limited partners have protective voting rights (as that term is defined in the Variable Interest Model) in the partnership and the general partner has all of the substantive decision making ability, will such an entity always be a VIE as a result of the Variable Interest Models anti-abuse clause? We do not believe all limited partnerships will be VIEs due to the anti-abuse clause. Although the limited partners have disproportionately few voting rights, the anti-abuse clause is applicable only if substantially all of the entitys activities are conducted on behalf of the limited partner (or the limited partners related parties except its de facto agents under ASC 810-10-25-43(d)). The factors discussed in Question 9(c).1 should be considered to determine if the anti-abuse clause is applicable. Illustration 9-32: Facts A limited partnership is formed to develop multi-family residential housing projects. A real estate development company identifies the site for the housing project, does pre-construction development work, syndicates the partnership interests and serves as the general partner. As general partner, the developer is responsible for constructing the housing project and maintaining and operating the project once constructed. The general partner holds a 1% interest in the partnership, and one limited partner holds the remaining 99% limited partnership interest. The limited partner is not actively involved in real estate development or the provision of residential housing and holds its interest for investment purposes. Analysis It could be viewed that the entity is a VIE because (1) the voting rights of the limited partner are not proportional to its obligations to absorb the expected losses of the entity or receive its expected residual returns (i.e., the limited partner has up to 99% of the partnerships economics and no significant voting rights) and (2) substantially all of the entitys activities are conducted on behalf of the limited partner (i.e., because it has up to a 99% investment in the partnership). However, we do not believe the size of the investment alone is determinative in assessing whether substantially all of the entitys activities are conducted on behalf of the investor with disproportionately few voting rights. Instead, the nature of the activities being performed by the entity should also be considered and compared to the activities performed by the investor as part of its ongoing operations to make this determination. In this case, because the partnership is providing residential housing, and the limited partner is not engaged in that
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Limited partnerships
same activity outside of the partnership, substantially all of the activities of the partnership are not being conducted on behalf of the limited partner with disproportionately few voting rights. Accordingly, the entity is not a VIE pursuant to the Variable Interest Models anti-abuse clause.
Related parties
Question 9(c).4 In part (1) of the first sentence of ASC 810-10-15-14(c) (i.e., voting rights of some investors not proportional to their economics), does the term investors denote a group of related parties, or an investor individually? In part (2) of the anti-abuse clause (i.e., substantially all of the entitys activities conducted on behalf of the investor with disproportionally few voting rights), does the term investor denote a group of related parties, or an investor individually? The term investors in part (1) denotes an individual investor, even if related parties hold variable interests in a potential VIE. In part (2), the term investor denotes the individual investor and its related parties, as defined in ASC 850, and de facto agents as defined by ASC 810-10-25-43 (but excluding de facto agents identified under ASC 810-10-25-43(d) see Question 9(c).5). The anti-abuse clause was designed to prevent an enterprise from avoiding consolidation of a VIE by organizing the entity with nonsubstantive voting interests. In applying the anti-abuse clause, the FASB intended that an individual investor with disproportionately few voting rights (without regard to interests held by its related parties) treat activities of the entity that involve or are conducted on behalf of the investors related parties as if they involve or are conducted on behalf of the investor. Illustration 9-33: Facts Oilco, an oil and gas exploration and production company, Refineco, a crude oil refining company and related party of Oilco, and Investco, an investment company, form an LLC to buy and sell chemical feedstocks commonly used in the refining of crude oil into various petroleum products. Oilco, Refineco and Investco receive economic interests in the LLC of 40%, 20% and 40%, respectively. Voting rights are shared equally between the three parties. The equity investment is deemed to be at risk and is sufficient to absorb the entitys expected losses. The LLC enters into a long-term contract to supply chemicals to Refineco. At inception of the entity, it is anticipated that sales to Refineco will constitute approximately two-thirds of the LLCs revenues. Analysis In this example, because Oilco shares voting rights equally with Investco and Refineco, its voting rights are disproportionate to its obligation to absorb expected losses or receive expected residual returns of the LLC through its equity ownership. If the voting rights held by Oilcos related party, Refineco, were aggregated with its interest, the related party group would not have disproportionately few votes in comparison to their combined economic interest. However, the equity ownership and related voting rights held by Refineco are ignored for purposes of determining if Oilco has disproportionately few voting rights. Although the activities of the entity buying and selling chemical feedstocks commonly used in crude oil refining are not substantially similar in nature to Oilcos own operations as an oil and gas exploration and production company, they are substantially similar to Refinecos operations. As a crude oil refiner, Refineco commonly acquires chemical feedstocks for use in its refining operations. Because sales of chemical feedstocks to Refinceco will constitute approximately two-thirds of the LLCs revenues, the activities of the LLC are deemed to be substantially on behalf of a related party of the investor (Oilco) with disproportionately few voting rights. Accordingly, the entity is a VIE. Related parties
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Analysis In this example, the first condition of the anti-abuse clause is met because Investco has disproportionately few voting rights in comparison with its 80% limited partnership interest. If Investco was required to include Restcos interest with its own because of the de facto agent relationship, the second condition also would be met because the activities of the partnership (the development of commercial real estate) are substantially similar to the activities of Restco. However, because an investor is not required to aggregate its interest with those of its de facto agents (as identified under ASC 810-10-25-43(d)) for purposes of evaluating the applicability of the second condition of the anti-abuse clause, the second condition is not met in this example, and the entity is not a VIE due to the anti-abuse clause.
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Example 2 Facts Assume the same facts as Example 1, except that Partner B makes a loan to the joint venture, which increases its obligation to absorb the entitys expected losses to 54%. Analysis Partner B has disproportionately few voting rights. Partner B has 50% of the ventures voting rights but is obligated to absorb 54% of the ventures expected losses. Part (2) of the anti- abuse clause must be evaluated to determine whether the venture is a VIE.
Illustrative examples
Question 9(c).7 The following examples illustrate the application of the anti-abuse clause: Illustration 9-36: Example 1 Facts Automobile Manufacturing Corp. (AMC) established an entity with Investor Big Bucks (IBB). The sole purpose of the entity is to purchase automobiles manufactured by AMC and to sell the automobiles to various car dealerships in New York, New Jersey and Connecticut. AMC contributed automobiles with a fair value of $200 million to the JV, and IBB contributed $100 million in exchange for a 50% share of the venture. The $100 million was distributed to AMC at inception. AMC and IBB share 50/50 in all decision making activities. Any major decisions (as defined in the operating agreement) that cannot be made because the parties cannot agree are to be submitted to binding arbitration. Profits and losses are shared pro rata until the investors achieve an IRR on their investments of 12%, at which point AMC receives 60% of the entitys profits. It is expected that the entity will generate profits to activate this allocation. Analysis In this example, AMC has disproportionately few voting rights compared with its right to receive expected residual returns. However, it is possible that AMC could conclude that substantially all of the entitys activities are not being conducted on its behalf because the entity has the ability to sell automobiles to entities other than AMC dealerships. Under that view, the entity is not a VIE. However, careful consideration of the facts and circumstances regarding the design and business purpose of the entity is necessary, which could result in a different conclusion. Example 2 Facts Assume the same facts as assumed in Example 1, except that the entity is required to sell all of its automobiles to AMC-owned automobile dealerships. Analysis As in Example 1, AMC has disproportionately few voting rights compared with its right to receive expected residual returns. Because the entity is limited to purchasing all of its automobiles from AMC and is limited to selling them to AMC dealerships, all of its activities involve or are conducted on behalf of AMC. Accordingly, both conditions of the anti-abuse clause are met, and the entity is a VIE. Anti-abuse clause
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Example 3 Facts Assume the same facts as assumed in Example 1, except that (1) AMC contributed $100 million for its share of the entity, (2) the entity initially purchased automobiles from Detroit Auto, an unrelated third party and (3) the entity is not limited to purchasing automobiles from AMC on an ongoing basis. Analysis AMC still has disproportionately few voting rights compared with its right to receive expected residual returns. However, because the entity is not limited to buying or selling automobiles directly with AMC, substantially all of its activities are not involving or conducted on behalf of AMC. As the second condition of the anti-abuse clause is not met, the anti-abuse clause is not violated. Example 4 Facts Assume the same facts as assumed in Example 1, except that certain decisions (as defined in the operating agreement) that constitute elements of power are to be made solely by AMC. Analysis In this example, IBB has disproportionately few voting rights on significant decisions to be made by the entity as compared with its obligation to absorb expected losses and right to receive expected residual returns of the entity. However, as the entitys activities are not substantially on behalf of IBB, the second condition of the anti-abuse clause is not met, and the anti-abuse clause is not violated.
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10.1
Interpretative guidance
The concepts of expected losses and expected residual returns are difficult aspects of the Variable Interest Model to understand and to apply. This difficulty arises primarily because expected losses and expected residual returns are not GAAP or economic losses that are expected to be incurred by the entity or GAAP or economic income that is expected to be earned by the entity. Instead, expected losses and expected residual returns are defined as amounts derived using the techniques described in CON 7. CON 7 requires expected cash flows to be derived by projecting multiple possible outcomes and assigning each possible scenario a probability weight. The multiple outcomes should be based on projections of how different assumptions regarding the factors most likely to significantly affect the entitys results of operations or the fair value of its assets would change the returns available to the entitys variable interest holders. Pursuant to the Variable Interest Model, expected losses and expected residual returns represent the potential for variability in a distribution of possible outcomes of the value of an entitys assets from the expected (or mean) outcome. Scenarios in the distribution in which projected outcomes exceed the expected outcome give rise to expected residual returns (overperformance or positive variability), while possible outcomes that are less than the amount of the expected outcome give rise to expected losses (underperformance or negative variability). The Variable Interest Model also provides that expected losses and expected residual returns represent amounts discounted and otherwise adjusted for market
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factors and assumptions rather than undiscounted cash flow estimates. Because expected losses and expected residual returns represent the potential variability from the expected cash flows of an entity, all entities will have expected losses even those entities that have a history of profitable operations and are projected to be profitable in the future. ASC 810-10 does not provide guidance on which of the various methods should be used to compute expected losses and expected residual returns (e.g., Fair Value, Cash Flow or Cash Flow Prime), each of which are described below. Instead, various methods have emerged in practice, and ASC 810-10-25-22 and ASC 810-10-25-23 require the entitys design to be the basis for applying the Variable Interest Models provisions. Judgment will be required to determine what variability the entity was designed to create and distribute to its interest holders. Variable interests, in turn, are identified based on whether they absorb the variability the entity was designed to create and distribute. ASC 810-10-25-35 and ASC 810-10-25-36 contain special provisions for certain market-based derivatives in that, notwithstanding that a derivative instrument may economically absorb the variability the entity was designed to create and distribute, it is to be considered a creator of variability (and thus not a variable interest) when certain conditions are met. Refer to Chapter 5 for further guidance on these concepts. Expected losses and expected residual returns are calculated after it is determined which variability the entity is designed to create and the instruments that absorb that variability. We are aware of three primary methods to measure variability: Fair Value, Cash Flow and Cash Flow Prime. Fair Value Method The Fair Value Method considers only fair value variability in determining whether an interest is a variable interest. In making this determination, a reporting enterprise considers only if the interest absorbs variability in the fair value of an entitys net assets (exclusive of variable interests). This view initially was developed based on the provisions of the Variable Interest Model that a VIEs expected losses and expected residual returns are based on the expected variability in the fair value of its net assets, exclusive of the effects of variable interests. Under the Fair Value Method, expected losses and residual returns are computed by projecting multiple possible cash flow outcomes under different interest rate environments and assigning each possible scenario a probability weight. Those possible cash flows are discounted to present value using the yield curve that was used in deriving the cash flows under the corresponding scenario. The Fair Value Method seeks to measure variability based on the relative value of cash flows. Interim changes in value are not considered in applying the Fair Value Method only distributable cash is used to measure variability. (As described in the next section, the same cash flows are used in computing variability under the Fair Value Method and Cash Flow Method, except that the Cash Flow Method discounts those cash flows using one constant yield curve, the yield curve that exists as of the evaluation date.) Cash Flow Method The Cash Flow Method computes expected losses and residual returns by projecting multiple possible cash flow outcomes under different interest rate environments and assigning each possible scenario a probability weight. The weighted multiple possible outcomes are discounted at the forward risk-free interest rate curve that exists at the time of the evaluation in computing expected losses and expected residual returns. Interim changes in value are not considered in applying the Cash Flow Method only distributable cash is used to measure variability.
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The Fair Value Method and the Cash Flow Method differ solely in the yield curves used to discount projected cash flow outcomes. The Fair Value Method uses multiple yield curves, representing the possible interest rate environments at the time the cash is distributable, while the Cash Flow Method uses only the yield curve at the evaluation date. There are no differences in the projected cash flows used under the Fair Value and Cash Flow Methods. Cash Flow Prime Method A variation of the Cash Flow Method also has been used in practice, which we refer to as the Cash Flow Prime Method. This approach assumes interest rate risk associated with the variability in periodic interest cash flows is not included in the calculation of expected losses and expected residual returns. That is, unlike the Cash Flow Method, in which numerous cash flow outcomes are projected under varying interest rate environments and then discounted using a static yield curve, the Cash Flow Prime Method projects periodic interest cash flows from variable rate instruments and discounts those cash flows at the same, static interest rate curve. That is, the cash flows are projected and discounted using the same yield curve. Mathematically, this results in the creation of no variability on periodic interest receipts from variable-rate instruments due to interest rate risk (both cash flow methods result in no variability due to interest rate risk for fixed-rate instruments). The Cash Flow Prime Methods cash flows differ from those used in the Fair Value and Cash Flow Methods because the Fair Value and Cash Flow Methods project multiple possible cash flow outcomes under different interest rate environments while the Cash Flow Prime Method projects future cash flows using only one interest rate environment the yield curve that is also used to discount those same cash flows. We generally expect the Cash Flow Prime Method will be used frequently in applying the Variable Interest Models provisions because: Many entities that hold primarily financial assets will not be designed to create and pass along interest rate risk because that risk is typically hedged through the use of interest rate swaps or other agreements and the entities often are not designed to create and distribute variability resulting from periodic interest receipts/payments (the Fair Value and Cash Flow Methods measure that variability), and The most practical way to measure variability for entities that are businesses or primarily hold or operate real estate or nonfinancial assets is based on variability in cash flow.
Appendix F includes a comprehensive example of the Cash Flow Prime Method for an entity holding real estate. Prior to Statement 167s amendments, expected losses and expected residual returns were used to determine the primary beneficiary of a VIE, which required an assessment of which party absorbed a majority of the entitys expected losses, received a majority of the entitys expected residual returns, or both. However, as a result of the amendments to the Variable Interest Model, the primary beneficiary is based upon a qualitative analysis. (See Interpretative guidance and Questions in Chapter 14 of this publication.) Therefore, FIN 46(R)s quantitative assessment for determining the primary beneficiary is no longer relevant after Statement 167s amendments to the Variable Interest Model. However, the Variable Interest Model continues to utilize the concepts of expected losses and expected residual returns for certain provisions. Namely, the concepts of expected losses and expected residual returns are still applicable in the following situations, among others: Determining whether the total equity investment at risk is sufficient to permit an entity to finance its activities without additional subordinated financial support and thus, whether an entity is a VIE
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Determining whether an enterprise has a variable interest (Chapters 5 and 6) Determining whether (1) the voting rights of some investors are not proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected residual returns of the entity, or both and (2) substantially all of the entitys activities either involve or are conducted on behalf of the investor that has disproportionately few voting rights and thus, whether an entity is a VIE
Thus, the Variable Interest Model still will require an enterprise to perform a quantitative analysis in certain scenarios.
$16million
Expectednetincome
$14million
$12million
} }
Expectedresidualreturns
Expectedlosses
Although the entity has been profitable historically and is expected to remain profitable, it has expected losses because there is variability around its mean, or expected outcome, of $14 million. Any possible outcome with net income of less than $14 million gives rise to expected losses. Conversely, any possible outcome that produces more than $14 million of net income gives rise to expected residual returns.
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Expected losses and expected residual returns are based on design of entity
Question 10.2 Are expected losses and expected residual returns based on variability in an entitys cash flows, based on variability in the fair value of an entitys net assets, or both? The provisions of the Variable Interest Model are to be applied based on the variability the entity was designed to create and distribute to its interest holders. Refer to Chapter 5 for further guidance on determining the design of the entity and identifying variable interests and the Interpretative guidance section of this chapter for information on the various methods to compute expected losses and expected residual returns.
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Assume an entity is capitalized with debt and equity and uses the proceeds to purchase a building. The entity enters into a contract with a management company to manage the day-to-day operations of the building. Assume it is determined that the management contract is not a variable interest. In developing the first years possible outcomes, the following should be considered:
Cash inflows from building (rent, etc.) Cash outflows to non-variable interest holders Cash available to variable interest holders used in computing expected losses and expected residual returns $ $ 1,000 (200) 800
Analysis The interest on the debt and any payments to the equity holders should not be deducted in determining the entitys expected losses and expected residual returns. The $800 should be used to determine the VIEs expected losses and expected residual returns, which should then be allocated to the entitys variable interest holders pursuant to the contractual arrangements that exist among the parties. For taxable entities (e.g., corporations but not partnerships), after-tax cash flow outcomes should be used. Except in certain circumstances (e.g., tax motivated structures such as affordable income housing partnerships), we believe that tax expense or benefit borne by or inuring to variable interest holders outside an entity should not be included in the cash flow outcomes used to determine if the entity is a VIE. Under the CON 7 approach, fair value (expected outcome) is the mean of a distribution of possible outcomes. Accordingly, the sum of the products of (1) each possible outcome of the entity and (2) the related probability for such outcome, when discounted using the risk-free rate, should derive the fair value of the entity. That is, the mean of the probability weighted, discounted outcomes of the entity under evaluation should equal its fair value. To illustrate the CON 7 expected outcome approach, assume a cash flow of $1,000 may be received in one year, two years or three years with probabilities of 10%, 60% and 30%, respectively.
Estimated outcome Year 1 Year 2 Year 3 $ 1,000 $ 1,000 $ 1,000 Probability 10% 60% 30% 100%
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Discounted at the interest rate on default risk-free investments (assumed to be 5.00% for all years). 189
In this example, the timing of the cash flows associated with the three outcomes is uncertain. Under CON 7s expected outcome approach, each estimated outcome is assigned a probability of being realized. That probability is multiplied by the estimated outcome to arrive at the expected outcome. Each expected outcome is then discounted to present value using the interest rate on the corresponding default risk-free investment, because the uncertainty about timing of collection is already reflected in the probabilities assigned. While any combination of outcomes and interest rates can be used to compute a present value, the CON 7 expected outcome approach should be used in performing the computations required by the Variable Interest Model. To illustrate how expected losses and expected residual returns are calculated, in the previous example, there were three different scenarios in which the $1,000 could be collected. Each was assigned a probability based on the estimate of that scenario occurring, and the expected outcome was computed. The expected outcome for each scenario was then discounted to obtain the expected outcome (which equals the fair value) of the instrument. The following table illustrates how expected losses and expected residual returns for the instrument are computed based on the expected outcome.
Expected Estimated outcome Year 1 Year 2 Year 3 $ 1,000 $ 1,000 $ 1,000 Discounted outcomes24 (a) $ 952.38 907.02 863.84 Fair value (b) $ 898.61 898.61 898.61 Expected probability (c) 10% 60% 30% 100%
Expected losses and expected residual returns are computed by subtracting the present value of each possible outcome from the fair value of the instrument and multiplying the difference by the probability associated with the possible outcome. An expected loss arises when the present value of the possible outcome is less than the fair value of the instrument. Conversely, if the present value of the possible outcome is more than the fair value of the instrument, an expected residual return results. Because expected losses and expected residual returns are computed based on the variability from the expected outcome (i.e., fair value), the absolute values of expected losses and expected residual returns will be equal. This simple example illustrates how expected losses and expected residual returns are calculated for an entity that is to realize a $1,000 cash flow on one of three dates. In practice, entities will have multiple assets, cash flows and fair values that could vary significantly among a large number of possible outcomes.
24
Discounted at the interest rate on default risk-free investments (assumed to be 5.00% for all years). 190
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To determine the present value of projected outcomes, each possible cash flow outcome is multiplied by its related judgmentally determined probability of occurrence. These products are then discounted using the interest rate on the appropriate default risk-free investment (the risk-free rate). The risk-free rate is used because all significant risks relating to the outcomes, and how those risks might impact the amount and timing of the outcomes, are explicitly considered when projecting multiple outcomes using differing assumptions about the factors that could significantly affect the entitys results of operations or the fair value of its assets and in judgmentally weighting the likelihood of occurrence of each outcome. Because this method results in projections that demonstrate how differing assumptions change the timing and amount of an entitys returns, it allows quantification of the potential variability in the returns available to the entitys variable interest holders. This quantification of potential variability is key in determining if an entity has sufficient equity to absorb its expected losses (if this cannot be determined qualitatively see the Interpretative guidance and Questions in Chapter 9) and may be relevant for evaluating other provisions of the Variable Interest Model as noted above. Use of a risk adjusted interest rate for discounting instead of the risk-free rate may disguise a portion of an entitys potential variability and could result in an inappropriate conclusion as to whether an entity is a VIE, even if multiple outcomes are projected for an entity.
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This illustration is based on a hypothetical pool of financial assets with total contractual cash flows of $1 million The entity issued to one enterprise for $733,333 an $800,000 par zero-coupon debt that matures in one year Another enterprise made an investment of $23,810 for all of the entitys equity The total proceeds of $757,143 were invested in a pool of assets All of the entitys assets will be liquidated at the end of one year The appropriate discount rate (the interest rate on default risk-free investments) is 5%
Analysis As illustrated below, the entitys expected losses and expected residual returns are $26,667. Because the equity investment at risk ($23,810) is insufficient to absorb the entitys expected losses ($26,667), the entity is a VIE (see the Interpretative guidance and Questions in Chapter 9). Table 1 shows the entitys possible outcomes, the probabilities associated with these outcomes (column b) and how the outcomes are allocated to the debt holder (column c) and the equity holder (column d). The debt holder receives all of the VIEs cash flow up to $800,000, at which point the debt has been repaid and any further cash flows are to be received by the equity holder.
Table 1 Allocation of outcomes to variable interest holders Possible end of year one outcomes (a) $ 650,000 700,000 750,000 800,000 850,000 900,000 Outcomes to: Probability (b) 5% 10% 25% 25% 20% 15% $ Debt (c) 650,000 700,000 750,000 800,000 800,000 800,000 $ Equity (d) 50,000 100,000
Table 2 shows how expected losses and expected residual returns for the debt holder are computed. The present value of each possible outcome received by the debt holder is compared to the fair value of the debt holders variable interest. That difference is multiplied by the probability of occurrence to compute the debt holders expected losses and expected residual returns. For example, in the potential outcome where $650,000 is received from the entitys assets, all of the cash flows would be allocated to the debt holder. The fair value of that outcome is $619,048 ($650,000 discounted at the assumed risk-free rate of 5%). That potential outcome represents negative variability from the expected outcome of the debt holder, which is $733,333. The difference between these two amounts is multiplied by the probability of occurrence (5%) and results in an expected loss of $5,714.
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Table 2 Debt holder expected losses and expected residual returns Present value of possible debt outcomes (e)=(c)/(1+RF rate) $ 619,048 666,667 714,286 761,905 761,905 761,905 (5,714) (6,667) (4,762) $ (17,143) $ 733,333 (f) $ Expected losses Expected residual returns [(e)-(f)]*(b) $ 7,143 5,714 4,286 17,143
Table 3 shows how expected losses and expected residual returns are computed for the equity holder. This computation is consistent with the computations presented in Table 2.
Table 3 Equity holder cash flow variability Equity holder outcome variability Present value of possible equity outcomes (g) = (d)/(1+RF rate) $ 47,619 95,238 (1,191) (2,381) (5,952) (5,952) $ (15,476) $ 23,810 (h) $ Expected losses Expected residual returns [(g)-(h)]*(b) $ 4,762 10,714 15,476
The expected losses and expected residual returns of the variable interest holders, and of the entity, may be summarized as follows:
Expected losses Debt holder (Table 2) Equity holder (Table 3) Total variable interests Total entity $ (17,143) (15,476) $ (32,619) $ (26,667) Expected residual returns $ $ $ 17,143 15,476 32,619 26,667
It should be noted that the sum of the expected losses and expected residual returns of the debt holder and equity holder exceeds the entitys expected losses and expected residual returns. This difference arises because an estimated outcome may cause one variable interest holder to receive an expected residual return while another variable interest holder absorbs an expected loss in the same outcome. For example, in the possible outcome in which $800,000 is to be received by the entity (Table 1), all of the returns are allocated to the debt holder, and based on the computation, the debt holder has an expected residual return ($7,143 from Table 2), while the equity holder has an expected loss ($5,952 from Table 3). We believe that the sum of the variable interest holders expected losses and expected residual returns must be adjusted to equal those of the entity. Question 10.7 discusses ways in which this adjustment may be made.
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Sum of expected losses and expected residual returns of variable interest holders exceed those of the VIE
Question 10.7 The sum of the expected losses and expected residual returns of the variable interest holders in an entity generally will exceed the expected losses and residual returns of the VIE. Should an adjustment be made to the expected losses and expected residual returns of the variable interest holders such that their sum equals the expected losses and expected residual returns of the VIE? If so, how? As noted above, it may be necessary in certain situations to allocate a VIEs expected losses and expected residual returns to its variable interest holders. In general, we believe that to perform this analysis, the possible outcomes of the entity should be allocated to the entitys variable interest holders pursuant to the contractual arrangements among the parties. The contractual arrangements will determine how the entitys outcomes are to be distributed (both in amount and priority) to its variable interest holders. The probability-weighted present value of each estimated outcome should be calculated and then used to compute each variable interest holders expected losses and expected residual returns based on the potential variability of these estimated outcomes from the expected outcome, which is the fair value of each holders variable interest. However, when the possible outcomes of the VIE are allocated, and expected losses and residual returns are computed for the variable interest holders, the sum of the variable interest holders expected losses and expected residual returns generally will exceed those of the VIE. This is due to one or more variable interest holders in an entity having a senior priority to other variable interests. The most common example of this may be debt and preferred stock holders having a senior priority to common equity holders, but this will occur in most entities regardless of the actual form of the capital structure. The following illustration builds on the example in Question 10.6: Illustration 10-3 Sum of expected losses and expected residual returns of variable interest holders exceed those of the VIE
Assume a VIE has the following potential outcomes and related expected losses and residual returns:
Potential outcome $ 650,000 700,000 750,000 800,000 850,000 900,000 $ Expected losses $ (6,905) (9,048) (10,714) (26,667) $ Expected residual returns $ 1,191 10,476 15,000 26,667
The VIE has two variable interest holders, a senior debt holder and an equity holder. The expected losses and expected residual returns of each are as follows, based on an allocation of the VIEs potential outcomes to each based on the contractual arrangements.
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Debt holder Potential outcome $ 650,000 700,000 750,000 800,000 850,000 900,000
Equity holder Expected losses $ (1,191) (2,381) (5,952) (5,952) $ (15,476) $ $ Expected residual returns 4,762 10,714 15,476 $
Total VIs Expected losses (6,905) (9,048) (10,714) (5,952) $ (32,619) $ Expected residual returns $ 7,143 10,476 15,000 32,619
As shown above, the sum of the expected losses and expected residual returns of the variable interest holders ($32,619) exceeds those of the entity ($26,667). The difference arises because in the $800,000 outcome, the debt holder receives an expected residual return of $7,143, while the equity holder absorbs an expected loss of $5,952. These two amounts net to the entity level expected residual return of $1,191. We believe that the expected losses and expected residual returns used to determine the primary beneficiary of an entity must equal the expected losses and expected residual returns of the entity under evaluation. There are two common approaches used to accomplish this: 1. For any outcome in which a variable interest holder experiences an expected loss while other variable interest holders receive an expected residual return, the expected loss is left with its variable interest holder(s). Further, beginning with the most senior variable interest holder, the variable interest holder(s) receiving the expected residual returns move the lesser of (1) the sum of the expected losses absorbed by the subordinated interests or (2) the expected residual returns inuring to the senior interests, from the expected residual returns of the senior interests to their expected losses. Using the amounts from the above examples, this is demonstrated below in the shaded portions of the table:
Debt holder Potential outcome $ 650,000 700,000 750,000 800,000 850,000 900,000 Expected losses $ (5,714) (6,667) (4,762) 5,952 $ (11,191) $ Expected residual returns $ 1,191 5,714 4,286 11,191 Equity holder Expected losses $ (1,191) (2,381) (5,952) (5,952) $ (15,476) $ Expected residual returns $ 4,762 10,714 15,476 Expected losses $ (6,905) (9,048) (10,714) $ (26,667) $ Total Expected residual returns $ 1,191 10,476 15,000 26,667
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After this adjustment, the sum of the expected losses and expected residual returns of the variable interest holders ($26,667) equals those of the entity ($26,667). 2. For any outcome in which a variable interest holder(s) experiences an expected loss while another variable interest holder(s) receives an expected residual return, all amounts allocated to each variable interest holder are shown as either an expected loss or expected residual return, depending on what the entity has experienced (i.e., the entity result serves as a control, such that if, for example, the entity experienced an expected loss for an outcome, all amounts for each variable interest holder will be reflected as an expected loss). Using amounts from the previous example, this method is demonstrated below in the shaded portions of the table:
Debt holder Potential outcome $ 650,000 700,000 750,000 800,000 850,000 900,000 Expected losses $ (5,714) (6,667) (4,762) $ (17,143) $ Expected residual returns $ 7,143 5,714 4,286 17,143 $ Equity holder Expected losses $ (1,191) (2,381) (5,952) (9,524) $ Expected residual returns $ (5,952) 4,762 10,714 9,524 Expected losses $ (6,905) (9,048) (10,714) $ (26,667) $ Total Expected residual returns $ 1,191 10,476 15,000 26,667
After this adjustment, the sum of the variable interest holders expected losses and residual returns again equals the entitys. However, under this method the debt holder is identified as the primary beneficiary because it absorbs 64% ($17,143 divided by $26,667) of the entitys expected losses. As ASC 810-10 does not provide any detailed interpretative guidance as to how any adjustment should be made, we believe either of the two methods is acceptable. However, an enterprise should make an accounting policy election as to which method it will use and apply that method consistently for all entities.
