Consolidation of Variable Interest Entities A Roadmap to Applying the Variable Interest Entities Consolidation Model

March 2010

FASB material, copyright © by the Financial Accounting Foundation, 401 Merritt 7, PO Box 5116, Norwalk, CT 06856-5116, is reproduced with permission.

This publication is provided as an information service by the Accounting Standards and Communications Group of Deloitte & Touche LLP. It does not address all possible fact patterns and the guidance is subject to change. Deloitte & Touche LLP is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte & Touche LLP shall not be responsible for any loss sustained by any person who relies on this publication. As used in this document, “Deloitte” means Deloitte & Touche LLP, a subsidiary of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. March 2010

Contents
Acknowledgments Introduction Section 1 — Overview, Background, and Scope
1.01 1.02 Determining Which Consolidation Model to Apply Consideration of Substantive Terms, Transactions, and Arrangements Substantive Terms and Arrangements Scope and Scope Exceptions Overall Scope Considerations 1.03 1.04 1.05 1.06 1.07 1.08 1.09 1.10 1.11 Application of the VIE Model in ASC 810-10 to Non-SPEs Qualification of a SPE as a Voting Interest Entity Application of the VIE Model in ASC 810-10 to Multitiered Legal Entity Structures Application of the VIE Model in ASC 810-10 to a Single Entity Held by a Holding Company Elimination of the QSPE Scope Exception Determining Whether Employee Benefit Plans Should Apply the VIE Model in ASC 810-10 to Their Investments Scope Exception for Certain Investment Companies Definition of Governmental Organization Determining Whether a Governmental Organization Was Used to Circumvent the Provisions of the VIE Model in ASC 810-10 Scope Exception for Not-for-Profit Organizations Scope Exception for Not-for-Profit Organizations: Circumvention of the VIE Model in ASC 810-10 Accounting Guidance for NFPs as a Result of the VIE Model in ASC 810-10 Determining Whether Entities That Present Their Financial Statements Similarly to a NFP Can Qualify for the Not-for-Profit Scope Exception Retention of a For-Profit Reporting Entity’s Accounting Policies in the Consolidated Financial Statements of a Not-for-Profit Reporting Entity Scope Exception for Separate Accounts of Life Insurance Entities Meaning of the Term “Exhaustive Effort” Application of Exhaustive-Efforts Scope Exception to an Inactive Entity Created Before December 31, 2003 Definition of a Business Under ASC 810-10-15-17(d) Effect of the Change in the Definition of a Business on the Business Scope Exception

1 2 5
6 8 8 9 10 10 10 11 12 13 14 14 14 15 15 15 16 17 17 17 18 18 18 19 19 19 20 20 21 21 21

Scope Exception for Employee Benefit Plans Scope Exception Related to Investments Accounted for at Fair Value Scope Exception for Governmental Organizations

Scope Exception for Not-for-Profit Organizations 1.12 1.13 1.14 1.15 1.16

Scope Exception Related to Separate Accounts of Life Insurance Entities 1.17 1.18 1.19 1.20 1.21 Exhaustive-Efforts Scope Exception

Business Scope Exception

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1.22 1.23 1.24 1.25 1.26 1.27 1.28 1.29 1.30 1.31

Applying the Business Scope Exception on a Reporting-Entity-by-Reporting-Entity Basis Determining When a Reporting Entity Should Assess Whether It Meets the Business Scope Exception Under the VIE Model in ASC 810-10 Definition of a Joint Venture and Joint Control as Used in the VIE Model in ASC 810-10-15-17(d)(1) Determining Whether the Reporting Entity Participated Significantly in the Design or Redesign of the Legal Entity Scope Exception for Legal Entities Deemed to Be a Business — Determining Whether Substantially All of the Activities Either Involve or Are Conducted on Behalf of the Reporting Entity Scope Exception for an Entity Deemed to Be a Business — Determining Whether Financing Is Subordinated Additional Financial Support — Put and Call Options Business Scope Exception — Determining Whether More Than Half the Total of Equity, Debt, and Other Subordinated Financial Support Has Been Provided Lessee’s Determination of Whether a Capital Lease With an Entity Should Be Assessed Under the VIE Model in ASC 810-10 Consideration of Leasing Activities in Which the Legal Entity Is the Lessor

22 22 24 25 25 27 28 29 30 30

Section 2 — Determination of Whether the Reporting Entity Holds a Variable Interest
Identifying a Variable Interest 2.01 2.02 2.03 2.04 2.05 2.06 2.07 2.08 2.09 2.10 2.11 2.12 2.13 2.14 2.15 2.16 2.17 2.18 2.19 2.20 2.21 2.22 2.23 2.24 2.25 Determining Whether a Holding Is a Variable Interest Identifying Whether a Reporting Entity Holds a Variable Interest Requiring Analysis Under the VIE Model in ASC 810-10 Determining When a Lease Represents a Variable Interest — Potential VIE Is a Lessor Determining When a Lease Represents a Variable Interest — Potential VIE Is a Lessee Determining Variable Interests Under the VIE Model in ASC 810-10 in a Synthetic CDO Structure When Decision-Maker Fees Are Not Treated as a Variable Interest Determining Variable Interests Under the VIE Model in ASC 810-10 in a Synthetic CDO Structure When Decision-Maker Fees Are Treated as a Variable Interest Netting of Instruments Other Than Equity Applying the VIE Model in ASC 810-10 to Trust Preferred Security Arrangements and Similar Structures Implicit Variable Interests and “Activities Around the Entity” — Illustration Implicit Variable Interests — Call and Put Options Implicit Variable Interests — Total Return Swap Implicit Variable Interests — Back-to-Back Asset Guarantee Determining When an Implicit Guarantee (Variable Interest) Exists in a Related-Party Transaction Implicit Variable Interests — Waiving of a Management Fee Overview of the Guidance in ASC 810-10-25-21 Through 25-36 Applying the Guidance in ASC 810-10-25-21 Through 25-36 to Purchase and Supply Arrangements Applying ASC 810-10-25-21 Through 25-36 to PPAs, Tolling Agreements, and Similar Arrangements Off-Market Supply Agreements Determining Whether a Variable Interest Is Subordinated Financial Support Analyzing a MMF for Consolidation How to Determine Whether an Embedded Derivative Is Clearly and Closely Related Economically to Its Asset or Liability Host Applying the Guidance in ASC 810-10-25-35 and 25-36 Meaning of the Term “Derivative Instrument” in ASC 810-10-25-35 and 25-36 Meaning of the Term “Market-Observable Variable” in ASC 810-10-25-35 Meaning of the Term “Essentially All” in ASC 810-10-25-36

32
32 32 35 36 37 37 39 39 40 43 43 46 46 47 47 51 51 53 55 56 58 59 60 62 63 65 66 66

Implicit Variable Interests

The By-Design Approach to Determining Variability

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Section 3 — Determination of Whether an Entity Is a VIE
Determination of Whether Equity Investment at Risk Is Sufficient Under ASC 810-10-15-14(a) 3.01 3.02 3.03 3.04 3.05 3.06 3.07 3.08 3.09 3.10 3.11 3.12 3.13 Determination of Equity Investment at Risk When the Investor’s Initial Accounting Basis of Its Equity Differs From Fair Value Including Mezzanine Equity Instruments in Total Equity Investment at Risk Determination of Whether a Personal Guarantee Provided by an Equity Holder Represents Equity Investment at Risk Determining Whether an Instrument With a Risks-and-Rewards Profile Similar to That of an Equity Investment Qualifies as Equity Impact of ASC 810-10-15-14(a) on the Determination of Total Equity Investment at Risk When the Investee Is a Foreign Entity Non-At-Risk Equity Investment as a Variable Interest Definition of “Profits and Losses,” as Used in ASC 810-10-15-14(a)(1) Including Fixed-Rate, Nonparticipating Preferred Stock in the Total Equity Investment at Risk Determining Whether an Equity Interest Participates Significantly in the Profits and Losses of an Entity Impact of Put Options, Call Options, and Total Return Swaps on Equity Investment at Risk Impact of Contracts and Instruments That Protect an Equity Investor on Equity Investment at Risk Qualification of Equity Investments Issued in Exchange for Promises to Perform Services as Equity Investment at Risk Determining Whether Fees Received by an Equity Investor for Services Performed at Inception or in the Future Reduce Equity Investment at Risk Determining Whether Funds Borrowed by a Reporting Entity Qualify as Equity Investment at Risk Determining Whether a Quantitative Assessment of Equity Investment at Risk Is Necessary Qualitative Versus Quantitative Analysis of Whether an Entity Is a VIE Quantitative Expected-Loss Calculation — After Adoption of ASU 2009-17 Consideration of Subordinated Debt in a Qualitative Assessment of Sufficiency of Equity at Risk

68
69 70 70 70 71 71 71 72 72 73 73 74 76 77 77 78 78 78 79 80 81 81 82 83 84 84 85 86 87 87 88 88 90 90 91 92 92 93 94 94 95

Equity Investments That Participate in Profits and Losses

Equity Investments Provided Directly or Indirectly by the Entity

Equity Investments Financed by the Entity 3.14 3.15 3.16 3.17 3.18 Sufficiency of Equity Investment at Risk

Determining Whether, as a Group, the Holders of the Equity Investment at Risk Lack Any of the Characteristics in ASC 810-10-15-14(b) 3.19 3.20 3.21 3.22 3.23 3.24 3.25 3.26 Characteristics in ASC 810-10-15-14(b) Held Within the Group of At-Risk Equity Investors Meaning of the Phrase “As a Group” in ASC 810-10-15-14(b) Impact of ASC 810-10-15-14(b) on Determining Characteristics of Control or Lack of Control by the Group of Holders of Equity Investment at Risk Minimum Amount of Equity Held By an Investment Manager or GP Ability of Holders of Equity Investment at Risk to Remove a Decision Maker Decision-Making Rights Granted to an Equity Holder Separately From Its Equity Investment at Risk Nonsubstantive Equity Investment of a GP Determining Whether a GP Interest Should Be Aggregated With an LP (or Other) Interest in the Evaluation of a Legal Entity Under ASC 810-10-15-14 Meaning of “Insignificant” in the Analysis of Fees Paid to a Decision Maker or Service Provider Meaning of the Term “Same Level of Seniority” Whether a Fee Paid to a Decision Maker or Service Provider That Represents a Variable Interest Could Potentially Not Be Significant to a VIE Determining Whether a Decision Maker or Service Provider Must Evaluate ASC 810-10-25-38A If the Fees Paid to the Decision Maker or Service Provider Do Not Represent a Variable Interest Reassessment of Fees Paid to a Decision Maker or Service Provider Determining Whether a Reporting Entity Lacks the Obligation to Absorb Expected Losses of the Entity Use of a Qualitative Approach to Determine Whether a Reporting Entity Has the Obligation to Absorb Expected Losses
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Analysis of Fees Paid to a Decision Maker or Service Provider 3.27 3.28 3.29 3.30 3.31 3.32 3.33

Obligation to Absorb the Expected Losses of the Legal Entity

3.34 3.35 3.36

Determining Whether a Put Option on an Equity Interest Causes the Holders of the Equity Investment at Risk to Lack the Obligation to Absorb the Expected Losses of the Entity Determining Whether a Put Option on a Potential VIE’s Assets Causes the Holders of the Equity Investment at Risk to Lack the Obligation to Absorb the Expected Losses of the Potential VIE Determining the Effect of Other Arrangements on the Ability of the Equity Group to Absorb Expected Losses or Receive Residual Returns Determining Whether an Investor Has the Right to Receive the Expected Residual Returns of a Legal Entity and Whether the Investor’s Return Is Capped Impact of an Outstanding Equity Call Option on Whether a Return Is Capped Impact of a Call Option on an Entity’s Assets on Whether a Return Is Capped Application of the VIE Test Under ASC 810-10-15-14(c) Considering a Reporting Entity’s Obligations to Absorb Expected Losses and Rights to Receive Expected Residual Returns Other Than Those Provided Through Equity Interests When Applying ASC 810-10-15-14(c) Anticipated Changes in the Assessment of Whether an Entity Is a VIE Future Sources of Financing to Include in a Potential VIE’s Expected Cash Flows Guidance on Reconsideration of Whether an Entity Is a VIE Valuation of Equity Investment at Risk When a Reconsideration Event Occurs Isolating the Impact of a Change in the Entity’s Governing Documents or Contractual Arrangements and the Impact of Undertaking Additional Activities or Acquiring Additional Assets Entering Into Bankruptcy Emerging From Bankruptcy Determining Whether a Development-Stage Entity Is a Business Development Stage Entities — Assessing the Sufficiency of Equity Investment at Risk

96 96 96 98 98 99 99 99 100 101 102 102 103 104 104 107 107 108 108 109 109 109

Right to Receive the Expected Residual Returns of the Legal Entity 3.37 3.38 3.39 3.40 3.41

Determining When the Equity Investors as a Group Are Considered to Lack the Characteristics in ASC 810-10-15-14(b)(1)

Initial Determination of Whether an Entity Is a VIE 3.42 3.43 3.44 3.45 3.46 3.47 3.48 3.49 3.50