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Assume that an entity has one asset, which is a zero coupon bond maturing in one year that has a fair value, based on quoted market prices, of $1.5 million. The possible cash flows that the entity may receive upon maturity of the bond, the judgmentally assigned probabilities of each possible outcome and the present values of each set of possible outcomes (discounted using an assumed risk-free rate of 5%) are as follows:
Possible end of year one outcomes $ 1,250,000 1,375,000 1,500,000 1,750,000 2,000,000 Present value of possible outcomes $ 1,190,476 1,309,524 1,428,571 1,666,667 1,904,762 Estimated probability of outcomes 20% 20% 20% 20% 20%
Analysis The fair value of the net assets of the enterprise, exclusive of variable interests, is equal to the fair value of the bond (as the bond is the entitys only asset and all other liabilities are variable interests). The fair value of the entity can be derived from the distribution of possible outcomes of the entity, as demonstrated below:
Possible end of year one outcomes $ 1,250,000 1,375,000 1,500,000 1,750,000 2,000,000 Present value of possible outcomes $ 1,190,476 1,309,524 1,428,571 1,666,667 1,904,762 Estimated probability of outcomes 20% 20% 20% 20% 20% 100% $ Fair value check $ 238,095 261,905 285,714 333,333 380,952 1,500,000
An entitys possible outcomes may have to be allocated to the entitys variable interest holders in certain situations. If so, the products of the possible outcomes allocated to the individual variable interest holders, when probability weighted (the probability weightings for each possible outcome should be the same as those of the entity for each variable interest holder that is, the probability weighting should remain constant throughout the computation) and discounted using the risk-free rate, should equal (or closely approximate) the fair value of each individual variable interest holders interest. Another reasonableness check is to ensure that the absolute value of expected losses equals expected residual returns. Expected losses and expected residual returns represent the potential variability in an entitys returns from an expected outcome, which is the mean of a distribution of possible outcomes for the entity. Because expected losses and expected residual returns represent potential negative and positive variability from the mean, the absolute value of expected losses and expected residual returns will be equal. This is true for expected losses and expected residual returns of an entity, as well as for expected losses and expected residual returns of variable interest holders in an entity.
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Using the same assumptions as in the example above, expected losses and expected residual returns of the entity can be computed as follows:
Possible end of year one outcomes $ 1,250,000 1,375,000 1,500,000 1,750,000 2,000,000 Present value of possible outcomes $ 1,190,476 1,309,524 1,428,571 1,666,667 1,904,762 Fair value of net assets $ 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000 Estimated probability of outcomes 20% 20% 20% 20% 20% 100% $ Expected losses (61,905) (38,095) (14,286) $ (114,286) Expected residual returns $ 33,333 80,952 $ 114,286
Analysis The absolute value of the entitys expected losses $114,286 is equal to its expected residual returns. Satisfying the reasonableness checks may prove challenging. Determining the possible outcomes and selecting the appropriate probability weightings of these possible outcomes that result in the expected outcome approximating the fair value of the entitys net assets exclusive of variable interests (and, if allocations must be made to variable interest holders, the fair value of the variable interest holders interests) will likely be an iterative process.
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Inability to obtain information necessary to calculate expected losses and expected residual returns
Question 10.11 An enterprise may need to obtain information from third parties to be able to calculate an entitys expected losses and expected residual returns. What if it is unable to obtain the necessary information? The inability to obtain information may make it difficult to complete a calculation of expected losses and expected residual returns for an entity in which a company has a variable interest. The Variable Interest Model does provide for a limited scope exception in situations in which an enterprise has a variable interest in a VIE, or potential VIE, but, after making exhaustive efforts, is unable to obtain the information necessary to (1) determine if the entity is a VIE, (2) determine whether it is the primary beneficiary of the VIE or (3) consolidate a VIE for which it determines it is the primary beneficiary (see the Interpretative guidance and Questions to Chapter 4). The exception is applicable only to entities formed prior to 31 December 2003. Additionally, the exception may be applied only until the necessary information is obtained, at which point the Variable Interest Models provisions apply. Companies have a continuing obligation to attempt to obtain the necessary information to make the appropriate accounting determinations. Disclosures are required during the period the scope exception is applied. The FASB limited the exception to entities formed prior to 31 December 2003 because it believes the need for the information necessary to apply the Variable Interest Model should have been contemplated in connection with the creation of an entity formed subsequent to 31 December 2003. If enterprises are unable to obtain information needed to complete the computation of the entitys expected losses and expected residual returns, and the entity was formed subsequent to 31 December 2003, the enterprise should make reasonable assumptions about the missing information and prepare the computation using those assumptions.
See the Interpretative guidance and Questions in Chapter 8 for further discussion of variable interests in specified assets of an entity.
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Because the loan by Lender A was made on a nonrecourse basis, it will absorb all expected losses related to any decreases in the value of Asset A from $300 to $200, or the total expected losses of $60 less the expected losses of $40 attributable to possible outcomes in which the value of Asset A decreases to amounts less than $200. Additionally, there is a 5% chance that Guarantor A will not perform on the guarantee. In such instances, the expected losses relating to decreases in Asset As value below $200 will be absorbed by Lender A. Accordingly, an additional $2 of expected losses are allocated to Lender A (5% of $40). Guarantor A is allocated the remaining expected losses relating to Asset A of $38 ($60-$22).
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Company A acquires a 99% limited partner interest in a limited partnership formed to provide affordable housing. It is anticipated that the partnership will generate housing credits and tax losses, including depreciation and interest expense, over the life of the project. These tax losses and credits will be allocated almost entirely to Company A, which anticipates that it will be able to utilize them in its consolidated income tax return to offset taxable income generated by its other operations and investments. Company As cost of acquiring the limited partner interest is based primarily on the estimated tax benefits to be earned. Analysis Because Company A has in substance acquired the right to receive tax benefits, and the fair value of the investment was based primarily on the anticipated receipt of those tax benefits, the tax benefits that Company A will realize should be included in the calculation of the partnerships expected losses and expected residual returns even though those benefits are realized outside of the partnership itself (by their inclusion in Company As consolidated income tax return). Excluding these benefits would not reflect the true variability in each variable interest holders returns.
Concepts underlying the application of Fair Value, Cash Flow and Cash Flow Prime Methods
Question 10.16 What are the underlying concepts in applying the Fair Value, Cash Flow and Cash Flow Prime Methods to computing expected losses and expected residual returns? The Fair Value, Cash Flow and Cash Flow Prime Methods measure variability differently because they use different combinations of cash flows and discount rates. We believe the probabilities assigned to the various scenarios should be consistent among the three methods. While the Fair Value and Cash Flow Methods use the same cash flows, they use different discounting techniques; the Fair Value Method varies the discount rate by scenario while the Cash Flow Method uses the forward yield curve to discount the cash flows. While the Cash Flow and Cash Flow Prime Methods both use the forward yield curve to discount the cash flows, the cash flows between the two methods vary. The Cash Flow Method projects various potential cash receipts from variable-rate assets, while the Cash Flow Prime Method projects and discounts the cash flows from variable-rate assets using the same forward yield curve. To illustrate the use of discounting techniques in applying the various approaches, consider the following examples:
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Fair Value Fixed rate US obligation Cash flow fixed. Discount rate varies by scenario. Expected losses and expected residual returns occur as fair value of cash flow varies. Cash flow projected based on forward yield curve and discounted at same curve. No expected losses and expected residual returns.
Cash Flow Cash flow fixed. Discounted using one yield curve. No expected losses and expected residual returns as cash flow is fixed. Cash flows vary by scenario but are discounted using one yield curve, giving rise to expected losses and expected residual returns.
Cash Flow Prime Cash flow fixed. Discounted using one yield curve. No expected losses and expected residual returns as cash flow is fixed. Cash flow projected based on forward yield curve and discounted at same curve. No expected losses and expected residual returns.
Assume a fixed rate US government obligation has a par value of $1,000, a 5% coupon and matures in one year. Its cash flows are fixed at $1,050. The Fair Value Method discounts this fixed cash flow by various rates, reflecting the potential for changes in the yield curve that is, changes in the fair value of those cash flows. These different discount rates give rise to variability in fair values, resulting in expected losses and expected residual returns. For example, if the discount rate in one scenario was assumed to be 2%, the present value of that cash flow is $1,029 ($1,050/1.02), which gives rise to an expected residual return ($1,029 is greater than $1,000). As a further example, if the discount rate in another scenario was assumed to be 7%, the present value of that cash flow is $981 ($1,050/1.07), which gives rise to an expected loss. As indicated in the table, for a variable rate US government obligation, the Fair Value Method produces no expected losses or expected residual returns (because the rate used to project the cash flow is the same rate used to discount that cash flow). By varying the discount rate, mathematically, the sum of the present value of the probability weighted scenarios will equal the fair value of the instrument for which expected losses and expected residual returns are being computed. The Cash Flow Method produces expected losses and expected residual returns for a variable rate US government obligation because the cash flows vary by scenario, but are discounted using one forward yield curve. Conversely, for a fixed rate US government obligation, no expected losses or expected residual returns arise because the cash flows do not vary (they are fixed and there is no credit risk assumed). The Cash Flow Prime Method differs from the Cash Flow Method in that under the Cash Flow Prime Method, the cash flows for a variable rate US government obligation are projected and discounted using the same forward yield curve. As such, the Cash Flow Prime Method yields no expected losses or expected residual returns for a US government obligation, as the cash flows are fixed. While a reporting enterprise must compute expected losses and expected residual returns for an entity using only one method, the varying designs of each entity may mean that each of the methods is used by the reporting enterprises in applying the Variable Interest Models provisions. That is, the selection of a method to compute expected losses and expected residual returns is not an enterprise-wide accounting policy election that must be followed consistently for all variable interests in VIEs. The calculations under the Fair Value, Cash Flow and Cash Flow Prime Methods should be performed by: 1. Projecting, in both cases at the time of their expected distribution to variable interest holders, under a variety of probabilistic scenarios: a. The cash flows from the VIEs net assets (excluding all variable interests), and
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b. The fair value of any VIE assets distributed to variable interest holders. To the extent distributed cash flows or asset values depend on future interest rates, foreign exchange rates or other factors (e.g., the price of oil), changes in those factors should be considered in making these calculations. 2. Allocating the cash flows computed in (1) to the applicable variable interest holders (or class of variable interest holders) pursuant to the VIEs contractual arrangements. 3. Discounting the cash flows computed in (1) and (2) to present value using the zero coupon risk-free rates that correspond to the cash flows of each scenario under the Fair Value Method and discounting using the same forward yield curve under the Cash Flow and Cash Flow Prime Methods. In addition, the present value of the probability-weighted cash flows should be reconciled to the fair value of the net assets and each variable interest. 4. Computing expected losses and expected residual returns for the VIEs net assets (excluding variable interests) and for each variable interest (or class of variable interests) using the net present values computed in (3). 5. Adjusting the variability computed in (4) so the sum of variability for the variable interests equals the variability for the VIE as a whole.
Effect of the application of the fair value accounting provisions in ASC 820
Question 10.17 How do the fair value provisions in ASC 820 affect the calculations of expected losses and expected residual returns? ASC 820, primarily codified from Statement 157, defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. Accordingly, the application of ASC 820s provisions generally should be considered in the measurement of fair value throughout GAAP. However, as noted in Chapter 2, the Variable Interest Model describes expected losses and expected residual returns as amounts derived from expected cash flows as described in [CON 7], and this guidance was not amended by the issuance of Statement 157. Under fair value theory, a market risk premium generally represents the compensation risk-averse market participants demand for bearing uncertainty in cash flows. Because of how expected losses and expected residual returns are defined, expected losses and expected residual returns are not fair value measurements themselves under either ASC 820 or CON 7. Therefore, we do not believe that the framework of the Variable Interest Model requires consideration of a market risk premium (as contemplated in a fair value measurement under ASC 820 and CON 7) in the computation of expected losses and expected residual returns. However, we do believe that consideration of the uncertainty in the timing and amount of the entitys cash flows themselves is an essential element of the calculation of expected losses and expected residual returns. (Said differently, while the compensation demanded for bearing the risk of cash flow uncertainty may not be included in the analysis, the uncertainty itself should be captured as it is fundamental to determining a variable interest entitys expected losses or expected residual returns under ASC 810-10.) Paragraphs 42 through 61 of CON 725 discuss two methodologies for incorporating cash flow uncertainty into a fair value measurement. The risk associated with cash flow uncertainty can be included in the discount rate (as described in the traditional approach) or in the cash flows of an expected cash flow approach.
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Since an expected loss and expected residual return analysis under the Variable Interest Model is predicated on identifying discrete, possible outcomes in order to assess variability, we do not believe the traditional approach is appropriate for this analysis. Instead, we believe that the use of a risk-free interest rate is appropriate under the Variable Interest Model as, ideally, all of the cash flow uncertainty associated with the entity should be captured in the expectations of the cash flows and not the discount rate. The analysis should incorporate a number of possible outcomes sufficient to describe the full probability distribution of outcomes. Although determining the appropriate number of possible outcomes is based on professional judgment, we believe that an analysis that considers a limited number of possible outcomes (e.g., worst case, base case and best case) will, in many situations, be insufficient to capture appropriately the variability in the expected cash flows. Adequately determining the probability distribution of possible outcomes is critical to this analysis and can have a significant effect on the determination of expected losses and expected residual returns. For example, the calculation of expected losses and expected residual returns can differ significantly when the distribution of possible outcomes is performed using a less defined distribution instead of an approach that considers outcomes at a more granular level.
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11.1
Interpretative guidance
The initial determination of whether an entity is a VIE is to be made on the date on which an enterprise becomes involved with the entity, which is generally when an enterprise obtains a variable interest (e.g., an investment, loan, lease, etc.) in the entity. The determination of whether an entity is a VIE and, if so, who is the entitys primary beneficiary, if any, is to be based on the circumstances that exist at the date of the assessment, including future changes that are required in existing governing documents and existing contractual arrangements. Anticipated (but not required) changes in contractual provisions should not be considered in this determination.
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When considering materiality, an enterprise should consider the magnitude of its variable interest(s) or the potential VIE(s), both individually, and in the aggregate. Professional judgment should be used to determine whether a reporting enterprise may be able to avail itself of the immateriality clause.
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Example 2 Facts A partnership is formed to construct and operate a commercial office building. A construction loan is obtained during the construction phase of the project, and permanent financing is expected to be obtained upon completion of the project. The construction loan is anticipated to be repaid from the proceeds of that permanent financing. Analysis In this situation, the initial determination of whether the entity is a VIE is based only on the contractual arrangements in place at inception of the venture (i.e., it should not be assumed that the permanent financing will be obtained and the construction loan will be repaid). The VIE status should be reconsidered when the construction loan is repaid and permanent financing is obtained because the contractual arrangements among the parties involved will have changed at that date (see Interpretative guidance and Questions in Chapter 12).
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Reconsideration events
Excerpt from Accounting Standards Codification
Consolidation Overall Subsequent Measurement Reconsideration of Initial Determination of VIE Status 810-10-35-4 A legal entity that previously was not subject to the Variable Interest Entities Subsections shall not become subject to them simply because of losses in excess of its expected losses that reduce the equity investment. The initial determination of whether a legal entity is a VIE shall be reconsidered if any of the following occur: a. b. c. The legal entitys governing documents or contractual arrangements are changed in a manner that changes the characteristics or adequacy of the legal entitys equity investment at risk. The equity investment or some part thereof is returned to the equity investors, and other interests become exposed to expected losses of the legal entity. The legal entity undertakes additional activities or acquires additional assets, beyond those that were anticipated at the later of the inception of the entity or the latest reconsideration event, that increase the entitys expected losses. The legal entity receives an additional equity investment that is at risk, or the legal entity curtails or modifies its activities in a way that decreases its expected losses. Changes in facts and circumstances occur such that the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entitys economic performance.
d. e.
12.1
Interpretative guidance
Reconsideration of whether an entity is a VIE An entity that previously was not subject to the Variable Interest Model does not become subject to it simply because of losses that reduce the equity investment, even if they are in excess of expected losses, and even if the equity investment is reduced to zero. In other words, if the amount of the equity investment at risk at the entitys inception was determined to be sufficient, the incurrence of losses (in and of itself) does not trigger a need to reconsider whether the entity continues to have sufficient equity. The Variable Interest Model requires an enterprise to reevaluate the status of an entity as a VIE upon certain events that are listed in ASC 810-10-35-4. In providing such a list, the FASBs intention was that enterprises not be required to reevaluate whether each entity with which they are involved is a VIE at each periodic reporting date, but rather only upon the occurrence of certain significant events. An event is significant if it changes the design of the entity such that the event calls into question (1) whether the entitys equity investment at risk is sufficient or (2) whether the rights and obligations provided to holders of the entitys at-risk equity investment are characteristic of a controlling financial interest. Presumably, these types of events are occurrences of which variable interest holders in an entity will be, or should be, aware.
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12 Reconsideration events
With the amendments to the Variable Interest Model in Statement 167, the FASB added an additional circumstance that requires reconsideration of whether an entity is a VIE. Under the amendments, an enterprise is required to reconsider whether an entity with which it is involved is a VIE when there are changes in facts and circumstances such that the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entitys economic performance. The FASB added this event to address the potential situations in which the equity investor(s) lost power over an entity without triggering one of the previously enumerated reconsideration events. For example, if an entity that was previously considered a voting interest entity experienced severe losses such that another party (e.g., a guarantor or lender) obtained a controlling financial interest in the entity, the previously listed criteria may not have required a reconsideration of an entitys status. The FASB was troubled that, in this situation, the entity may not have been considered a VIE and may not have been consolidated by the party with a controlling financial interest. The addition of this provision could lead to more consolidation of borrowers by lenders in circumstances when a lender obtains power over the VIEs activities (see further discussion of troubled debt restructurings below). Upon the occurrence of a reconsideration event described above, we believe a redetermination must be made about the risks the entity is designed to create and distribute to its interest holders. The steps followed in Chapter 5 of this publication should be reperformed to determine whether there have been any changes to the risks the entity was designed to create and distribute. In addition, the amendments to the Variable Interest Model remove the previous exemption for troubled debt restructurings. Prior to the adoption of Statement 167, a troubled debt restructuring, as defined in ASC 310-40-15-5 and ASC 470-60-15-5, did not require a reconsideration of whether the entity involved is a VIE. The removal of the exemption for troubled debt restructurings could lead to more consolidation of borrowers by lenders in loan workouts that provide the lender with the power over the VIEs activities. Additionally, this amendment could expand the disclosure requirements for lenders that have variable interests in entities that become VIEs as a result of troubled debt restructurings. In removing the exception, the FASB concluded that application of the Variable Interest Model typically would identify the borrower as a VIE since economic events indicate that the entitys equity is not sufficient to permit it to finance its activities without additional subordinated financial support or a restructuring of the terms of its financing. The FASB believed removing the exemption for troubled debt restructuring will provide more relevant and reliable information to users of financial statements. The circumstances that will require an enterprise to reconsider whether an entity is a VIE will present ongoing accounting and reporting challenges. It is possible under the Variable Interest Model for entities to go in and out of VIE status as a result of events triggering the need to reassess the entitys status as a VIE. As a result, enterprises will be required to understand whether any of these events could occur and, if so, to monitor the activities of entities in which it holds variable interests. Companies must establish internal control procedures so that significant events requiring reconsideration of whether an entity is a VIE are identified on a timely basis. This may require establishing procedures for the routine receipt of information from entities in which companies holds variable interests (even if the company is not the primary beneficiary of the entity or the entity is not currently a VIE).
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12 Reconsideration events
Primary beneficiary reconsideration Prior to Statement 167s amendments to the Variable Interest Model, an enterprise was required to reconsider the primary beneficiary determination upon certain events. For example, the primary beneficiary of a VIE was reevaluated in the event of a change in an entitys design or capital structure and for transactions that impact the entitys equity at risk. The amendments to the Variable Interest Model eliminate the primary beneficiary reconsideration concept and effectively require a VIEs primary beneficiary to be evaluated continuously as facts and circumstances change. These ongoing assessments should not be limited to the end of each reporting period but, rather, should occur when circumstances warrant a change in an enterprises status as primary beneficiary. The FASB believes that the ongoing qualitative assessment of which enterprise, if any, is the primary beneficiary will require less effort and be less costly than the quantitative assessment previously required for determining the primary beneficiary of a VIE. Further, the FASB expects that the amendments to the requirements for determining the primary beneficiary will reduce the frequency in which the enterprise with the controlling financial interest changes. Intuitively, for the primary beneficiary to change, there must be a change in either the power or benefits. In practice, we believe that most changes to power will be evident to the party that ceases to be the primary beneficiary as a result of losing power or becomes the primary beneficiary as a result of obtaining power. Some examples of circumstances that may cause a change in the primary beneficiary include, but are not limited to: Acquisition or sale of interests that constitute a change of control Lapse of certain rights such as participating or substantive kick-out rights (e.g., a lapse in participating rights held by one party to determine the operating budget of a VIE after the first two years of a VIEs existence) Termination of contractual arrangements that conveyed power
The FASB believes that eliminating the specific reconsideration guidance and requiring ongoing assessments will provide users with more relevant and timely information about the nature of an enterprises interest(s) in a VIE and the associated risks and obligations of this interest. The amendment to require the continuous assessment of a primary beneficiary is more consistent with the application of ASC 810-10 to voting interest entities, which does not incorporate a reconsideration concept in its requirements and implicitly requires continuous consideration of whether consolidation is required. Given that the primary beneficiary analysis is required to be performed continuously, enterprises may need to establish new processes to capture shifts in power, changes in variable interests or changes to the status of de facto agent and related party relationships, in addition to those events that would qualify as a reconsideration of an entitys status as a VIE. Refer to Questions 6.8 for a discussion of reconsideration of a decision makers or service providers fees as variable interests.
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Any of the above may trigger a need to reconsider whether an entity is a VIE if the event represents a significant change in the design of the entity in a manner that calls into question whether (1) the entitys at-risk equity investment is sufficient or (2) the rights and obligations provided to holders of the entitys at-risk equity investment are characteristic of a controlling financial interest. Nonsubstantive changes or events do not trigger the need for reconsideration. Judgment will be needed to determine whether an event is a significant occurrence requiring reconsideration of the entitys status.
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Analysis Because the acquisition is significant and significantly increases the entitys expected losses, which could change the determination of whether the entitys at-risk equity investment is sufficient, we believe Leaseco should be reconsidered as a potential VIE. Additional facts After six years of operations, the governing documents of Leaseco are modified to reflect a change in the way in which the equity investors can cast a vote. Equity investors are no longer required to be present in person to cast a vote at a board meeting but instead can do so via a conference call. Analysis Although this is a contractual change, it is not a substantive change to the design of the entity and, accordingly, there would be no need to reconsider whether the entity is a VIE. Additional facts After 10 years of operations, the equity holders agree to restructure Leaseco into a limited partnership. In connection with the restructuring, the partnership refinances the debt and issues additional equity to new investors. Analysis In this case, the restructuring of the entity would constitute a substantive change in the design of the entity requiring a reconsideration of whether the entity is a VIE.
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A leasing company, Leaseco, is formed as an LLC and acquires two commercial office buildings for $200 million. The acquisition of the two buildings is financed with $100 million of equity contributions from Leasecos equity investors and $100 million of senior, secured debt financing. At the end of five years, Leaseco borrows $100 million from an unrelated lender and uses the proceeds to acquire an additional office building. The purchase of the office building significantly increases Leasecos expected losses. Analysis In this example, at the end of the fifth year, the variable interest holders in Leaseco should reconsider whether Leaseco is a VIE because the acquisition of the additional office building is a significant asset purchase that has increased the entitys expected losses and could change the determination as to whether Leasecos at-risk equity investment is sufficient. It should be noted that if the $100 million borrowing and related asset met the qualifications to be considered a silo (see Questions in Chapter 7), the variable interest holders in Leaseco would not be required to reconsider whether Leaseco is a VIE. The acquisition of the additional office building, although significant, does not increase the entitys expected losses (because expected losses related to siloed assets are not considered expected losses of the larger entity). Additional facts During year eight, two of the three buildings are sold at a substantial gain, and the proceeds from the sales are distributed in their entirety to Leasecos equity investors in accordance with the contractual arrangements among the investors. Analysis This is an event requiring reconsideration of whether Leaseco is a VIE. The sale of the buildings is a significant curtailment of the entitys activities, decreasing the entitys expected losses and potentially changing the determination of whether the entitys equity investment at risk is sufficient. Additionally, the distribution may represent a reconsideration event (see Question 12.8).
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A leasing company, Leaseco, is formed as an LLC and acquires commercial office buildings to be leased to multiple unrelated parties under operating leases based on market terms at inception of the lease. At the end of five years, the LLC begins to annually dividend 80% of its annual net income to its members. Analysis These dividends represent distributions of returns on equity to the LLC equity holders. Accordingly, we believe the distributions would not trigger a requirement to reconsider whether the entity is a VIE. Additional facts At the end of eight years, Leaseco refinances the debt and, due to the buildings appreciation in fair value, is able to distribute to the LLC members an amount that exceeds the earnings of the LLC. Analysis In this example, the distribution exceeds the entitys return on equity and the lender is now exposed to more expected losses. Additionally, the loan represents a contractual change among the parties involved in the entity. Accordingly, the loan and distribution require the parties involved in the entity to reconsider whether Leaseco is a VIE.
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An entity is formed with a temporary construction loan ($900) and equity ($100). At formation, the entity is determined to be a VIE. The proceeds from the debt and equity issuances are used to build a hotel. At the end of the construction phase, the hotels fair value is $3,000. At that time, the VIE obtains permanent financing at 80% of the hotels value ($2,400) and uses the proceeds to repay the construction loan ($900) and to make a distribution to the equity holders ($1,000). Analysis Obtaining permanent debt financing upon completion of construction is an event requiring reconsideration of whether the entity is a VIE. The replacement of the temporary financing (as well as the large distribution) is a substantive change in the contractual arrangements among the parties and could affect the determination of whether the entity is a VIE.
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As the amendments to the Variable Interest Model eliminate the primary beneficiary reconsideration concept and effectively require a VIEs primary beneficiary to be evaluated continuously as facts and circumstances change, any primary beneficiary assessments of the acquiree should be reconsidered upon acquisition as appropriate.
Bankruptcy
Question 12.13 Does filing for bankruptcy by an entity constitute a VIE reconsideration event? Generally, when an entity files for bankruptcy, the equity holders of the entity as a group lose the power from voting rights or similar rights to direct the activities of the entity that most significantly impact the entitys economic performance. Therefore, subsequent to Statement 167s amendments to the Variable Interest Model, we believe that when an entity files for bankruptcy, an enterprise should reconsider whether the entity is a VIE. In most instances, if an entity files for bankruptcy, it would be a VIE due to the lack of sufficient equity at risk, and the equity holders may lose power. In addition, it is typical that once an entity files for bankruptcy, the entity is under the control of the bankruptcy court. Therefore, if the enterprise previously consolidated the entity that filed for bankruptcy under either the voting interest or variable interest model, it is likely that the enterprise will deconsolidate the bankrupt entity as the enterprise will no longer have the power to direct the activities that most significantly impact the entitys economic performance.
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13.1
Interpretative guidance
A development stage enterprise devotes substantially all of its efforts to establishing a new business and either (1) planned principal operations have not begun or (2) those operations have begun, but there has been no significant revenue generated from them. For purposes of applying the Variable Interest Model, a development stage enterprise is an entity that, if reporting using US GAAP, would prepare its financial statements in accordance with the provisions of ASC 915. In many development stage enterprises, the initial equity investment at risk of the enterprise is the amount necessary to achieve a certain goal (e.g., to develop a drug for clinical trials). Subsequent rounds of financing typically are anticipated in order to get to the next milestone (e.g., to perform the clinical trials and obtain FDA approval of a new drug). Without special provisions for determining whether to apply the Variable Interest Model, most development stage enterprises likely would be VIEs because the initial equity investment at risk (set at an amount to achieve a certain goal) will be less than the expected losses of the entity over its lifetime (because future activities must be performed to get the product ready for sale). Accordingly, the FASB provided an exception from ASC 810-10-15-14(a) such that the entitys equity at risk need only be sufficient to finance its current activities if certain conditions are met.
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Development stage enterprises are not exempt from all VIE provisions
Question 13.1 Must the characteristics of a development stage enterprises equity investment at risk meet the criteria established in ASC 810-10-15-14(b) and (c)? The Variable Interest Model provides guidance on the application of the equity sufficiency criteria in the VIE determination for development stage enterprises that limits the amount of equity required to that sufficient to permit the entity to finance its current activities. Development stage enterprises are not exempt from the requirements of ASC 810-10-15-14(b) and (c) that relate to the characteristics of an equity investment at risk. Accordingly, for the consolidation of a development stage enterprise to be based upon the ownership of voting equity interests, the entitys equity investment at risk must have the characteristics of a controlling financial interest as described in ASC 810-10-15-14(b) and (c) of the Variable Interest Model.
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Analogies to the provisions of the Variable Interest Model for development stage enterprises
Question 13.4 May other entities analogize to the Variable Interest Models provisions relating to the sufficiency of the equity investment at risk for development stage enterprises? We believe that provisions relating to the sufficiency of the equity investment at risk for development stage enterprises are restricted to entities that prepare their financial statements in accordance with ASC 915. Accordingly, we believe it would be inappropriate for enterprises that are not within the scope of ASC 915 to analogize to these provisions.
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14
Only one reporting entity, if any, is expected to be identified as the primary beneficiary of a VIE. Although more than one reporting entity could have the characteristic in (b) of this paragraph, only one reporting entity if any, will have the power to direct the activities of a VIE that most significantly impact the VIEs economic performance. 810-10-25-38B A reporting entity must identify which activities most significantly impact the VIEs economic performance and determine whether it has the power to direct those activities. A reporting entitys ability to direct the activities of an entity when circumstances arise or events happen constitutes power if that ability relates to the activities that most significantly impact the economic performance of the VIE. A reporting entity does not have to exercise its power in order to have power to direct the activities of a VIE.