Reconsideration of Whether the Entity Is a VIE

Development-Stage Entities

Section 4 — Expected Variability and the Calculation of Expected Losses and Expected Residual Returns
4.01 4.02 4.03 4.04 4.05 4.06 4.07 4.08 4.09 4.10 4.11 4.12 4.13 4.14 4.15 4.16 Definitions of Expected Losses and Expected Residual Returns The Meaning of “Net Assets” Under the VIE Model in ASC 810-10 Purpose of Calculating the Expected Losses and Expected Residual Returns of the Entity How to Determine the Expected Losses and Expected Residual Returns of the Entity How to Determine the Expected Losses and Expected Residual Returns of the Entity — Example Use of the Indirect Method to Calculate Estimated Cash Flows Noncash Receipts or Distributions in the Determination of an Entity’s Estimated Cash Flow Scenarios Inclusion of Low-Income Housing or Similar Tax Credits in a Calculation of Expected Losses and Expected Residual Returns Effect of Options on Specific Assets in the Determination of the Entity’s Estimated Cash Flows Developing Estimated Cash Flow Scenarios and Assigning Probabilities for Expected Loss and Expected Residual Return Calculations Discount Rate to Use in the Calculation of Expected Losses and Expected Residual Returns Cash Flow and Fair Value Approaches to Calculating Expected Losses and Expected Residual Returns Appropriateness of Using Either the Cash Flow Approach or Fair Value Approach to Calculate Expected Losses and Expected Residual Returns Determining Whether Decision-Maker and Service-Provider Fees Are Included in Expected Losses and Expected Residual Returns Whether ASC 820-10 Affects an Expected Losses/Residual Returns Calculation Allocation Methods That May Be Used to Determine Whether Fees Paid to Decision Makers or Service Providers Are Variable Interests
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111
111 112 113 113 116 121 123 124 124 125 127 128 128 129 129 130

Section 5 — Interests in Specified Assets of the VIE and Silo Provisions
5.01 5.02 5.03 5.04 5.05 5.06 5.07 5.08 5.09 Accounting for Interests in Specified Assets and Silos Consideration of Interests in Specified Assets Guarantees That Represent a Variable Interest in the Entity Versus a Variable Interest in Specified Assets of the Entity Considering a Party’s Other Interests in the Analysis of a Variable Interest in Specified Assets of an Entity Considering a Related Party’s Interest in the Analysis of a Variable Interest in Specified Assets of an Entity Determining Whether a Silo Exists Determining Whether a Host Entity Is a VIE When a Silo Exists Determining Whether the Silo Is a VIE If the Host Entity Is a VIE Determining the Primary Beneficiary of the Host Entity and Silo

133
133 135 136 136 137 138 139 140 141

Section 6 — Determination of the Primary Beneficiary
6.01 6.02 6.03 6.04 6.05 6.06 6.07 6.08 6.09 6.10 6.11 6.12 6.13 6.14 6.15 6.16 6.17 6.18 6.19 6.20 6.21 6.22 6.23 6.24 6.25 6.26 6.27 6.28 6.29 How a Reporting Entity Applies the VIE Model in ASC 810-10 When It Appears Not to Be the Primary Beneficiary Determining Whether More Than One Reporting Entity Can Consolidate a VIE Risks to Which an Entity Is Designed to Be Exposed Risks and Related Activities Assessing Power to Direct When Decisions Are Made by a Board of Directors and a Manager Consideration of All Risks in the Determination of the Power to Direct Activities of the VIE Evaluating Power to Direct the Most Significant Activities of the VIE in Scenarios Involving a PPA Determination of a Primary Beneficiary for Every VIE Evaluating the Characteristic in ASC 810-10-25-38A(b) Reconsideration of the Primary Beneficiary of a VIE The Effect of Contingencies on Determining the Primary Beneficiary Consideration of Forward Starting Rights in the Primary Beneficiary Analysis Determination of Whether Kickout Rights are Substantive Consideration of a Board of Directors as a Single Party in the Assessment of Kickout Rights Withdrawal and Liquidation Rights Evaluation of Shared Power Versus Multiple Unrelated Parties Performing Different Significant Activities Shared Power Within a Related-Party Group VIEs With No Ongoing Activities That Significantly Affect Their Economic Performance Factors to Consider in the Determination of Whether a Relationship Represents a De Facto Agency Aggregation of Variable Interests When the Reporting Entity Does Not Hold a Variable Interest Directly in the Entity De Facto Agency Relationship When Only Part of an Interest Is Received as a Loan or Contribution From Another Reporting Entity Related-Party Determination — Interests Received as a Loan Considering Whether Restrictions on a Reporting Entity’s Ability to Sell, Transfer, or Encumber Its Interests in a VIE Constitute Constraint The Effect of a Put Option on a De Facto Agency Relationship Consideration of De Facto Agent Requirements in the Determination of the Primary Beneficiary in a Joint Venture Arrangement Determining Which Party in a Related-Party Group Is Most Closely Associated With a VIE Determining the Primary Beneficiary in a Related-Party Group When Members of the Related-Party Group Are Under Common Control Consideration of the Factors in ASC 810-20 in the Determination of Which Related Party Is Most Closely Associated Application of ASC 810-10-25-38A and ASC 810-10-25-44 When a Fee Paid to an Asset Manager Represents a Variable Interest and the Asset Manager Is Part of a Related-Party Group

142
143 143 144 144 145 147 148 149 149 151 153 155 156 156 157 157 158 159 160 160 162 162 163 164 165 166 166 169 169 170

Related-Party Considerations

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Section 7 — Initial Measurement and Subsequent Accounting
Initial Measurement 7.01 7.02 7.03 Balance Sheet Classification of Parent’s Interest — Primary Beneficiary and VIE Under Common Control Qualification of an Entity as a Business for Recording Goodwill Upon Consolidation of a VIE Accounting After Initial Measurement — Intercompany Eliminations

173
173 173 174 175 175

Accounting After Initial Measurement

Section 8 — Presentation and Disclosures
Presentation 8.01 8.02 8.03 8.04 8.05 Application of the Presentation Requirements of ASC 810-10-45-25 to a Consolidated VIE Separate Presentation of Certain Assets and Liabilities of Consolidated VIEs Optional Separate Presentation of Certain Assets and Liabilities of Consolidated VIEs Disclosures About Securitizations Under ASC 860 Versus Disclosures About Securitizations Under the VIE Model in ASC 810-10 Definition of Maximum Exposure to Loss for Disclosure Purposes

177
177 177 178 179 179 181 182

Disclosures

Section 9 — Transition
9.01 9.02 Whether a Reporting Entity Can Elect the FVO for a VIE Upon Adopting ASU 2009-17 Determining VIE and Primary-Beneficiary Status Upon Transition to ASU 2009-17

183
186 186

Appendix A — Implementation Guidance Appendix B — Glossary of Terms and Abbreviations Used in the VIE Model in ASC 810-10
Glossary of Terms Abbreviations

189 205
205 206

Appendix C — Key Differences Between U.S. GAAP and IFRSs — Consolidated Financial Statements Appendix D — Reference Guide Appendix E — Glossary of Standards

208 212 214

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Acknowledgments
Ashley Carpenter, Rob Comerford, Jon Howard, Jeff Nickell, Randall Sogoloff, Joe Ucuzoglu, and Bob Uhl provided the thought leadership necessary to formulate our views on the application of the key principles of Statement 167. James Barker worked with our Energy & Resources practice to develop our views on the application of Statement 167 to power purchase arrangements. Jim Schnurr continues to work with our Investment Management practice to provide input on Statement 167 and the ongoing joint consolidations project. Xihao Hu and Sherif Sakr provided invaluable insight and perspective from our Financial Accounting and Reporting Services group. Joe Renouf, Michael Lorenzo, Lynne Campbell, Yvonne Donnachie, and Joan Meyers delivered the first class production effort that we have come to rely on for all of Deloitte’s publications. Courtney Sachtleben worked tirelessly to ensure this Roadmap was of the highest quality. Her dedication and commitment got this publication to the finish line. Others deserving of mention and appreciation are Robin Kramer, Shan Nemeth, Adrian Schwartz, Kirsten Aunapu, Angela Bacarella, Chris Rogers, Trevor Farber, Catherine Smith, Madhu Gopinath, Shane Burak, Joseph Berry, Kirby Rattenbury, Will Estilo, Chris Toppin, and Thalia Smith.

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Introduction
March 2010 To the clients, friends, and people of Deloitte: Welcome back to the land of variable interest entities (VIEs). It’s been two-and-a-half years since we last updated our Roadmap on consolidation of VIEs, and the consolidations terrain has changed significantly in that time. The most noteworthy changes are (1) the issuance of Statement 167, (2) the release of the FASB Accounting Standards Codification (the “Codification”), and (3) the continued work of the FASB and IASB on a joint consolidations project.

Statement 167 — What’s All the Fuss About?
In June 2009, the FASB issued Statement 167, which amends the consolidation guidance applicable to VIEs. The Statement 167 amendments are effective as of the first annual reporting period that begins after November 15, 2009, and for interim periods within that first annual reporting period. Statement 167 replaces Interpretation 46(R)’s risks-and-rewards-based quantitative approach to consolidation with a more qualitative approach that requires a reporting entity to have some economic exposure to a VIE along with “the power to direct the activities that most significantly impact the economic performance of the entity.” The FASB also reminded its constituents that only substantive terms, transactions, and arrangements should affect the accounting conclusions under Statement 167; the SEC has reiterated this principle in numerous public speeches. It’s not surprising that many initially concentrated on understanding how Statement 167 would affect qualifying special-purpose entities (QSPEs) and other structured finance entities because that seemed to be the FASB’s focus, particularly given that six of the nine implementation examples in Statement 167 address structured finance entities. However, the initial adoption of Statement 167 has proved time-consuming because it does not just apply to structured finance entities or entities historically considered VIEs under Interpretation 46(R). In addition, even if a reporting entity determines that it does not need to consolidate a VIE under Statement 167, it must provide extensive disclosures for any VIEs in which it holds a variable interest. In addition to the overall change in the Interpretation 46(R) consolidation model, Statement 167 contains the following significant provisions and amendments: • • The scope exemption for QSPEs is removed from Interpretation 46(R). As a result, transferors, sponsors, and investors in QSPEs need to consider the consolidation and disclosure provisions in Statement 167. Kickout rights and participating rights are ignored in (1) the determination of whether an entity is a VIE and (2) the identification of the VIE’s primary beneficiary, unless the rights are held by a single reporting entity. A reporting entity must continually reconsider which variable interest holder is the VIE’s primary beneficiary. A reporting entity must reconsider an entity’s VIE status if the equity interest holders lose the power from the voting rights of those investments to direct the entity’s most significant activities. An exemption to the de facto agent requirements exists when mutual transfer restrictions are based on terms mutually agreed to by willing, independent parties. A reporting entity must meet six conditions to determine that fees paid to a decision maker or service provider do not represent a variable interest. The FASB believes that fees paid to a reporting entity that acts solely as a fiduciary or agent should typically not represent a variable interest because those fees would typically meet these six conditions.
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• • • •

A primary beneficiary must present separately, on the face of the balance sheet, (1) assets of consolidated VIEs that can only be used to settle obligations of those VIEs and (2) liabilities of consolidated VIEs for which creditors do not have recourse to the general credit of the primary beneficiary. Power is only considered shared (and no party consolidates) if (1) two or more unrelated parties together have the power to direct the VIE’s most significant activities and (2) decisions about those activities require the consent of each of the parties sharing power.

To address the new consolidations guidance under Statement 167, this edition of the Roadmap (1) includes over 30 new Q&As and (2) updates our existing Interpretation 46(R) Q&As.

The Codification — Do You Have All the New Topics, Subtopics, Sections, Subsections, and Paragraphs Memorized?
In July 2009, the Codification became the single source of authoritative nongovernmental U.S. GAAP. The Codification’s hierarchy is topic, subtopic, section, and paragraph, in that order, each with a numerical designation (e.g., ASC 810-10-25-37, which was formerly paragraph 6 of Interpretation 46(R)). ASU 2009-17 incorporated Statement 167’s amendments to the VIE model into the Codification. The beginning of each section of this Roadmap contains quotes from the appropriate Codification paragraphs. In addition, for those of you still trying to find your way through the Codification, we thought it would be helpful for each Codification paragraph to be followed by a reference to the corresponding pre-Codification paragraph from Interpretation 46(R), as amended by Statement 167. Although ASC 810-10-55-37 (paragraph B22 of Interpretation 46(R)1) might not roll off your tongue like “B22 of FIN 46(R)” used to, the Codification is here to stay. However, we suspect that just as there are probably a few accountants who are clinging to their last version of the FASB’s Original Pronouncements (we know you are out there!), there are some that might need a little help finding the new VIE guidance in the Codification. Accordingly, Appendix D of this Roadmap includes a guide that cross-references the paragraphs from ASC 810-10 to the guidance in Interpretation 46(R), as amended by Statement 167. The reference guide also lists the accounting topic and section from the Roadmap that these paragraph references apply to. (We thought a few hints and a little “cheat sheet” among friends might be helpful while we all adjust to the new layout of the Codification.)

No More Big Changes Expected Anytime Soon — Right?
Well — not really. Did we mention the joint consolidations project that the FASB and the IASB are working on? The IASB and FASB are jointly developing guidance for consolidation of all entities, including entities currently considered VIEs. Although Statement 167 was not developed as part of the joint project, the IASB staff closely followed the FASB’s work on Statement 167. The boards’ goal is to have one consolidation model whose principles are similar to those in Statement 167 and that would apply to all entities. In December 2008, the IASB issued Exposure Draft 10 (ED 10), Consolidated Financial Statements. Although the boards believe that the objectives for assessing control of structures under Statement 167 and ED 10 are fundamentally consistent, they also acknowledged that the guidance in ED 10 can potentially result in different consolidation conclusions — particularly for certain investment funds. The boards are continuing to jointly deliberate several critical issues, including the evaluation of principal and agent relationships, the concept of effective control (e.g., the ability to control a voting interest entity when a reporting entity holds fewer than half of the voting rights), related parties, disclosures, and presentation requirements. The boards have stated their goal to issue an exposure draft during the second quarter of 2010 and a final standard before the end of 2010. We will continue to keep you updated on these developments through our Heads Up newsletters as well as through our Dbriefs webcast series.2 For a discussion of the current differences between the consolidation models under IFRSs and U.S. GAAP, see Appendix C of this Roadmap.

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You see – that’s helpful – isn’t it? If you wish to receive Heads Up and other accounting publications issued by Deloitte’s Accounting Standards and Communications Group, please register at www.deloitte.com/us/subscriptions. Join Dbriefs to receive notifications about future webcasts at www.deloitte.com/us/dbriefs.
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What’s This I Hear About a Deferral of Statement 167? Can I Get One Too?
In February 2010, the FASB issued ASU 2010-10, which amends certain provisions of the VIE model in ASC 810-10. The ASU defers the effective date of Statement 167 for a reporting entity’s interest in certain entities and certain money market mutual funds. It also addresses concerns that the joint consolidation model under development by the FASB and IASB may result in a different consolidation conclusion for asset managers and that an asset manager consolidating certain funds would not necessarily provide useful information to investors. In addition, the ASU amends certain provisions of ASC 810-10-55-37 (paragraph B22 of Interpretation 46(R), as amended by Statement 167) to change how a decision maker or service provider determines whether its fee is a variable interest. This Roadmap reflects the changes to ASC 810-10-55-37. The ASU will defer the application of Statement 167 for a reporting entity’s interest in an entity (1) that has all the attributes of an investment company or (2) for which it is industry practice to apply measurement principles for financial reporting purposes that are consistent with those followed by investment companies. The deferral does not apply in situations in which a reporting entity has the explicit or implicit obligation to fund losses of an entity that could potentially be significant to the entity. The deferral also does not apply to interests in securitization entities, asset-backed financing entities, or entities formerly considered QSPEs. In addition, the deferral applies to a reporting entity’s interest in an entity that is required to comply with or operate in accordance with requirements similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. These entities will be subject to the deferral even if the money market fund manager has an explicit or implicit obligation to fund losses of the entity. For reporting entities that meet the deferral conditions, the guidance on VIEs in ASC 810-10 (before the amendments in ASU 2009-17 and the amendments to 810-10-55-37 in ASU 2010-10) would be used to determine whether (1) the legal entity is a VIE, (2) the reporting entity has a variable interest in a VIE, and (3) the reporting entity is the primary beneficiary of a VIE. However, all reporting entities must provide the disclosures in ASC 81010, as amended by ASU 2009-17, for all VIEs in which they hold a variable interest or for which they are the primary beneficiary — regardless of whether the entity qualifies for the deferral. Q&A 1.01 of this Roadmap includes a decision tree to help you understand how the deferral may affect which consolidation model you will need to apply. In addition, see our January 27, 2010, Heads Up for information about the ASU’s other significant provisions.

The Road Forward
We understand that Statement 167 (like Interpretation 46(R) before it) can be a difficult standard to apply — particularly when you are new to its provisions. We believe this Roadmap can help you find your way and can help make the complex sound a little simpler. To those new to VIE land, and to our grizzled VIE veterans, we look forward to working with you. Deloitte & Touche LLP

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Section 1 — Overview, Background, and Scope
ASC 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 entity’s 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 81010-15-8 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. [Paragraph 1] 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 VIE’s 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. [Paragraph 1A]

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. [Paragraph E5] 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 VIE’s activities. A VIE’s 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 VIE’s activities through contracts or the VIE’s governing documents. There may be other techniques for protecting a reporting entity’s 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). [Paragraph E7] The power to direct the activities of a VIE that most significantly impact the entity’s economic performance and the reporting entity’s exposure to the entity’s losses or benefits [Paragraph 14A] are determinants of consolidation in the Variable Interest Entities Subsections. [Paragraph E7] 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.

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ASC 810-10 (continued)
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. [Paragraph E18] 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. [Paragraph E19] 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 entity’s activities may be predetermined or decision-making 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 that requires ownership of voting stock is not appropriate for such entities. [Paragraph E20]

1.01

Determining Which Consolidation Model to Apply

Under ASC 810-10, there are two primary1 models for determining whether consolidation is appropriate: the VIE model and the voting interest model. ASU 2009-17 amends the VIE model and is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, and for interim periods within those reporting periods. ASU 2010-10 indefinitely defers the amendments in ASU 2009-17 for a reporting entity’s interest in certain entities and amends the guidance in paragraph 810-10-55-37 (as amended by ASU 2009-17) on determining whether a decision-maker or service-provider fee represents a variable interest. The deferral will be most applicable to interests in certain investment funds. For reporting entities that meet the deferral conditions, the guidance on VIEs in ASC 810-10 (before the amendments in ASU 2009-17 and the amendments to 810-10-55-37 in ASU 2010-10) would be used to determine whether the legal entity is a VIE, whether the reporting entity has a variable interest in a VIE, and whether the reporting entity is the primary beneficiary of a VIE. However, all reporting entities must provide the disclosures in ASC 810-10, as amended by ASU 2009-17, for all VIEs in which they hold a variable interest or for which they are the primary beneficiary — regardless of whether the entity qualifies for the deferral.

Question
How should a reporting entity determine which consolidation model is appropriate under ASC 810-10?

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While ASC 810-10 primarily focuses on the voting interest model and the VIE model, it also discusses consolidation of entities controlled by contract. Although the guidance in the Consolidation of Entities Controlled by Contract subsection applies to all entities (except entities that are determined to be VIEs), the context of the guidance is physician practice management entities.
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Answer
When determining which consolidation model to apply, a reporting entity should consider the following flowchart:
Does one of the scope exceptions in ASC 810-10-15-12 or 15-17 apply? No Does the potential VIE and the reporting entity’s interest in the potential VIE meet the deferral conditions in ASC 810-10-65-2(aa)? Yes Apply the voting interest model in ASC 810-10.

Yes

No

Does the reporting entity have a variable interest in the potential VIE under ASC 810-10 (before the amendments by ASU 2009-17)? Yes Is the entity a VIE under ASC 81010 (before the amendments by ASU 2009-17)? Yes Determine whether the reporting entity is the primary beneficiary of the VIE under ASC 810-10 (before the amendments by ASU 2009-17). No

No

No

Does the reporting entity have a variable interest in the potential VIE under ASC 810-10 (as amended by ASU 2009-17)? Yes No Is the entity a VIE under ASC 81010 (as amended by ASU 2009-17)? Yes

Apply the voting interest model in ASC 810-10 to the entity.

Determine whether the reporting entity is the primary beneficiary of the VIE under ASC 810-10 (as amended by ASU 2009-17)?

Apply the disclosure requirements in ASC 810-10-5 (as amended by ASU 2009-17) for all VIEs in which the reporting entity holds a variable interest, regardless of whether the deferral conditions in ASC 810-10-65-2(aa) are met.

If one of the scope exceptions in ASC 810-10-15-12 or 15-17 does not apply to the potential accounting parent or potential accounting subsidiary, determining whether the potential VIE and the reporting entity’s interest in the potential VIE meet the deferral conditions in ASC 810-10-65-2(aa) is the first step in the assessment of whether an entity should be consolidated. Note that this determination is performed first because the analysis of whether the reporting entity has a variable interest in the entity, the entity is a VIE, or the reporting entity is the primary beneficiary may differ depending on whether the potential VIE and the reporting entity’s interest in the potential VIE meet the deferral conditions in ASC 810-10-65-2(aa). After a reporting entity determines whether the deferral criteria are met, determining whether an entity is a VIE is the next step in assessing whether an entity should be consolidated. Even a company with wholly owned consolidated subsidiaries must determine whether any of its subsidiaries (as well as any interests it may have in other entities) are VIEs. Note that because of a change in facts and circumstances, a potential VIE and the reporting entity’s interest in a potential VIE that initially met the deferral conditions in ASC 810-10-65-2(aa) may subsequently lose the ability to apply the deferral. In this situation, ASU 2009-17 becomes effective for the potential VIE and the reporting entity’s interest in the potential VIE. If a reporting entity must consolidate an entity that no longer qualifies for the deferral, the assets, liabilities, and noncontrolling interests of the VIE should be measured in accordance with ASC 810-1030-1 through 30-6. Once a reporting entity applies the amendments of ASU 2009-17 to the potential VIE, it cannot subsequently requalify for the deferral conditions in ASC 810-10-65-2(aa).

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Example
Enterprise A has 60 percent of the voting interest in Entity B. Enterprise A also receives fees for providing asset management services to B. Unless one of the scope exceptions in ASC 810-10-15-12 and 15-17 applies to A (the potential accounting parent) or B (the potential accounting subsidiary), A must determine (1) whether B, and A’s interest in B, meets the conditions in ASC 810-10-65-2(aa), (2) whether A holds a variable interest or variable interests in B, and (3) whether B is a VIE. Scenario 1: If B, and A’s interest in B, meets the conditions in ASC 810-10-65-2(aa), A must determine whether B is a VIE, as defined in ASC 810-10-15-14 (before the amendments in ASU 2009-17). If A holds a variable interest, as defined in ASC 810-10-20 and illustrated in ASC 810-10-55-16 through 55-41 (before the amendments in ASU 2009-17), in B and B is a VIE, A should assess whether it is the primary beneficiary in accordance with ASC 810-1025-38 (before the amendments in ASU 2009-17). Enterprise A should also provide the disclosures in ASC 810-10 (as amended by ASU 2009-17). Scenario 2: If B does not meet the conditions in ASC 810-10-65-2(aa), A must determine whether B is a VIE, as defined in ASC 810-10-15-14 (as amended by ASU 2009-17). If A holds a variable interest, as defined in ASC 81010-20 and illustrated in ASC 810-10-55-16 through 55-41 (as amended by ASU 2009-17), in B and B is a VIE, A should assess whether it is the primary beneficiary in accordance with ASC 810-10-25-38A (as amended by ASU 2009-17). Enterprise A should also provide the disclosures in ASC 810-10 (as amended by ASU 2009-17). Scenario 3: If B meets the conditions in ASC 810-10-65-2(aa) but is not a VIE, as defined in ASC 810-10-15-14 (before the amendments by ASU 2009-17), A should apply the voting interest model in ASC 810-10 to B. Scenario 4: If B does not meet the conditions in ASC 810-10-65-2(aa) and is not a VIE, as defined in ASC 810-1015-14 (as amended by ASU 2009-17), A should apply the voting interest model in ASC 810-10 to B.

Substantive Terms and Arrangements
ASC 810-10
15-13A For purposes of applying the Variable Interest Entities Subsections, only substantive terms, transactions, and arrangements, whether contractual or noncontractual, shall be considered. Any term, transaction, or arrangement shall be disregarded when applying the provisions of the Variable Interest Entities Subsections if the term, transaction, or arrangement does not have a substantive effect on any of the following: a. b. c. A legal entity’s status as a VIE A reporting entity’s power over a VIE A reporting entity’s obligation to absorb losses or its right to receive benefits of the legal entity. [Paragraph 2A]

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. [Paragraph 2A]

1.02

Consideration of Substantive Terms, Transactions, and Arrangements

Question
What is meant by “substantive terms, transactions, and arrangements” in ASC 810-10-15-13A?

Answer
In ASU 2009-17, the FASB added guidance to emphasize that when applying the provisions of the VIE subsections of ASC 810-10, a reporting entity should only consider substantive terms, transactions, and arrangements, whether contractual or noncontractual. The Board thought that it needed to add this language to avoid situations in which the form of an entity may indicate that an entity is not a VIE or that a reporting entity is not a primary beneficiary when the substance of the arrangement may indicate otherwise. Paragraph A35 in the Basis for Conclusions of Statement 167 states, in part:
The Board considered whether additional guidance was needed for determining whether a variable interest holder has power when the economics of the holder’s interest(s) or other involvements is inconsistent with its stated power from such interest(s) or other involvements. The Board agreed that an increased level of skepticism is needed in situations in which an enterprise’s economic interest in a [VIE], including its obligation to absorb losses or its right to receive benefits, is disproportionately greater than its stated power. In the Board’s view, the level of skepticism about an enterprise’s lack of power should increase as the disparity between an enterprise’s economic interest and its power increases.
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When the provisions of ASC 810-10 (as amended by ASU 2009-17) are applied, the consolidation conclusion should not be affected by any term, transaction, or arrangement that does not truly affect the reporting entity’s power or rights to receive benefits or obligations to absorb losses. A reporting entity should use judgment, based on consideration of all the facts and circumstances, to distinguish substantive terms, transactions, and arrangements from nonsubstantive terms, transactions, and arrangements. To further emphasize this point, the SEC has reminded registrants of the staff’s skepticism about accounting conclusions that do not conform to the economic substance of the arrangement. For example, in remarks regarding the implementation of ASU 2009-17 before the 2009 AICPA National Conference on Current SEC and PCAOB Developments, Arie Wilgenburg, a professional accounting fellow in the SEC’s Office of the Chief Accountant, discussed the following examples:
[A]ssume a company has transferred assets to a structure to be managed by a third party, but the manager’s equity interest in the structure is minimal and appears to be guaranteed given the management fee structure. In addition, assume the manager can be removed by the reporting enterprise if the manager’s performance is unsatisfactory. The combination of the above factors indicates that the company may not have relinquished control; rather the manager may simply be acting as an agent on behalf of the reporting enterprise. We have also seen other, similar structures that include a buy-sell clause rather than a removal right, as a mechanism for dissolving the structure. However, if the manager does not have the financial ability to exercise its rights under the buy-sell provision, the substance of this provision may be a call option by the transferor. Again, this may be an indication that the manager is simply acting as an agent on behalf of the reporting enterprise.