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810-10-25-38C A reporting entitys determination of whether it has the power to direct the activities of a VIE that most significantly impact the VIEs economic performance shall not be affected by the existence of kick-out rights or participating rights unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those kick-out rights or participating rights. A single reporting entity (including its related parties and de facto agents) that has the unilateral ability to exercise kick-out rights or participating rights may be the party with the power to direct the activities of a variable interest entity that most significantly impact the entitys economic performance. These requirements related to kick-out rights and participating rights are limited to this particular analysis and are not applicable to transactions accounted for under other authoritative guidance. Protective rights held by other parties do not preclude a reporting entity from having the power to direct the activities of a variable interest entity that most significantly impact the entitys economic performance. Glossary 810-10-20 Kick-Out Rights The ability to remove the reporting entity with the power to direct the activities of a VIE that most significantly impact the VIEs economic performance. Participating Rights The ability to block the actions through which a reporting entity exercises the power to direct the activities of a VIE that most significantly impact the VIEs economic performance. Protective Rights Rights designed to protect the interests of the party holding those rights without giving that party a controlling financial interest in the entity to which they relate. For example, they include any of the following: a. Approval or veto rights granted to other parties that do not affect the activities that most significantly impact the entitys economic performance. Protective rights often apply to fundamental changes in the activities of an entity or apply only in exceptional circumstances. Examples include both of the following: 1. A lender might have rights that protect the lender from the risk that the entity will change its activities to the detriment of the lender, such as selling important assets or undertaking activities that change the credit risk of the entity. Other interests might have the right to approve a capital expenditure greater than a particular amount or the right to approve the issuance of equity or debt instruments.
2. b. c.
The ability to remove the reporting entity that has a controlling financial interest in the entity in circumstances such as bankruptcy or on breach of contract by that reporting entity. Limitations on the operating activities of an entity. For example, a franchise agreement for which the entity is the franchisee might restrict certain activities of the entity but may not give the franchisor a controlling financial interest in the franchisee. Such rights may only protect the brand of the franchisor.
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Recognition 810-10-25-38D If a reporting entity determines that power is, in fact, shared among multiple unrelated parties such that no one party has the power to direct the activities of a VIE that most significantly impact the VIEs economic performance, then no party is the primary beneficiary. Power is shared if two or more unrelated parties together have the power to direct the activities of a VIE that most significantly impact the VIEs economic performance and if decisions about those activities require the consent of each of the parties sharing power. If a reporting entity concludes that power is not shared but the activities that most significantly impact the VIEs economic performance are directed by multiple unrelated parties and the nature of the activities that each party is directing is the same, then the party, if any, with the power over the majority of those activities shall be considered to have the characteristic in paragraph 810-10-25-38A(a). 810-10-25-38E If the activities that impact the VIEs economic performance are directed by multiple unrelated parties, and the nature of the activities that each party is directing is not the same, then a reporting entity shall identify which party has the power to direct the activities that most significantly impact the VIEs economic performance. One party will have this power, and that party shall be deemed to have the characteristic in paragraph 810-10-25-38A(a). 810-10-25-38F Although a reporting entity may be significantly involved with the design of a VIE, that involvement does not, in isolation, establish that reporting entity as the entity with the power to direct the activities that most significantly impact the economic performance of the VIE. However, that involvement may indicate that the reporting entity had the opportunity and the incentive to establish arrangements that result in the reporting entity being the variable interest holder with that power. For example, if a sponsor has an explicit or implicit financial responsibility to ensure that the VIE operates as designed, the sponsor may have established arrangements that result in the sponsor being the entity with the power to direct the activities that most significantly impact the economic performance of the VIE. 810-10-25-38G Consideration shall be given to situations in which a reporting entitys economic interest in a VIE, including its obligation to absorb losses or its right to receive benefits, is disproportionately greater than its stated power to direct the activities of a VIE that most significantly impact the VIEs economic performance. Although this factor is not intended to be determinative in identifying a primary beneficiary, the level of a reporting entitys economic interest may be indicative of the amount of power that reporting entity holds.
14.1
The FASB believes that a qualitative approach focusing on power and benefits is more effective for determining the primary beneficiary of a VIE. An evaluation under this principles-based approach will require the use of significant judgment. Power In evaluating the power criterion, an enterprise first should consider the purpose and design of the VIE and the risks that the VIE was designed to create and pass to its variable interest holders. In evaluating purpose and design, an enterprise should consider the nature of the entitys activities, including the terms of the contracts the entity has entered into, the nature of variable interests issued and how the entitys interests were marketed to potential investors. The entitys governing documents, marketing materials and contractual arrangements should be closely reviewed. The risks that the VIE was designed to create and pass to its variable interest holders may include, but are not limited to: Credit risk Interest rate risk (including prepayment risk) Foreign currency exchange risk Commodity price risk Equity price risk Operations risk
Refer to Chapter 5 for further discussion on the evaluation of the purpose and design of a VIE and the risks that a VIE is designed to create and pass to its variable interest holders. Prior to the adoption of Statement 167, many enterprises may not have considered where power rests within the VIEs that they were involved with. We believe that it will be critical for an enterprise to establish a disciplined approach in evaluating the power criterion. To assess power, an enterprise must identify which activities most significantly impact the VIEs economic performance. Those activities may differ by the type of entity being analyzed. Generally, some subset of the total activities and decisions made within an entity would be considered significant. Additionally, particular care should be given to ensure the activities identified are part of the VIE being evaluated for consolidation and are not activities outside of the entity.26 In assessing which activities are significant, it may be helpful to consider how the activities of the VIE affect fair value, revenues, margins or cash flows of the VIE. After the activities that are considered to have the most significant impact on the VIEs economic performance have been identified, an enterprise should evaluate whether it has power to direct those activities. Power may be exercised through the voting rights of the equity holders, the board of directors (on behalf of the equity holders), a management contract or other arrangements. An enterprises ability to direct the activities of a VIE when circumstances arise or events occur constitutes power if that ability relates to the activities that most significantly impact the economic performance of the VIE. It is important to note that an enterprise does not actively have to exercise its power in order to have power to direct the activities of an entity. We believe that virtually all entities have some level of decision-making and that few, if any, are on auto-pilot. As more fully discussed below, involvement in the design of an entity may indicate that an enterprise had the opportunity and incentive to establish arrangements that result in the enterprise being the party with the power. However, that involvement in isolation does not establish that enterprise as the enterprise with the power. For entities with a limited range of activities, such as certain securitization entities or other special-purpose entities, we believe that power should be determined based on how that limited range of activities is directed.
26
See speech made by Wesley R. Bricker at the 2010 AICPA National Conference on Current SEC and PCAOB Developments available at www.sec.gov. 227
In some limited circumstances, an enterprise may conclude that no one party has the power over a VIE. To illustrate one such scenario in which no party has the power, assume that three unrelated parties form a venture (which is a VIE) to manufacture, distribute and sell beverages. Each party has one-third of the voting rights and each has one seat on the board of directors. The board of directors hires a management team to carry out the day-to-day operations of the venture. All significant decisions are taken to the board of directors for approval. Decisions are made by the board of directors based on majority vote. Under this fact pattern, the VIE does not have a primary beneficiary as no one party has the power to direct the activities that most significantly impact the economic performance of the entity. Refer to the Shared power heading below for a discussion on when power within an entity may be shared. The following is a summary of certain examples included in ASC 810-10 illustrating the application of the Variable Interest Model. Refer to ASC 810-10-55-93 through 55-205 for all examples in their entirety. Illustration 14-1: Power
Power-Example 1 (Securitization) Assume a VIE that is financed with debt and equity uses the proceeds from its financing to purchase commercial mortgage loans from a Transferor. The primary purposes for which the entity was created were to (1) provide liquidity to the Transferor and (2) provide investors with the ability to invest in a pool of commercial mortgage loans. The entity was marketed to debt investors as an entity that would be exposed to the credit risk associated with the possible default by the borrowers with respect to principal and interest payments with the equity tranche designed to absorb the first dollar risk of loss. The Transferor retains primary servicing responsibilities, which are administrative in nature and include remittance of payments on the loans, administration of escrow accounts and collections of insurance claims. Upon delinquency or default by the borrower, the responsibility for administration of the loan is transferred from the Transferor to the Special Servicer (the equity holder). The Special Servicer, as the equity holder, also has the approval rights for budgets, leases and property managers of foreclosed properties. The economic performance of the entity is impacted most significantly by the performance of its underlying assets. Thus, the activities that most significantly impact the entitys economic performance are the activities that most significantly impact the performance of the underlying assets. Therefore, the Special Servicers ability to manage the entitys assets that are delinquent or in default provides the Special Servicer with the power. Power-Example 2 (Asset-backed collateralized debt obligation) Assume a VIE that is financed with debt and equity uses the proceeds from its financing to purchase a portfolio of asset-backed securities with varying tenors and interest rates. The equity tranche is held 35% by the manager of the entity (Manager) and 65% by a third-party investor. The primary purposes for which the entity was created were to (1) provide investors with the ability to invest in a pool of asset-backed securities, (2) earn a positive spread between the interest that the entity earns on its portfolio and the interest paid to debt investors and (3) generate management fees for the Manager. The entity was marketed to potential debt investors as an investment in a portfolio of asset-backed securities with exposure to the credit risk associated with the possible default by the issuers of the asset-backed securities in the portfolio and to the interest rate risk associated with the active management of the portfolio. The equity tranche was designed to absorb first dollar risk of loss and receive any residual returns from a favorable change in interest rates or credit risk.
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The assets of the entity are managed with the parameters established by the underlying trust documents. The parameters provide the Manager with the latitude to manage the entitys assets while maintaining an average portfolio rating of single B-plus or higher. If the average rating of the portfolio declines, the entitys governing documents require that the Managers discretion in managing the portfolio be curtailed. The third-party equity investor has rights that are limited to administrative matters. The economic performance of the entity is impacted most significantly by the performance of the entitys portfolio of assets. Thus, the activities that most significantly impact the entitys economic performance are the activities that most significantly impact the performance of the portfolio of assets. Therefore, the Managers ability to manage the entitys assets within the parameters of the trust documents provides the Manager with the power. Power-Example 3 (Lease) Assume a VIE that is financed with five-year fixed-rate debt and equity uses the proceeds from its financing to purchase property to be leased to a lessee with an AA rating. The lease has a five-year term and is classified as a direct finance lease by the lessor and as an operating lease by the lessee. However, the lessee is considered the owner of the property for tax purposes and, thus, receives tax depreciation benefits. Additionally, the lessee is required to provide a first-loss residual value guarantee for the expected future value of the leased property at the end of the five years (the option price) up to a specified percentage of the option price, and it has a fixed-price purchase option to acquire the property for the option price. If the lessee does not exercise the fixed-price purchase option at the end of the lease term, the lessee is required to remarket the property on behalf of the entity. The lessee is entitled to the excess of the sales proceeds over the option price. The primary purpose for which the VIE was created was to provide the lessee with the use of the property for five years with substantially all of the rights and obligations of ownership, including tax benefits. The entity was marketed to potential investors as an investment in a portfolio of AA-rated assets collateralized by leased property that would provide a fixed-rate return to debt holders equivalent to AA-rated assets. The return to the equity investors is expected to be slightly greater than the return to the debt investors because the equity is subordinated to the debt. The residual value guarantee transfers substantially all of the risk associated with the underlying property to the lessee, and the fixed-price purchase option effectively transfers substantially all of the rewards from the underlying property to the lessee. The entity is designed to be exposed to the risks associated with a cumulative change in fair value of the leased property at the end of five years as well as credit risk related to the potential default by the lessee of its contractually required lease payments. The governing documents for the entity do not permit the entity to buy additional assets or sell existing assets during the five-year holding period, and the terms of the lease agreement and the governing documents for the entity do not provide the equity holders with the power to direct any activities of the VIE. The economic performance of the VIE is significantly impacted by the fair value of the underlying property and the credit of the lessee. The lessees maintenance and operation of the leased property has a direct effect on the fair value of the underlying property, and the lessee directs the remarketing of the property. Therefore, the lessee has the power. Benefits In evaluating whether an enterprise has satisfied the benefits criterion, the use of professional judgment will be required to determine whether the benefits could potentially be significant to the VIE. An enterprise should consider all facts and circumstances regarding the terms and characteristics of the variable interest(s), the design and characteristics of the VIE and the other involvements of the enterprise with the VIE. Benefits can be current benefits or future benefits. The FASB decided not to
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provide additional guidance or bright-lines on determining whether an enterprise has satisfied the benefits criterion. The FASB noted that if an enterprise concludes that it does not have a variable interest in an entity, then it would not meet this criterion. We believe that if an interest meets the definition of a variable interest,27 it would often represent an obligation or benefit that could potentially be significant to the VIE. Additionally, we believe that if an enterprise has a variable interest in a VIE, the presumption should be that the enterprise has satisfied the benefits criterion as we believe that it will be uncommon that an enterprise would conclude that it has a variable interest but does not have benefits. Refer to Chapter 6 for guidance on assessing whether fees paid to a decision maker or a service provider represent a variable interest.
While the primary beneficiary must have both power and benefits, the primary beneficiary need not have both the obligation to absorb losses and the right to receive benefits. Either the obligation to absorb losses or the right to receive benefits constitutes benefits. For example, if an enterprise has power and has provided a significant guarantee on assets or obligations of the VIE, it is the primary beneficiary even though it may not be entitled to receive any upside. Similarly, if an enterprise has power and has the right to receive upside but has no obligation to absorb losses, it is the primary beneficiary.
27
analyses of the pertinent factors and characteristics of both the variable interests and the variable interest entity are performed using sound judgment, then the risk of inconsistency should be mitigated to an acceptable level.
to absorb losses or receive benefits, the more likely that it would be incented to have the power over the enterprise. Accordingly, a conclusion that an entity with the obligation to absorb significant losses or the right to receive significant benefits does not have power should be evaluated carefully
Relationship of the assessment of power in the VIE determination vs. the primary beneficiary determination
Question 14.6 Are the activities that most significantly impact the economic performance in the assessment of power in the VIE determination the same as those in the assessment of power in the primary beneficiary determination? Yes. The Variable Interest Model requires that, as a group, the holders of the equity investment at risk have the power to direct the activities of an entity that most significantly impact the entitys economic performance. Otherwise, the entity is a VIE. Likewise, when evaluating whether an enterprise is the primary beneficiary of a VIE, the enterprise also must have the power to direct the activities of an entity that most significantly impact the entitys economic performance. We believe that the identified activities that most significantly impact an entitys economic performance would be the same for the purposes of the VIE determination (ASC 810-10-15-14(b)(1)) and the determination of the primary beneficiary.
Refer to Question 14.25 for further discussion of different parties having power over the entitys life cycle.
The above listing may not be all-inclusive. Additionally, in each of the above circumstances, to the extent that an enterprise has a related party or de facto agent with involvement in a VIE, it may be necessary for the enterprise to evaluate the related party provisions of the Variable Interest Model to determine which party should consolidate the VIE (refer to Question 14.5 for further discussion).
Power under the Variable Interest Model vs. control for voting interest entities
Question 14.9 Does the power to direct the activities of an entity that most significantly impact the economic success of an entity under the Variable Interest Model equate to control for voting interest entities? No. While the concepts of power and control have their similarities, we do not believe that the two concepts are necessarily synonymous. Control for voting interest entities generally is based upon whether an enterprise owns more than 50% of the outstanding voting shares of an entity. For other entities such as partnerships, the general partner is presumed to control an entity unless certain rights (i.e., substantive kick-out or participating rights) are held by the limited partners. For voting interest entities, there is not a requirement to identify which decisions are most significant. Rather, there is a rebuttable presumption that the controlling party has the unilateral ability to make all significant decisions. In determining whether an entity is a VIE, an enterprise must evaluate whether the equity holders, as a group, have the ability to make decisions that most significantly impact the entitys economic performance. Not all activities of an entity will have a significant impact on the economic performance of the entity. This concept requires an enterprise to identify the most significant decisions from the population of all decisions that may affect an entity. As such, we generally believe that power would be based upon the ability to make decisions on a subset of the total activities and decisions made within an entity. Additionally, we believe that the identified activities that most significantly impact an entitys economic performance would be the same for the purposes of the VIE determination (ASC 810-10-15-14(b)(1)) and the determination of the primary beneficiary.
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It is important to note that, for the purpose of determining the primary beneficiary of a VIE, it is possible that an enterprise may be the primary beneficiary of a VIE without having the power to direct all activities that most significantly impact economic performance. ASC 810-10-25-38E indicates if the power rests with multiple unrelated parties, and the nature of the activities that each party is directing is not the same, then an enterprise should identify which party has the power over the activities that are most significant.
Evaluating rights held by the board of directors and an operations manager in an operating venture
Question 14.11 In many operating ventures, the venture is governed by a board of directors with an operations manager performing certain day-to-day functions. In these circumstances, how should an enterprise assess whether the equity holders have power (through their representation on the board of directors) or the manager has power? To assess power, an enterprise must identify which activities most significantly impact the VIEs economic performance based upon the purpose and design of the entity. Power may be exercised through the voting rights of the equity holders, the board of directors (on behalf of the equity holders), a management contract or other arrangements. In many operating ventures, decision-making over certain activities may rest with the board of directors, while decision-making over other activities may rest with an operations manager. In these circumstances, it may be challenging to assess whether the board of directors or the manager has the power over the VIE. To illustrate through a possible scenario, assume that an operating venture (a VIE) is formed by two unrelated equity investors to distribute a product to an unrelated third party. Each equity investor receives one seat on the ventures board of directors, with all board decisions requiring a unanimous vote of the two board members. The two venture partners decide to hire an unrelated third party with distribution management experience to manage the day-to-day operations of the venture. Assume that the operations manager has a variable interest in the venture through the fees it receives as a manager. After giving consideration to the purpose and design of the entity, assume that there are three activities that most significantly impact the ventures economic performance: financing decisions, capital decisions and operating decisions. The board of directors makes all financing and capital decisions and thus has power over those activities. The board of directors approves the operating budget. However, the
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operating manager makes day-to-day decisions with respect to carrying out the operating budget and has certain latitude with respect to decisions including product procurement, product pricing, contract negotiation, hiring/firing line employees, etc. In these circumstances, determining whether the board of directors has power over operating decisions (through the budgeting process) or whether the operations manager has power over operating decisions (through day-to-day management) will require judgment. In making this assessment, relevant considerations may include, but may not be limited to, the following: The amount of detail set forth in the operating budget (greater detail may suggest that power rests with the board of directors). For example, if the budget is sufficiently detailed to effectively constrain the activities of the operating manager within the budget, then power over operating decisions may rest with the board of directors. It would be more likely that an operating budget that includes budgeted sales by product type and budgeted costs by department would effectively constrain the decision-making of an operating manager than a one-page operating budget containing a single line for sales and limited number of expense line items. The frequency and manner in which a comparison of the budget to actual results is reviewed by the board of directors (greater frequency and rigor in the review process may suggest that power rests with the board of directors). For example, if the budget reviews occur frequently, it may serve effectively to constrain the decision-making of the operating manager, which would indicate that power over operating decisions rests with the board of directors. It would be more likely that a monthly review of the operating budget to actual results by the board of directors would serve to constrain the operating manager than a review that occurs annually. Additionally, it would be more likely that the board of directors has power when protocols are in place forcing the operating manager to report budget deviations of 1% to the board of directors for resolution rather than deviations of 20%. The ability for the budget to be changed. The ability for the board of directors to make changes to the budget may suggest that power rests with the board of directors and may suggest that activities of the operating manager are constrained by the budgeting process. The manner in which the budget is prepared and reviewed. If the board of directors has significant involvement in the budgetary preparation and approval process, it may be more likely that power over operating decisions rests with the board of directors. If the operating manager is responsible for the budget preparation, then the involvement of the board of directors in the review process may provide insight into the party with power over operating decisions. For example, an on-site review process that spans multiple days and results in meetings with numerous management personnel might be more indicative of the budgeting process constraining the operating activities of the manager than a review that takes place remotely with little to no contact with the operations manager.
Careful evaluation of the facts and circumstances of each arrangement will be necessary. While none of these considerations are individually, or collectively, intended to be determinative, they may prove useful in evaluating power in similar arrangements. Continuing with the illustration above, if it is determined that the board of directors has power over the operating decisions, then neither equity holder would have power over the venture, as decision-making at the board of directors is shared. On the other hand, if it is determined that power over operating decisions rests with the operating manager, then further consideration is necessary to determine whether the operating manager would be the primary beneficiary of the venture because the board of directors (on behalf of the equity holders) direct capital and financing decisions (see additional discussion below when power to direct different activities rests with different parties).
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ASC 810-10-25-38B indicates that [a] reporting entitys ability to direct the activities of an entity when circumstances arise or events happen constitutes power if that ability relates to the activities that most significantly impact the economic performance of the VIE. A reporting entity does not have to exercise its power in order to have power to direct the activities of a VIE. To illustrate, in many receivable securitization structures, the securitizations economic performance is impacted most significantly by the performance of its underlying assets. Generally, the investors are exposed to the credit risk associated with the possible default by the underlying borrowers with respect to principal and interest payments. Therefore, if the purpose and design indicates that the entitys most important activity is to manage the assets when they become delinquent, the enterprise may determine that the party with the ability to manage the entitys assets upon default is the primary beneficiary. The decision-making by the party that has power is subject to the event of default occurring. Notwithstanding the fact that defaults may not yet have occurred and this power has not been exercised, the party that has the current right to make these decisions has the power. While the provisions of ASC 810-10-25-38B are applicable to all arrangements, we believe that these provisions may be more relevant to entities in which decision-making is limited.
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Consideration of potential voting rights (e.g., call options, convertible instruments) when assessing power
Question 14.18 How should potential voting rights (e.g., call options, convertible instruments) be considered when assessing power in the Variable Interest Model? The Variable Interest Model does not specifically address potential voting rights. However, we generally do not believe that the existence of a potential voting right alone provides its holder with power. While potential voting rights should be considered in the evaluation of an entitys purpose and design and in the evaluation of power, an arrangement providing an enterprise with a potential voting right generally does not, in and of itself, give that enterprise the power over the most significant activities of a VIE when decisions about those activities need to be made. Rather, such a right provides the holder with an economic benefit that potentially includes an opportunity to obtain power at a future date. Consequently, the holder of a potential voting right has power only when another incremental contractual right gives the holder power. However, the exercise of a potential voting right would require reconsideration of the primary beneficiary of a VIE. We understand that the FASB staff shares these views. Consistent with these views, we generally do not believe that an instrument that is contingently exercisable or a forward contract should be included in the analysis of power until exercise or settlement of such contingently exercisable instrument or forward contract. In certain circumstances, the terms and conditions of a potential voting right (e.g., a fixed-price call option that is deep in the money with little economic outlay required to exercise) may require further consideration to determine whether the substance of the potential voting right conveys power to the holder. For example, if an enterprise acquires fixed-priced call options to purchase shares of an entity for $1 when the per-share price of the entity is $200 at inception of the arrangement, consideration of the purpose and design of the entity and the arrangement would be warranted to evaluate whether the call option conveys power to the enterprise.
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14.2
The Variable Interest Model defines participating rights as the ability to block the actions of the enterprise with the power. Although the FASB agreed that a participating right is the ability of one party to block certain actions, the FASB believes that this ability should affect the determination of the primary beneficiary only if those actions are related to the activities that most significantly impact the economic performance of an entity. Examples of participating rights would be the rights to block decisions that would convey power. Determining what would constitute participating rights likely will vary by entity. Selecting, terminating and setting the compensation of management or establishing operating budgets as discussed in ASC 810-10 for voting interest entities may or may not represent participating rights. Power and, more specifically, the activities that most significantly impact the economic performance of the entity, likely will be different for different entities. Protective rights Protective rights held by other parties do not preclude an enterprise from having the power. The Variable Interest Models notion of protective rights is similar to that for voting interest entities in ASC 810-1025-10 and ASC 810-20-25-19. However, these lists of protective rights should not be viewed as allinclusive, and determining whether a right is participating or protective is a matter of professional judgment.
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The following barriers to exercise may indicate that the kick-out rights held by a single enterprise are not substantive: Kick-out rights subject to conditions that make it unlikely they will be exercisable; for example, conditions that narrowly limit the timing of the exercise Financial penalties or operational barriers associated with replacing the decision maker that would act as a significant disincentive for removal The absence of an adequate number of qualified replacement decision makers or inadequate compensation to attract a qualified replacement The absence of an explicit, reasonable mechanism in the arrangement by which the party that possesses the kick-out rights can exercise them
In addition, the economic terms could make it unlikely that the kick-out rights would be exercised and thus the presumption of control would not be overcome. For example, a partnership that is a VIE has within its partnership agreement a provision that the general partner can be removed by one limited partner, but is still entitled to its economic interest (i.e., 1% from its legal ownership and its 20% carried interest, which is earned after the limited partners receive a preferred return) over the remaining life of the partnership. We believe that the kick-out rights would not be substantive in this example because it is unlikely that the limited partner would remove the general partner when it must continue to pay that general partner for services for which the replacement general partner also will be compensated. Other partnership agreements may provide that the general partner is to be paid an amount equal to the fair value of its interest on the termination date. All of the related facts and circumstances should be evaluated to determine whether such a provision acts as a financial barrier. For example, a partnership that is invested in one real estate property may have insufficient liquidity to pay the general partner without selling the property, creating a significant disincentive for a limited partner to exercise the kickout rights.
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As noted in Question 14.21, we generally do not believe that participating rights, in and of themselves, constitute power.
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14.3
28
29
For example, an enterprise should consider what occurs in the event that consent is not given (e.g., remedies) and how those provisions may affect the determination of whether consent is truly substantive. See speeches made by Wesley R. Bricker at the 2010 AICPA National Conference on Current SEC and PCAOB Developments, and Paul A. Beswick at the 29th Annual SEC and Financial Reporting Institute Conference available at www.sec.gov. 243
Assume two parties form a venture (which is a VIE) to manufacture, distribute and sell beverages with each holding an equity interest. Assume that one party is the manufacturer and the other party is responsible for distribution and sales. In this instance, either the manufacturer or the distributor/seller is the primary beneficiary. Determining which of these roles require decisions that most significantly impact the entitys performance could prove difficult and will require a careful assessment of the facts and circumstances.
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14.4
14.5
30
Speech made by Arie S. Wilgenburg at the 2009 AICPA National Conference on Current SEC and PCAOB Developments, available at www.sec.gov. 245
Effect of VIE determination anti-abuse clause (ASC 810-10-15-14(c)) on the identification of the primary beneficiary
Question 14.27 If an enterprise concludes that an entity is a VIE pursuant to the anti-abuse clause (ASC 810-10-1514(c)), does that conclusion affect the primary beneficiary determination? To prevent an entity from avoiding consolidation of a VIE by structuring it with non-substantive voting rights, ASC 810-10-15-14(c) provides that an entity is a VIE when (1) the voting rights of some investors are not proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected residual returns of the entity, or both and (2) substantially all of the entitys activities either involve or are conducted on behalf of an investor (including the investors related parties, except its de facto agents under ASC 810-10-25-43(d)) that has disproportionately few voting rights. We do not believe that the holders of the equity interests of an entity that meet the criterion of ASC 810-10-15-14(c) should be presumed to have non-substantive voting rights. As such, determining the primary beneficiary of an entity that is a VIE pursuant to ASC 810-10-15-14(c) will require a careful examination of all facts and circumstances. In particular, the provisions of ASC 810-10-25-38G addressing situations in which a reporting entitys economic interest in a VIE, including its obligation to absorb losses or its right to receive benefits, is disproportionately greater than its stated power to direct the activities of a VIE should be considered carefully. Additionally, the provisions of ASC 810-10-1513A and 15-13B addressing substantive terms, transactions and arrangements should be evaluated. Under the Variable Interest Model prior to Statement 167s amendments, the primary beneficiary of an entity that was a VIE as a result of ASC 810-10-15-14(c)s provisions was often the party with disproportionally few voting rights. This outcome was due to the previous Variable Interest Models quantitative approach for assessing which party was the primary beneficiary. Subsequent to the amendments, the primary beneficiary of a VIE is the party that has (1) the power to direct activities of a VIE that most significantly impact the entitys economic performance and (2) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. Therefore, the party with disproportionally few voting rights may or may not be the primary beneficiary. However, in circumstances in which an enterprise has a disproportionately greater obligation to absorb losses or right to receive benefits compared to its stated power, an enterprise should approach the evaluation of the primary beneficiary with greater skepticism.
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15.1
Interpretative guidance
Subsequent to the effective date of Statement 167s amendments to the Variable Interest Model, an enterprise first determines whether it individually has the power to direct the activities of the VIE that most significantly impact the entitys economic performance and also has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. That is, if the enterprise meets the requirements to be the primary beneficiary under the power and benefits criteria, then it is not necessary to assess the enterprises related parties or de facto agents as the enterprise must consolidate the VIE. However, if an enterprise concludes that neither it nor one of its related parties individually meets the power and benefits criteria, but, as a group, the enterprise and its related parties have those characteristics, an enterprise then considers the related party provisions in determining the primary beneficiary (discussed further in the next chapter).
Financial reporting developments Consolidation of variable interest entities 247
The Variable Interest Model defines related parties as those identified by the related party guidance in ASC 850. The following summarizes related parties identified in ASC 850-10-20: Affiliates Entities for which investments would be required, absent the election of the fair value option under ASC 825, to be accounted for by the equity method Trusts for the benefit of employees that are managed or under the trusteeship of management Principal owners and members of their immediate families Management and members of their immediate families Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests
In addition, the Variable Interest Model incorporates the concept of de facto agents into its consideration of related party relationships. Under the Variable Interest Model, a party that has an agreement that it cannot sell, transfer or encumber its interests in a VIE without the prior approval of an enterprise is considered a de facto agent of that enterprise if that right could constrain the partys ability to manage the economics of its interest in a VIE. When applying the Variable Interest Model, de facto agents are considered along with related parties when evaluating the Variable Interest Models related party provisions. Historically, many enterprises have found themselves evaluating whether a de facto agency relationship exists as sale, transfer or encumbrance restrictions are present in many arrangements. Given the breadth of the definition of a de facto agent in the Variable Interest Model, enterprises frequently determined that a de facto agency relationship was present. During the comment process on Statement 167, some respondents expressed concerns over the broad applicability of the de facto agency provisions and that a de facto agent relationship currently exists in circumstances where the transfer restrictions are the result of negotiations between willing and independent parties. Respondents also noted that these provisions often are important to preserve the strategic intent of the entity. As a result, the FASB decided to amend the de facto agency provisions to address the concerns raised by these respondents who were troubled that many enterprises with substantive mutual transfer restrictions would be required to consolidate VIEs even in situations in which power is in fact shared (refer to Chapter 14 for Interpretative Guidance and Questions). Statement 167 amended the guidance to provide an exception to the de facto agency provision, in certain circumstances. Under the amended Variable Interest Model, a de facto agency relationship does not exist if both the enterprise and the other party have the right of prior approval and those rights are based on mutually agreed terms entered into by willing, independent parties and the rights are substantive. Notwithstanding the above amendment, substantive transfer restrictions that create de facto agency relationships will continue to arise in practice. Such a transfer restriction might exist when the restriction is one-sided (i.e., one party approves transfers but is not restricted itself). However, the existence of a substantive transfer restriction does not obviate the need for each party involved with such a restriction to determine if it is the primary beneficiary of a VIE (as further discussed in Chapter 14). That is, if the enterprise meets the requirements to be the primary beneficiary, it is not necessary to assess the enterprises related parties or de facto agents; the enterprise must consolidate the VIE.