At the same conference, James Kroeker, chief accountant in the SEC’s Office of the Chief Accountant, indicated that the staff would consider involving the Division of Enforcement if it becomes aware of arrangements such as those discussed by Mr. Wilgenburg.

Scope and Scope Exceptions
ASC 810-10
15-12 a. b. c. d. e. The guidance in this Topic does not apply in any of the following circumstances: 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. [Paragraph 4]

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 25-44. 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 VIE’s primary beneficiary Perform the accounting required to consolidate the VIE for which it is determined to be the primary beneficiary.

b. c.

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ASC 810-10 (continued)
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). [Paragraph 4]

Overall Scope Considerations 1.03 Application of the VIE Model in ASC 810-10 to Non-SPEs

Question
Does the VIE model in ASC 810-10 apply only to SPEs?

Answer
No. ASC 810-10-15-12 and 15-17 provide scope exceptions for certain reporting entities and potential VIEs. Variable interest holders should evaluate all entities that do not fall under these scope exceptions (such entities may include limited partnerships, joint ventures, cooperatives, and trusts) to determine whether they represent VIEs. (For more information about the determination of which consolidation model to apply, see Q&A 1.01.) Note that ASU 2009-16 eliminated the scope exception for QSPEs. Therefore, transferors, sponsors, and investors in QSPEs should consider the consolidation and disclosure provisions in ASC 810-10. (For more information about the elimination of the QSPE scope exception, see Q&A 1.07.)

1.04

Qualification of a SPE as a Voting Interest Entity

If an SPE is a VIE, it is subject to consolidation under the VIE model in ASC 810-10.

Question
Are all SPEs automatically considered VIEs and within the scope of the VIE model in ASC 810-10?

Answer
No. An SPE can qualify as a voting interest entity and therefore be outside the scope of the VIE model in ASC 81010. To determine whether the SPE is outside the scope of the VIE model, a reporting entity must evaluate the SPE under ASC 810-10-15-14. To not be a VIE, such an entity must fail to satisfy all conditions in ASC 810-10-15-14. Demonstrating only that an entity possesses one attribute of a voting interest entity, as described in ASC 810-1015-14 (e.g., simply having sufficient equity investment at risk, giving the equity holders voting rights with respect to activities of the entity), is not sufficient evidence that an entity is not a VIE.
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If an entity is outside the scope of the VIE model in ASC 810-10, it should be considered for consolidation under the voting interest model in ASC 810-10.

1.05

Application of the VIE Model in ASC 810-10 to Multitiered Legal Entity Structures

Question
In an ownership structure in which multiple layers of legal entities exist, should a reporting entity apply the VIE model in ASC 810-10 to each of its subsidiaries on a consolidated or nonconsolidated basis?

Answer
In a multitiered legal-entity structure, a reporting entity should generally begin its evaluation at the lowest-level entity. Each entity within the structure should then be evaluated on a consolidated basis. The attributes and variable interests of the underlying consolidated entities become those of the parent company upon consolidation. When a reporting entity applies the VIE model in ASC 810-10 to a consolidated entity, it should analyze the design of the consolidated entity, including an analysis of the risks of the entity, why the entity was created (e.g., the primary activities of the entity), and the variability the entity was designed to create and pass along to its interest holders (see ASC 810-10-25-21 through 25-36). Note that there are situations in which a reporting entity may “look through” a holding company and in which it therefore would not be required to examine the structure on a consolidated basis. For more information, see Q&A 1.06.

Example 1
Two investors each hold 50 percent of the ownership interests in Company H. Company H has 100 percent of the ownership interests in Entity X and consolidates X. Entity X is a business as defined in ASC 805 and represents substantially all of H’s consolidated activities and cash flows. On a nonconsolidated basis, H does not meet the definition of a business in ASC 805. There are no other relationships or agreements between the investors, H, or X. As noted above, the attributes of a consolidated entity become the attributes of the parent company. In this example, X’s attributes become those of H. When the investors are evaluating their ownership interests, they should consider H’s design on a consolidated basis. Because X meets ASC 805’s definition of a business and its activities and cash flows represent substantially all of H’s consolidated activities and cash flows, H also meets ASC 805’s definition of a business. Before applying the business scope exception, the investors must first determine whether any of the four conditions in ASC 810-10-1517(d) exist for H’s consolidated activities and cash flows. If so, the business scope exception cannot be applied. A holding company that has ownership interests in a single entity in multitiered structures should also consider the guidance in Q&A 1.06.

Example 2
Two investors each hold 50 percent of the ownership interests in a holding company. The holding company has 100 percent of the ownership interests in Entity E and consolidates E. Entity E meets ASC 805’s definition of a business and represents substantially all of the holding company’s consolidated activities and cash flows. The holding company also consolidates Entity N, which does not meet ASC 805’s definition of a business. Other than its investments in E and N, the holding company has no assets, liabilities, or activities. There are no other relationships or agreements between the investors, the holding company, E, or N. As in Example 1, the attributes of the consolidated entity become those of the parent company. In this example, the attributes of E and N become those of the holding company. When the investors are evaluating their ownership interests, they should consider the holding company’s design on a consolidated basis. Because substantially all of the holding company’s consolidated activities and cash flows are derived from E, the holding company meets ASC 805’s definition of a business. Before applying the business scope exception, the investors must first determine whether any of the four conditions in ASC 810-10-15-17(d) exist for the holding company’s consolidated activities and cash flows. If so, the business scope exception cannot be applied.

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Example 3
An investor holds 50 percent of the ownership interests in a holding company. The holding company consolidates the following two entities, both of which meet ASC 805’s definition of a business: • • Entity J, an operating entity. Entity L, whose only asset is a building that is leased to the investor.

Entity L’s activities and cash flows represent substantially all of the holding company’s activities and cash flows. Other than its investments in J and L, the holding company has no assets, liabilities, or activities. There are no other relationships or agreements between the investor, the holding company, J, or L. As in the previous two examples, the attributes of the consolidated entity become those of the parent company. In this example, the attributes of J and L become those of the holding company. When the investor is evaluating its ownership interests, it should consider the holding company’s design on a consolidated basis. While J and L both meet ASC 805’s definition of a business, the investor would not be able to apply the business scope exception because the holding company is designed primarily to facilitate a single-lessee leasing arrangement with one of the investors, which is a condition in which the business scope exception cannot be applied (see ASC 810-10-15-17(d)(4)).

1.06 Application of the VIE Model in ASC 810-10 to a Single Entity Held by a Holding Company
Holding companies are frequently established (often for legal or tax purposes) to hold some or all of the ownership interests in an entity. In many cases, reporting entities have ownership interests in these holding companies for the sole purpose of investing in an underlying entity. Questions can arise about whether a reporting entity with an interest in a holding company can “look through” (i.e., ignore) a holding company and apply the provisions of the VIE model in ASC 810-10 directly to the underlying entity as if the holding company does not exist. This is particularly relevant to the business scope exception in ASC 810-10-15-17(d). For example, assume that an investor has a 40 percent ownership interest in a holding company that is not a joint venture. The holding company was designed for the sole purpose of acquiring 100 percent of the ownership interests in an existing business (as defined in ASC 805). The investor was involved in the design of the holding company, but was not involved in either the design or redesign of the business. Assume that the investor and the holding company do not meet any of the other conditions in ASC 810-10-15-17(d). If the investor can look through the holding company to the underlying entity, it can apply the business scope exception. If the investor cannot look through the holding company, it cannot apply the business scope exception because the investor was involved in the design of the holding company (see ASC 810-10-15-17(d)(1)).

Question
Is it appropriate for a reporting entity to look through a holding company and apply the provisions of the VIE model in ASC 810-10 directly to a single underlying entity as if the holding company does not exist?

Answer
A reporting entity is never required to look through a holding company, and doing so often would be inappropriate under the VIE model in ASC 810-10. (For more information, see Q&A 1.05.) In limited circumstances, however, an investor may be able to look through a holding company and apply the VIE model in ASC 810-10 directly to a single underlying entity. The investor can only do this when (1) the holding company is truly a nonsubstantive entity because it does not have any substantive identity separate from that of the underlying entity and (2) the economics of the arrangement do not change as a result of inserting a holding company in between the investors and the underlying entity. A holding company is considered to have no substantive identity separate from its investment in the entity when all variable interests in the holding company represent indirect variable interests in the underlying entity because of being virtually indistinguishable from the direct variable interests in the underlying entity (i.e., the variable interests in the holding company are essentially “back-to-back” with the variable interests in the underlying entity, with the holding company representing a pass-through entity). In general, the conclusions reached under a VIE evaluation (regarding (1) whether an entity is a VIE and (2) who consolidates the entity as its primary beneficiary) with respect to looking through a holding company should be the same conclusions that would be reached if the analysis were

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performed separately for the holding company and the underlying entity. All facts and circumstances should be considered, including the (1) design of both the holding company and the underlying entity and (2) nature of the relationships with the variable interest holders and their related parties. The existence of all the following conditions may indicate that a reporting entity can look through a holding company to a single underlying entity when applying the VIE model in ASC 810-10: • Other than its ownership interests in the single underlying entity, the holding company is restricted by its governing documents from holding any assets, issuing debt, or engaging in any operating activities on its own behalf. The governing documents of the holding company and the underlying entity are substantively the same. The governing documents associated with the holding company and the underlying entity require that both entities have the same individuals on the board of directors or other bodies that determine the financial and operating policies of the entity. The risks and rewards of the interest holders (including their interests in profits and losses and in liquidation) would be identical if their interests were directly in the underlying entity instead of in the holding company. The reporting entity holds no variable interests in the single underlying entity.

• •

Example 1
An investor holds 40 percent of the ownership interests in a holding company. The holding company has 100 percent of the ownership interests in a single entity and consolidates that entity. The entity is a business as defined in ASC 805. Other than its ownership interests in the entity, the holding company has no assets, liabilities, or activities. There are no other relationships or agreements between the investor, the holding company, and the entity. Assume that the five conditions described above exist in this arrangement. Although not required to do so, in this example, the investor can look through the holding company and apply the VIE model in ASC 810-10 directly to the entity. To apply the business scope exception, the investor must first determine whether any of the four conditions in ASC 810-10-15-17(d) exist for either the investor or the single underlying entity. If so, the business scope exception cannot be applied.

Example 2
Assume the same facts as in Example 1, except that the holding company takes out a loan from a third-party bank. In this example, the investor would not be able to look through the holding company because the holding company’s loan precludes the investor from looking through the holding company to the underlying entity.

Example 3
An investor has 40 percent of the ownership interests in a holding company, which holds 100 percent of the ownership interests in an entity. The entity takes out a loan from a third-party bank. The investor has guaranteed repayment of the loan in the event of default. In this example, the investor would not be able to look through the holding company because the guarantee represents a direct variable interest in the entity.

1.07

Elimination of the QSPE Scope Exception

Before the adoption of ASU 2009-17, variable interests held in certain QSPEs were outside the scope of the VIE consolidation model.

Question
Can a reporting entity involved with a QSPE continue to apply the scope exception upon adopting ASU 2009-17?

Answer
No. ASU 2009-16 eliminated the QSPE concept. As a result, the scope exception for a QSPE was also eliminated from the VIE model in ASC 810-10. Therefore, transferors, sponsors, and investors involved with QSPEs that were previously outside the scope of the VIE consolidation model need to apply the VIE model in ASC 810-10 upon the effective date of ASU 2009-17. However, an entity that previously qualified for the QSPE scope exemption may
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qualify for the exemption in ASC 810-10-15-17(c) if (1) the reporting entity is unable to obtain the information required to complete its consolidation analysis after making an exhaustive effort and (2) the entity was created before December 31, 2003. In addition, an entity that did not previously qualify for the scope exception may not reassess whether it now qualifies simply as a result of adopting ASU 2009-17.

Scope Exception for Employee Benefit Plans
ASC 810-10
15-12 a. The guidance in this Topic does not apply in any of the following circumstances: An employer shall not consolidate an employee benefit plan subject to the provisions of Topic 712 or 715. [Paragraph 4(b)]

1.08 Determining Whether Employee Benefit Plans Should Apply the VIE Model in ASC 810-10 to Their Investments
Employee benefit plans (either defined benefit or defined contribution) may have significant investments (e.g., equity or debt securities, other investments) in entities that give them a controlling financial interest in those entities through voting rights or other arrangements.

Question
Are employee benefit plans within the scope of the VIE model in ASC 810-10?

Answer
No. Employee benefit plans are not within the scope of the VIE model in ASC 810-10.

Defined Benefit Plans
For defined benefit plans, a reporting entity should apply the guidance in ASC 960 (i.e., fair value for all plan investments). ASC 960-325-35-1 states, in part, “Plan investments — whether equity or debt securities, real estate, or other types (excluding insurance contracts) — shall be presented at their fair value at the reporting date.” Since these investments must be carried at fair value, defined benefit plans should not apply the VIE model in ASC 81010.

Other Employee Benefit Plans
For other employee benefit plans (defined contribution plans, employee health and welfare benefit plans), a reporting entity should apply the guidance in ASC 962 and ASC 965, respectively. Because that guidance generally requires that investments be carried at fair value (see ASC 962-325-35-1), the VIE model in ASC 810-10 would not apply to other employee benefit plans.

Other Parties
Other parties involved with employee benefit plans, such as service providers, should apply the VIE model in ASC 810-10, as warranted by the facts and circumstances. For employee benefit plans that are subject to the provisions of ASC 715 and ASC 712 (see ASC 810-10-15-12(a)), employer-sponsors are allowed a scope exception from applying the VIE model in ASC 810-10.

Scope Exception Related to Investments Accounted for at Fair Value
ASC 810-10
15-12 d. The guidance in this Topic does not apply in any of the following circumstances: 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. [Paragraph 4(e)]

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1.09

Scope Exception for Certain Investment Companies

Question
What entities qualify for the scope exception in ASC 810-10-15-12(d)?

Answer
SEC Regulation S-X, Rule 6-03(c)(1), states, in part, that consolidated statements of a registered investment company “may be consolidated only with the statements of subsidiaries which are investment companies.” ASC 810-10-15-12(d) states that investments accounted for at fair value in accordance with the specialized accounting guidance in ASC 946 are exempt from the provisions of ASC 810-10. However, a reporting entity that adopts the implementation guidance in ASC 946-10-55 is subject to the provisions of the VIE model in ASC 810-10 at the time of adoption. Upon the adoption of ASC 946-10-55, the guidance in this Q&A is no longer applicable. The original effective date for the implementation guidance in ASC 946-10-55 was fiscal years beginning on or after December 15, 2007. However, the implementation guidance in ASC 946-10-55 has been indefinitely deferred. See ASC 946-10-65-1 for more details.

Scope Exception for Governmental Organizations
ASC 810-10
15-12 e. The guidance in this Topic does not apply in any of the following circumstances: 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. [Paragraph 4(i)]

1.10

Definition of Governmental Organization

Question
What is the definition of “governmental organization,” as used in ASC 810-10-15-12(e)?

Answer
Paragraph 1.01 of the AICPA Audit and Accounting Guide State and Local Governmental Units defines governmental organization as follows:
Public corporations and bodies corporate and politic are governmental entities. Other entities are governmental entities if they have one or more of the following characteristics: • • • Popular election of officers or appointment (or approval) of a controlling majority of the members of the organization’s governing body by officials of one or more state or local governments; The potential for unilateral dissolution by a government with the net assets reverting to a government [without compensation by that government]; or The power to enact and enforce a tax levy.

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 if their determination is supported by compelling, relevant evidence.

Paragraph 3 of the GASB staff paper Applicability of GASB Standards lists additional characteristics that may indicate an entity is a governmental organization, including the following: • • • Legal decisions that provide the entity with the privileges or responsibilities of government. Classification as government by the U.S. Bureau of Census. Evidence of managerial control by a governmental entity (e.g., ability to designate day-to-day operating management, imposition by statute of day-to-day operating requirements).
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• • •

Possession of other sovereign powers. Exemption of income from federal taxation through revenue rulings based on the governmental character of the entity. If acquired rather than created by a government, the purpose of the acquisition and its expected permanence.

The ASC 810-10-15-12(e) scope exception applies to nongovernmental reporting entities involved with a governmental organization or financing entities established by a governmental organization. Without this scope exception, governmental entities could be considered VIEs because of their lack of equity at risk. Therefore, a nongovernmental reporting entity could be identified as the primary beneficiary of the governmental entity. The FASB did not intend this outcome for entities that are subject to accounting standards promulgated by the FASAB or the GASB.

1.11 Determining Whether a Governmental Organization Was Used to Circumvent the Provisions of the VIE Model in ASC 810-10
ASC 810-10-15-12(e) states:
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.

Question
How does a reporting entity determine whether a governmental organization is used to circumvent the provisions of the VIE model in ASC 810-10?

Answer
A reporting entity should determine whether the governmental organization is used to circumvent the provisions of the VIE model in ASC 810-10 (either intentionally or unintentionally) on the basis of a number of factors, including why the potential VIE was created, the activities of the potential VIE, the extent of involvement by the reporting entity in the activities of the potential VIE, and the nature of the potential VIE’s interests issued. The reporting entity must use significant judgment in making this determination.

Example 1
A U.S. city (considered a governmental organization) establishes and manages a nongovernmental entity to purchase a water treatment plant. The entity issues debt to finance the plant’s acquisition. The debt is purchased by several unrelated third-party private investors, institutional investors, or both. The entity is established on behalf of and for the benefit of the U.S. city, and the investors are not involved in any activities of the entity. In the absence of evidence to the contrary, the investors would be able to apply the scope exception for governmental organizations because (1) the entity was set up on behalf of and for the benefit of the U.S. city, (2) the U.S. city manages the entity, and (3) interests held by the investors do not allow the investors to be involved in the activities of the entity.

Example 2
A state government establishes a nongovernmental entity to build an airline terminal. The entity issues debt to finance the purchase of the terminal. The airline terminal is designed to the specifications of the airline. The airline is the sole lessee of the terminal, and the lease payments service the debt issued by the entity. In this example, (1) the entity has been established on behalf of, and solely for the benefit of, the airline and (2) the interest held by the airline (the lease) allows the airline to manage the activities of the entity. In the absence of evidence to the contrary, the airline would not be able to apply the governmental scope exception to the entity and would need to consider the provisions of the VIE model in ASC 810-10 (as long as no other scope exception is met).

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Scope Exception for Not-for-Profit Organizations
ASC 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 25-44. 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. [Paragraph 4(a)]

1.12

Scope Exception for Not-for-Profit Organizations

Question
Does the scope exception in ASC 810-10-15-17(a) exempt for-profit entities from consolidating NFPs under the VIE model in ASC 810-10 and exempt NFPs from consolidating a VIE?

Answer
Yes. A for-profit entity is exempt from consolidating a NFP unless the latter is used in a manner similar to a VIE and the intent is to circumvent the provisions of the VIE model in ASC 810-10 (see Q&A 1.13 for guidance on identifying circumvention of ASC 810-10). In addition, a NFP is not required to determine, under the VIE model in ASC 810-10, whether to consolidate any entity for which it holds an interest. However, the NFP may be a related party of a for-profit entity that must be analyzed pursuant to ASC 810-10-25-42 through 25-44. In both cases, to the extent the reporting entity is exempt from the scope of the VIE model in ASC 810-10, other U.S. GAAP for the consolidation of NFPs are applicable (see Q&A 1.14 for additional guidance).

1.13 Scope Exception for Not-for-Profit Organizations: Circumvention of the VIE Model in ASC 810-10
Question
ASC 810-10-15-17(a) states that if a business entity uses a NFP to circumvent the provisions of the VIE model in ASC 810-10, the NFP is subject to the VIE model in ASC 810-10. How should the “effort to circumvent” provisions in ASC 810-10-15-17(a) be analyzed?

Answer
The determination of whether a NFP has been established to circumvent the VIE model in ASC 810-10 requires significant judgment. As part of this analysis, an entity should consider all facts and circumstances associated with the creation and design of the NFP as well as the NFP’s relationship with business entities. For example, an entity should consider the following: • • • Whether the party (the sponsor) who will transact with the NFP created or designed the entity. Why the entity was formed as a not-for-profit organization. The nature of the NFP’s operations (e.g., whether substantially all of its activities are on behalf of the sponsor).

Example
Enterprise A, a business enterprise, establishes Entity B, a single-purpose entity in the form of a not-for-profit organization, to lease a building to A. To purchase this building, B uses the proceeds of various tranches of senior and subordinated debt it has issued. The terms of the lease are designed so that A can attain operating lease treatment. The terms include a first-loss residual value guarantee from A (the guarantee is capped to meet the operating lease criteria), and A has a fixed-price purchase option at the end of the lease term (the option is not considered to be a bargain purchase option). It is expected that all of the lease payments (including those from the residual value guarantee) and the proceeds from final sale of the property will be sufficient to redeem the debt. Although no excess funds are expected after the debt is redeemed, any excess funds must be contributed to a local foundation.
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Enterprise A cannot use the not-for-profit scope exception in analyzing whether it must consolidate B because the form of B as a not-for-profit organization was used simply to circumvent the provisions of the VIE model in ASC 810-10. Therefore, A would need to analyze its arrangement with B under this model.

1.14

Accounting Guidance for NFPs as a Result of the VIE Model in ASC 810-10

Question
What accounting literature should be followed by NFPs that qualify for the scope exception in ASC 810-1015-17(a)?

Answer
NFPs should look to ASC 958 and ASC 954.

1.15 Determining Whether Entities That Present Their Financial Statements Similarly to a NFP Can Qualify for the Not-for-Profit Scope Exception
The Codification Master Glossary defines a not-for-profit entity as “an entity that possesses the following characteristics, in varying degrees, that distinguish it from a business entity: a. b. c. Contributions of significant amounts of resources from resource providers who do not expect commensurate or proportionate pecuniary return Operating purposes other than to provide goods or services at a profit Absence of ownership interests like those of business entities.”

Question
Can an entity that presents its financial statements similarly to a NFP, but that does not meet the Codification’s definition, qualify for the not-for-profit scope exception in ASC 810-10-15-17(a)?

Answer
No. Only entities that meet the Codification’s definition of a NFP qualify for the not-for-profit scope exception.

Example
Company A (a for-profit organization) sells properties to a CIRA in exchange for time-share memberships, which A then sells to consumers. The CIRA presents its financial statements similarly to a NFP pursuant to ASC 972, but does not meet the Codification’s definition of a NFP. We understand that the SEC staff does not believe that a CIRA is a NFP because typically it does not meet part (a) or part (c) of the Codification’s definition as follows: • •

Part (a) — The investors (consumers who purchase the time-share units) expect the CIRA to use their contributions to maintain the properties, which maintains (or increases) the value of their time-share units. Part (c) — The investors have a residual claim on the properties and voting rights with respect to the activities of the CIRA, and the units are exchangeable. These attributes are characteristics of “ownership interests like those of business entities.”

The CIRA, therefore, would not meet the scope exception for NFPs in ASC 810-10-15-17(a). Note that the next step in applying the VIE model in ASC 810-10 is to determine whether the CIRA entity is a VIE. If the CIRA entity is not a VIE, A is not required to apply the VIE model in ASC 810-10 to that entity, even though the CIRA does not meet the not-for-profit scope exception.

1.16 Retention of a For-Profit Reporting Entity’s Accounting Policies in the Consolidated Financial Statements of a Not-for-Profit Reporting Entity
Company N, a not-for-profit health care company that applies the guidance in ASC 954, has a wholly owned subsidiary, W, a for-profit holding company that directly operates several for-profit businesses. Company W has a 75 percent equity interest in Company V and consolidates V under the provisions of the VIE model in ASC 810-10. ASC 810-10-15-17(a) exempts NFPs from the provisions of the VIE model in ASC 810-10.
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Question
Should W’s accounting for V be retained in the consolidated financial statements of N (a not-for-profit reporting entity)?

Answer
Yes. For-profit reporting entities that are owned by not-for-profit reporting entities must apply the VIE model in ASC 810-10. That guidance does not change as a result of consolidation by the not-for profit reporting entity. Therefore, W’s decision to consolidate V should be retained in N’s consolidated financial statements. This position is supported by ASC 810-10-25-15, which states, in part:
The application of guidance in an industry-specific Topic of this Codification to a subsidiary within the scope of that industry-specific Topic shall be retained in consolidation of that subsidiary.

While the example above describes a not-for-profit health care organization, the conclusion above applies to all not-for-profit reporting entities.

Scope Exception Related to Separate Accounts of Life Insurance Entities
ASC 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: b. 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. [Paragraph 4(f)]

1.17

Scope Exception for Separate Accounts of Life Insurance Entities

Question
ASC 810-10-15-17(b) exempts separate accounts of life insurance entities, as described in ASC 944-80, from applying the VIE model in ASC 810-10. However, must a separate account apply the VIE model in ASC 810-10 to an entity in which it holds a variable interest?

Answer
Yes. When financial statements are prepared in accordance with GAAP, the financial statements of the separate account are not exempt from consolidating VIEs under ASC 810-10. The scope exception applies to investors in assets held by a separate account of an insurance company. The insurance company would follow the guidance in ASC 944-80-45-1, which states, in part, that “[s]eparate account assets and liabilities shall be included in the financial statements of the insurance entity.” The FASB included this scope exception because it did not intend to change the accounting under ASC 944.

Exhaustive-Efforts Scope Exception
ASC 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: c. 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 VIE’s primary beneficiary Perform the accounting required to consolidate the VIE for which it is determined to be the primary beneficiary.