Financial reporting developments Consolidation of variable interest entities 248
The amendments to the de facto agency provisions represent a significant change to the previous practice of determining the primary beneficiary through an evaluation of the Variable Interest Models related party provisions, as fewer enterprises will be required to do so under the amended Variable Interest Model. Thus, it is possible that an enterprise that is the primary beneficiary of a VIE prior to the adoption of Statement 167 to conclude that it is no longer the primary beneficiary upon adoption of Statement 167. This may be true for enterprises with involvement in joint ventures and other business ventures in which transfer restrictions are prevalent, but those restrictions qualify for the exception.
Application of the phrase without the prior approval of the reporting entity to common contractual provisions
Question 15.1 How should the phrase without the prior approval of the reporting entity be applied to contractual provisions such as a right of first refusal, right of first offer and an approval that cannot be unreasonably withheld? Following are common contractual terms and our analysis of how the Variable Interest Models de facto agent concept should be applied to them. Right of first refusal A right of first refusal gives the holder the right to meet any other offer before the proposed contract is accepted. For example, a right of first refusal may exist between two parties to a joint venture that is a VIE that requires one party to notify the other as to the price and payment terms of a variable interest that is proposed to be sold and provides the other party the right and option to purchase the transferring partys interest at the same price. These are also common in the sale and leaseback of real estate. We believe that a right of first refusal generally does not create a de facto agency relationship because the variable interest holder is permitted to sell or transfer its interest. The right of first refusal simply provides the holder the right to meet another offer before an interest is sold or transferred to another party. Right of first offer A right of first offer provision requires a party to give notice to another party prior to selling it to a third party. That notice constitutes an offer by the party to sell its interest on the price, terms and conditions set forth in such notice. The potential buyer can decide either to accept or reject the terms of the offer. If the potential buyer fails to accept the offer, it generally is deemed to have consented to the proposed sale and the party may sell its interest to another party, provided, however, that the party may not sell the interest at any price less than the price stated in the first offer and on terms any more favorable to the purchaser than the terms included in the first offer notice. The right of first offer may provide some constraint over the sellers ability to sell its interest to a party of its own choosing. However, we believe that a right of first offer provision does not create a de facto agency relationship among parties because the seller is not limited in its ability to sell its interest. Approval not to be unreasonably withheld A party may have an agreement that it cannot sell, transfer or encumber its interests in the entity without the prior approval of the enterprise, and such approval is not to be unreasonably withheld. Because the Variable Interest Model does not distinguish the degree of difficulty to obtain such approval, we believe that any sale, transfer or encumbrance that requires prior approval of the enterprise may
Financial reporting developments Consolidation of variable interest entities 249
result in a de facto agency relationship. For purposes of analyzing whether a de facto agency relationship exists for an enterprise when the sale, transfer or encumbrance of a variable interest cannot occur without prior approval of another variable interest holder, the fact that the approval is not to be unreasonably withheld should not be considered in the analysis, even if it is explicitly stated in the contractual arrangements among the parties. * * *
Also in evaluating whether a de facto agency relationship exists, we believe that the provisions generally were intended to apply to equity interests. However, we also believe that these provisions may be applicable to variable interests other than equity interests depending on the facts and circumstances. Professional judgment should be used after considering all relevant facts and circumstances in applying the Variable Interest Models without prior approval criterion.
Conditions in ASC 810-10-25-43(d) on an agreement that it cannot sell, transfer or encumber its interests in the VIE without the prior approval of the reporting entity are inclusive
Question 15.2 How should ASC 810-10-25-43(d) conditions on an agreement that it cannot sell, transfer or encumber its interests in the VIE without the prior approval of the reporting entity be applied when an agreement provides for a restriction on only one of the activities specified in that paragraph, but not all three? We believe that the or in this criterion should be inclusive, meaning that if the party has the ability to obtain all or most of the cash inflows that are the primary economic benefit of the variable interest either by selling, transferring, or encumbering it, then a de facto agency relationship does not exist. Otherwise, a de facto agency relationship could be constructed to achieve a desired accounting result by simply adding a prohibition that may be unimportant to that party. The legal agreements and the defined terms used in them should be read carefully before concluding as to whether each of the three restrictions exists. For example, we have observed instances in which it appears that only transfers of the interest are restricted, but the term transfer is defined in the legal agreement as any sale, exchange, assignment, encumbrance, hypothecation, pledge, foreclosure, conveyance in trust, gift or other transfer of any kind, among other actions. Legal counsel may need to be consulted in evaluating this criterion. We believe all of the relevant facts and circumstances should be considered in determining whether restrictions on a partys ability to sell, transfer or encumber its variable interest creates a de facto agency relationship. For example, an enterprise may seek to avoid creating a de facto agency relationship with a party by restricting it only from selling or transferring its variable interest (but not from encumbering it), knowing that the party is already restricted from encumbering its interest for a separate regulatory or legal reason. In that instance, we believe a de facto agency relationship exists because the enterprise restricted the party from selling or transferring its interest, and is aware that the party is also restricted from encumbering its interest. Restrictions on the sale, transfer or encumbrance of a variable interest should be carefully evaluated to ensure that they are substantive before concluding that a de facto agency relationship exists among parties. We believe that ASC 810-10-25-43s provisions generally were intended to apply to equity interests. However, we also believe that these provisions may be applicable to variable interests other than equity interests depending on the facts and circumstances.
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31
The guidance in this response applies if the separate account arrangement (as defined in ASC 944-80-20) meets the conditions in ASC 944-80-25-2. 251
However, separate accounts interests held for the benefit of a related party policy holder should be combined with the insurance enterprises general account interest when the Variable Interest Model requires the consideration of related parties. For this purpose, a related party policy holder includes any party identified in ASC 810-10-25-43 except: An employee of the insurance enterprise (and its other related parties), except if the employee is used in an effort to circumvent the provisions of the Variable Interest Model An employee benefit plan of the insurance enterprise (and its other related parties), except if the employee benefit plan is used in an effort to circumvent the provisions of the Variable Interest Model
The above guidance was issued as part of Accounting Standards Update (ASU) 2010-15, How Investments Held through Separate Accounts Affect an Insurers Consolidation Analysis of Those Investments (ASU 2010-15). ASU 2010-15 should be applied retrospectively in fiscal years beginning after 15 December 2010, and interim periods within those fiscal years. Earlier application is permitted. We believe that ASU 2010-15 largely will codify existing practice within the insurance industry.
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16.1
Interpretative guidance
Prior to Statement 167s amendments to the Variable Interest Model, if two or more related parties (including de facto agents) held variable interests in a VIE, and the aggregate variable interests held by the related party group would, if held by a single party, identify the group as the primary beneficiary, then the party within the related party group that is most closely associated with the VIE is the primary beneficiary. These related party provisions were considered prior to determining whether an enterprise is individually the primary beneficiary (i.e., excluding related parties and de facto agents). Statement 167 amends the Variable Interest Model with respect to the circumstances in which the related party provisions are considered. As discussed in Chapter 14, when determining the primary beneficiary of a VIE, an enterprise first determines whether it individually has the power to direct the activities of the VIE that most significantly impact the entitys economic performance and also has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. That is, if the enterprise meets the requirements to be the primary beneficiary under the power and benefits criteria, then the enterprise does not need to assess its related parties or de facto agents as the enterprise must consolidate the VIE. However, if an enterprise concludes that neither it nor one of its related parties individually meets the criteria to be the primary beneficiary, but, as a group, the enterprise and its related parties have those characteristics, an enterprise then considers the Variable Interest Models related party provisions in determining the primary beneficiary. The member of the related party group that is most closely associated with the VIE should consolidate it as the primary beneficiary.
Financial reporting developments Consolidation of variable interest entities 253
Furthermore, in situations in which no one member, but rather the related party group, is considered the primary beneficiary of a VIE, the parties within the related party group cannot conclude that power is shared. In other words, the parties within the related party group are required to identify one party within the related party group as the primary beneficiary of the entity. Statement 167 also amends the portion of the most closely associated test within ASC 810-10-25-44 to require that an enterprise consider exposure to variability associated with the anticipated economic performance of the VIE rather than expected losses. While ASC 810-10-25-44 no longer requires a calculation of expected losses, the FASB decided that the evaluation of which party within a related party group is most closely associated with a VIE should include an evaluation of each partys exposure to variability (both positive and negative) associated with the anticipated economic performance of the VIE. While a detailed calculation of expected losses may not be required, ASC 810-10-25-44 does require an analysis of variability associated with anticipated economic performance and, therefore, may require some quantitative analysis in its application. We believe that in certain circumstances, the Variable Interest Models requirement to consider the power and benefits principle prior to the related party provisions will have a significant effect on the primary beneficiary determination of a VIE. As an example, enterprises that have previously identified themselves as the primary beneficiary under the most closely associated test but do not have power will deconsolidate these VIEs upon adoption of Statement 167s amendments to the Variable Interest Model if (1) another enterprise in the related party group is the enterprise with the power, or (2) the parties are not related or de facto agents because of the amendments to the de facto agency provisions discussed in Chapter 15. The determination of which party from a related party group is most closely associated with a VIE is generally qualitative and is dependent upon the facts and circumstances. The qualitative assessment also requires the use of professional judgment. The Variable Interest Model lists factors to consider in making the determination but does not identify any single factor as determinative.
Principal-agency relationship
Question 16.1 How should a member of a related party group determine if a principal-agency relationship exists and, if so, which party is the principal and which party is the agent? Generally, a principal-agency relationship exists if one member of a related party group (the agent) is acting on behalf of another member (the principal). In certain cases, the existence of this type of relationship may not be readily identifiable based on the facts and circumstances of the arrangement. A principal-agency relationship is presumed to exist if a de facto agent is identified through application of the concepts in ASC 810-10-25-43 (see the Interpretative guidance and Questions in Chapter 15). In some cases (such as when one member of the related party group is the employer of another, or one member is the parent company of another), it may be apparent that one member is a principal and another is an agent. However, in other cases, the determination of whether one member is acting on behalf of another member may not be clear and should be based on an analysis of the specific facts and circumstances of the arrangement. The general indicators of a principal and an agent as described in ASC 605-45 may be helpful in making this determination.
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Based on the provisions of ASC 605-45, we believe the following would be characteristics of a member that is a principal in a principal-agency relationship with other members: The member is easily identifiable as the prime representative or leader of the related party group to outside parties (i.e., that member is the one in charge). The member either directly or indirectly influenced other members to obtain a variable interest in the entity. One member previously has acted as an agent of another member.
An agent, by contrast, generally would not possess these characteristics. Other characteristics also exist and should be considered, if present.
Determining the relationship and significance of a VIEs activities to members of a related party group
Question 16.2 What factors should be considered when assessing the relationship and significance of a VIEs activities to members of a related party group that, in the aggregate, is identified as the primary beneficiary of a VIE? When assessing the relationship and significance of a VIEs activities to the members of a related party group, the following factors should be considered: Did any member significantly influence the design or redesign of the entity or the determination of its primary operations, products or services? Are the operations of any member substantially similar in nature to the activities of the VIE? Does the variable interest in the VIE represent a substantial portion of the total assets of any member? Are the products or services produced by the VIE significant inputs to any members operations? Has any member outsourced certain of its activities to the VIE? Are the majority of any members products or services sold to the VIE? Are the products or services of any member significant inputs to the VIEs operations? Are employees of any member actively involved in managing the operations of the VIE? Do employees of the VIE receive compensation tied to the stock or operating results of any member? Is any member obligated to fund operating losses of the VIE if they occur? If the entity conducts research and development activities, does any member have the right to purchase any products or intangible assets resulting from the entitys activities? Has a significant portion of the VIEs assets been leased to or from any member? Does any member have a call option to purchase the interests of the other members? Do the other members have an option to put their interests to any member?
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An automobile manufacturer, Autoco, establishes an entity (a VIE), Safetyco, to research and develop enhanced safety technologies for automobiles. Autoco contributes technology with a fair value of $2 million to the entity in exchange for a 50% common equity interest. An auto parts supplier, Partco, invests $2 million in exchange for the remaining common equity interest. Autoco holds 25% of the common stock of Partco and accounts for this investment using the equity method, as specified by ASC 323. Safetyco obtains a $10 million loan from Autoco Credit, a majority owned consolidated subsidiary of Autoco. Autoco has an option to acquire a five year exclusive license for any enhanced safety technologies developed by Safetyco for use in the automobiles it manufactures. After five years, Partco may also license the technologies and sell products incorporating the technologies to other auto manufacturers. Autoco, Autoco Credit and Partco are related parties under ASC 850. If each party concludes that neither it nor one of its related parties individually meets the power and benefits criteria, they are required to aggregate their variable interests for purposes of determining the primary beneficiary of Safetyco since, as a group, Autoco, Autoco Credit and Partco meet the power and benefits criteria. Analysis In this example, we believe the relationship and significance of the VIEs activities are more closely associated with Autoco. The following facts were considered in making this determination: Safetyco was formed to research and develop enhanced safety technologies for automobiles. Autoco is a manufacturer of automobiles. Autoco contributed the primary technology that Safetyco will attempt to further develop. Autoco has an option to acquire an exclusive license to any new technologies developed by Safetyco for an extended period of time.
The other factors in ASC 810-10-25-44 also should be considered in determining which party is the VIEs primary beneficiary. In the specific circumstance described above, based on the assumptions presented, Autoco should consolidate Safetyco as the primary beneficiary. However, the 50% ownership held by Partco should be accounted for in consolidation as a noncontrolling interest (see Question 16.4).
One member of a related party group not clearly identified as primary beneficiary
Question 16.3 ASC 810-10-25-44 provides certain factors to consider when determining which member of a related party group should be identified as a VIEs primary beneficiary. How should a member be identified as the primary beneficiary if the factors tend to point to multiple members of the related party group? In certain cases, the factors provided may tend to identify multiple members of the related party group as a VIEs primary beneficiary. In such cases, we believe that careful consideration of the individual facts and circumstances is necessary to determine the enterprise that is most closely associated to the VIE.
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One member of a related party group not clearly identified as primary beneficiary
Two parties (Party A and Party B) form a joint venture (which is a VIE) to manufacture, distribute and sell widgets. Both parties have 50% of the voting rights, and each represents 50% of the board of directors. Party A and Party B are related parties, and each requires the consent of the other party to make any decisions related to manufacturing, distributing, and sale of the widgets. Both parties through their voting interests and board representation jointly decide all other matters related to the VIE. In general, Party As core business is to manufacture, distribute and sell widgets, while Party Bs core business is to manufacture, distribute and sell other products. Analysis In this example, Party A and Party B together have the power to direct the activities of the VIE that most significantly impact the entitys economic performance, and decisions about those activities require the consent of each other. However, since Party A and Party B are related parties, one of the parties must be identified as the primary beneficiary because, together, they have power to direct the activities that most significantly impact the VIEs economic performance. Both Party A and Party B were involved in the design of the VIE and are equally exposed to the expected losses of the VIE. Also, since Party A and Party B are not related parties by virtue of a de facto agency relationship, a principal-agency relationship does not appear to exist between Party A and Party B. However, since Party A is in the business to manufacture, distribute and sell widgets while Party Bs core business is to manufacture, distribute and sell other products, the activities of the VIE are most closely related to Party A. Therefore, in this example, we believe Party A should consolidate the VIE because it is the member of the related party group to which the activities of the VIE are most closely associated.
Equity interests held by related parties of the primary beneficiary are noncontrolling interests
Question 16.4 If related parties of a VIEs primary beneficiary hold equity interests in the VIE, should these interests be accounted for as a noncontrolling interest in consolidation? Yes. Unless the related parties also are consolidated by the primary beneficiary, equity interests that the related party of the VIEs primary beneficiary hold in the VIE should be accounted for as noncontrolling interests by the primary beneficiary when consolidating the VIE.
Determining which party within the related party group is primary beneficiary
Question 16.5 How should the determination be made of which party within the related party group is most closely associated with the VIE? As discussed in the Interpretative guidance section, we believe the determination should be based on an analysis of all relevant facts and circumstances. While ASC 810-10-25-44 provides certain factors to consider in making this determination, these factors are not all-inclusive, and the use of professional judgment is required. We do not believe any one factor is determinative. The SEC staff has indicated that it shares this view. Note that while the following speech was intended to address accounting under FIN 46(R) (prior to the Statement 167 amendments), we believe that the concepts remain relevant to the Variable Interest Model in ASC 810-10. Note that the references to paragraph 17 of FIN 46(R) equate to ASC 810-10-25-44.
Financial reporting developments Consolidation of variable interest entities 257
Quantitative analysis in determining the primary beneficiary from a related party group
Question 16.6 Should an enterprise perform a quantitative analysis in determining the primary beneficiary from a related party group? Under ASC 810-10-25-44, an enterprise is required to consider exposure to variability associated with the anticipated economic performance of the VIE rather than expected losses. While a detailed calculation of expected losses may not be required, ASC 810-10-25-44 does require consideration of the variability associated with anticipated economic performance and, therefore, may require some quantitative analysis in its application.
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The net amount of the VIEs identifiable assets and liabilities recognized and measured in accordance with Topic 805.
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17.1
Interpretative guidance
ASC 810-10-30-1 through 30-4 provide guidance for the initial consolidation of a VIE by its primary beneficiary. Chapter 21 discusses the recognition and measurement of a VIEs assets, liabilities and noncontrolling interests upon the initial adoption of the amendments to the Variable Interest Model. The primary beneficiary of a VIE is required to measure the assets, liabilities and noncontrolling interests of the newly-consolidated entity in accordance with ASC 805s guidance for business combinations at the date the enterprise first becomes the primary beneficiary, with the following two exceptions: Exception #1 (ASC 810-10-30-1) When a VIEs primary beneficiary changes between entities that are under common control, the new primary beneficiary initially should measure the assets, liabilities and noncontrolling interests of the VIE at the amounts at which they were carried in the accounts of the enterprise that formerly controlled the VIE (i.e., carryover basis should be used with no adjustment to current fair values, and no gain or loss should be recognized). This accounting is similar to the accounting applied to transactions between entities under common control as described in ASC 805-50-30-5. Exception #2 (ASC 810-10-30-3) When an enterprise transfers assets and liabilities to a VIE that is not a business shortly before, in connection with, or shortly after becoming the VIEs primary beneficiary, the primary beneficiary initially should measure the assets and liabilities transferred to the VIE (and only those assets and liabilities) at the same amounts at which the assets and liabilities would have been measured had they not been transferred. All other assets (except goodwill), liabilities and noncontrolling interests should be measured in accordance with the provisions of ASC 805. The objective of this provision is to prevent the improper recognition of gains or losses due to the transfer of assets and liabilities to a VIE by its primary beneficiary. If an enterprise transfers assets and liabilities to a VIE shortly after becoming its primary beneficiary, then the transaction would represent a transaction among entities under common control (i.e., a transaction between a parent and subsidiary). Thus, the transaction should be accounted for similarly to transactions falling under the common control provisions of ASC 805-50-30-5. With respect to transfers of assets and liabilities occurring shortly before an enterprise becomes a VIEs primary beneficiary, it may be unclear as to whether the transaction is a separate economic exchange or is in contemplation of the change in control. As a result, the Variable Interest Model requires that when an enterprise transfers assets and liabilities to a VIE that is not a business shortly before becoming the VIEs primary beneficiary that the transaction be treated as a common control transaction. An enterprise will be required to exercise professional judgment in determining what would qualify as shortly before. Any goodwill recognized in the initial consolidation of a VIE should be evaluated for impairment pursuant to the provisions of ASC 350. Refer to our Financial reporting developments publication, Business combinations, for additional discussion regarding the provisions of ASC 805.
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Form 8-K and SEC Regulation S-X Rules 3-05 and 3-14 reporting requirements
Question 17.2 Rule 3-05 of SEC Regulation S-X (Rule 3-05) and Item 9.01(a) of Form 8-K describe the SECs requirements for registrants to provide audited financial statements of a business acquired or to be acquired, including the acquisition of an interest in a business accounted for under the equity method. Rule 3-14 of SEC Regulation S-X (Rule 3-14) describes the requirements for audited financial statements of real estate operations acquired or to be acquired. Does consolidation of a VIE trigger a financial statement reporting requirement pursuant to Rule 3-05, Rule 3-14 or Item 9.01(a) of Form 8-K by the primary beneficiary? The SEC staff has indicated that consolidation upon the initial adoption of the provisions of Statement 167 would not trigger a requirement to report under Rule 3-05, Rule 3-14 or Item 9.01(a) of Form 8-K.32 However, the SEC staff does believe that subsequent to the adoption of Statement 167 a registrant may be required to report under Rule 3-05, Rule 3-14 or Item 9.01(a) of Form 8-K for the ongoing application of the Variable Interest Model.
32
The SEC staff shared this view with the Center for Audit Quality SEC Regulations Committee (CAQ Alert #2010-20 April 9, 2010). 261
to be applicable only to the initial application of FIN 46 or FIN 46(R), we believe that subsequent consolidation or deconsolidation required pursuant to the Variable Interest Model (including under Statement 167 on or subsequent to its adoption) should not result in the immediate recognition of previously deferred derivative gains and losses if a surrogate hedge item can be identified. Issue E22 states that its guidance should also be applied by analogy to situations in which the issuance of new authoritative guidance results in a reporting entity becoming a primary beneficiary under FIN 46(R) and, therefore, must consolidate the related VIE. We believe that Statement 167 represents an amendment to FIN 46(R)s variable interest model, and as such, we believe that Issue E22 provides for an explicit analogy to its guidance upon adoption of Statement 167. Illustration 17-1: Statement 133 Implementation Issue No. E22
Hedging General: Accounting for the Discontinuance of Hedging Relationships Arising from Changes in Consolidation Practices Related to Applying FASB Interpretation No. 46 or 46(R) Example 1 Discontinued Cash Flow Hedge Arising from Consolidation A special purpose leasing entity is established based on a $3,000 equity contribution by an independent equity participant. The leasing entity borrows $97,000 with LIBOR-based interest payable quarterly and principal repayable as a lump sum at maturity and purchases a $100,000 asset. Company A leases the asset for a variable quarterly lease payment equal to the sum of (a) the leasing entitys LIBOR-based quarterly interest payment, (b) a fixed return to the equity participant that is paid quarterly, and (c) a fixed amount to cover the leasing entitys insurance, maintenance, and other costs. Assume that the due dates for the quarterly interest payments and the quarterly lease payments are the same. Company A enters into a receive-LIBOR, pay-fixed interest rate swap (with a notional amount not exceeding $97,000) and designates the swap as a cash flow hedge of all or a portion of its exposure to the variability of its LIBOR-based cash outflows under the lease. Prior to the initial application of Interpretation 46 or 46(R), Company A had not been consolidating the special-purpose leasing entity. Upon initial application of Interpretation 46 or 46(R), the special-purpose leasing entity is considered a variable interest entity; assume that it must be consolidated by Company A. The original cash flow hedge must be discontinued because the hedged forecasted transactions (the LIBOR-based lease payments) are no longer eligible forecasted transactions of the consolidated entity with a third party (because they are now intercompany transactions that are eliminated in consolidation). Assume that upon consolidation of the variable interest (leasing) entity, the noncontrolling interest in the newly consolidated leasing entity will be reported as equity (minority interest). At issue is the accounting upon consolidation for the net gain or loss that had been reported in accumulated OCI related to that discontinued cash flow hedge. Example 2 Discontinued Cash Flow Hedge Arising from Consolidation A special-purpose leasing entity is established based on a $3,000 equity contribution by an independent equity participant whose terms are mandatorily redeemable for a fixed amount. The leasing entity borrows $97,000 with LIBOR-based interest payable quarterly and principal repayable as a lump sum at maturity and purchases a $100,000 asset. Company A leases the asset for a variable quarterly lease payment equal to the sum of (a) the leasing entitys LIBOR-based quarterly interest payment, (b) a LIBOR-based return to the equity participant that is paid quarterly, and (c) a fixed amount to cover the leasing entitys insurance, maintenance, and other costs. Company A enters into a receive-LIBOR, pay-fixed interest rate swap (with a $100,000 notional amount) and designates the swap as a cash flow hedge of all of its exposure to the variability of its LIBOR-based cash outflows under the lease. Prior to the initial application of Interpretation 46 or 46(R), Company A had not been consolidating the special-purpose leasing entity.
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Upon initial application of Interpretation 46 or 46(R), the special-purpose leasing entity is considered a variable interest entity; assume that it must be consolidated by Company A. The original cash flow hedge must be discontinued because the hedged forecasted transactions (the LIBOR-based lease payments) are no longer eligible forecasted transactions of the consolidated entity with a third party (because they are now intercompany transactions that are eliminated in consolidation). Assume that upon consolidation of the variable interest (leasing) entity, the noncontrolling interest in the newly consolidated leasing entity will be reported as a liability in the consolidated financial statements. At issue is the accounting upon consolidation for the net gain or loss that had been reported in accumulated OCI related to that discontinued cash flow edge. Example 3 Discontinued Fair Value Hedge Arising from Deconsolidation Bank B establishes a special-purpose trust to issue preferred stock to investors. The preferred stock is mandatorily redeemable on a specified date and specifies a fixed periodic (such as quarterly or annual) dividend. The proceeds of the issuance are paid to Bank B and the bank records a liability to the trust. However, because Bank B consolidates the trust, the banks liability to the trust is eliminated in its consolidated financial statements. Assume that the trusts mandatorily redeemable preferred stock is reported as a trust preferred certificates liability in the consolidated financial statements. Bank B enters into a receive-fixed, pay-LIBOR interest rate swap (with a $100,000 notional amount) and designates the swap as a fair value hedge of its exposure to changes in the fair value of the liability for the trust preferred certificates. (Had the trusts mandatorily redeemable preferred stock not been reported as a liability in the consolidated financial statements, the preferred stock could not have been designated as the hedged item in a fair value hedge under Statement 133.) Assume that upon initial application of Interpretation 46 or 46(R), Bank B concludes that the specialpurpose trust is a variable interest entity and that the bank is not the primary beneficiary of the trust; consequently, Bank B deconsolidates the trust, thereby excluding the trust preferred certificates from the consolidated financial statements. However, Bank B would report its liability to the trust in the consolidated financial statements. The original fair value hedge must be discontinued because the hedged item (that is, the liability for the trust preferred certificates) no longer exists as a liability in Bank Bs consolidated financial statements. At issue is the accounting upon deconsolidation for the net effect of fair value hedge accounting adjustments on the carrying amount of the hedged item and whether that net effect on the date of deconsolidation can be reported as an adjustment of the carrying amount for the banks liability to the trust. Response If a reporting entity is required to discontinue a pre-existing hedging relationship upon the initial application of Interpretation 46 or 46(R) due to the required consolidation of another entity in (or the deconsolidation of that entity from) the reporting entitys consolidated financial statements, the adjustments of the reporting entitys financial statements must reflect the ongoing effect of the previous hedge accounting for those discontinued relationships in a manner consistent with the reporting entitys risk management policy and the objectives of those discontinued hedging relationships. Reflecting that ongoing effect of those discontinued relationships will involve identification and designation of surrogate hedged items for discontinued fair value hedges and surrogate hedged forecasted transactions for discontinued cash flow hedges. The surrogate hedged items and hedged forecasted transactions would need to have met (on a retroactive basis) the qualifying criteria applicable to those items and transactions (other than the requirement for contemporaneous documentation).