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. [Paragraph 4(g)]
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1.18

Meaning of the Term “Exhaustive Effort”

Question
How should the term “exhaustive effort,” as used in ASC 810-10-15-17(c), be interpreted?

Answer
A reporting entity should consider all facts and circumstances associated with its ability to obtain information from a legal entity in which it has an interest in determining whether the reporting entity has the information necessary to apply the provisions of the VIE model in ASC 810-10. ASC 810-10-15-17(c) states that the “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.” Therefore, a reporting entity that concludes it is subject to the exemption in ASC 810-10-15-17(c) should compile documentation demonstrating that it has made a significant effort to obtain the information (e.g., date, time, and nature of requests; evidence that the appropriate parties at the legal entity have been contacted; copies of requests for written information; evidence that other holders of similar variable interests are also unable to obtain the information; the nature of any responses from the legal entity). A reporting entity is not required to resort to legal action to obtain information if it does not have a contractual right to obtain the information. The reporting entity should make an exhaustive effort, supported by appropriate documentation, for each legal entity to which it is unable to apply the VIE model in ASC 810-10. As long as the reporting entity has an interest in the legal entity in question, the reporting entity should continue to make exhaustive efforts to obtain the necessary information in at least every reporting period. At the 2004 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff emphasized that management should be prepared to support how it has satisfied the exhaustive-effort requirements. Note that reporting entities can apply this scope exception only for entities created before December 31, 2003. At the 2003 AICPA National Conference on Current SEC Developments, the SEC staff stated the following:
[T]he staff has begun to contemplate the meaning of “an exhaustive effort” in applying this limited scope exception. Consistent with the thoughts of the FASB, as expressed in the modifications to FIN 46 [codified in ASC 810-10], the staff anticipates that the use of the exception will be infrequent. We plan to deal with instances where the information scope exception is being applied on a case-by-case basis, considering all of the relevant facts and circumstances. In assessing those facts and circumstances, the staff can be expected to consider whether registrants operating in the same industry with similar types of arrangements were able to obtain the requisite information.

ASC 810-10-50-6 requires that certain disclosures be made about interests in VIEs that apply this provision. ASC 810-10-30-7 provides transition guidance for a reporting entity that subsequently obtains the information necessary to apply the VIE model in ASC 810-10 to an entity previously subject to this exception.

1.19 Application of Exhaustive-Efforts Scope Exception to an Inactive Entity Created Before December 31, 2003
The exhaustive-efforts scope exception in the VIE model in ASC 810-10 applies only to an entity that both (1) was created before December 31, 2003, and (2) meets the other requirements of ASC 810-10-15-17(c). An entity may have been created before December 31, 2003, remained inactive for a number of years, and then been reactivated after December 31, 2003, to carry out new activities and issue new variable interests.

Question
Can the exhaustive-efforts scope exception be applied to an entity that has been reactivated after December 31, 2003?

Answer
No. At the 2003 AICPA Annual Conference on Current SEC Developments, the SEC staff stated the following:
For instance, in making a determination whether to apply the scope exception, registrants should carefully consider whether the entity was really created prior to December 31st or was merely in existence prior to that date and re-configured in such a way that the “creation date” of the legal entity is not relevant. For instance, if an entity was inactive for a number of years and then re-activated after December 31st to carry out new activities and issue new variable interests, the staff would consider the use of the information scope exception abusive.
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Business Scope Exception
ASC 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: 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). [Paragraph 4(h)]

1.20

Definition of a Business Under ASC 810-10-15-17(d)

Question
What is the definition of a business with respect to the scope exception in ASC 810-10-15-17(d)?

Answer
ASC 805 defines a business with respect to qualifying for the ASC 810-10-15-17(d) scope exception. ASC 805-1020 defines a business as follows:
An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members or participants.

ASC 805-10-55-4 through 55-9 provide additional guidance on what a business consists of. Note that ASC 810-10-15-17(d) indicates that even if a potential VIE meets the definition of a business, a reporting entity may still need to analyze its interest in that potential VIE if any of the four conditions in ASC 810-10-15-17(d) are met.

1.21 Effect of the Change in the Definition of a Business on the Business Scope Exception
Before adopting ASC 805, reporting entities used the definition of a business in ASC 810-10-55-9 through 55-15 in evaluating whether they qualified for the scope exception under ASC 810-10-15-17(d). ASC 805 amends the definition of a business.

Question
Should a reporting entity reassess whether it qualifies for the scope exception under ASC 810-10-15-17(d) solely as a result of the amendment to the definition of a business?

Answer
No. A reporting entity should not reassess whether it qualifies for the scope exception solely because of the change in the definition of a business. Q&A 1.23 notes that a reporting entity must reassess whether it qualifies for the scope exception when certain events occur. In the absence of the occurrence of any of these events, a reporting entity should not reassess whether it qualifies for the scope exception.
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However, if such an event has occurred and the reporting entity is required to reassess whether it qualifies for the scope exception, the reporting entity should use the ASC 805 definition of a business beginning in its first annual reporting period that begins on or after December 15, 2008.

1.22 Applying the Business Scope Exception on a Reporting-Entity-by-Reporting-Entity Basis
ASC 810-10-15-17(d) states, in part:
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 [enumerated] conditions exist.

Question
Does the business scope exception in ASC 810-10-15-17(d) have to be evaluated on a reporting-entity-byreporting-entity basis?

Answer
Yes. Each reporting entity involved with the legal entity must evaluate whether the legal entity fails to meet any of the conditions in ASC 810-10-15-17(d) and thus fails to qualify for the scope exception. It is possible that one reporting entity with an interest in a legal entity will fail to qualify for the scope exception while another reporting entity with an interest in the same legal entity will qualify. The following conditions in ASC 810-10-15-17(d) should be based on an analysis of the legal entity (and thus should be the same analysis for all holders of interests in the legal entity): • • Whether the legal entity is a business as defined in ASC 805. Whether the activities of the legal entity are primarily related to securitizations or other forms of assetbacked financings or single-lessee leasing arrangements (see ASC 810-10-15-17(d)(4)).

The following conditions in ASC 810-10-15-17(d) should be based on an analysis of the relationship each interest holder (reporting entity) and its related parties have with the legal entity (the analysis may, therefore, be different for different holders of interests in the legal entity): • Whether the reporting entity, its related parties,2 or both participated significantly in the design or redesign of the legal entity, unless the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee (ASC 810-10-15-17(d)(1)). Whether 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 (ASC 810-10-15-17(d)(2)). Whether the reporting entity and its related parties provide more than half the total of the equity, subordinated debt, and other forms of subordinated financial support to the legal entity (ASC 810-10-1517(d)(3)).

• •

Example
A joint venture (Entity A) is formed by two enterprises. Entity A meets the definition of a business in ASC 805 and does not meet the condition in ASC 810-10-15-17(d)(4). Enterprise 1 provides 50 percent of the equity and a subordinated loan to Entity A. Enterprise 2 provides the other 50 percent of the equity. Enterprise 2 would be outside the scope of the VIE model in ASC 810-10 because it did not provide more than half the support under the condition in ASC 810-10-15-17(d)(3). However, Enterprise 1 must analyze its interest under the VIE model in ASC 810-10 because it provided more than half the total subordinated support to the joint venture.

1.23 Determining When a Reporting Entity Should Assess Whether It Meets the Business Scope Exception Under the VIE Model in ASC 810-10
ASC 810-10-15-17(d) states, in part:
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).
2

The term “related parties,” as used in this list of conditions, refers to all parties identified in ASC 810-10-25-43, except for de facto agents under ASC 810-10-25-43(d).
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Question
If an entity is deemed to be outside the scope of the VIE model in ASC 810-10 in accordance with ASC 810-1015-17(d), how frequently should a reporting entity evaluate whether the legal entity continues to meet the scope exception? Conversely, if a legal entity does not initially meet the scope exception under ASC 810-10-15-17(d), can the legal entity subsequently meet the scope exception?

Answer
Each reporting entity should continually evaluate the legal entity to determine whether the reporting entity still qualifies for the ASC 810-10-15-17(d) scope exception. A reporting entity should perform this evaluation (1) on the date it becomes involved with the legal entity, (2) when events occur that would require reconsideration under ASC 810-10-35-4, and (3) as of each reporting date (see note below). If a reporting entity determines that the legal entity qualifies for the scope exception under ASC 810-10-15-17(d), the VIE model in ASC 810-10 does not apply and consolidation should be evaluated under the voting interest model in ASC 810-10. This reassessment could result in a reporting entity’s no longer being able to claim the scope exception in ASC 81010-15-17(d) in subsequent periods. Conversely, a reporting entity that has not been able to claim the scope exception should reassess whether it meets the scope exception in ASC 810-10-15-17(d) only if one of the following types of events occurs: • • Reconsideration events under ASC 810-10-35-4 regarding whether an entity is a VIE (see Q&A 3.44). Events that cause a change in the design of the entity.

Note that ASC 810-10-15-17(d), read literally, requires a reporting entity to evaluate all the factors in ASC 81010-15-17(d) in each reporting period. The condition in ASC 810-10-15-17(d)(3) indicates that the reporting entity cannot provide more than half the subordinated financial support to the entity. However, in performing the ASC 810-10-15-17(d)(3) evaluation, the reporting entity should not conclude that operating losses incurred by the entity would, by themselves, cause it to fail to qualify for the scope exception (if it did qualify in previous periods). That is, losses that have reduced the entity’s equity such that, on a fair value basis, the reporting entity now provides more than half the subordinated financial support do not cause a reporting entity to no longer be able to apply the business scope exception. This view is supported by ASC 810-10-35-4, which states:
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. [Emphasis added]

Example 1
Enterprise A and Enterprise B, two unrelated parties, form a joint venture, Entity C. The two venturers contribute an equal amount of equity and have joint control of the entity. Entity C sells all of its manufactured product to an unrelated third party. At inception, C is determined to be a business under ASC 805 and neither C nor A or B meet any of the four conditions in ASC 810-10-15-17(d). Therefore, both A and B rely on the ASC 810-10-15-17(d) scope exception. Subsequently, C loses its customer and no longer sells to an unrelated third party. Enterprise A enters into a contract to purchase the entire output of the entity. Therefore, A now meets the condition in ASC 810-10-1517(d)(2) that “the legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity.” As of the date this condition is met, A must apply the VIE model in ASC 810-10 to C. Note that because B still does not meet any of the conditions in ASC 810-10-15-17(d), it can still rely on the scope exception.

Example 2
Assume the same facts as in Example 1 except that A also loans C an additional amount to fund the venture. The loan has a bullet maturity of 20 years. Because A has provided more than half the total equity and financial support to C, A meets the condition in ASC 810-10-15-17(d)(3) and thus must apply the VIE model in ASC 810-10 to C. Five years after the inception of the entity, C determines that its cash flows have exceeded original expectations and decides to repay A the entire principal on the debt. This event changes the design of the entity (i.e., the design was to pay off the debt after 20 years). As of that date, A may qualify for the scope exception because the condition in ASC 810-10-15-17(d)(3) no longer applies — the remaining variable interests are two 50-50 equity interests from A
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and B. On a fair value basis as of the reconsideration date, the reporting entity (A) is no longer providing more than half the total equity and financial support.

1.24 Definition of a Joint Venture and Joint Control as Used in the VIE Model in ASC 810-10-15-17(d)(1)
Question
What are the definitions of “joint venture” and “joint control,” as used in ASC 810-10-15-17(d)(1)?

Answer
Because authoritative accounting literature provides little guidance on the definition of a joint venture or joint control, a reporting entity must determine whether an entity is a joint venture under joint control on the basis of facts and circumstances. The most significant distinguishing characteristic of a joint venture from other forms of entity is the owners’ joint control over the significant operating decisions of an entity. Below are several references in authoritative accounting literature to joint venture arrangements and joint control, which a reporting entity should consider in analyzing whether an entity is a joint venture. The Codification Master Glossary defines a corporate joint venture as:
A corporation owned and operated by a small group of entities (the joint venturers) as a separate and specific business or project for the mutual benefit of the members of the group. A government may also be a member of the group. The purpose of a corporate joint venture frequently is to share risks and rewards in developing a new market, product or technology; to combine complementary technological knowledge; or to pool resources in developing production or other facilities. A corporate joint venture also usually provides an arrangement under which each joint venturer may participate, directly or indirectly, in the overall management of the joint venture. Joint venturers thus have an interest or relationship other than as passive investors. An entity that is a subsidiary of one of the joint venturers is not a corporate joint venture. The ownership of a corporate joint venture seldom changes, and its stock is usually not traded publicly. A noncontrolling interest held by public ownership, however, does not preclude a corporation from being a corporate joint venture.

In a speech at the 1993 AICPA National Conference on Current SEC Developments, a professional accounting fellow discussed certain indicators of whether any of the joint venturers individually control an entity. The speech stated, in part:
An agreement between the venturers that requires consent of both venture parties for typical corporate actions generally indicates that control is not present as to either venturer. If the majority holder cannot order the sale of assets in the ordinary course of business without the consent of its joint venture partner, the staff believes control is not present. However, if the joint venture agreement requires the consent of both parties only in the case of a disposition of substantially all assets (an action that is clearly not in the ordinary course of business), the staff would not conclude that provision would negate the other aspects of control.