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The identification of surrogate hedged items and hedged transactions relates solely to reflecting the ongoing effect of the discontinued hedging relationships, that is, how the basis adjustments arising from fair value hedge accounting and the amounts in OCI arising from cash flow hedge accounting should affect earnings in future periods. Example 1 Discontinued Cash Flow Hedge Arising from Consolidation Because the hedged forecasted transactions (that is, the LIBOR-based lease payments to the specialpurpose leasing entity) on the discontinued cash flow hedge were related to the LIBOR-based interest payments on the leasing entitys LIBOR-based variable-rate debt, Company A should, upon consolidation of the variable interest (leasing) entity, designate the LIBOR-based interest payments on that newly consolidated debt as the surrogate hedged forecasted transactions for purposes of the subsequent accounting for the amounts in accumulated OCI related to the discontinued cash flow hedge at the date the hedge was discontinued. Under that surrogate designation, the amounts in accumulated OCI related to the discontinued cash flow hedge would be reclassified into earnings in the same period or periods during which the hedged LIBOR-based interest payments on the newly consolidated debt affects earnings, pursuant to the provisions of paragraph 31 of Statement 133. The amounts in accumulated OCI related to the discontinued cash flow hedge would not be reclassified into earnings immediately upon consolidation. The provisions of paragraphs 28 and 37 of Interpretation 46 and Interpretation 46(R) do not specifically address the amounts in OCI because those paragraphs address the carrying amounts of only the assets, liabilities, and noncontrolling interests of the variable interest (leasing) entity. But the notion in those paragraphs about measurement in the consolidated financial statements being determined as if the Interpretation had been effective when the reporting entity first met the conditions to be the primary beneficiary is relevant to the subsequent accounting for the amounts in OCI related to the discontinued cash flow hedge. The accounting under Statement 133 should be based on the assumption that if the leasing entity had been consolidated, that entitys receive-LIBOR, pay-fixed interest rate swap would have likely been designated as the hedging instrument in a cash flow hedge of all or a portion of the consolidated entitys exposure to the variability of the LIBORbased cash outflows related to the interest payments on the leasing entitys debt. Example 2 Discontinued Cash Flow Hedge Arising from Consolidation Because the hedged forecasted transactions (that is, the LIBOR-based lease payments to the specialpurpose leasing entity) on the discontinued cash flow hedge were related to (a) the quarterly LIBORbased interest payments on the leasing entitys LIBOR-based variable-rate debt and (b) the LIBORbased return to the equity participant that is being paid quarterly, Company A should, upon consolidation of the variable interest (leasing) entity, designate both the quarterly LIBOR-based interest payments on that newly consolidated debt and the quarterly payments on the newly consolidated liability to the equity participant as the surrogate hedged forecasted transactions for purposes of the subsequent accounting for the amounts in accumulated OCI related to the discontinued cash flow hedge at the date the hedge was discontinued. Under that surrogate designation, only 97 percent of the amounts in accumulated OCI related to the discontinued cash flow hedge would relate to the LIBOR-based interest payments (on that newly consolidated debt) that are being designated as the surrogate hedged forecasted transactions (for 97 percent of the hedging swap). Because the noncontrolling interest is reported as a liability, the remaining 3 percent of the amounts in accumulated OCI related to the discontinued cash flow hedge would relate to the LIBOR-based payments to that noncontrolling interest (the equity participant), which would be designated as the surrogate hedged forecasted transactions (for 3 percent of the hedging swap). (In contrast, if the noncontrolling interest would have been reported as equity (minority
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interest) in the consolidated financial statements, the LIBOR-based payments to that noncontrolling interest would not be eligible under paragraph 29(f) of Statement 133 for designation as the hedged forecasted transaction, in which case the remaining 3 percent of the amounts in accumulated OCI related to the discontinued cash flow hedge would be removed from accumulated OCI and recognized as part of the cumulative effect of an accounting change.) If any timing difference exists between the LIBOR-based lease payments to the special-purpose leasing entity (the original hedged transaction) and the LIBOR-based interest payments on the leasing entitys variable-rate debt (the surrogate hedged transaction) that creates ineffectiveness with respect to the surrogate hedged transaction that would have been recognized under paragraph 30 of Statement 133, that ineffectiveness should be recognized as part of the cumulative effect of an accounting change and should adjust the 97 percent of the amounts in accumulated OCI related to the discontinued cash flow hedge. For the 97 percent of the amounts in accumulated OCI related to the discontinued cash flow hedge, they would be reclassified into earnings in the same period or periods during which the LIBOR-based interest payments on the newly consolidated debt affect earnings, pursuant to the provisions of paragraph 31 of Statement 133. Similarly, for the remaining 3 percent of those amounts in accumulated OCI, they would be reclassified into earnings in the same period or periods during which the LIBOR-based payments on the liability to the equity participant affect earnings. The amounts in accumulated OCI related to the discontinued cash flow hedge would not all be reclassified into earnings immediately upon consolidation. Example 3 Discontinued Fair Value Hedge Arising from Deconsolidation Because the hedged item (that is, the liability for the trust preferred certificates) on the discontinued fair value hedge was related to Bank Bs liability to the trust, Bank B should, upon deconsolidation of the variable interest entity (the trust), designate its liability to the trust as the surrogate hedged item for purposes of removing the trust from the consolidated financial statements. The net basis adjustment of the liability for the trust preferred certificates made under fair value hedge accounting and remaining at the date the fair value hedge is discontinued should be used to adjust the carrying amount of Bank Bs liability to the trust. Although the classification of trust preferred certificates is addressed in FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, at the time this Implementation Issue was cleared, the Board had deferred the effective date of the guidance in Statement 150 with respect to certain instruments, including the trust preferred certificates in this example. Refer to FASB Staff Position No. FAS 150-3, Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. Special Application of the Shortcut Method If the initial application of Interpretation 46 or 46(R) causes the discontinuance of a pre-existing hedging relationship for which effectiveness was being assessed under the shortcut method in paragraph 68 of Statement 133 and the company designates a new hedging relationship, the new hedging relationship can qualify for the shortcut method if the following criteria are met: The new hedging relationship meets all conditions in paragraph 68 other than the condition in paragraph 68(b). The designation of the new hedging relationship was completed at the same time that the preexisting hedging relationship was discontinued. The hedging derivative in the new hedging relationship is all or a proportion of the hedging derivative used in the discontinued pre-existing hedging relationship.
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The hedged item or the hedged transaction in the new hedging relationship is the surrogate for the discontinued pre-existing hedging relationship. The discontinued pre-existing hedging relationship had qualified for and had been accounted for under the shortcut method.
If an entity had already applied Interpretation 46 and had designated a new hedging relationship (that meets all of the above criteria) contemporaneous with the discontinuance of a pre-existing hedging relationship due to the change in consolidation practices, the entity is allowed to apply the shortcut method to that new hedging relationship even though the use of the shortcut method had not been documented at the inception of that new hedging relationship. That entity should report the accounting effects of initially applying the shortcut method to the new hedging relationship as a cumulative change in accounting principles in the first fiscal quarter that ends after November 10, 2003 (as discussed in the effective date and transition section below). Application of This Guidance The guidance in this Issue applies to the adjustments made with respect to the previous hedge accounting for a pre-existing hedging relationship that was discontinued because of the consolidation or deconsolidation of another entity due to the initial application of Interpretation 46 or 46(R). The guidance in this Issue should also be applied by analogy to situations in which the issuance of new authoritative guidance results in a reporting entity becoming a primary beneficiary under Interpretation 46(R) and, therefore, must consolidate the related VIE. The guidance does not address the discontinuance of hedging relationships attributable to the consolidation or deconsolidation of another entity due to a change in ownership, control, or other circumstances. The guidance in this Issue does not affect the designation of new hedging relationships on or after the date of initial application of Interpretation 46 or 46(R). Such new hedging relationships need to comply with all applicable requirements of Statement 133 (as amended) except with respect to the special use of the shortcut method as previously discussed. At its November 5, 2003 meeting, the Board reached the above answer. Absent that, the staff would not have been able to provide guidance that permits (a) the identification of a surrogate hedged item or hedged transaction that would impact the ongoing effect of the previous hedge accounting for those hedging relationships discontinued due to a change in consolidation practices related to application of Interpretation 46 or 46(R) and (b) the new hedging relationship to qualify for the shortcut method without meeting the conditions in paragraph 68(b) at the inception of that hedging relationship.
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18
18.1
Interpretative guidance
After initial measurement, the assets, liabilities and noncontrolling interests of a consolidated VIE should be accounted for in the primary beneficiarys consolidated financial statements as if the entity were consolidated based on voting interests. The consolidation principles in ASC 810-1045 and disclosure requirements in ASC 810-10-50-1 through ASC 810-10-50-1B should be followed subsequent to the initial measurement of a VIEs assets, liabilities and noncontrolling interests. For example, intercompany balances and transactions should be eliminated in their entirety. The amount of intercompany profit or loss to be eliminated is not affected by the existence of a noncontrolling interest. The complete elimination of the intercompany profit or loss is consistent with the underlying assumption that the primary beneficiarys consolidated statements represent the financial position and operating results of a single enterprise. However, there is a significant difference between the general consolidation guidance contained in ASC 810-10 and the consolidation procedure guidance under the Variable Interest Model as to how the effect of intercompany eliminations may be attributed to the noncontrolling interests in consolidation. ASC 810-10-45-18 states that such effects may be allocated between the majority (controlling) and noncontrolling interests. Under the Variable Interest Model, when a VIE is consolidated, the effect of intercompany eliminations must be attributed to the primary beneficiary. The difference is intended to address the effect of fees or other sources of income from a consolidated VIE, which may continue to be recognized in the consolidated net income of the primary beneficiary when these fees have been realized. For example, if the primary beneficiary has no equity interest in the variable interest entity and receives a fee from the entity that simultaneously expensed that fee, the amount of the fee that is eliminated in consolidation would be allocated to the primary beneficiary even if the remainder of the entitys net income is allocated to the entitys noncontrolling interest. On a consolidated basis, the primary beneficiary will no longer recognize revenue for the fees received from the VIE (these will be eliminated in consolidation), but will recognize the benefit of the fee income in its share of net income.
Financial reporting developments Consolidation of variable interest entities 267
Given that the requirements for accounting for the elimination of intercompany transactions and the allocation of a subsidiarys income under the Variable Interest Model may differ significantly from the general consolidation guidance in ASC 810-10, the results of accounting for the elimination of intercompany transactions pursuant to the Variable Interest Model may be counterintuitive. Accordingly, the nature and terms of the intercompany transactions should be evaluated carefully in determining how they should be eliminated. Similar to the general consolidation guidance in ASC 810-10-45-21, when losses applicable to the noncontrolling interest exceed the noncontrolling interest equity of a consolidated VIE, such excess and any further losses applicable to the noncontrolling interest should continue to be charged to the noncontrolling interest.
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Assume that an entity is a VIE and has two variable interest holders, A and B. B holds all of the equity investment in the VIE. A has made a loan to the VIE from which it has recognized interest income of $100 in its stand-alone financial statements. A is the primary beneficiary of the VIE. Analysis If A consolidated the VIE pursuant to the general consolidation procedure guidance in ASC 810-10 and allocated the effects of the intercompany eliminations proportionately between the controlling and noncontrolling interests based on ownership of equity interests, the consolidating adjustments and the consolidated income statement of A would be as follows: A
Revenues Cost of revenues Operating income Selling, general and administrative Other Interest income Interest expense Net income Net income attributable to noncontrolling interest Net income attributable to controlling interest $ 10,000 6,000 4,000 1,000 100 3,100 3,100 $
VIE
1,000 600 400 200 (100) 100 100
Adjustments
$ (100) 100 200 (200)
Consolidated
$ 11,000 6,600 4,400 1,200 3,200 200 3,000
$ $ $
$ $ $
$ $ $
$ $ $
If the effects of the intercompany eliminations are allocated to the noncontrolling interest in proportion to equity ownership, the interest income that A has recognized due to the intercompany transactions with the VIE is eliminated in consolidation. As net income has been reduced by $100 to $3,000. The effect of the intercompany elimination of As interest income has been attributed to the noncontrolling interest through elimination of the interest expense at the VIE (because A does not have an equity interest in the VIE). However, because the VIE is consolidated pursuant to the Variable Interest Model, the consolidating adjustments and the consolidated income statement of A would be as follows:
A Revenues Cost of revenues Operating income Selling, general and administrative Other Interest income Interest expense Net income Net income attributable to noncontrolling interest Net income attributable to controlling interest $ 10,000 6,000 4,000 1,000 100 3,100 3,100 $ VIE 1,000 600 400 200 (100) 100 100 Adjustments $ Consolidated
$ $ $
$ $ $
$ $ $
(100) 100
100 (100)
$ $ $
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As above, the interest income that A has recognized due to the intercompany transactions with the VIE has been eliminated in consolidation. However, As net income has remained unchanged as the effect of the interest income eliminated in consolidation has been attributed entirely to A. The differing results can also be summarized as follows:
General consolidation guidance in ASC 810-10 Separate net income of A Interest income attributed to noncontrolling interest Net income attributable to controlling interest Variable Interest Model Separate net income of A Interest income attributed to noncontrolling interest Net income attributable to controlling interest $ $ 3,100 3,100 $ $ 3,100 (100) 3,000
Assume Investor A and Investor B each contribute $200,000 in exchange for an equal ownership interest in the equity of a VIE. The VIE obtains debt of $800,000 and uses a portion of the proceeds ($500,000) to buy and construct a building. Investor A provided development services to the VIE for a fee of $300,000, and it incurred costs of $100,000 to provide those services. Investor A is the primary beneficiary of the VIE. The consolidated financial presentation and consolidating adjustments of Investor A in Year 1, pursuant to the provisions of the Variable Interest Model are as follows:
Investor A Balance sheet Cash Building Investment in VIE Total assets Debt Noncontrolling interest (equity) Stockholders equity Total liabilities/equity Income statement Revenues Cost of revenues Net income Net income attributable to noncontrolling interest Net income attributable to controlling interest
(a) (b)
Adjustments $ (200,000) (a) (200,000) (b) $ (400,000) 200,000 (b) (400,000) (b) (200,000) (a) $ (400,000) $
700,000 $ 700,000
400,000 $ 1,200,000
500,000 $ 1,500,000
$ $ $ $
$ $ $ $
$ 200,000
$ (200,000)
To reduce consolidated revenues, costs of revenues and the capitalized cost of the building for the effect of fees charged by Investor A to the consolidated VIE. To eliminate the intercompany investment in the consolidated VIE and to record the noncontrolling interest.
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This example illustrates how the entire fee is eliminated in the consolidated financial statements. The fees that have been capitalized by the consolidated VIE are not recognized in consolidated income because they have not been realized. The benefit of the eliminating entry is recognized prospectively through the recognition of an increase to the subsidiary VIEs income due to the elimination of the depreciation expense arising from the capitalized development fee, and the benefit of that elimination is allocated to the parent (Investor A). However, if instead of capitalizing the cost, the VIE currently expensed the fee, we believe net income attributable to controlling interest would include the benefit of the portion of the fee that was absorbed by the noncontrolling interest. That is, had the consolidated VIE expensed the fees charged to it by Investor A, a $150,000 loss would be reflected in the net income attributable to noncontrolling interest line in the consolidated entitys income statement as illustrated in the previous example above. Facts Year 2 Assume the VIE depreciates the building over 10 years, which results in annual depreciation expense of $80,000 ($800,000/10 years = $80,000). Further, assume there were no other transactions occurring in Year 2. The consolidated financial presentation and consolidating adjustments of Investor A in Year 2 are as follows:
Investor A Balance sheet Cash Building, net Investment in VIE Total assets Debt Noncontrolling interest (equity) Stockholders equity $ 500,000 200,000 $ 700,000 $ VIE $ 400,000 720,000 $1,120,000 $ 800,000 Adjustments $ (180,000) (a) (200,000) (b) $ (380,000) $ 160,000 (b) (400,000) (b) (200,000) (a) 60,000 $ (380,000) Consolidated $ 900,000 540,000 $ 1,440,000 $ 800,000 160,000
Total liabilities/equity Income statement Revenues Cost of revenues Net income Net income attributable to noncontrolling interest Net income attributable to controlling interest
(a)
700,000 $ 700,000
320,000 $1,120,000
480,000 $ 1,440,000
$ $ $ $
$ $ $ $
$ $ $ $
To reduce the net prior year impact for the effect of the fees charged by Investor A to the consolidated VIE that were capitalized as a cost of the building by the VIE. The VIE capitalized the development fee of $300,000. Investor A incurred $100,000 of costs to provide these services, which were capitalized by the consolidated entity. Accordingly, the net impact is a reduction of depreciation expense totaling $20,000 [($300,000/10 years) ($100,000/10 years) = $20,000]. To eliminate the intercompany investment in the consolidated VIE and to record the net income attributable to noncontrolling interest.
(b)
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33
The amendments in Accounting Standards Update 2010-11, Scope Exception Related to Embedded Credit Derivatives, are effective for each reporting enterprise at the beginning of its first fiscal quarter beginning after 15 June 2010. Early adoption is permitted at the beginning of each reporting enterprises fiscal quarter beginning after the issuance of ASU 2010-11 (i.e., 5 March 2010). 273
to a beneficial interest by a written credit default swap in a securitization structure, the related embedded credit derivative feature is not clearly and closely related to the host contract, and, therefore, such a feature would be bifurcated. Except for the effect of a freestanding written credit default swap in a securitization structure, which is required to be bifurcated under ASU 2010-11, we generally do not believe that an embedded put option (arising due to the limited recourse nature of the beneficial interests) should be bifurcated from its host instrument for the following reasons: ASC 815 requires holders of interests in securitized financial assets to evaluate and determine, based on an analysis of the contractual terms of the interests, whether the beneficial interests are freestanding derivatives or contain an embedded derivative that would be required to be separated from the host contract. The creditworthiness of an obligor and the interest rate on a debt instrument are considered to be clearly and closely related. We believe ASC 815 provides that the creditworthiness of the financial instruments that a special purpose debtor holds (other than written credit default swaps) and the creditworthiness of the special purpose debtor itself are one and the same. The holders of beneficial interests in VIEs have only the credit risk exposure from the assets in the legally isolated entity (i.e., the VIE). That is, those beneficial interest holders will be paid if there is sufficient cash generated by the legally isolated entitys assets. Because the risk exposure of the investors return comes solely from the VIEs assets (unless one of those beneficial interests explicitly introduces a new credit risk not heretofore present in any of the assets held by that entity), and there is no risk exposure arising from the overall creditworthiness of the consolidating enterprise, we do not believe multiple credit risks exist such that bifurcation of an embedded derivative would be required pursuant to ASC 815. We do not believe that additional credit risk is introduced when a VIE is consolidated because the credit risk of the instruments issued by the VIE is the same regardless as to whether that VIE is consolidated by another enterprise. Accordingly, we also do not believe that the consolidation of a VIE is determinative as to whether a derivative should be bifurcated from its host. We have confirmed our understanding of ASC 815s provisions with the FASB staff.
in a consolidated VIE that consists of preferred stock should be accounted for similar to preferred stock issued by the consolidating enterprise (although the preferred stock is classified as noncontrolling interest). Accordingly, earnings of the VIE are allocated to the noncontrolling interest based on the preferred stocks stated dividend and liquidation rights, and losses of the subsidiary normally are not allocated to the preferred stock classified as noncontrolling interest. In other words, the balance of the preferred stock noncontrolling interest generally should be equal to its liquidation preference. In some cases, the preferred stock does not have a liquidation preference and truly represents a residual equity interest in the entity (e.g., the equity interest may be called preferred stock because it participates disproportionally in returns but otherwise participates pari passu in losses). In these instances, the interest is tantamount to common stock. Therefore, in these circumstances, we believe it would be appropriate for a primary beneficiary to charge losses against the preferred stock noncontrolling interest, as it would the common interest. The guidance above only relates to preferred stock and should not necessarily be analogized to residual equity interests that provide preferential returns, which are common in partnerships.
Consolidation procedure Following the initial consolidation of an asset-backed financing entity, subsequent changes in the measurement of the assets and liabilities of the entity are recorded by the primary beneficiary (if any) in its consolidated income statement. However, subsequent changes in the measurement of the assets and liabilities may not fully offset in each reporting period giving rise to income or loss (e.g., the assets and liabilities are being recorded at fair value and the measurement guidance in ASC 820 results in the assets and liabilities being recorded at different amounts). Often the primary beneficiarys economic claim to the difference (i.e., the amount by which the changes in assets and liabilities do not offset) is limited to its proportion of the beneficial interests (if any). Therefore, questions have arisen as to how income or loss should be attributed to the primary beneficiary and the other variable interest holders (e.g., beneficial interest holders) of an asset-backed financing entity. ASC 810-10-20 defines noncontrolling interest as the portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent However, ASC 810-10-45-16A indicates that only a financial instrument classified as equity in the subsidiarys financial statements can represent noncontrolling interest. Through its service arrangement or beneficial interests (if any), the primary beneficiary of an assetbacked financing entity generally is not contractually (nor economically) entitled to all of the income or loss. Therefore, in the absence of a substantive equity-classified noncontrolling interest, the accounting literature is not clear as to how the income or loss of an asset-backed financing entity should be attributed to its variable interest holders on the consolidated income statement or balance sheet. Accounting considerations Outside of any service arrangement fees earned, we believe that it would be most appropriate for income or loss to be attributed to its primary beneficiary only to the extent the primary beneficiary holds beneficial interests that are economically and contractually entitled to income or loss. If there is no substantive-equity classified noncontrolling interest, we believe that it would be most appropriate for the remaining income or loss to be attributed to the noncontrolling interest line item on the face of the consolidated income statement, despite the fact that the beneficial interests are classified as liabilities. We understand that the SEC staff has not objected to this accounting application but has objected to a view that any excess of the amount of assets over the amount of liabilities be recorded as expense in the consolidated income statement (i.e., with a corresponding adjustment to the liability to the beneficial interest holders). We also understand that the SEC staff has not objected to a view that the portion of the income or loss attributable to noncontrolling interest on the consolidated income statement be reclassified into appropriated retaining earnings of parent in the consolidated balance sheet. It is relevant to note that, upon adoption of Statement 167, ASC 810-10-65-2(c) requires any cumulative effect adjustment to be recorded to retained earnings. We understand that the SEC staff view above also would apply to the relevant portion of the cumulative effect adjustment being recorded to appropriated retained earnings for asset-backed financing entities consolidated upon adoption. Different facts and circumstances might result in different acceptable accounting conclusions. In any event, we believe that an enterprises accounting policies should be fully disclosed and made transparent to the readers of the financial statements. Additionally, we understand that the FASB staff is aware of this issue. Readers should monitor any future developments in this area closely.
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Presentation
Excerpt from Accounting Standards Codification
Consolidation Overall Other Presentation Matters 810-10-45-25 A reporting entity shall present each of the following separately on the face of the statement of financial position: a. b. Assets of a consolidated variable interest entity (VIE) that can be used only to settle obligations of the consolidated VIE Liabilities of a consolidated VIE for which creditors (or beneficial interest holders) do not have recourse to the general credit of the primary beneficiary.
19.1
Interpretative guidance
Statement 167 amends the Variable Interest Model to require that a reporting enterprise separately present on the face of the balance sheet certain assets and liabilities of a consolidated VIE. The FASB concluded that separate presentation should be required by enterprises consolidating a VIE. In arriving at its conclusion, the FASB considered but rejected a single line-item display of assets and liabilities or net assets and liabilities of VIEs. In other words, qualifying assets and liabilities of VIEs should be presented separately on the balance sheet for each major class of assets and liabilities (e.g., cash, accounts receivable, property, plant and equipment). Although noncontrolling interests are not subject to separate presentation requirements, we believe an enterprise is permitted to do so in the equity section of the balance sheet so long as it is an accounting policy choice that is applied to all consolidated VIEs. While the Variable Interest Model requires separate presentation, it does not provide examples or detailed implementation guidance with respect to how enterprises would satisfy the separate presentation requirements. We believe that enterprises will have to consider carefully the separate presentation requirements and ensure that adequate financial reporting systems are established to track and capture the assets and liabilities of consolidated VIEs that meet the criteria for separate presentation.
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disclosures for similar entities in situations in which separate reporting would not provide information that is more useful to financial statement users. In circumstances in which an enterprise consolidates numerous VIEs, we believe that the aggregation principle for disclosure should be considered when applying the separate presentation requirement. Enterprises should establish (and disclose) a policy for how similar entities are aggregated. That policy should contemplate both quantitative and qualitative information about the different risk and reward characteristics of each VIE and the significance of each VIE to the enterprise. For example, consider a circumstance in which an enterprise is required to consolidate three VIEs (VIE 1, VIE 2 and VIE 3). Each of those VIEs has accounts receivable, investments and liabilities that meet the separate presentation requirement. The enterprise determines VIEs 1 and 2 are similar under the enterprises established policy such that the separate assets and liabilities of VIEs 1 and 2 would be eligible for aggregation. In addition, the enterprise determines that separate presentation of those two VIEs assets and liabilities on a combined basis would provide information that is more useful to financial statement users. Accordingly, the enterprise will aggregate the receivables of VIEs 1 and 2, the investments of VIEs 1 and 2 and the liabilities of VIEs 1 and 2, respectively. The receivables, investments and liabilities of VIE 3 will be presented separately from those of the other VIEs.
Can Enterprise A report VIE 1s assets and liabilities in its consolidated financial statements at its net asset value of $50? Alternatively, can Enterprise A aggregate VIE 1s assets and liabilities separately and present its total assets at $600 and its total liabilities at $550? No. The Variable Interest Model permits aggregation of disclosures for similar entities in situations in which separate reporting would not provide information that is more useful to financial statement users. While we believe that aggregation of similar assets and liabilities of consolidated VIEs may be appropriate (as discussed in Question 19.1), we do not believe that a net presentation for a VIEs assets and liabilities as one line item would be acceptable. As such, Enterprise A should not present VIE 1s assets and liabilities as a single line item in its financial statements at $50. In addition, we believe that presenting VIE 1s aggregate assets and aggregate liabilities as suggested above ($600 and $550, respectively) also is inconsistent with the separate presentation requirements in ASC 810-10-45-25.
Financial reporting developments Consolidation of variable interest entities 278
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As noted above, the Variable Interest Model does not provide detailed implementation guidance with respect to separate presentation. As a result, enterprises may choose different approaches to satisfy the separate presentation requirements. Using the above example, Enterprise A may choose to present a separate line item for accounts receivable for VIE 1 or it may choose to include the receivables of VIE 1 within its consolidated accounts receivable amount and parenthetically disclose the accounts receivable for VIE 1. Other presentation alternatives may be acceptable.
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Disclosures
Excerpt from Accounting Standards Codification
Consolidation Overall Disclosure All Entities within the Scope of Subtopic 810-10-50-2AA The principal objectives of this Subsections required disclosures are to provide financial statement users with an understanding of all of the following: a. The significant judgments and assumptions made by a reporting entity in determining whether it must do any of the following: 1. 2. b. c. d. Consolidate a variable interest entity (VIE) Disclose information about its involvement in a VIE.
The nature of restrictions on a consolidated VIEs assets reported by a reporting entity in its statement of financial position, including the carrying amounts of such assets and liabilities. The nature of, and changes in, the risks associated with a reporting entitys involvement with the VIE. How a reporting entitys involvement with the VIE affects the reporting entitys financial position, financial performance, and cash flows.
810-10-50-2AB A reporting entity shall consider the overall objectives in the preceding paragraph in providing the disclosures required by this Subsection. To achieve those objectives, a reporting entity may need to supplement the disclosures otherwise required by this Subsection, depending on the facts and circumstances surrounding the VIE and a reporting entitys interest in that VIE. 810-10-50-2AC The disclosures required by this Subsection may be provided in more than one note to the financial statements, as long as the objectives in paragraph 810-10-50-2AA are met. If the disclosures are provided in more than one note to the financial statements, the reporting entity shall provide a cross reference to the other notes to the financial statements that provide the disclosures prescribed in this Subsection for similar entities. Primary Beneficiary of a VIE 810-10-50-3 The primary beneficiary of a VIE that is a business shall provide the disclosures required by other guidance. The primary beneficiary of a VIE that is not a business shall disclose the amount of gain or loss recognized on the initial consolidation of the VIE. In addition to disclosures required elsewhere in this Topic, the primary beneficiary of a VIE shall disclose all of the following (unless the primary beneficiary also holds a majority voting interest): a. [Subparagraph superseded by Accounting Standards Update No. 2009-17]
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b.
bb. The carrying amounts and classification of the VIEs 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. For example, if the VIEs assets can be used only to settle obligations of the VIE, the reporting entity shall disclose qualitative information about the nature of the restrictions on those assets. c. d. Lack of recourse if creditors (or beneficial interest holders) of a consolidated VIE have no recourse to the general credit of the primary beneficiary Terms of arrangements, giving consideration to both explicit arrangements and implicit variable interests that could require the reporting entity to provide financial support (for example, liquidity arrangements and obligations to purchase assets) to the VIE, including events or circumstances that could expose the reporting entity to a loss.
A VIE may issue voting equity interests, and the entity that holds a majority voting interest also may be the primary beneficiary of the VIE. If so, and if the VIE meets the definition of a business and the VIEs assets can be used for purposes other than the settlement of the VIEs obligations, the disclosures in this paragraph are not required. Nonprimary Beneficiary Holder of Variable Interest in a VIE 810-10-50-4 In addition to disclosures required by other guidance, a reporting entity that holds a variable interest in a VIE, but is not the VIEs primary beneficiary, shall disclose: a. b. The carrying amounts and classification of the assets and liabilities in the reporting entitys statement of financial position that relate to the reporting entitys variable interest in the VIE. The reporting entitys maximum exposure to loss as a result of its involvement with the VIE, including how the maximum exposure is determined and the significant sources of the reporting entitys exposure to the VIE. If the reporting entitys maximum exposure to loss as a result of its involvement with the VIE cannot be quantified, that fact shall be disclosed. A tabular comparison of the carrying amounts of the assets and liabilities, as required by (a) above, and the reporting entitys maximum exposure to loss, as required by (b) above. A reporting entity shall provide qualitative and quantitative information to allow financial statement users to understand the differences between the two amounts. That discussion shall include, but is not limited to, the terms of arrangements, giving consideration to both explicit arrangements and implicit variable interests, that could require the reporting entity to provide financial support (for example, liquidity arrangements and obligations to purchase assets) to the VIE, including events or circumstances that could expose the reporting entity to a loss. Information about any liquidity arrangements, guarantees, and/or other commitments by third parties that may affect the fair value or risk of the reporting entitys variable interest in the VIE is encouraged. If applicable, significant factors considered and judgments made in determining that the power to direct the activities of a VIE that most significantly impact the VIEs economic performance is shared in accordance with the guidance in paragraph 810-10-25-38D.
c.
d.
e.
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Primary Beneficiaries or Other Holders of Interests in VIEs 810-10-50-5A A reporting entity that is a primary beneficiary of a VIE or a reporting entity that holds a variable interest in a VIE but is not the entitys primary beneficiary shall disclose all of the following: a. Its methodology for determining whether the reporting entity is the primary beneficiary of a VIE, including, but not limited to, significant judgments and assumptions made. One way to meet this disclosure requirement would be to provide information about the types of involvements a reporting entity considers significant, supplemented with information about how the significant involvements were considered in determining whether the reporting entity is the primary beneficiary. If facts and circumstances change such that the conclusion to consolidate a VIE has changed in the most recent financial statements (for example, the VIE was previously consolidated and is not currently consolidated), the primary factors that caused the change and the effect on the reporting entitys financial statements. Whether the reporting entity has provided financial or other support (explicitly or implicitly) during the periods presented to the VIE that it was not previously contractually required to provide or whether the reporting entity intends to provide that support, including both of the following: 1. 2. d. The type and amount of support, including situations in which the reporting entity assisted the VIE in obtaining another type of support The primary reasons for providing the support.
b.
c.
Qualitative and quantitative information about the reporting entitys 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. Paragraphs 810-10-25-48 through 25-54 and Example 4 (see paragraph 810-10-55-87) provide guidance on how to determine whether a reporting entity has an implicit variable interest in a VIE.
810-10-50-5B A VIE may issue voting equity interests, and the entity that holds a majority voting interest also may be the primary beneficiary of the VIE. If so, and if the VIE meets the definition of a business and the VIEs assets can be used for purposes other than the settlement of the VIEs obligations, the disclosures in the preceding paragraph are not required. Scope-Related Disclosures 810-10-50-6 A reporting entity that does not apply the guidance in the Variable Interest Entities Subsections to one or more VIEs or potential VIEs because of the condition described in paragraph 810-10-15-17(c) shall disclose all the following information: a. The number of legal entities to which the guidance in the Variable Interest Entities Subsections is not being applied and the reason why the information required to apply this guidance is not available The nature, purpose, size (if available), and activities of the legal entities and the nature of the reporting entitys involvement with the legal entities
b.
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20 Disclosures
c. d.
The reporting entitys maximum exposure to loss because of its involvement with the legal entities The amount of income, expense, purchases, sales, or other measure of activity between the reporting entity and the legal entities for all periods presented. However, if it is not practicable to present that information for prior periods that are presented in the first set of financial statements for which this requirement applies, the information for those prior periods is not required.
Aggregation of Certain Disclosures 810-10-50-9 Disclosures about VIEs may be reported in the aggregate for similar entities if separate reporting would not provide more useful information to financial statement users. A reporting entity shall disclose how similar entities are aggregated and shall distinguish between: a. b. VIEs that are not consolidated because the reporting entity is not the primary beneficiary but has a variable interest VIEs that are consolidated.
In determining whether to aggregate VIEs, the reporting entity shall consider quantitative and qualitative information about the different risk and reward characteristics of each VIE and the significance of each VIE to the entity. The disclosures shall be presented in a manner that clearly explains to financial statement users the nature and extent of an entitys involvement with VIEs. 810-10-50-10 A reporting entity shall determine, in light of the facts and circumstances, how much detail it shall provide to satisfy the requirements of the Variable Interest Entities Subsections. A reporting entity shall also determine how it aggregates information to display its overall involvements with VIEs with different risk characteristics. The reporting entity must strike a balance between obscuring important information as a result of too much aggregation and overburdening financial statements with excessive detail that may not assist financial statement users to understand the reporting entitys financial position. For example, a reporting entity shall not obscure important information by including it with a large amount of insignificant detail. Similarly, a reporting entity shall not disclose information that is so aggregated that it obscures important differences between the types of involvement or associated risks.
20.1
Interpretative guidance
In general, Statement 167 retains the disclosure requirements in the Variable Interest Model previously applicable to public enterprises with only minor editorial changes. Additionally, the Variable Interest Model requires disclosures in situations in which an enterprise determines that it shares the power over a VIE. As nonpublic enterprises previously were not required to apply all of the provisions in the Variable Interest Model, the adoption of Statement 167 will significantly expand the disclosure requirements for those enterprises as the Variable Interest Model will no longer provide an exception for these enterprises. In response to financial statement users concerns over the transparency of entities involvement with VIEs, Statement 167s amendments to the Variable Interest Model will require expanded disclosures in the following areas: The significant judgments and assumptions considered by the enterprise in determining whether it must consolidate a VIE or disclose information about its involvement with a VIE
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The nature of restrictions on a consolidated VIEs assets and on the settlement of its liabilities reported by the enterprise in its statement of financial position, including the carrying amounts of such assets and liabilities The nature of, and changes in, the risks associated with the enterprises involvement in a VIE How an enterprises involvement with a VIE affects its financial position, financial performance and cash flows
An enterprise must consider these overall objectives in providing the disclosures required by the Variable Interest Model. To achieve these objectives, an enterprise may need to supplement the required disclosures, depending on the facts and circumstances surrounding the VIE and the enterprises interest in that entity. Accordingly, if the enterprises involvement with the VIE is not adequately described by any of the required disclosures, the enterprise should provide further information, as needed. The disclosure requirements are extensive and, for certain enterprises, obtaining the information to prepare these disclosures may present challenges. Many VIEs do not prepare financial statements on a timely basis, and the reporting enterprise may not have a legal or contractual right to obtain the information, particularly for those over which the enterprise does not have the power to direct the activities of a VIE that most significantly impact the entitys economic performance. As a result, variable interest holders should ensure that they have access to the necessary information and develop control procedures to be able to obtain and analyze the information in order to prepare the required disclosures. While we believe an enterprise that is the primary beneficiary may have access to the information necessary to comply with the disclosure requirements, the ability of the primary beneficiary to develop the systems and processes necessary to gather the data may prove challenging.
20 Disclosures
The definition of a variable interest, in this context, is intended to be consistent with the concept of a variable interest included in the Variable Interest Model.
Aggregation
Question 20.3 What factors should an enterprise consider when aggregating disclosures about VIEs? In determining whether to aggregate disclosures with respect to multiple VIEs pursuant to ASC 810-10-50-9, the reporting enterprise should consider both quantitative and qualitative information about the different risk and reward characteristics of each VIE and the significance of each VIE to the enterprise. The disclosures must be presented in a manner that clearly explains to financial statement users the nature and extent of an enterprises involvement with VIEs. We believe that the qualitative information an enterprise may consider in determining whether VIEs are similar such that aggregating disclosures is appropriate may include, but is not limited to: The purpose and design of the VIE including the nature of the risks that the entity was designed to create. For example, the purpose and the design of a VIE may be to provide liquidity to the transferor of assets and to provide investors with the ability to invest in a pool of highly rated medium-term assets. Another VIEs purpose and design may be to provide the lessee with use of the property for a certain number of years with substantially all of the rights and obligations of ownership. We believe aggregating disclosures based on the purpose and design of a VIE as described herein is appropriate and, therefore, the assets and liabilities of these two VIEs should not be aggregated. The nature of the assets in the entity (e.g., residential mortgage vs. commercial mortgage). The type of involvement an enterprise may have with the VIEs. Examples of an involvement in an entity can vary and may relate to ones role (e.g., a special servicer, provider of guarantees or liquidity reserves) or to the types of interests one holds (e.g., equity vs. debt).
We believe that the objectives of the disclosure requirements are to provide more decision useful information to users. As such, the manner in which an enterprise applies the aggregation provisions should be consistent with these overall objectives, and an enterprise will be required to exercise judgment based upon its facts and circumstances in determining how much detail it must provide to satisfy the requirements of the Variable Interest Model. When considering whether to aggregate disclosures with respect to multiple VIEs, the enterprise should attempt to consider the disclosure alternatives from the perspective of a third party trying to understand the amount and nature of the enterprises exposure to the VIEs. That is, the reporting enterprise should consider whether the disclosures are more informative on an aggregated or disaggregated basis. While disaggregated information arguably is always more useful, that may not be true when it results in excessively lengthy disclosures. However, amounts relating to consolidated VIEs may never be aggregated with amounts relating to VIEs that are not consolidated.
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iii.
286
2.
A reporting entitys interest in an entity that is required to comply with or operate in accordance with requirements that are similar to those included in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. An entity that initially meets the deferral requirements in this subparagraph may subsequently cease to qualify for the deferral as a result of a change in facts and circumstances. In that situation, the pending content that links to this paragraph shall become effective for the entity. Accordingly, if the reporting entity is required to consolidate an entity because the entity no longer qualifies for the deferral, the reporting entity shall initially measure the assets, liabilities, and noncontrolling interests of the VIE in accordance with paragraphs 810-10-30-1 through 30-6, as of the date the entity ceases to qualify for the deferral.
aaa. Public and nonpublic entities shall provide the disclosures required by the pending content in paragraphs 810-10-50-1 through 50-19 that links to this paragraph for all variable interests in variable interest entities (VIEs). This includes variable interests in VIEs that qualify for the deferral in the preceding subparagraph but are considered VIEs under the provisions of the Variable Interest Entities Subsections of this Subtopic before the amendments in the pending content that links to this paragraph (that is, before the effects of Accounting Standards Updates 2009-17 and 2010-10). For public entities, in periods after initial adoption, comparative disclosures for those disclosures that were not previously required by paragraphs 810-10-50-7 through 50-19 are required only for periods after the effective date. Comparative information for disclosures previously required by those paragraphs that also are required by the pending content in the Variable Interest Entities Subsections shall be presented. For nonpublic entities, in periods after initial adoption, comparative disclosures for those disclosures that were not previously required are required only for periods after the effective date. Comparative information for disclosures previously required that also are required by the pending content in the Variable Interest Entities Subsections shall be presented. b. If a reporting entity is required to consolidate a VIE as a result of the initial application of the pending content that links to this paragraph, the initial measurement of the assets, liabilities, and noncontrolling interests of the VIE depends on whether the determination of their carrying amounts is practicable. In this context, carrying amounts refers to the amounts at which the assets, liabilities, and noncontrolling interests would have been carried in the consolidated financial statements if the requirements of the pending content that links to this paragraph had been effective when the reporting entity first met the conditions to be the primary beneficiary. 1. If determining the carrying amounts is practicable, the consolidating entity shall initially measure the assets, liabilities, and noncontrolling interests of the VIE at their carrying amounts at the date the requirements of the pending content that links to this paragraph first apply. If determining the carrying amounts is not practicable, the assets, liabilities, and noncontrolling interests of the VIE shall be measured at fair value at the date the pending content that links to this paragraph first applies. However, as an alternative to this fair value measurement requirement, the assets and liabilities of the VIE may be measured at their unpaid principal balances at the date the pending content that links to this paragraph first applies if both of the following conditions are met: i. The activities of the VIE are primarily related to securitizations or other forms of asset-backed financings.
2.
287
ii.
The assets of the VIE can be used only to settle obligations of the entity.
This measurement alternative does not obviate the need for the primary beneficiary to recognize any accrued interest, an allowance for credit losses, or other-than-temporary impairment, as appropriate. Other assets, liabilities, or noncontrolling interests, if any, that do not have an unpaid principal balance, and any items that are required to be carried at fair value under other applicable standards, shall be measured at fair value. c. Any difference between the net amount added to the balance sheet of the consolidating entity and the amount of any previously recognized interest in the newly consolidated VIE shall be recognized as a cumulative effect adjustment to retained earnings. A reporting entity shall describe the transition method(s) applied and shall disclose the amount and classification in its statement of financial position of the consolidated assets or liabilities by the transition method(s) applied. A reporting entity that is required to consolidate a VIE as a result of the initial application of the pending content in the Variable Interest Entities Subsections may elect the fair value option provided by the Fair Value Option Subsections of Subtopic 825-10, only if the reporting entity elects the option for all financial assets and financial liabilities of that VIE that are eligible for this option under those Fair Value Option Subsections. This election shall be made on a VIE-by-VIE basis. Along with the disclosures required in those Fair Value Option Subsections, the consolidating reporting entity shall disclose all of the following: 1. 2. 3. Managements reasons for electing the fair value option for a particular VIE or group of VIEs The reasons for different elections if the fair value option is elected for some VIEs and not others Quantitative information by line item in the statement of financial position indicating the related effect on the cumulative-effect adjustment to retained earnings of electing the fair value option for a VIE.
d.
e.
If a reporting entity is required to deconsolidate a VIE as a result of the initial application of the pending content in the Variable Interest Entities Subsections, the deconsolidating reporting entity shall initially measure any retained interest in the deconsolidated subsidiary at its carrying amount at the date the requirements of the pending content in the Variable Interest Entities Subsections first apply. In this context, carrying amount refers to the amount at which any retained interest would have been carried in the reporting entitys financial statements if the pending content in the Variable Interest Entities Subsections had been effective when the reporting entity became involved with the VIE or no longer met the conditions to be the primary beneficiary. Any difference between the net amount removed from the balance sheet of the deconsolidating reporting entity and the amount of any retained interest in the newly deconsolidated VIE shall be recognized as a cumulative-effect adjustment to retained earnings. The amount of any cumulative-effect adjustment related to deconsolidation shall be disclosed separately from any cumulative-effect adjustment related to consolidation of VIEs. The determinations of whether a legal entity is a VIE and which reporting entity, if any, is a VIEs primary beneficiary shall be made as of the date the reporting entity became involved with the legal entity or if events requiring reconsideration of the legal entitys status or the status of its variable interest holders have occurred, as of the most recent date at which the pending content in the Variable Interest Entities Subsections would have required consideration.
f.
288
g.
If at transition it is not practicable for a reporting entity to obtain the information necessary to make the determinations in (f) above as of the date the reporting entity became involved with a legal entity or at the most recent reconsideration date, the reporting entity should make the determinations as of the date on which the pending content in the Variable Interest Entities Subsections is first applied. If the VIE and primary beneficiary determinations are made in accordance with subparagraphs (f) and (g) above, then the primary beneficiary shall measure the assets, liabilities, and noncontrolling interests of the VIE at fair value as of the date on which the pending content in the Variable Interest Entities Subsections is first applied. However, if the activities of the VIE are primarily related to securitizations or other forms of asset-backed financings and the assets of the VIE can be used only to settle obligations of the VIE, then the assets and liabilities of the VIE may be measured at their unpaid principal balances (as an alternative to a fair value measurement) at the date the pending content in the Variable Interest Entities Subsections first applies. This measurement alternative does not obviate the need for the primary beneficiary to recognize any accrued interest, an allowance for credit losses, or other-than-temporary impairment, as appropriate. Other assets, liabilities, or noncontrolling interests, if any, that do not have an unpaid principal balance, and any items that are required to be carried at fair value under other applicable standards, shall be measured at fair value. The pending content in the Variable Interest Entities Subsections may be applied retrospectively in previously issued financial statements for one or more years with a cumulative-effect adjustment to retained earnings as of the beginning of the first year restated. The pending content linked to this paragraph may amend or supersede either nonpending content or other pending content with different or the same effective dates. If a paragraph contains multiple pending content versions of that paragraph, it may be necessary to refer to the transition paragraphs of all such pending content to determine the paragraph that is applicable to a particular fact pattern.
h.
i.
j.
21.1
Interpretative guidance
Note: In February 2010, the FASB issued an Accounting Standards Update (ASU) primarily to address concerns with the application of Statement 167 for reporting enterprises in the asset management industry by deferring the effective date of Statement 167 for certain investment funds. See additional discussion of this ASU later in this chapter. The FASB currently has a project on its agenda that would eliminate the deferral discussed above. In addition, the FASBs tentative decisions would modify the Variable Interest Models provisions for evaluating an enterprise as a principal or an agent (see Chapter 6) and the provisions for evaluating the substance of kick-out rights and participating rights (see Chapters 9 and 14), among other things. Readers should monitor developments in this area closely. Effective date Statement 167 is effective as of the beginning of an enterprises first annual reporting period that begins after 15 November 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter, with earlier application prohibited. For example, Statement 167 is effective for calendar year-end companies beginning on 1 January 2010.
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Disclosures In periods after the initial adoption, comparative information for disclosures previously required for nonpublic enterprises or for public enterprises is required. In periods after initial adoption, comparative disclosures for those disclosures that were not previously required for nonpublic enterprises or public enterprises only are required for periods subsequent to the effective date. That is, disclosures need not be provided for periods prior to the effective date unless those disclosures had been required when financial statements for those periods were originally prepared. Transition It is important to note that the amendments to the Variable Interest Model are applicable to all enterprises and to all entities with which those enterprises are involved, regardless of when that involvement arose. Therefore, upon adoption of Statement 167, all enterprises must reconsider their consolidation conclusions for all entities with which they are involved. Recognition Upon transition, an enterprise may be required to consolidate entities that it did not consolidate prior to the adoption of Statement 167. Conversely, an enterprise may be required to deconsolidate entities that it consolidated prior to the adoption of Statement 167. In evaluating the effects of Statement 167, an enterprise should assume that Statement 167s requirements always have been effective. The determination of whether an entity is a VIE and which enterprise, if any, is the VIEs primary beneficiary should be made as of the date the enterprise first became involved with the entity. That conclusion should then be reevaluated when events requiring reconsideration of the entitys status as a VIE or when a change in the primary beneficiary would have occurred under Statement 167. However, only if the enterprise would be a VIEs primary beneficiary at the adoption date if Statement 167s provisions had always been applied, should a VIE be consolidated by the enterprise on the adoption date. Alternatively, if the enterprise would not be an entitys primary beneficiary at the adoption date if Statement 167 had always been applied, the entity should not be consolidated by the enterprise on the adoption date. Situations may arise in which it is not practicable for an enterprise to determine whether an entity would have been a VIE or whether the enterprise would have been the primary beneficiary had Statement 167s provisions always been effective. That is, it may not be practicable for an enterprise to determine whether an entity is a VIE or whether the enterprise is the primary beneficiary from the date the enterprise first became involved with an entity, or if a reconsideration has occurred, at the most recent reconsideration date. In these instances, the enterprise should make the determination of whether it should consolidate an entity as of the effective date of the Statement 167. That is, an enterprise that takes the practicability exception performs the VIE and primary beneficiary analysis as of different date (the adoption date). Measurement If an enterprise is required to consolidate a VIE upon the implementation of Statement 167, the enterprise initially will measure and recognize all assets, liabilities and noncontrolling interests of the VIE at their carrying amounts at the date of adoption. Carrying amounts are the amounts at which the assets, liabilities and noncontrolling interests would have been carried in the consolidated financial statements if Statement 167 was effective when the enterprise first would have met the conditions to be the primary beneficiary under Statement 167. Any differences between the net amounts added to the balance sheet upon initial consolidation and the amount of any previously recognized interest in the newly consolidated VIE should be recognized as a cumulative effect adjustment to retained earnings.
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The Variable Interest Model generally requires that accounting subsequent to initial measurement follow the same accounting for a consolidated voting interest entity. Subsequent accounting may include, but would not be limited to, the elimination of intercompany transactions and balances, asset valuations (including analysis of asset impairments) and depreciation and amortization. Refer to Chapter 17 for further discussion regarding initial measurement and consolidation considerations. To illustrate, assume an enterprise determines upon the adoption of Statement 167 that it is the primary beneficiary of a VIE that was not consolidated previously. The enterprise determines it first met the conditions to be the primary beneficiary under Statement 167 on 1 January 2005. The enterprise also determines that the entity would have remained a VIE and that it would have remained the primary beneficiary under Statement 167 through the date of adoption. Therefore, the enterprise initially calculates the values of all assets, liabilities and noncontrolling interests of the VIE at the date the enterprise first met the conditions to be the primary beneficiary under Statement 167. The enterprise then subsequently adjusts those assets, liabilities and noncontrolling interests as if the entity was a consolidated subsidiary from 1 January 2005 to the date of adoption. The resulting amounts are recognized in consolidation at the date of adoption, with the difference between those amounts recognized as a cumulative effect adjustment to retained earnings. Assume now that VIE reconsideration events occurred on 1 May 2006 and on 1 August 2008. The VIE would have been deconsolidated as of 1 May 2006 as power and benefits were lost and then consolidated as of 1 August 2008 as power and benefits were re-gained. In this scenario, the determination of the carrying amounts upon adoption of Statement 167 would be made starting with 1 August 2008. If the VIE and primary beneficiary determinations are made as of the effective date of Statement 167 (in accordance with the practicability exception discussed above with respect to recognition), then the primary beneficiary should measure the assets, liabilities and noncontrolling interests of the VIE at fair value on the adoption date. However, certain exceptions (as described more fully below) related to securitization vehicles, transfers between entities under common control and transfers shortly before, in connection with, or shortly after becoming the VIEs primary beneficiary, would apply. In addition to the situations in which the VIE and primary beneficiary determinations are made as of the effective date of the Statement 167, there may be circumstances in which it is not practicable to determine carrying amounts. In those circumstances, the assets, liabilities and noncontrolling interests of the VIE should be measured at fair value at the date of adoption. However, if a VIEs primary beneficiary changes between entities that are under common control, we believe that the new primary beneficiary initially should measure the assets, liabilities and noncontrolling interests of the VIE at carryover basis.34 In addition, we believe that when an enterprise transfers assets and liabilities to a VIE shortly before, in connection with, or shortly after becoming the VIEs primary beneficiary, the primary beneficiary initially should measure those assets and liabilities transferred to the VIE at the same amounts at which the assets and liabilities would have been measured had they not been transferred. Refer to Chapter 17 for further discussion regarding initial measurement and consolidation considerations. In the circumstances in which determining the carrying amounts of assets, liabilities and noncontrolling interests is not practicable, Statement 167 provides an additional measurement alternative for certain assets. In the circumstances in which the activities of the VIE are primarily related to securitizations or other forms of asset-backed financings, and the assets of the VIE can be used only to settle obligations of the VIE, the enterprise upon adoption may choose to measure the assets and liabilities of the VIE at their
34
Carryover basis is the amount at which the assets, liabilities and noncontrolling interests were carried in the accounts of the enterprise that formerly controlled the VIE (i.e., carryover basis should be used with no adjustment to current fair values, and no gain or loss should be recognized). 291
unpaid principal balance. The primary beneficiary also must consider the need to recognize accrued interest, allowances for credit losses or other-than-temporary impairments, as appropriate, under this measurement alternative. It is important to note that in these circumstances, other assets, liabilities or noncontrolling interests, if any, that do not have an unpaid principal balance, and any items that are required to be carried at fair value under other applicable standards, should be measured at fair value. The FASB intends for the additional transition measurement alternative to be available in situations in which an enterprise would need to incur an excessive amount of cost and effort to determine carrying amounts of a consolidated entitys assets, liabilities and noncontrolling interests. If an enterprise is required to deconsolidate an entity upon the adoption of Statement 167, the deconsolidating enterprise initially should measure any retained interest in the deconsolidated entity at its carrying amount upon adoption. Carrying amount refers to the amount at which any retained interest would have been carried in the enterprises financial statements if Statement 167 had been effective when the enterprise became involved with the entity or no longer met the conditions to be the primary beneficiary (as defined by the Variable Interest Model). Any difference between the net amount removed from the balance sheet of the deconsolidating enterprise and the amount of any retained interest in the deconsolidated entity should be recognized as a cumulative effect adjustment to retained earnings. The amount of any cumulative effect adjustment related to deconsolidation should be disclosed separately from cumulative effect adjustments related to consolidation. To illustrate, assume an enterprise determines upon the adoption of Statement 167 that it is not the primary beneficiary of an entity that was previously consolidated. The enterprise became involved with the entity on 1 January 2005. In considering Statement 167, the entity concludes that it would have accounted for its initial investment under the equity method in accordance with ASC 323-10. Therefore, the enterprise calculates its initial investment at cost in accordance with the equity method of accounting on 1 January 2005. The enterprise then subsequently adjusts the investment balance in accordance with the equity method of accounting to the date of adoption of Statement 167. The amount resulting from these calculations through the adoption date is recognized on the enterprises balance sheet at the date of adoption, all assets and liabilities previously recognized through consolidation of the entity are derecognized, and the difference is recognized as a cumulative effect adjustment to retained earnings. Fair value option An enterprise that is required to consolidate a VIE as result of Statement 167 may elect the fair value option for qualifying assets and liabilities of a newly consolidated VIE pursuant to ASC 825-10 but only as of the date that Statement 167 becomes effective (i.e., the adoption date). An enterprise may elect the fair value option for items of a VIE that are eligible for this option so long as the election is applied to all eligible items within the VIE. While ASC 825-10 allows entities to elect the fair value option for individual qualifying financial instruments without regard to consistency, the FASB was concerned that allowing the fair value option on an instrument-by-instrument basis upon adoption of Statement 167 may result in enterprises electing the option to achieve accounting results that are inconsistent with the objectives of ASC 825-10. However, enterprises may elect the fair value option on an entity-by-entity basis. Subsequent to transition, an enterprise should follow the provisions of ASC 825-10 for newly consolidated VIEs. That is, for VIEs consolidated after the initial adoption of Statement 167, the fair value option may be elected on an item-by-item basis and need not be consistently applied to all qualifying assets and liabilities of the newly consolidated VIE. An enterprise electing the fair value option should disclose its rationale for electing the option for certain entities. If the fair value option is elected for some entities and not others, the reasons for those elections must be disclosed. Additionally, the consolidating enterprise must disclose quantitative information by line item in the statement of financial position indicating the related effect on the cumulative effect adjustment
Financial reporting developments Consolidation of variable interest entities 292
of electing the fair value option for an entity. Thus, an enterprise must compare the amounts of the line items for which the fair value option was elected to the carrying amounts of the same line items (assuming determining carrying amounts is practical). Subsequent to transition, an enterprise will continue to be subject to the ongoing disclosure requirements of ASC 825-10. Retrospective application Statement 167 may be applied retrospectively in previously issued financial statements for one or more years with a cumulative effect adjustment to retained earnings as of the beginning of the first year restated. If an entity restates its financial statements, we believe the restatement should include the effects of all entities for which the enterprise had involvement during the restated period. Additionally, we believe that by restating and promoting comparability between periods, an enterprise should consider the appropriateness of providing the disclosures required by ASC 250.
Under Statement 167, Company A would have been the primary beneficiary of a VIE from inception on 1 January 2005. On 31 July 2008, an event occurred that would have required a reconsideration of the status of the entity as a VIE. After reconsideration, the entity is a VIE, and Company A remains the primary beneficiary. In accordance with the transition provisions of Statement 167, the determinations of whether an entity is a VIE and which enterprise, if any, is a VIEs primary beneficiary is made as of (a) the date the enterprise became involved with the entity or (b) if a reconsideration has occurred that would change the determination of whether the entity is a VIE or the enterprise is the primary beneficiary, at the most recent reconsideration date. Assuming that the entity is a VIE, and Company A is the primary beneficiary under Statement 167, Company A would not adjust the measurement of any of VIEs assets, liabilities or noncontrolling interests as a result of the reconsideration event (i.e., in this scenario, the reconsideration event does not affect the measurement of assets, liabilities and noncontrolling interests previously recognized). Assume now that certain events occurred that would have required reconsideration of the entitys VIE status on 1 May 2006 and on 1 August 2008 under Statement 167. Pursuant to Statement 167, the VIE would have been deconsolidated as of 1 May 2006 and then consolidated as of 1 August 2008. In this scenario, the determination of the carrying amounts upon adoption of Statement 167 would be made starting with the reconsolidation on 1 August 2008. Company A initially measures the VIEs assets, liabilities and noncontrolling interests as of 1 August 2008 and rolls them forward to 1 January 2010 to determine the carrying amounts upon adoption of Statement 167. The fact that Company A was the primary beneficiary prior to 1 May 2006 does not affect the requirement for Company A initially to measure the VIEs assets, liabilities and noncontrolling interests as of 1 August 2008 for the purpose of determining the carrying amounts upon adoption of Statement 167.
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Transition for an enterprise that is not the primary beneficiary on the adoption date but would have been in prior periods presented if Statement 167 had applied
Question 21.2 Assume Company C, which has a calendar year-end, determines pursuant to Statement 167 that it would have been the primary beneficiary of a collateralized debt obligation (CDO) when the CDO was created on 31 July 2005. Company C sells its only variable interest in the CDO on 1 December 2009 and concludes that it would no longer be the CDOs primary beneficiary if Statement 167 were adopted. No other events triggering reconsideration have occurred. Even though Company C is not the primary beneficiary of the CDO on the date of adoption, since it would have been the primary beneficiary of the CDO under Statement 167 during the years for which the financial statements are presented, does Company C have to apply the transition provisions of Statement 167 to the CDO? No. Upon adoption of Statement 167 on 1 January 2010, Company C would not consolidate the CDO as it was not the primary beneficiary on 31 December 2009 under Statement 167 (it would have deconsolidated the CDO under Statement 167 at the time it sold its interest). However, if Company C were to elect to retrospectively apply the provisions of Statement 167, it would consolidate the CDO in the financial statements until the sale of its interest.
Practicability exception for measurement when the activities of the entity are primarily related to securitizations or other forms of asset-backed financings
Question 21.4 If the activities of the entity are primarily related to securitizations or other forms of asset-backed financings, and the assets of the entity can be used only to settle obligations of the entity, can an enterprise measure the assets and liabilities of the entity at their unpaid principal balances in all circumstances? Before the enterprise can elect to measure the eligible assets, liabilities and noncontrolling interests at their unpaid principal balances, the enterprise needs first to establish that it is not practicable to measure the assets, liabilities and noncontrolling interests of the VIE at their carrying amounts.
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It is important to note that the primary beneficiary also must consider the need to recognize accrued interest, allowances for credit losses or other-than-temporary impairments, as appropriate, under this measurement alternative. In addition, other assets, liabilities or noncontrolling interests, if any, that do not have an unpaid principal balance, and any items that are required to be carried at fair value under other applicable standards, must be measured at fair value.
Given the challenges that some may face in applying Statement 167s transition provisions, we believe that the use of Statement 167s practicability exceptions may not be uncommon. If an entity concludes that applying Statement 167s transition provisions are impracticable, we would expect that this conclusion would be supported by a thoroughly documented analysis.
However, assets and liabilities transferred shortly before or after the date the enterprise became the primary beneficiary are measured at the same amounts at which those assets and liabilities would have been measured had the transfer not occurred (i.e., no gain or loss is recorded by the transferor).
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Given that an enterprise is required to calculate carrying amounts from the date the enterprise first would have met the conditions to be the primary beneficiary under Statement 167, the initial measurement date could be prior to the effective date of Statement 141(R). We note that prior to the incorporation of Statement 141(R)s provisions, FIN 46(R) required initial measurement of assets, liabilities and noncontrolling interests at fair value. As such, we believe an approach to measure assets, liabilities and noncontrolling interests initially at fair value prior to Statement 141(R)s effective date would be appropriate. In addition, Statement 167 clearly states that Statement 141(R) should be followed in circumstances in which the basis of initial measurement would be fair value. Therefore, as an alternative, we believe that applying the provisions of Statement 141(R) would be acceptable even if an enterprise first would have met the conditions to be the primary beneficiary under Statement 167 prior to the effective date of Statement 141(R). Given that the measurement approaches in both Statement 141(R) and FIN 46(R)s original approach to initial measurement are based principally upon fair value, the differences in valuation approaches often will not be significant. However, we believe the initial measurement of newly recognized assets, liabilities and noncontrolling interests based upon Statement 141 would be inappropriate since the Variable Interest Model has never permitted the use of Statement 141 as a basis for initial measurement.
Determining initial carrying amounts when involvement precedes the effective date of current accounting standards
Question 21.7 Should Statement 160 (codified in ASC 810-10) (or other accounting standards that may not have been effective when an enterprise first became involved with an entity or no longer met the conditions to be the primary beneficiary) be applied in determining carrying amounts upon transition to Statement 167? Statement 167 does not provide detailed implementation guidance on the determination of initial measurement and subsequent accounting in computing carrying amounts upon adoption. Given that an enterprise is required to calculate carrying amounts from the date the enterprise first would have been the primary beneficiary (or from the date the enterprise was no longer the primary beneficiary), initial and subsequent accounting for purposes of determining carrying amounts may occur for periods prior to the effective date of Statement 160. Additionally, certain other accounting standards may not have been effective at the date an enterprise first became involved with an entity or no longer met the conditions to be the primary beneficiary. We do not believe it was the FASBs intent to require the adoption of accounting standards prior to their effective date in rolling forward the carrying amounts or initial measurement of deconsolidated VIEs. Refer to Question 21.6 for initial measurement for consolidated VIEs. Therefore, we believe that in the circumstances in which an enterprise is required to determine carrying amounts, it should apply new accounting standards in rolling forward carrying amounts from the date at which the new accounting standards would have been effective.