Further, the AcSEC indicated in its advisory conclusion in the July 17, 1979, Issues Paper Joint Venture Accounting that the element of “joint control” of major decisions should be the central distinguishing characteristic of a joint venture. The Committee also recommended that the definition from Section 3055 of the CICA Handbook should be adopted in substance as the definition of a joint venture. This definition states:
A joint venture is an arrangement whereby two or more parties (the venturers) jointly control a specific business undertaking and contribute resources towards its accomplishment. The life of the joint venture is limited to that of the undertaking which may be of short or long-term duration depending on the circumstances. A distinctive feature of a joint venture is that the relationship between the venturers is governed by an agreement (usually in writing) which establishes joint control. Decisions in all areas essential to the accomplishment of a joint venture require the consent of the venturers, as provided by the agreement; none of the individual venturers is in a position to unilaterally control the venture. This feature of joint control distinguishes investments in joint ventures from investments in other enterprises where control of decisions is related to the proportion of voting interest held.

While not considered to constitute GAAP, the G4+1 Organization Special Report Reporting Interests in Joint Ventures and Similar Arrangements may be helpful in the determination of joint control. Paragraph 2.14 of the Special Report states:
Joint control — Joint control over an enterprise exists when no one party alone has the power to control its strategic operating, investing, and financing decisions, but two or more parties together can do so, and each of the parties sharing control (joint venturers) must consent.
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1.25 Determining Whether the Reporting Entity Participated Significantly in the Design or Redesign of the Legal Entity
ASC 810-10-15-17(d) exempts reporting entities from evaluating whether a legal entity deemed to meet the definition of a business in ASC 805 is a VIE (i.e., such an entity would be outside the scope of the VIE model in ASC 810-10), unless one or more of several conditions are met. The condition in ASC 810-10-15-17(d)(1) is that the “reporting entity, its related parties . . ., or both participated significantly in the design or redesign of the legal entity.”

Question
How does a reporting entity determine whether it “participated significantly in the design or redesign of the legal entity”?

Answer
In determining whether it participated significantly in the design or redesign of the legal entity, the reporting entity must consider all relevant facts and circumstances. The following are situations (not all-inclusive) in which the reporting entity would be presumed to have participated significantly in the design or redesign of the legal entity: • The reporting entity’s interest in the legal entity was obtained at the inception of the legal entity or shortly thereafter. This presumption may be overcome in certain circumstances, such as when the interest is not significant to the legal entity. However, if the lack of participation by a reporting entity would have prevented the creation of the legal entity, that reporting entity always will be deemed to have participated significantly in the design of the legal entity. The reporting entity was involved in the execution of the legal entity’s initial or amended governing documents or contractual arrangements (if the amendment to the governing documents or contractual arrangements effectively redesigns the legal entity). The legal entity was initially formed, or subsequently restructured, by others on behalf of the reporting entity or its related parties. The reporting entity participated significantly (or, via protective or participating rights, had the opportunity to participate regardless of whether these rights were exercised) in significant changes to the legal entity’s operations.

• •

Example 1
Entity 1 is a corporation formed with investments by two equity holders and an unrelated debt holder. All of the enterprises were involved in determining the amount of equity and debt financing necessary to fund the entity. The equity holders and the debt holder would be deemed to have participated significantly in the design of Entity 1 because all parties were involved in the entity’s design (i.e., the funding requirements of the entity) and in executing the contractual arrangements that established the design.

Example 2
Entity 2 is a real estate partnership that entered into a service contract with Enterprise D, a developer, concurrently with Entity 2’s formation. The service contract is determined to be a variable interest. According to the terms of the service contract, Enterprise D will construct and manage a majority of Entity 2’s assets, and has advised Entity 2 about the type of assets to construct for its operations. Because the service contract is negotiated and executed concurrently with the formation of Entity 2 and allows Enterprise D to significantly influence its activities, Enterprise D would be deemed to have participated significantly in the entity’s design.

1.26 Scope Exception for Legal Entities Deemed to Be a Business — Determining Whether Substantially All of the Activities Either Involve or Are Conducted on Behalf of the Reporting Entity
ASC 810-10-15-17(d) exempts reporting entities from evaluating whether a legal entity deemed to be a business as defined in ASC 805 is a VIE (i.e., such an entity would be outside the scope of the VIE model in ASC 810-10), unless one or more of several conditions are met. The condition in ASC 810-10-15-17(d)(2) is that 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.”3
3

In this analysis, the term “related parties” would apply to those parties identified in ASC 810-10-25-43, except for de facto agents, as described in ASC 810-10-25-43(d).
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Question
How does a reporting entity determine whether substantially all of a legal entity’s activities either involve or are conducted on behalf of the reporting entity and its related parties?

Answer
This determination should be based on the design of the legal entity and should compare the nature and extent of the activities between the reporting entity and the legal entity with the entire set of the legal entity’s activities. Generally, if 90 percent or more of the legal entity’s activities are conducted on behalf of a reporting entity and its related parties, it is presumed to be “substantially all” of the legal entity’s activities. However, less than 90 percent is not a safe harbor. The evaluation should not necessarily be based on the reporting entity’s economic interest. However, a significant economic interest may indicate that substantially all of the legal entity’s activities either involve, or are conducted on behalf of, the reporting entity and its related parties. The following conditions may indicate (depending on relative significance) that substantially all of an entity’s activities are conducted on behalf of a reporting entity and its related-party group: • • • • • • • The reporting entity has entered into an agreement to purchase the output of the legal entity. The legal entity purchases the inputs for its products, services, or both from the reporting entity, and the activities of the legal entity are an extension of the reporting entity’s activities. The legal entity acts as a reseller of the reporting entity’s finished products or services. The legal entity was designed or redesigned to provide goods, services, or both exclusively to the reporting entity’s customers. The legal entity’s assets are leased to or from the reporting entity. The legal entity depends on the reporting entity when conducting its ongoing business activities (without a similar level of dependency on other parties). The legal entity enters into an outsourcing or tolling arrangement in which the reporting entity agrees to (1) provide raw materials, other inputs, or both, and (2) purchase all of the related finished product from the legal entity. The legal entity enters into a TSA in which the reporting entity provides the legal entity with a variety of technical, consulting, and administrative services. The legal entity is dedicated to developing pharmaceutical, biotech, software, or other in-process technology, and the reporting entity has rights to the resulting product. The reporting entity holds options or other securities to acquire the other investors’ interests in the legal entity. The other investors in the legal entity hold options or other securities that allow them to put their interests to the reporting entity. The reporting entity is obligated to provide additional funding when operating losses occur, current funding is insufficient, or both. The economics of the legal entity are designed or redesigned to be heavily weighted toward the reporting entity. The reporting entity’s employees act as management for the legal entity. The legal entity’s employees receive incentive compensation that depends on the financial results of the reporting entity.

• • • • • • • •

Note that these conditions are also important to the determination of whether an entity is a VIE under ASC 81010-15-14(c). See Q&A 3.40 for additional examples.

Example 1
Enterprise A owns an equity interest in Entity B, a public utility company that meets the definition of a business in ASC 805. Entity B provides electricity to unrelated third parties. There are no other interests or agreements between A and B. Because B conducts activities (i.e., producing electricity) on behalf of third-party customers, it does not

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conduct its activities on behalf of A. Therefore, substantially all of B’s activities neither involve nor are conducted on behalf of A. However, A would still need to determine whether the other conditions in ASC 810-10-15-17(d) are met. Conversely, assume that A enters into a long-term PPA for 100 percent of B’s output and that this arrangement does not constitute a lease under ASC 840. In this case, A would not be able to apply the business scope exception because substantially all of B’s activities are conducted on A’s behalf.

Example 2
Entity G is created solely to lease diagnostic equipment to hospitals. Enterprise H owns several hospitals and enters into an agreement to exclusively lease its diagnostic equipment from G. This arrangement represents 40 percent of G’s total leasing activities. Assume that there are no other arrangements between G and H and that G is a business as defined in ASC 805. Although H leases 100 percent of its diagnostic equipment from G, the exclusive leasing arrangement does not, in itself, represent substantially all of G’s activities because G conducts the remaining 60 percent of its leasing activities with unrelated parties.

Example 3
A joint venture entity (Entity C) is formed by two unrelated parties, Enterprises A and B. Each investor has a 50 percent equity interest. Entity C’s activities consist solely of purchasing a product from A and selling and distributing it to third-party customers. Because of its current design, C represents another distribution or sales channel for A’s merchandise. Entity C appears to be an extension of A’s business because it is so closely aligned in appearance and purpose. Therefore, substantially all of C’s activities either involve or are conducted on A’s behalf.

Example 4
A joint venture entity (Entity C) is formed by two unrelated parties, Enterprises A and B. Each investor has a 50 percent equity interest in C. Entity C has contracted to purchase all of its raw materials from A. Entity C uses these raw materials to manufacture finished goods to sell to third-party customers. In this example, C (unlike C in Example 3) does not appear to be an extension of A’s business, even though A provides all C’s raw materials. Thus, C has not been designed so that substantially all of its activities either would involve or would be conducted on A’s behalf. See also Q&A 2.18, which addresses off-market supply agreements.

Example 5
An investment hedge fund is established by a 99 percent LP and a 1 percent GP. The fund has no other activities, and profits and losses are allocated according to ownership interests. In this scenario, the only activity of the fund is to invest its money and to provide returns to the GP and LP. As currently designed, the fund’s activities, as well as its economics, are heavily weighted toward the LP. Therefore, substantially all of the fund’s activities involve or are conducted on behalf of the LP.

1.27 Scope Exception for an Entity Deemed to Be a Business — Determining Whether Financing Is Subordinated
ASC 810-10-15-17(d) exempts reporting entities from evaluating whether a legal entity deemed to meet the definition of a business in ASC 805 is a VIE (i.e., such an entity would be outside the scope of the VIE model in ASC 810-10), unless one or more of several conditions are met. The condition in ASC 810-10-15-17(d)(3) is that 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.”

Question
How should a reporting entity interpret the term “subordinated,” as used in ASC 810-10-15-17(d)(3)?

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Answer
In general, all forms of financing are “subordinated financial support” unless the financing is the most senior class of liabilities and is considered “investment-grade.” Standard & Poor’s and Moody’s categorize investment-grade debt as that rated BBB or higher and Baa or higher, respectively. If the debt is not rated, it should be considered investment-grade only if it possesses characteristics that warrant such a rating. Evaluating whether a nonrated instrument possesses the same characteristics to be considered investment-grade requires careful consideration. ASC 810-10-20 defines subordinated financial support as variable interests that will absorb some or all of an entity’s expected losses. The determination that non-investment-grade debt is subordinated is based on the view that the debt holder is exposed to a more than remote chance of experiencing a credit loss. Therefore, unless the financing is investment-grade or, if the debt is not rated, possesses the same characteristics as investment-grade debt, the financing should be considered subordinated. This conclusion is consistent with ASC 810-10-55-23, which states, in part, “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)” (emphasis added).

Example
Two unrelated parties, Enterprise A and Enterprise B, form a joint venture, Entity C, that meets the definition of a business in ASC 805. Enterprises A and B each contribute equity with a fair value of $20 and share equally in all voting matters. In addition, A lends $10 to C. The fair value of the loan is $10 and it is not considered investmentgrade. Enterprise A has provided support with a fair value of $30 ($20 in equity and $10 in debt), which is more than half the total support of C ($50). Therefore, A cannot apply the business scope exception. However, if none of the conditions in ASC 810-10-15-17(d)(1), 15-17(d)(2), or 15-17(d)(4) are met, B can apply the business scope exception because it does not provide more than half the financial support.

1.28

Additional Financial Support — Put and Call Options

ASC 810-10-15-17(d) exempts reporting entities from evaluating whether a legal entity deemed to be a business as defined in ASC 805 is a VIE (i.e., such an entity would be outside the scope of the VIE model in ASC 810-10), unless one or more of several conditions are met. The condition in ASC 810-10-15-17(d)(3) is that 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” (emphasis added). ASC 810-10-20 defines subordinated financial support as follows:
Variable interests that will absorb some or all of a [VIE’s] expected losses.

Question
What impact does a put or call option between joint venture partners have on whether a reporting entity meets the condition in ASC 810-10-15-17(d)(3) and, therefore, on whether it can apply the business scope exception?

Answer
The following two examples answer this question from the perspective of a put option (Example 1) and a call option (Example 2).

Example 1 (Put Option)
Investor A and Investor B form Entity X with equal contributions of equity. Investor B purchases a put option from A that permits it to put its interest in X to A at a fixed price. Investor A 50% Owned Entity X Fixed-Price Put Option Investor B 50% Owned

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The fair value of the fixed-price put option should be considered additional subordinated financial support provided by A to X because A will absorb expected losses of X upon exercise of that put option (i.e., it meets the definition of subordinated financial support in ASC 810-10-20). Therefore, A would consider the fair value of the fixed-price put option (presumably the price paid) in determining whether the condition in ASC 810-10-15-17(d)(3) is met. If the fair value of the put option is greater than zero, A would not meet the condition in ASC 810-10-1517(d)(3) and therefore would not be able to use the “business scope exception,” since the fair value of the equity provided by A and the fair value of the put option written by A would constitute more than half the total of the equity, subordinated debt, and other forms of subordinated financial support to the entity. This answer suggests that a fixed-price put option between parties related to the entity would cause B’s investment to be deemed not at risk (see Q&A 3.10 for further discussion of the impact of put options on the determination of equity investments at risk).