Application of accounting standards that require an assessment of managements intent or application of judgment retrospectively
Question 21.8 How should an enterprise apply accounting standards that require an assessment of managements intent or application of judgment retrospectively in the determination of carrying amounts? Statement 167 requires an enterprise upon initial adoption to determine the carrying amounts of the assets, liabilities and noncontrolling interests of a newly consolidated entity, or the carrying amount of an investment in an entity that is no longer consolidated, as if it always had applied the provisions of
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Statement 167. This requires calculating the initial carrying amounts and subsequent changes in those carrying amounts as if Statement 167always had been applied. Statement 167 does not provide detailed implementation guidance regarding the determination of subsequent accounting in computing carrying amounts upon adoption. Therefore, application of standards that require judgment or an assessment of managements intent will require careful consideration in rolling forward initial carrying amounts for the purpose of determining the cumulative effect adjustment. For example, assume an enterprise determines upon the adoption of Statement 167 that it is not the primary beneficiary of an entity that was consolidated previously. The enterprise became involved with the entity on 1 January 2005. In considering Statement 167, the entity concludes that it would have accounted for its initial investment under the equity method in accordance with ASC 323. Therefore, the enterprise calculates its initial investment at cost in accordance with the equity method of accounting on 1 January 2005. The enterprise is required subsequently to adjust the initial investment balance in accordance with the equity method of accounting to the date of adoption of Statement 167. In subsequently adjusting the investment balance in accordance with the equity method of accounting to the date of adoption of Statement 167, an enterprise may encounter circumstances that require judgment. For example, in rolling forward the initial investment balance, the enterprise may be required to evaluate whether the equity-method investment is other-than-temporarily impaired. An enterprise carefully should evaluate how accounting standards that require judgment or an assessment of managements intent should be applied in the determination of carrying amounts. Those judgments should be based on information that would have been available at the time judgments would have been required. For example, it would be inappropriate to recognize an impairment based solely on subsequent events that could not have been known on the impairment assessment date.
Retrospective application when an enterprise no longer consolidates a VIE at the date of adoption
Question 21.10 If an enterprise elects to retrospectively apply Statement 167, should the restatement include all VIEs for which the enterprise was the primary beneficiary during the restated period, even if it was not the primary beneficiary of the VIE at the date of adoption? Yes. We believe the restatement should include all VIEs of which the enterprise was the primary beneficiary during the restated period, even if it was not the primary beneficiary of the VIE at the date of adoption. For example, assume Company Y, a calendar year-end company, would have been the primary beneficiary of two VIEs when they were created in 2002 under Statement 167. Company Y determines at 1 January 2010 (the date of adoption) that it is still the primary beneficiary of VIE 1 under Statement 167 but, because of the sale of all of its variable interests in VIE 2 on 31 May 2009, it would no longer be VIE
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2s primary beneficiary under Statement 167. If Company Y elects to retrospectively apply Statement 167 in previously issued financial statements with a cumulative effect adjustment at 1 January 2008, Company Ys financial statements should reflect the consolidation of VIE 1 for 2008 and 2009 and VIE 2 through 31 May 2009, the date at which Company Y is no longer the primary beneficiary.
Derivatives hedge designation for newly consolidated VIEs upon adoption of Statement 167
Question 21.12 Upon adoption of Statement 167, Enterprise A determines that it will consolidate VIE B. VIE B has never prepared financial statements in accordance with US GAAP. VIE B has a derivative that is an economic hedge on its fixed rate debt that VIE B had issued to an unrelated party prior to the Statement 167 adoption date. Because VIE B has never prepared US GAAP financial statements, it previously has not considered the provisions of ASC 815 inclusive of the documentation requirements. Under Statement 167, Enterprise A must determine the carrying amounts of VIE Bs assets and liabilities from the date Enterprise A originally would have been the primary beneficiary. In determining carrying amounts, can Enterprise A designate a hedge relationship for VIE B from the inception of the derivative? No. We believe that hedge accounting is available as of the date that the relationship is formally designated and documented. Thus, we believe that hedge accounting can be evaluated under ASC 815 from the date of adoption Statement 167. For further discussion of hedge designation and documentation, see our Financial reporting developments publication, Accounting for derivative instruments and hedging activities.
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The SEC staff shared this view with the Center for Audit Quality SEC Regulations Committee (CAQ Alert #2010-20 April 9, 2010). 298
beneficiary under Statement 167. While specifically not addressed in the transition guidance to Statement 167, we believe that an enterprise also should record any AOCI that would have been carried in the consolidated financial statements in the enterprises determination of carrying amounts at the adoption date. For example, we believe it would be appropriate to include AOCI amounts for any foreign currency translation adjustments that would have been recorded from the date the enterprise would have been the primary beneficiary of an entity newly consolidated under Statement 167 to the date of adoption.
Internal control over financial reporting requirements for an entity newly consolidated pursuant to the adoption Statement 167
Question 21.15 What are the internal control over financial reporting (ICFR) requirements for an entity newly consolidated pursuant to the adoption of Statement 167? The SEC staff has indicated that VIEs consolidated upon adoption of Statement 167 should be included in managements reports on ICFR. Because the criteria for consolidation of a VIE under the revised guidance are based on control, the SEC staff has indicated that a registrant would not be able to justify excluding consolidated VIEs from the scope of their internal control assessment. That is, registrants likely will have the right or authority to assess the internal controls of those VIEs. Furthermore, because the consolidation of VIEs under Statement 167 will occur as of the first day of the registrants fiscal year, the SEC staff believes the registrant will have sufficient time to perform that assessment and would be unable to rely on the temporary relief provided under FAQ #3 on Managements Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Period Reports (see also Section 4310.11(c) in the Division of Corporation Finance Financial Reporting Manual). FAQ #3 addresses a situation where a registrant acquires a business during a year but it is not possible to conduct an assessment of the acquired business internal controls during the period between the consummation date and year end. A registrant may exclude an acquired business from the scope of its internal control assessment in this situation. The SEC staff indicated a registrant may consider the guidance in FAQ #3 when evaluating whether it would be appropriate to exclude a newly consolidated VIE from the scope of its internal control assessment in periods after the adoption of Statement 167.37 We believe that FAQ #3 is expressly limited to situations in which a registrant acquires a business (as defined by the SEC).
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The SEC staff shared these views with the Center for Audit Quality SEC Regulations Committee (CAQ Alert #2010-20 April 9, 2010). The SEC staff shared these views with the Center for Audit Quality SEC Regulations Committee (CAQ Alert #2010-21 April 19, 2010). 299
21.2
ASU 2010-10 indicates that entities that may meet the conditions for the deferral include mutual funds, hedge funds, mortgage real estate investment funds, private equity funds and venture capital funds.
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ASC 946-10-15-2(a) through (d) describe the attributes of investment companies as follows: (a) Investment activity: the investment companys primary business activity involves investing its assets, usually in the securities of other entities not under common management, for current income, appreciation, or both, (b) Unit ownership: ownership in the investment company is represented by units of investments, such as shares of stock or partnership interests, to which proportionate shares of net assets can be attributed, (c) Pooling of funds: the funds of the investment companys owners are pooled to avail owners of professional investment management and (d) Reporting entity: the investment company is the primary reporting entity. 300
Attributes of an investment company In addition to those entities subject to ASC 946, the FASB recognized that there are investment funds that are (a) not subject to US GAAP or (b) not included in the scope of ASC 946 but have the same characteristics as those entities. An example of an entity that could meet these conditions includes a non-US registered fund (e.g., a foreign fund registered within its local jurisdiction) that is not subject to US GAAP but may have the same characteristics as those entities in the scope of ASC 946. The FASB concluded that those entities should be eligible for the deferral. In ASC 810-10-65-2(aa), the FASB clarified that examples of entities to which this deferral should not apply include structured investment vehicles, collateralized debt and loan obligations, commercial paper conduits, credit card securitization structures, residential or commercial mortgage-backed entities and government sponsored mortgage entities. In addition, in its Basis for Conclusions, the FASB provided further that the deferral should not apply to entities including, but not limited to, securitization entities, asset-backed financing entities, or entities that were formerly considered qualifying special-purpose entities, even if practice considers those entities to have characteristics similar to those of an investment company, as defined in Topic 946, or for which it is industry practice to apply the measurement principles for financial reporting purposes that are consistent with that Topic. The FASB considers entities with multiple levels of subordinated investors (such as those noted above) to be asset-backed financing entities rather than investment companies. Obligation to fund losses One of the conditions for the deferral specifies that the reporting enterprise does not have the obligation to fund losses of the entity that could potentially be significant to the entity. The FASB noted that if a reporting enterprises exposure to the obligations of an investment fund such as a partnership is limited based on the legal structure of its interest, the entity may qualify for the deferral. For example, ASU 2010-10s Basis for Conclusions states that a general partners unlimited liability with respect to its interest in a limited partnership that has general recourse debt obligations would not be deemed to expose the reporting entity (general partners investor) to losses of the partnership that could potentially be significant to the partnership, if the general partner has no assets other than its interest in the limited partnership and the partnerships creditors have no recourse to assets of the financial reporting entity (general partners investor). Under such a circumstance, the reporting enterprises exposure to the obligations of the partnership may be limited, and it may qualify for the deferral. Additionally, even if the reporting enterprise had a general partner interest directly in a limited partnership (versus through an entity that would act as a general partner such as a limited liability company) and was not legally insulated from the liabilities of the partnership, the reporting enterprise may still qualify for the deferral in certain circumstances. Qualifying for the deferral will depend upon whether the reporting enterprise has an explicit, implicit or legal obligation to use consolidated assets to fund the losses of the partnership (e.g., the limited partnership is unlevered or if levered, the debt is truly non-recourse to the general partner). However, if the reporting enterprise guaranteed the returns of the assets of the partnership or could be obligated to repay significant liabilities of the partnership, the entity would not be eligible for the deferral. We believe the phrase that could potentially be significant contemplates all possible outcomes relevant to the entitys purpose and design. In other words, we believe that a consideration of the likelihood or probability of funding such losses is not relevant for this assessment. Accordingly, a reporting enterprise would not meet this criterion even if the events that would lead to the significant funding obligation are not expected.
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Entities subject to the deferral If an entity is subject to the deferral, it should continue to be evaluated under the consolidation literature in ASC 810 prior to Statement 167s amendments. However, the deferral only applies to the recognition and measurement requirements of Statement 167, and, therefore, a reporting enterprise with a variable interest in a variable interest entity (under FIN 46(R)) that qualifies for the deferral is still required to follow Statement 167s disclosure requirements (see Chapter 20 for further discussion of Statement 167s disclosure requirements). Continuous evaluation of the deferral A reporting enterprise that initially qualifies for the deferral should continually reevaluate its circumstances to ensure it continues to meet the conditions of the deferral. For example, if a reporting enterprise subsequently enters into an agreement to guarantee debt of the entity, it would no longer qualify for the deferral. Under such a circumstance, the reporting enterprise will need to apply the guidance in Statement 167 in evaluating whether its interest represents a variable interest, whether the entity is a variable interest entity and whether it is the primary beneficiary of such an entity. If the reporting enterprise determines that the entity is a variable interest entity and it is the primary beneficiary, the reporting enterprise should apply the initial measurement guidance in Statement 167 as of the date of the change in assessment as if it had become newly involved with the variable interest entity (see discussion in Chapter 17). Consequently, the transition provisions of Statement 167 should not be applied in such a situation. Effective date deferral money market funds (MMF) The FASB also deferred the provisions of Statement 167 for MMFs. This deferral applies to a reporting enterprises interest in an MMF that is required to comply with or operate in accordance with requirements that are similar to those included in Rule 2a-7 of the Investment Company Act of 1940 (the 1940 Act) for registered money market funds. Given the restrictive requirements of the 1940 Act and the credit quality of the permitted assets held, the FASB reasoned that investment managers should not consolidate MMFs pursuant to Statement 167. The deferral for MMFs applies regardless of an asset managers involvement with the MMFs, including any potential obligation to provide additional funding. MMFs subject to the deferral should continue to be evaluated for consolidation under existing US GAAP, including the Variable Interest Model prior to Statement 167s amendments, but reporting enterprises holding variable interests in those entities are still required to follow Statement 167s disclosure provisions. This deferral also will be revisited as part of the joint FASB/IASB project.
Disclosures
Question 21.17 If an entity does qualify for the deferral, what disclosures should a reporting enterprise provide? ASU 2010-10 did not defer Statement 167s disclosure requirements. Therefore, regardless of whether the entity qualifies for the deferral, all reporting enterprises (both public and nonpublic) should provide all disclosures related to variable interests and VIEs as required by ASC 810, as amended by Statement 167. Illustration 21-2: Disclosure requirements
Assume that a reporting enterprise determines its interest in an entity qualifies for the deferral pursuant to ASU 2010-10 but concludes its interest would be deemed a variable interest in a VIE under the Variable Interest Model before the Statement 167 amendments (i.e., FIN 46(R)). In this scenario, even though the reporting enterprise does not apply the recognition and measurement guidance of Statement 167, it is still required to provide all disclosures required by ASC 810, as amended by Statement 167.
Subsequent loss of status to qualify for the deferral Recognition and measurement principle
Question 21.20 If an entity no longer qualifies for the deferral, what recognition and measurement principle should a reporting enterprise apply? If the reporting enterprise is required to consolidate an entity because the reporting enterprise or the entity no longer qualifies for the deferral, the reporting enterprise should initially recognize and measure the assets, liabilities and noncontrolling interests of the VIE in accordance with the initial measurement provisions of the Variable Interest Model. That is, assets, liabilities and noncontrolling interests of the newly-consolidated entity generally will be measured at their fair values. The initial measurement provisions should be applied as of the date the reporting enterprise or the entity ceases to qualify for the deferral. It is important to note that the transition guidance in Statement 167 does not apply in this circumstance.
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Chapter 1
Introduction
Section 1.2 was updated to reflect the current status of the standard-setting and convergence efforts of the FASB and IASB.
Chapter 4
Scope
Section 4.1 was updated to provide additional interpretative guidance for evaluating whether a structure meets the definition of a legal entity. Section 4.8 was updated to provide additional clarity for evaluating the scope exception for not-forprofit organizations. Question 4.25 was updated to provide additional clarity for evaluating the joint venture aspect of the business scope exception.
Chapter 5
Chapter 7
Silos
Section 7.1 and subsequent Questions were updated to provide additional clarity for identifying silos.
Chapter 9
Chapter 12
Reconsideration events
Section 12.1 was updated to provide additional clarity that the amendments to the Variable Interest Model could lead to more consolidation of borrowers by lenders. Question 12.5 was added to highlight SEC reporting considerations following a consolidation or deconsolidation event.
Chapter 14
Chapter 15
Chapter 17
Chapter 18
Chapter 21
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FASB ASC Topic 205-20, Discontinued Operations FASB ASC Topic 250, Accounting Changes and Error Corrections FASB ASC Topic 310, Receivables FASB ASC Topic 320, Investments Debt and Equity Securities FASB ASC Topic 323, Investments Equity Method and Joint Ventures FASB ASC Topic 350, Intangibles Goodwill and Other FASB ASC Topic 360, Property, Plant, and Equipment FASB ASC Topic 470, Debt FASB ASC Topic 480, Distinguishing Liabilities from Equity FASB ASC Topic 605, Revenue Recognition FASB ASC Topic 710, Compensation General FASB ASC Topic 712, Compensation Nonretirement Postemployment Benefits FASB ASC Topic 715, Compensation Retirement Benefits FASB ASC Topic 718, Compensation Stock Compensation FASB ASC Topic 805, Business Combinations FASB ASC Topic 808, Collaborative Arrangements FASB ASC Topic 810, Consolidation FASB ASC Topic 815, Derivatives and Hedging FASB ASC Topic 820, Fair Value Measurements and Disclosures FASB ASC Topic 825, Financial Instruments FASB ASC Topic 840, Leases FASB ASC Topic 850, Related Party Disclosures FASB ASC Topic 860, Transfers and Servicing FASB ASC Topic 915, Development Stage Entities FASB ASC Topic 944, Financial Services Insurance FASB ASC Topic 946, Financial Services Investment Companies FASB ASC Topic 958, Not-for-Profit Entities FASB ASC Topic 960, Plan Accounting Defined Benefit Pension Plans FASB ASC Topic 976, Real Estate Retail Land
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Other authoritative standards SEC Accounting Series Release No. 268, Presentation in Financial Statements of
Redeemable Preferred Stock Governmental Accounting Standards Board Statement No. 20, Accounting and Financial Reporting for Proprietary Funds and Other Governmental Entities That Use Proprietary Fund Accounting SEC Final Rule 67, Disclosure in Managements Discussion and Analysis about OffBalance Sheet Arrangements and Aggregate Contractual Obligations
FR-67
Non-authoritative standards FASB Statement of Financial Accounting Concepts No. 7, Using Cash Flow
Information and Present Value in Accounting Measurements
Issue E22
Statement 141 Statement 141(R) Statement 157 Statement 160 Statement 166 Statement 167 SOP 07-1
FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R) AICPA Statement of Position 07-1, Clarification of the Scope of the Audit and
Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies
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310
ASC paragraph 810-10-25-26 810-10-25-27 810-10-25-29 810-10-25-31 810-10-25-32 810-10-25-33 810-10-25-34 810-10-25-35 810-10-25-36 810-10-25-37 810-10-25-38 810-10-25-38A 810-10-25-38B 810-10-25-38C 810-10-25-38D 810-10-25-38E 810-10-25-38F 810-10-25-38G 810-10-25-42 810-10-25-43 810-10-25-44 810-10-25-45
Section Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 11 Chapter 14 Chapter 14 Chapter 14 Chapter 14 Chapter 14 Chapter 14 Chapter 14 Chapter 14 Chapter 15 Chapter 15 Chapter 16 Chapter 9 Evaluation of variability and the variable interest determination Evaluation of variability and the variable interest determination Evaluation of variability and the variable interest determination Evaluation of variability and the variable interest determination Term of interests issued Evaluation of variability and the variable interest determination Subordination Evaluation of variability and the variable interest determination Certain interest rate risk Evaluation of variability and the variable interest determination Certain derivative instruments Evaluation of variability and the variable interest determination Certain derivative instruments Evaluation of variability and the variable interest determination Certain derivative instruments Initial determination of VIE status Primary beneficiary determination Primary beneficiary determination Primary beneficiary determination Primary beneficiary determination Primary beneficiary determination Primary beneficiary determination Primary beneficiary determination Primary beneficiary determination Related parties and de facto agents Related parties and de facto agents Determining the primary beneficiary from a related party group Determining whether an entity is a variable interest entity Interpretative guidance Equity investment at risk (ASC 810-10-15-14(a)) Determining whether an entity is a variable interest entity Interpretative guidance Equity investment at risk (ASC 810-10-15-14(a)) Determining whether an entity is a variable interest entity Interpretative guidance Equity investment at risk (ASC 810-10-15-14(a)) Implicit variable interests Implicit variable interests Implicit variable interests Implicit variable interests Implicit variable interests
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810-10-25-46
Chapter 9
810-10-25-47
Chapter 9
Question 5-18 Question 5-18 Question 5-18 Question 5-18 Question 5-18
ASC paragraph 810-10-25-53 810-10-25-54 810-10-25-55 810-10-25-56 810-10-25-57 810-10-25-58 810-10-30-1 810-10-30-2 810-10-30-3 810-10-30-4 810-10-35-3 810-10-35-4 810-10-45-25 810-10-50-2AA 810-10-50-2AB 810-10-50-2AC 810-10-50-3 810-10-50-4 810-10-50-5A 810-10-50-5B 810-10-50-6 810-10-50-9 810-10-50-10 810-10-55-17 810-10-55-18 810-10-55-19 810-10-55-20 810-10-55-21 810-10-55-22 810-10-55-23 810-10-55-24 810-10-55-25 810-10-55-26 810-10-55-27
Section Question 5-18 Question 5-18 Chapter 8 Chapter 8 Chapter 7 Chapter 7 Chapter 17 Chapter 17 Chapter 17 Chapter 17 Chapter 18 Chapter 12 Chapter 19 Chapter 20 Chapter 20 Chapter 20 Chapter 20 Chapter 20 Chapter 20 Chapter 20 Chapter 20 Chapter 20 Chapter 20 Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 5 Question 5-11 Question 5-11 Chapter 5 Implicit variable interests Implicit variable interests Variable interests interests in specified assets Variable interests interests in specified assets Silos Silos Initial measurement and consolidation Initial measurement and consolidation Initial measurement and consolidation Initial measurement and consolidation Accounting after initial measurement Reconsideration events Presentation Disclosures Disclosures Disclosures Disclosures Disclosures Disclosures Disclosures Disclosures Disclosures Disclosures Evaluation of variability and the variable interest determination Interpretative guidance Evaluation of variability and the variable interest determination Interpretative guidance Evaluation of variability and the variable interest determination Interpretative guidance Evaluation of variability and the variable interest determination Interpretative guidance Evaluation of variability and the variable interest determination Interpretative guidance Evaluation of variability and the variable interest determination Interpretative guidance Evaluation of variability and the variable interest determination Interpretative guidance Evaluation of variability and the variable interest determination Interpretative guidance Financial guarantees as variable interests Financial guarantees as variable interests Evaluation of variability and the variable interest determination Certain derivative instruments
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ASC paragraph 810-10-55-28 810-10-55-29 810-10-55-30 810-10-55-31 810-10-55-37 810-10-55-37A 810-10-55-38 810-10-55-39 810-10-55-87 810-10-55-88 810-10-55-89 810-10-65-2
Section Chapter 5 Chapter 5 Chapter 5 Chapter 5 Chapter 6 Chapter 6 Chapter 6 Question 5-13 Question 5-18 Question 5-18 Question 5-18 Chapter 21 Evaluation of variability and the variable interest determination Certain derivative instruments Evaluation of variability and the variable interest determination Certain derivative instruments Evaluation of variability and the variable interest determination Certain derivative instruments Evaluation of variability and the variable interest determination Certain derivative instruments Variable interests fees paid to decision makers or service providers Variable interests fees paid to decision makers or service providers Variable interests fees paid to decision makers or service providers Operating leases as variable interests Implicit variable interests Implicit variable interests Implicit variable interests Effective date and transition
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No
Step 4:
Do the interests or other contractual arrangements of the entity (excluding interests in silos) qualify as variable interests in the entity as a whole? (Chapter 8) Yes
No
Step 5:
Qualitatively or quantitatively determine expected losses of the entity. These should exclude expected losses related to (1) variable interests in specified assets and (2) interests in silos. (Chapter 9)
Step 6:
Is the total equity investment at risk sufficient and as a group, do their holders have the characteristics of a controlling financial interest? (Chapter 9) No
Step 7:
Step 8:
Determine whether the VIE has a primary beneficiary. A variable interest holder in a VIE assesses whether it is the VIEs primary beneficiary by reference to the power and benefits principle. (Chapter 14)4
Step 9:
If no party meets the primary beneficiary criteria under the power and benefits principle, an enterprise should consider the related party provisions (Chapters 15 and 16) if its related parties and de facto agents have power and benefits.
Notes: 1. Including other GAAP consolidation guidance. 2. Consider the risks the entity was designed to create and distribute and whether the instrument absorbs that variability (Chapter 5). 3. A silo is not to be treated as a separate entity for purposes of applying the Variable Interest Model unless the host entity is a VIE. If this silo is deemed to be treated as a separate entity, perform steps 5-9 for the silo. 4. The primary beneficiary should consolidate the VIE. Other holders of variable interests should make the disclosures required by the Variable Interest Model. Financial reporting developments Consolidation of variable interest entities 314
3. Any legal structure used to conduct activities or to hold assets is in the scope of ASC 810-10s variable interest consolidation model (the Variable Interest Model)2 with limited exceptions as follows: Not-for profit organizations3 Governmental organizations Separate accounts of life insurance companies4 Employee benefit plans5 Investments accounted for at fair value in accordance with ASC 946 An entity deemed to be a business (in certain circumstances)
When we use the term enterprise in this publication, we refer to the enterprise that is evaluating its potential variable interest in a potential VIE for purposes of determining whether it must consolidate that entity or to the enterprise that consolidates a VIE. When we use the term entity, we refer to the potential VIE or to the VIE. That is, the purpose of the Variable Interest Model is to determine whether the enterprise is the party that must consolidate an entity that is a VIE. Generally, ASC 810-10 includes guidance with respect to the consolidation considerations for voting interest entities and variable interest entities for each of ASC 810-10s sections. In each of ASC 810-10s sections there is a General subsection with respect to the consolidation model. This guidance applies to voting interest entities and also may apply to variable interest entities in certain circumstances. The Variable Interest Entities subsection within each of ASC 810-10s sections contains considerations with respect to variable interest entities. In referring to the Variable Interest Model in ASC 810-10, we are referring to the guidance applicable to variable interest entities in each of ASC 810-10s sections. However, if the not-for-profit entity is used in a manner similar to a variable interest entity in an effort to circumvent the Variable Interest Model, then that not-for-profit entity is subject to the scope of the Variable Interest Model. For the separate account investors evaluation only. For the employers evaluation only. 315
4 5
4. Although expected to be very infrequent, an enterprise is not required to apply the Variable Interest Model if the entity subject to evaluation was created before 31 December 2003 and if the enterprise is unable to obtain information necessary to (1) determine whether the entity is a variable interest entity, (2) determine whether the enterprise is the variable interest entitys primary beneficiary or (3) perform the accounting required to consolidate the variable interest entity for which it is determined to be the primary beneficiary. The left hand column of this tool asks a question about the feature of the entity being evaluated. A No response indicates that the entity is a variable interest entity. The right-hand column provides background for the question and the implications of the answer. Refer to Chapter 9 for additional discussion.
Sufficiency of the equity investment at risk 1. Is the total equity investment at risk sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders? (Refer to Question 1(a) for what constitutes an equity investment at risk.) (ASC 810-10-15-14(a)) Interpretative guidance An entity may not have enough equity to induce lenders or other investors to provide the funds necessary for the entity to conduct its activities, in which case it would be a variable interest entity. We expect that in many instances it will be difficult to establish that the equity investment is sufficient without calculating expected losses (Method 3). Entities with a capital structure more complex than senior debt with a market-based interest rate and common stock will likely be unable to conclude that the entity has a sufficient amount of equity at risk under Method 1. Examples of an entitys features that indicate Method 1 should not be used to determine the sufficiency of the equity include (1) the entity has preferred stock that is classified as a liability, (2) the entity issues multiple classes of debt with different priorities of payment, (3) the owners of the entity or others guarantee the entitys debt. To determine whether an entity is comparable pursuant to Method 2:
The legal entity has demonstrated that it can finance its activities without additional subordinated financial support (Method 1) The legal entity has at least as much equity invested as other entities that hold only similar assets of similar quality in similar amounts and operate with no additional subordinated financial support (Method 2) The amount of equity invested in the legal entity exceeds the estimate of the legal entitys expected losses based on reasonable quantitative evidence (Method 3) Yes No
Response:
If yes, describe:
The size and composition of the entitys assets should be similar, The type and amount of the entitys liabilities, including maturities and interest rates should be similar, The type and amount of capital used to finance the entity should be similar, The nature of the entitys operations should be similar (product lines, service lines, markets, etc.), and The comparable entity should not have any of the features that would prohibit the use of Method 1 described previously.
We believe that, generally, it will be infrequent that entities are capable of demonstrating the sufficiency of the equity investment at risk through Method 2. Regulatory capital requirements (e.g., risk-based capital) may be considered, in part, in determining whether an entity has sufficient equity for purposes of applying Method 1 or Method 2.
Financial reporting developments Consolidation of variable interest entities 316
Equity investment at risk 1(a). The equity investment at risk under evaluation in Question 1 must:
Interpretative guidance If Method 3 is used to answer Question 1, the equity investment at risk is compared to the entitys expected losses to determine the sufficiency of the equity. Equity investments in an entity are interests that are required to be reported as equity in that entitys GAAP financial statements. Certain portions of that amount may not be considered an equity investment at risk for purposes of comparison to the entitys expected losses. An equity investment at risk must participate significantly in profits and losses. Examples of instruments that do not participate significantly in profits and losses are:
Exclude equity instruments that do not participate significantly in profits and losses (even if those investments do not carry voting rights) (ASC 810-10-15-14(a)(1))
Equity that may be put to the entity or to other parties involved with the entity at a price that does not allow for the potential of a significant loss of the investment. Equity that may be callable by the entity or by other parties involved with the entity at a price that does not allow for a significant participation in the entitys profits. Preferred stock that has no or a small coupon that results in an insignificant participation in the entitys profits. Convertible preferred stock may participate significantly in the entitys profits depending on the conversion price relative to the market price at its issuance date.
Exclude equity interests that the legal entity issued in exchange for subordinated interests in other VIEs (ASC 810-10-15-14(a)(2))
The Variable Interest Model precludes the same equity investment from being used to capitalize multiple entities. For example, if Investor X invests $10 in VIE 1, in exchange for VIE 1s common stock, and then contributes that investment to VIE 2 in exchange for VIE 2s common stock, the investment by Investor X should be excluded in analyzing the sufficiency of the equity in VIE 2 because the same equity is capitalizing two variable interest entities and, thus, is not considered to be equity at risk for VIE 2.
Exclude amounts provided to the equity investor directly or indirectly by the legal entity or by other parties involved with the legal entity, unless the provider is a parent, subsidiary or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor (ASC 810-10-1514(a)(3))
An equity investment obtained directly or indirectly through fees, charitable contributions or other means should not be included in the equity sufficiency test. We believe that any type of fee, including fees for other services that are market-based, that the recipient has received or is unconditionally entitled to receive at inception should reduce that recipients equity investment at risk. If fees are to be paid over time, the present value of the amount that the recipient is entitled to at inception in the event it
317
terminates its relationship with the entity is to be subtracted from that recipients equity investment at risk for purposes of the sufficiency test.
Exclude amounts financed for the equity investor directly by the legal entity or by other parties involved with the legal entity, unless the provider is a parent, subsidiary or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor (ASC 810-10-15-14(a)(4))
Any amounts financed for the equity investor pursuant to this criterion are to be excluded from the equity sufficiency test. We believe, however, that amounts financed for the equity investor by a party that is not related to the other parties involved with the entity qualify as an equity investment at risk. Additionally, we believe that the holders of the equity investments at risk may hedge the risks in their investment with parties not involved with the entity being evaluated.
Power 2. As a group, do the holders of the equity investments at risk (identified in Question 1) have the power, through voting rights or similar rights, to direct the activities of the legal entity that most significantly impact the entitys economic performance? The investors do not have that power through voting rights or similar rights if no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation or a general partner in a partnership). Kick-out rights or participating rights held by the holders of the equity investment at risk do not prevent interests other than the equity investment from having this characteristic unless a single equity holder (including its related parties and de facto agents) has the unilateral ability to exercise such rights. Alternatively, interests other than the equity investment at risk that provide the holders of those interests with kick-out rights or participating rights do not prevent the equity holders from having this characteristic unless a single enterprise (including its related parties and de facto agents) has the unilateral ability to exercise those rights. A decision maker also shall not prevent the holders from having this characteristic unless the fees paid to the decision maker represent a variable interest based on ASC 810-10-55-37 and 55-38. (ASC 810-10-15-14(b)(1))
Interpretative guidance For an entity not to be a VIE, the Variable Interest Model requires that, as a group, the holders of the equity investment at risk must have the power to direct the activities of an entity that most significantly impact the entitys economic performance through voting or similar rights, embodied in the equity instruments they hold. This power must be able to have a significant effect on the success of the entity, because as the decisions to be made by the equity holders become less significant in nature, a model that bases consolidation on ownership of voting interests becomes less relevant. Professional judgment will be required to determine whether the at-risk equity holders have sufficient decision making ability. Kick-out rights or participating rights held by the owners of the equity investment at risk should not be considered in determining whether the at-risk equity investors have the power to direct the activities of an entity that most significantly impact the entitys economic performance unless a single enterprise (including its related parties and de facto agents) has the unilateral ability to exercise those rights. This is consistent with how kick-out rights are considered when determining the primary beneficiary. Alternatively, interests other than the equity investment at risk that provide the holders of those
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Response: Describe:
Yes
No
interests with kick-out rights or participating rights do not prevent the equity holders from having the characteristic in criterion ASC 810-10-1514(b)(1) unless a single enterprise (including its related parties and de facto agents) has the unilateral ability to exercise such rights. However, many structures do not provide for interests other than the equity investment at risk to hold kick-out rights or participating rights. If an interest other than the equity investment at risk provides the holder of that interest with power, but the interest does not represent a variable interest, that interest does not make the entity a VIE. The FASB reasoned that such a decision maker would never be the primary beneficiary of the VIE because it would not hold a variable interest. Additionally, such an interest would typically indicate that the decision maker was acting as a fiduciary, and the FASB observed that this fact alone should not lead to a conclusion that entity is a VIE (see Interpretative guidance and Questions in Chapters 5-6 for evaluating whether a party has a variable interest in an entity).
Anti-abuse provisions 2(a). If the voting rights of all investors are not proportional to their obligations to absorb the legal entitys expected losses or the rights to receive its expected residual returns, or both (considering all of the equity investors interests in the entity, not only its equity investment at risk), are substantially all of the legal entitys activities not involved with or conducted on behalf of an investor that has disproportionately few voting rights? (ASC 810-1015-14(c)) NOTE: Activities that involve or are conducted on behalf of the related parties of an investor with disproportionately few voting rights should be treated as if they involve or are conducted on behalf of that investor. Related parties refers to all related parties identified in ASC 810-10-25-43, except de facto agents under ASC 810-10-25-43(d). Response: Yes No
Interpretative guidance Whenever expected losses and expected residual returns are not allocated based exactly on the investors voting rights or are allocated through instruments without voting rights (e.g., a loan), the substantially all condition under ASC 810-10-1514(c)(2) must be evaluated. The following is an example of a situation in which profits and losses are not allocated proportionately. Investor A and Investor B form a partnership by each contributing an equal amount of capital. Profits and losses are allocated based upon voting rights until Investor A has received a return of 15% on its investment, at which point Investor A and Investor B receive 35% and 65%, respectively, of the entitys profits. In this instance, the allocation of profits and losses is not proportional to the investors voting rights. Determining if substantially all of an entitys activities are on behalf of an investor with disproportionately few voting rights will require consideration of all of the facts and circumstances. The determination should be based on a comparison of the activities to those of the investor, and the substantially all test should not be based solely on the relative size of the investors investments or the allocation of the entitys economic benefits. For example, in a partnership with a single general partner (GP) with a 1% interest and a limited partner (LP) with a 99% non-voting interest (the LP interest has disproportionately few voting rights)
If yes, describe:
319
consideration must be given as to whether the activities of the partnership are clearly or closely related to the activities of the LP. If the partnership manufactures cars and if the LP is an investment bank providing financing to the entity and the GP is the strategic partner, the activities of the entity (making cars) would be compared to the investment banks activities (because it, as the LP, has disproportionately few voting rights). If the activities were determined to be dissimilar, as in this example, the anti-abuse provision would not be applicable. Obligation to absorb entitys expected losses 3. As a group, do the holders of the equity investment at risk have the obligation to absorb the legal entitys expected losses? (ASC 810-10-15-14(b)(2)) Response: Yes If no, describe: No Interpretative guidance An entity is a VIE if, by design, the holders of the equity investment at risk are directly or indirectly protected from expected losses or are guaranteed a return by the entity itself or by other parties involved with the entity. Instruments that may directly or indirectly protect the holders from the entitys expected losses include, among others:
If exposure to losses is shared with holders that do not have an equity investment at risk, or allocated to the holders of the equity investment at risk through instruments other than equity investments, the entity is a VIE. Guarantees and other arrangements that protect lenders to the entity after the holders of the equity investments at risk have suffered a total loss of their investment are permitted. The allocation of losses (including allocations disproportionate to ownership or voting percentages) among the holders of the equity investment at risk does not result in the entity being a VIE as long as the equity owners, as a group, are exposed to first dollar risk of loss in the entity.6 Losses may not be shared by a holder of an instrument that is not an equity investment at risk until the equity investment at risk has been exhausted. Guarantees on a portion of an entitys assets may be permitted if that asset is less than half of the total fair value of the entitys assets or is a siloed asset (see Interpretative guidance and Questions in Chapters 7 and 8).
In situations in which the allocation of profits and losses among the equity holders is disproportionate to their voting interests, the anti-abuse provisions (described in Question 2(a)) should be carefully evaluated. 320
Right to receive entitys expected residual returns 4. As a group, do the holders of the equity investments at risk have the right to receive the legal entitys expected returns? (ASC 810-10-15-14(b)(3)) Response: Yes If no, describe: No
Interpretative guidance As a group, the holders of the equity investments at risk cannot have their returns capped (1) through arrangements with the entity or with other variable interest holders, (2) through the allocation of profits to instruments that are not equity investments at risk (even if held by an equity investor) or (3) by the entitys governing documents. Instruments that may directly or indirectly limit the equity holders from receiving the entitys expected residual returns include, among others:
The allocation of profits among the holders of the equity investments at risk does not result in the entity being a VIE as long as the holders of the equity investments at risk, as a group, receive the entitys profits, even if the allocation is disproportionate to ownership or voting percentages.6 Profits may be shared through instruments that are not equity investments at risk as long as that sharing does not directly or indirectly cap the equity holders returns. An example of such a cap would be when an investment manager (that does not hold an equity investment at risk) keeps all profits of the entity after the investors receive a stated return. That arrangement would cap those holders return and the entity would be a VIE. Certain instruments that cap the return of a portion of an entitys assets may be permitted if that asset is less than half of the total fair value of the entitys assets or a silo (see the Interpretative guidance and Questions in Chapters 7 and 8).
321
Each note receives interest only payments (at a rate of 5.0% per annum) during the five-year life of the LLC, and the principal is to be repaid when the buildings are sold at the end of five years. (We have assumed that the interest rates on the loans are equal to the interest rate on a five-year default-risk-free investment to simplify the example calculations included in this Appendix.) Under the terms of the debt agreements, Big Building cannot be sold prior to the end of the five-year term of the LLC without the approval of Lender A. Additionally, under the terms of the debt agreement, Little Building also cannot be sold prior to the end of the five-year term of the LLC without the approval of both Lender A and Lender B (collectively, the Lenders). Furthermore, the Lenders must approve all tenants, and related lease terms, of Big Building and Little Building (Lender A for Big Building, and Lender A and Lender B for Little Building) and the LLCs annual operating budgets. In connection with the debt financing, Lender A requires that the LLC acquire a guarantee that the value of Big Building will not be less than $63,000,000 in five years from Guarantor A for a premium of $1,300,000. Lender B requires that the LLC acquire a guarantee from Guarantor B that the value of Little Building will not be less than $27,000,000 in five years for a premium of $500,000. The LLC has no employees but has engaged Manage Co. to actively manage Big Building and Little Building. In this role, Manage Co. makes decisions regarding the selection of tenants, negotiation of lease terms, setting of rental rates, capital expenditures and repairs and maintenance, among other
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things. For these services, Manage Co. will receive fees equal to 10% of the annual net rental revenue of each building per year. Lease terms with the tenants of Big Building and Little Building are consistent with market terms for such leases at the date of inception of the leases and contain no fixed price purchase options, residual value guarantees or similar features. At its acquisition date, Building Three is leased to one tenant for a five-year term. Upon expiration of the lease term, the lessee must either purchase Building Three for $45,000,000, or arrange for the sale of the building to a third party. If the sale option is elected, the Lessee is required to pay any shortfall between the sales proceeds and $45,000,000. If the sales proceeds are more than the Purchase Price, the lessee is entitled to such excess. Upon sale of the buildings, the LLC will pay off the debt and distribute any remaining proceeds to Manage Co. and Passive Co. based on their respective ownership interests.
The sources and uses of the LLCs financing can be summarized as follows:
Sources of funds: Manage Co. Equity Passive Co. Equity Lender A Loan Lender B Loan Lender C Loan $ $ 6,000,000 4,000,000 63,000,000 27,000,000 45,000,000 145,000,000 Uses of funds: Big Building Purchase Little Building Purchase Building Three Purchase Guarantee Fees Big Building Little Building $ 1,300,000 500,000 145,000,000 $ 68,700,000 29,500,000 45,000,000
The related fair values of the assets of the LLC are as summarized in Table A below. The fair values of each building and the guarantee are allocated to Manage Co. and Passive Co. in proportion to their relative ownership in the LLC (60% to Manage Co. and 40% to Passive Co., respectively). The fair values of the assets are allocated to the lenders based on the principal amounts loaned to the LLC. In some cases, it may not be necessary to allocate the fair value of an entitys individual assets (e.g., because all variable interests are considered to be variable interests in the entity and there are no silos).
Table A Fair value of the LLCs assets Manage Co. Big Building Building Guarantee Total Little Building Building Guarantee Total Passive Co. Lender A Lender B N/A N/A Lender C Total fair value
$ 3,420,000 $ 2,280,000 $63,000,000 780,000 520,000 4,200,000 2,800,000 63,000,000 1,500,000 300,000 1,800,000 1,000,000 200,000 1,200,000
N/A $ 68,700,000 N/A 1,300,000 70,000,000 N/A N/A 29,500,000 500,000 30,000,000
Building Three Building N/A N/A N/A N/A $45,000,000 45,000,000 Total Amounts Financed $ 6,000,000 $ 4,000,000 $63,000,000 $27,000,000 $45,000,000 $145,000,000
In the tables presented throughout the remainder of this Appendix, certain immaterial differences may arise in the summations of totals due to rounding.
Financial reporting developments Consolidation of variable interest entities 323
F.2
VIE analysis
The illustrative analysis of the LLC described next follows the approach outlined in Appendix D, Step-bystep guide to applying the Variable Interest Model, in determining whether an entity is a VIE. Step 1 Determine whether any of the Variable Interest Models scope exceptions1 are applicable to the LLC. Analysis In this example, none of the Variable Interest Models scope exceptions are applicable. Step 2 Determine which interests are variable interests2 that require the holder to evaluate the LLC as a potential VIE that may require consolidation pursuant to the provisions in the Variable Interest Model. Analysis The following parties hold variable interests in the LLC: 1. The equity investors (Manage Co. and Passive Co.) 2. Lenders A, B and C 3. Guarantors A and B 4. Building Three Lessee The lessees of Big Building and Little Building do not have a variable interest in the LLC because the lease terms are consistent with market terms for such leases at the date of inception of the leases and contain no fixed price purchase options, residual value guarantees or similar features. Accordingly, receivables under these respective operating leases are assets that provide returns to the variable interest holders in the LLC during the lease terms. These leases do not absorb variability in the fair value of Big Building and Little Building because they are a component of that variability. In contrast, the lessee of Building Three has a variable interest due to the residual value guarantee and fixed price purchase option included in the lease. Step 3 Determine whether any silos3 exist in the LLC. Analysis In this example, Building Three represents a silo. The building has been financed in its entirety with debt that has recourse only to Building C and its related cash flows. The lessee has provided a residual value guarantee that will absorb any depreciation in the value of the building and has a fixed price purchase option that allows it to capture any appreciation in the value of the building during the lease term. If the lessee defaults on the lease payments or the residual value guarantee, Lender C will absorb any related losses. Accordingly, essentially all of the expected losses and essentially all of the expected residual
1 2
The Variable Interest Models scope exceptions are discussed in the Interpretative guidance and Questions in Chapter 4. Variable interests are interests that are contractual, ownership or other pecuniary interests in an entity that change with changes (exclusive of the effects of variable interests) in the fair value of the entitys net assets. Identification of variable interests is discussed in the Interpretative guidance and Questions in Chapter 5. The Variable Interest Models silo provisions are discussed in the Interpretative guidance and Questions in Chapter 7. 324
returns relating to Building Three are allocable to either the lessee or Lender C, and none of the expected losses or expected residual returns are borne by, or inure to, Manage Co. or Passive Co. as the LLCs equity holders (or any other variable interest holders in the LLC). Because Building Three is a silo, any expected losses and expected residual returns allocable to the silos variable interest holders (i.e., the Building Three Lessee and Lender C) are not considered in determining whether the LLC is a VIE. Accordingly, Building Three, the associated lease and the related debt will not be considered in evaluating the LLC for the remainder of this example. However, because Building Three is a silo of a host entity that is a VIE (see discussion below on the determination of the host entity as a VIE), the variable interest holders in the silo (i.e., Lender C and the lessee of Building Three) would be required to evaluate the Building Three silo as a separate VIE to determine if either party is the silos primary beneficiary that should consolidate the silo. Step 4 Determine if any of the variable interests identified in Step 2 above (excluding interests in silos) qualify as variable interests in specified assets of the LLC and not variable interests in the entity as a whole.4 Analysis Neither Lender B nor Guarantor B have a variable interest in the LLC because the specified asset in which they have a variable interest (Little Building) does not comprise more than half of the fair value of the LLCs assets (after exclusion of the Building Three silo). Any expected losses that would be absorbed by Lender B or by Guarantor B will be excluded from the expected losses of the LLC for purposes of determining the sufficiency of the LLCs equity investment at risk. Conversely, Guarantor A and Lender A are variable interest holders in the LLC as a whole because each holds a variable interest in a specified asset (Big Building) that comprises more than half of the total fair value of the LLCs assets (after exclusion of the Building Three silo). Step 5 Determine the expected losses of the LLC excluding expected losses related to (1) variable interests in specified assets and (2) interests in silos. In certain instances, it may be possible to qualitatively determine the expected losses of an entity that are attributable to and absorbed by specific variable interest holders. However, the following provides an example calculation of the expected losses of the LLC. To compute the LLCs expected losses and expected residual returns, a distribution of possible outcomes for the LLC, on a discounted basis, first must be projected. Due to the nature of the LLCs assets in this example (i.e., only two assets with distinctly separable values and cash flow streams), the expected losses and expected residual returns are separately computed for Big Building and Little Building. In many cases, the possible outcomes will be projected on an aggregate basis for an entity as whole.
The Variable Interest Models provisions relating to variable interests in specified assets are discussed in the Interpretative guidance and Questions in Chapter 8. 325
The possible outcomes for Big Building are presented in Table B below.
Table B Big Building possible outcomes
Fees paid to Manage Co. for acting as the decision maker. Assumed to be 10% of net possible rental income, before interest expense. Possible values of Big Building upon disposal by the LLC at the end of five years. All outcomes are before amounts paid to Lender A or received from Guarantor A, as each is a variable interest holder in the LLC. Total possible undiscounted outcomes, discounted using the assumed rate of interest on a five-year default-riskfree investment of 5%.
Net of all operating costs, including fees paid to Manage Co. but prior to interest expense.
Possible Cash Flows From Sale Of Building 55,000,000 58,000,000 64,200,000 70,000,000 71,750,000 76,500,000 $
Total Possible Undiscounted Outcomes 75,000,000 78,833,333 85,866,667 92,777,778 95,361,111 101,500,000 $
Present Value of Possible Outcomes 60,411,846 63,484,004 69,063,445 74,570,003 76,662,753 81,587,135
The possible outcomes for Little Building are presented in Table C below.
Table C Little Building possible outcomes
Net of all operating costs, including fees paid to Manage Co. but prior to interest expense. Fees paid to Manage Co. for acting as the decision maker. Assumed to be 10% of net possible rental income, before interest expense. Possible values of Little Building upon disposal by the LLC at the end of five years. Amounts paid to or received from Lender B and Guarantor B are included in the possible outcomes as these parties do not have a variable interest in the LLC (see Step 4 above). Total possible undiscounted outcomes, discounted using the assumed rate of interest on a fiveyear default-risk-free investment of 5%.
Possible Cash Flows From Sale Of Building 22,000,000 25,000,000 26,000,000 27,000,000 29,500,000 32,000,000 $
Total Possible Undiscounted Outcomes 527,778 1,638,889 2,333,333 3,722,222 6,361,111 9,416,667 $
Present Value of Possible Outcomes 389,948 1,352,054 1,953,370 3,156,003 5,235,081 7,674,950
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In Tables B and C above, we have assumed that the possible rental income in each possible outcome for the buildings is comprised of an equal amount in each of the five years the properties are rented. In an actual situation, net rental income likely would vary in each of the periods, and outcome projections should reflect risks such as vacancy risk, tenant credit risk, rental rate risk, etc. In addition, the number of possible outcomes generally would be significantly more than the six assumed for each building in this illustration (see Question 10.9). Amounts paid to or received from Lender A and Guarantor A are not considered in determining the distribution of possible outcomes of Big Building, because these interests are variable interests in the LLC as a whole. Expected losses and expected residual returns are based on the expected variability in an LLCs net assets, exclusive of the effects of variable interests (which serve to allocate the variability in the fair value of the LLCs net assets). Conversely, because Lender B and Guarantor B do not have a variable interest in the LLC as a whole (see Step 4 above), amounts paid to and received from Lender B and Guarantor B are included in the determination of the distribution of possible outcomes of Little Building, as they represent cash outflows to and inflows from parties that are not variable interest holders in the LLC. Interest and principal payments are based on the assumed terms of the loan. The possible cash inflows from the guarantee are derived by subtracting the assumed value received upon the disposal of Little Building from the guarantee amount. For example, if $22 million is received from the sale of the building, the LLC would be entitled to receive $5 million from Guarantor B, because the guarantee is for $27 million. This example does not include any adjustments for the risk that Guarantor B will not perform on the guarantee. In an actual situation, that risk should be included in the possible outcomes (see Question 10.13). Once the distribution of possible outcomes for each of the buildings has been determined, each possible outcome should be probability weighted based on its estimated likelihood of occurrence and the mean of the distribution of all possible outcomes calculated. The mean of the distribution of all possible outcomes should equal, or closely approximate, the fair value of the variable interests in the assets, including the fair value of any fees paid to a decision maker (computed as the probability-weighted, present value of the amounts that the decision maker may receive). Table D demonstrates that the mean of the distribution of Big Buildings possible outcomes closely approximates (within 1%) the sum of the fair value of the variable interests in the asset.
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Table D Mean of distribution of possible outcomes closely approximates fair value of variable interests in Big Building
From Table B above. Probabilities are judgmentally determined and assigned to each outcome based on estimated likelihood of occurrence. Present value of the possible outcomes, multiplied by the associated probability of occurrence.
Present Value of Possible Outcomes Big Building $ 60,411,846 63,484,004 69,063,445 74,570,003 76,662,753 81,587,135
Fair values of variable interests held by Manage Co., Passive Co., Lender A and Guarantor A are from Table A above. Computation of the fair value of the decision maker fees is demonstrated below in Table I.
Variable Interests in Big Building Manage Co. $ Passive Co. Lender A Guarantor A Decision Maker fees $
The fair value of Guarantor As interest is included as a negative amount because the LLC paid a premium to obtain the guarantee.
Table E demonstrates that, as for Big Building, the mean of the distribution of Little Buildings possible outcomes closely approximates (also within 1%) the sum of the fair value of the variable interests in the asset.
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Table E Mean of distribution of possible outcomes closely approximates fair value of variable interests in Little Building
Probabilities are judgmentally determined and assigned to each outcome based on estimated likelihood of occurrence.
Present Value of Possible Outcomes Little Building $ 389,948 1,352,054 1,953,370 3,156,003 5,235,081 7,674,950
Fair values of variable interests held by Manage Co. and Passive Co. are from Table A above. Computation of the fair value of the decision maker fees is demonstrated below in Table I.
Present value of the possible outcomes, multiplied by the associated probability of occurrence.
Variable Interests in Little Building Manage Co. $ Passive Co. Decision Maker fees $
Ensuring that the mean of the distribution of the possible outcomes equals, or closely approximates, fair value of the variable interests is one of the reasonableness checks for an expected losses and expected residual returns calculation (see Question 10.8). Satisfying this reasonableness check may prove challenging and may require the use of trial and error relating to the projection of possible outcomes and the probability weights assigned to each possible outcome. Once the distribution of possible outcomes has been determined and probability weighted, and the mean of the distribution equals or closely approximates the fair value of the variable interests under evaluation, expected losses and expected residual returns can be computed, as demonstrated in Table F.
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Table F Calculation of the LLCs expected losses and expected residual returns
See Tables B and C above as to the computation of the present value of the possible outcomes of each building. Fair values for each building represent the mean of the buildings distributions of possible outcomes. The computation of each amount is demonstrated in Tables D and E. Probabilities are the same for each building as demonstrated above in Tables D and E. Once probabilities are assigned to possible outcomes, these should be held constant throughout the computation.
Present Value of Possible Outcomes Big Building $ 60,411,846 63,484,004 69,063,445 74,570,003 76,662,753 81,587,135
Fair Value
Difference
Expected losses and expected residual returns are computed by subtracting the fair value of the variable interests in the buildings from the present value of each possible outcome and multiplying the difference by the probability associated with the possible outcome. To illustrate, the Big Building expected loss of $(1,017,533) for the first possible outcome is computed as the possible outcomes present value of $60,411,846, less the fair value of the variable interests of $70,587,180 (a difference of $10,175,334) multiplied by the associated probability of 10%. The absolute value of expected losses equals expected residual returns.
Expected losses and expected residual returns are computed by subtracting the fair value of the variable interests in each building (i.e., the mean of the distribution of all possible outcomes computed as the sum of the products of (1) each possible outcome, discounted using the interest rate on default risk-free investments, in the distribution of outcomes and (2) the related probability for each such outcome) from the present value of each possible outcome and multiplying the difference by the judgmentally assigned probability weighting associated with the specific outcome. Because the fair values of the variable interests in the buildings are computed as the mean of the distribution of each buildings possible outcomes, the absolute value of total expected losses is equal to the expected residual returns. This is also one of the reasonableness checks that a calculation of expected losses and expected residual returns must satisfy (see Question 10.8).
Financial reporting developments Consolidation of variable interest entities 330
Step 6 Determine if (1) the LLCs equity investment at risk is sufficient to absorb its expected losses (excluding expected losses attributable to silos and variable interests in specified assets) and (2) as a group, the holders have the characteristics of a controlling financial interest.5 Analysis To assess the sufficiency of the LLCs equity investment at risk, the LLCs equity instruments first must be identified and the fair value of the instruments determined. Once identified, the characteristics of the equity instruments must be assessed to ensure that each is an equity investment at risk. In this example, the LLCs equity investments are comprised of the amounts contributed by Manage Co. and Passive Co. There are no features to the investments that suggest that they would not be reported as equity in the LLCs GAAP balance sheet (e.g., they are not mandatorily redeemable except upon the planned liquidation of the LLC). Because the analysis is being performed at inception of the LLC, the fair value of the interests is equal to the amounts contributed. The equity investments made by Manage Co. and Passive Co. are deemed to be at risk, based on the following analysis. a. The equity investments participate significantly in the profits and losses of the LLC, as they are not protected from the risk of losing their equity investments (the protection provided by the guarantee of the residual value of Big Building only provides protection to Lender A if the value of Big Building declines to an amount that reduces the equity investment at risk in Big Building to zero). Note that for purposes of this analysis, the losses and returns that will be absorbed by or inure to variable interests in silos (i.e., to the lessee and Lender C for Building Three) or to variable interests in specified assets (i.e., to Guarantor B and Lender B for Little Building) are not considered, because these interests are not variable interests in the LLC. b. The equity interests were not issued in exchange for subordinated interests in other VIEs. c. The equity investments were not provided to Manage Co. or Passive Co. directly or indirectly by the LLC or by other parties involved with the LLC.
d. The equity investments were not financed for Manage Co. or Passive Co. by the LLC or by other parties involved with the LLC. Accordingly, the LLC is deemed to have an equity investment at risk equal to the combined investments of Manage Co. and Passive Co., or $10,000,000. The sufficiency of the equity investment at risk may be demonstrated through any one of the following methods:6 a. The LLC has demonstrated the ability to finance its activities without additional subordinated financial support. The LLC has not demonstrated an ability to finance its activities without additional subordinated financial support because Lender A required that a guarantee of the residual value of Big Building be obtained in connection with providing the loan. The guarantee is additional subordinated financial support provided to the entity and indicates that the LLCs equity investment at risk may be insufficient to absorb its expected losses.
5 6
See the Interpretative guidance and Questions in Chapter 9. See the Interpretative guidance and Questions in Chapter 9. 331
b. The LLC has at least as much equity as a similar entity that finances its operations with no additional subordinated financial support. To determine whether another entity is comparable: The type and amount of the entitys assets should be similar, The type and amount of the entitys liabilities, including maturities and interest rates, should be similar, The type and amount of capital used to finance the entity should be similar, and The comparable entity should not have any of the features that would prohibit it from demonstrating the ability to finance its activities without additional subordinated financial support.
Generally, it will be rare that entities are capable of demonstrating the sufficiency of the equity investment at risk through this method. In this example, it is assumed that the sufficiency of the LLCs equity investment at risk cannot be demonstrated via comparison to similar entities. c. The LLCs equity investment at risk can be quantitatively demonstrated to be greater than its expected losses. As demonstrated in Table F, the expected losses of the LLC are $3,470,243 (the sum of the expected losses associated with Big Building and Little Building). The LLCs equity investment at risk ($10,000,000, as determined above) is sufficient, because it exceeds the LLCs expected losses. To assess whether the holders of the LLCs equity investment at risk have the characteristics of a controlling financial interest, they must have the following characteristics: a. As a group, the holders of the equity investments at risk (i.e., Manage Co. and Passive Co.) must have the ability to make significant decisions about the LLCs activities through voting or similar rights.7 Generally, the holders of the equity investments at risk should have the power to direct the activities of an entity that most significantly impact the entitys economic performance in order for the entity not to be a VIE. If parties other than holders of the equity investment at risk have the power to direct the activities of an entity that most significantly impact the entitys economic performance, the entity would be a VIE. In particular, it is important to determine whether the decision maker has a variable interest based upon an evaluation of the criteria on fees paid to decision makers or service providers. This analysis focuses on whether the decision maker or service provider is acting in a fiduciary capacity (as an agent of the equity holders) or as a principal to the transaction. Often in the circumstances in which it is determined that the service provider has a variable interest based upon the analysis of provisions on fees paid to decision makers or service providers, the entity will be a VIE unless an equity holder has the unilateral ability to exercise kick-out or liquidation rights and those rights are otherwise substantive. In this example, under the terms of the debt agreements, Lender A is given significant rights to participate in decisions affecting the LLCs operations that can be unilaterally exercised (i.e., Big Building cannot be sold prior to the end of the five-year term of the LLC without the approval of Lender A, and Lender A must approve all tenants, and related lease terms, of the Big building). These rights are deemed to be of such significance that Manage Co. and Passive Co. do not have substantive decision making ability regarding the LLCs activities. Accordingly, the LLC is a VIE.
b. As a group, the holders of the equity investments at risk must have the obligation to absorb the LLCs expected losses.8 Manage Co. and Passive Co. have the obligation to absorb expected losses of the LLC to the extent of their at risk equity investments. Although the guarantee obtained from Guarantor A provides protection from a decline in the value of Big Building, this protection only exists for declines in value after the equity investment at risk is eliminated. Note that because Guarantor B does not have a variable interest in the entity (see Step 4), the guarantee of Little Buildings value is not considered in making this assessment. Additionally, the residual value guarantee provided by the lessee of Building Three, and the fact that Building Three has been financed in its entirety by nonrecourse debt, is not considered in this assessment because Building Three is a silo (see Step 3). c. As a group, the holders of the equity investments at risk must have the right to receive the LLCs expected residual returns.9 Manage Co. and Passive Co. have the right to receive the LLCs expected residual returns. No features of their equity instruments indicate that the returns that might inure to them from the LLCs assets are either directly or indirectly capped. Note that the fixed price purchase option held by the lessee of Building Three is not considered in this assessment because Building Three is a silo (see Step 3). Step 7 As determined in Step 6, the LLC is a VIE because the holders of the LLCs equity investment at risk do not have the power to direct the activities of an entity that most significantly impact the entitys economic performance.
8 9
See the Interpretative guidance and Questions in Chapter 9. See the Interpretative guidance and Questions in Chapter 9. 333
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