Example 2 (Call Option)
Investor A and Investor B form Entity X with equal contributions of equity. Investor A purchases a call option from B that permits it to call B’s interest at a fixed price (the call option’s strike price is at or above the fair value of the equity interest at inception of the option). Investor A 50% Owned Entity X The fair value of the fixed-price call option should not be considered additional subordinated financial support to X because A will not absorb expected losses of X upon exercise of that call option (i.e., the option does not meet the definition of subordinated financial support in ASC 810-10-20). Investor A can exercise its call and obtain additional residual returns of X, but the call option does not expose it to additional expected losses. Therefore, A would not consider the fair value of the fixed-price call option in determining whether it meets the condition in ASC 81010-15-17(d)(3). Investors A and B would meet the condition in ASC 810-10-15-17(d)(3), since the fair value of the equity provided by each investor would not constitute more than half the total of the equity, subordinated debt, and other forms of subordinated financial support to the entity. To use the business scope exception, A and B must determine whether the other conditions in ASC 810-10-15-17(d) are met. This answer suggests that a call option between parties related to the entity would generally not disqualify B’s investment from being deemed at risk (see Q&A 3.10 for further discussion of the impact of call options on the determination of equity investments at risk). Fixed-Price Purchased Call Option Investor B 50% Owned

1.29 Business Scope Exception — Determining Whether More Than Half the Total of Equity, Debt, and Other Subordinated Financial Support Has Been Provided
Question
Under ASC 810-10-15-17(d)(3), a reporting entity must identify all forms of subordinated financial support it provides to the entity (see Q&A 1.27 for how to determine whether the financing is subordinated). What should a reporting entity consider in determining whether it has provided more than half the equity, debt, and other forms of subordinated financial support to an entity?

Answer
The reporting entity should aggregate the fair value of the total equity, subordinated debt, and other forms of subordinated financial support it provides to the entity. If that amount is greater than half the fair value of the total equity, subordinated debt, and other forms of subordinated financial support of the entity, the reporting entity would meet the condition in ASC 810-10-15-17(d)(3) and therefore would not be able to use the “business scope exception.” ASC 810-10-20 defines subordinated financial support as “[v]ariable interests that will absorb some or all of a [VIE’s] expected losses.” Therefore, a reporting entity must consider whether any variable interests it holds (in addition to equity or subordinated debt) constitute additional subordinated financial support. Many of the examples of variable interests cited in Table 1 of Q&A 2.01 (such as certain guarantees, put options, and
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agreements to provide services to the entity) will be considered a form of subordinated financial support if they absorb some or all of the expected losses of the entity. See Q&A 1.27 for guidance on determining whether financing is “subordinated financial support.”

Example
Company A contributes $5 million cash in exchange for 50 percent of the equity of Entity X. Other equity holders contribute $3 million in cash to the entity in exchange for the remaining 50 percent of the equity in X, and X raises additional funds via a $2 million note payable to a financial institution that is considered additional subordinated financial support. Company A provides the financial institution with a guarantee of the note payable. The guarantee absorbs expected losses of the entity and is therefore also considered to be additional subordinated financial support. The fair value of the guarantee is determined to be $1 million. Since the aggregate fair value of A’s equity and the guarantee ($6 million) is more than half of the total equity, debt, and other forms of subordinated financial support of X ($11 million), A would not be able to avail itself of the ASC 810-10-15-17(d) scope exception. See Q&A 1.28 for information about how puts and calls between variable interest holders in a VIE should be considered in the evaluation of whether a reporting entity has provided more than half the equity, debt, and other forms of subordinated financial support to a VIE.

1.30 Lessee’s Determination of Whether a Capital Lease With an Entity Should Be Assessed Under the VIE Model in ASC 810-10
Question
A lessor entity holds a single asset that it leases to a reporting entity. The lease contains a residual value guarantee and a purchase option. The lessee reporting entity accounts for the lease as a capital lease. Is the lessee reporting entity required to determine whether its lease is a variable interest subject to ASC 810-10 even though the capital lease asset is already recorded on the reporting entity’s balance sheet?

Answer
Yes. While the accounting treatment of a capital lease under ASC 840 may be similar to consolidation of the asset and related debt obligation under the VIE model in ASC 810-10, a holder of a variable interest must evaluate its interest in the VIE unless it meets a scope exception in either ASC 810-10-15-12 or ASC 810-10-15-17.

1.31

Consideration of Leasing Activities in Which the Legal Entity Is the Lessor

ASC 810-10-15-17(d) exempts reporting entities from evaluating whether a legal entity that meets the definition of a business in ASC 805 is a VIE (i.e., such an entity would be outside the scope of the VIE model in ASC 810-10), unless one or more of several conditions are met. The condition in ASC 810-10-15-17(d)(4) is that the “activities of the legal entity are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements.” The primary purpose of this condition is to ensure that entities that were previously (i.e., before the VIE model in ASC 810-10) considered SPEs are evaluated under the VIE model in ASC 810-10.

Question
Should an entity that is designed to lease equipment or other assets to one or more reporting entities as part of its ongoing operations apply the business scope exception?

Answer
It depends. Whether an entity meets the condition in ASC 810-10-15-17(d)(4) depends on whether the primary activity of the entity is leasing to a single lessee. This evaluation is based on various qualitative and quantitative factors, including why the entity was created, the terms of the lease contracts the entity has entered into, the significance of the entity’s cash flows derived from leasing activities compared with its other activities, and the significance of the assets being leased compared with the entity’s other assets. For entities whose primary activity is leasing, the next step is to determine whether the assets or group of assets is being leased by a single lessee. In making this determination, a reporting entity should look to the substance of the arrangement. For example, although governing documents may permit the leasing of assets of the entity to more than one party, the reporting entity should consider the intent of the entity and the actual leasing arrangements. The leasing of assets to multiple parties that are all part of a related-party group would generally be equivalent to leasing assets to a single lessee.
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Example 1
Entity A is designed to lease medical equipment to various hospitals and meets the definition of a business in ASC 805. About 60 percent of A’s leasing activities are conducted with Enterprise B, an equity investor that owns various hospitals; the remaining 40 percent are conducted with unrelated third-party customers. There are no other arrangements between B and A. In this example, although A’s primary activity is leasing, A was designed to lease its equipment (and is actually leasing its equipment) to B as well as to unrelated third-party customers. Therefore, A would not meet the condition in ASC 810-10-15-17(d)(4) and should apply the business scope exception, provided that none of the other conditions in ASC 810-10-15-17(d) are met.

Example 2
Enterprise B obtains 100 percent of the equity in Entity A in exchange for a building. At the same time, B leases the building from A. In this example, A meets the condition in ASC 810-10-15-17(d)(4) and B cannot apply the business scope exception because this transaction is considered a single-lessee leasing arrangement.

Example 3
Entity A leases construction equipment to unrelated third parties, which represents 30 percent of A’s cash flows. Entity A’s remaining business activities do not involve leasing, securitizations, or asset-backed financings. Enterprise B enters into a contract in which it will lease several pieces of construction equipment from A. Once executed, the lease contract will represent all the cash flows from A’s leasing business. There are no other arrangements between A and B. Although the cash flows from the lease contract represent all of A’s leasing business, A was not specifically designed to enter into single-lessee leasing arrangements. In addition, A’s activities are not primarily related to either leasing or asset-backed financings, as demonstrated by its significant business activities with parties other than B. Therefore, A does not meet the condition in ASC 810-10-15-17(d)(4) and B should apply the business scope exception, provided that none of the other conditions in ASC 810-10-15-17(d) are met.

Example 4
Entity A owns 10 office buildings. It leases each of these buildings to a different enterprise that is either partially or wholly owned by the same parent, Enterprise X. The governing documents of A do not restrict it from entering into lease contracts with parties other than X and its related-party group, and A was not designed solely to lease office buildings to X. However, even though A’s governing documents allow it to enter into lease contracts with parties outside of X and its related-party group, the actual activities of A involve leasing the office buildings to a single related-party group. The individual lease contracts should be viewed as a single-lessee leasing arrangement because all of the lessees of A’s assets are part of a single related-party group. Therefore, A meets the condition in ASC 810-10-15-17(d)(4) and cannot apply the business scope exception.

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Section 2 — Determination of Whether the Reporting Entity Holds a Variable Interest
ASC 810-10-20
Variable Interests The investments or other interests that will absorb portions of a variable interest entity’s (VIE’s) expected losses or receive portions of the entity’s expected residual returns are called variable interests. [Paragraph 6] 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 VIE’s 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. [Paragraph 2]

ASC 810-10
55-17 The identification of variable interests requires an economic analysis of the rights and obligations of a legal entity’s assets, liabilities, equity, and other contracts. Variable interests are contractual, ownership, or other pecuniary interests in a legal entity that change with changes in the fair value of the legal entity’s net assets exclusive of variable interests. The Variable Interest Entities Subsections use the terms expected losses and expected residual returns to describe the expected variability in the fair value of a legal entity’s net assets exclusive of variable interests. [Paragraph B2] 55-18 For a legal entity that is not a VIE (sometimes called a voting interest entity), all of the legal entity’s assets, liabilities, and other contracts are deemed to create variability, and the equity investment is deemed to be sufficient to absorb the expected amount of that variability. In contrast, VIEs are designed so that some of the entity’s assets, liabilities, and other contracts create variability and some of the entity’s assets, liabilities, and other contracts (as well as its equity at risk) absorb or receive that variability. [Paragraph B3] 55-19 The identification of variable interests involves determining which assets, liabilities, or contracts create the legal entity’s variability and which assets, liabilities, equity, and other contracts absorb or receive that variability. The latter are the legal entity’s variable interests. The labeling of an item as an asset, liability, equity, or as a contractual arrangement does not determine whether that item is a variable interest. It is the role of the item—to absorb or receive the legal entity’s variability—that distinguishes a variable interest. That role, in turn, often depends on the design of the legal entity. [Paragraph B4]

Identifying a Variable Interest 2.01 Determining Whether a Holding Is a Variable Interest

ASC 810-10-20 defines variable interests in a VIE, in part, as “contractual, ownership, or other pecuniary interests in a VIE that change with changes in the fair value of the VIE’s net assets exclusive of variable interests.” (For more information about the meaning of the term “net assets” under the VIE model in ASC 810-10, see Q&A 4.02.) In addition, ASC 810-10-55-19 states that variable interests absorb or receive the expected variability created by assets, liabilities, or contracts of a VIE that are not, themselves, variable interests. Generally, assets and operations of an entity create its variability while its liabilities and equity interests absorb that variability. Other contracts or arrangements entered into by the entity may appear both to create and to absorb variability (e.g., interest rate swaps) because they can be assets or liabilities depending on prevailing market conditions. In addition, a contract or arrangement may absorb many different types of risks (e.g., credit risk, interest rate risk, and foreign currency exchange risk).

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Question
What are some examples of interests that generally would or would not be considered variable interests?

Answer
Table 1 and Table 2 below indicate when an interest held by a reporting entity generally would or would not, respectively, be considered a variable interest pursuant to the VIE model in ASC 810-10. Determining whether a reporting entity’s interest in another entity is a variable interest is only one step in applying this model. In the following situations, for example, holders of certain types of variable interests may be exempt from the VIE model’s consolidation requirements or may require special treatment: • • A reporting entity, or the entity in which it has an interest, may qualify for one of the scope exceptions in ASC 810-10-15-12 or ASC 810-10-15-17. A reporting entity’s variable interest in specified assets of a VIE may not be considered a variable interest in that entity (as described in ASC 810-10-25-55 and 25-56). However, a reporting entity’s variable interest in specified assets of a VIE may need to be “siloed,” as described in ASC 810-10-25-57.

Determining whether an interest holder has a variable interest in an entity requires an economic analysis of the associated rights and obligations (such as the two-step analysis in Q&A 2.02). The principle behind this analysis is that variable interests absorb or receive portions of a VIE’s variability in results. For a hybrid instrument (see ASC 815-15-25-1), the host instrument and the embedded feature should be evaluated separately if the embedded feature is not clearly and closely related (see ASC 815-15-25-26 through 25-29) to the host (see Q&A 2.21 for further discussion). ASC 810-10-25-22 discusses the “by-design” approach to determining which variability to consider in the evaluation of whether an interest is a variable interest (i.e., an interest that absorbs variability in the entity). Therefore, the determination of whether a particular interest is a variable interest will be affected by which variability is considered in performing the analysis. The by-design approach requires analysis of (1) the entity’s design, including the nature of the risks in the entity; (2) why the entity was created; and (3) the variability that the entity is designed to create and pass along to its interest holders. In performing this analysis, a reporting entity should review in detail the terms of the contracts that the entity has entered into, including the original formation documents, governing documents, marketing materials, and other contractual arrangements entered into by the entity and provided to potential investors or other parties associated with the entity. ASC 810-10-55-55 through 55-86 provide additional guidance, including indicators and examples, to help reporting entities apply this approach. Table 1 below lists examples (not all-inclusive) of financial instruments and other contracts with an entity that generally would be considered variable interests in that entity. For purposes of this table, remember that the determination of whether a particular interest is a variable interest depends on the design of the entity and the role of that interest. Also note that “entity” means the potential VIE in which the reporting entity holds an interest.
Table 1 — Examples of Variable Interests Financial Instruments or Other Contracts Trade accounts payable. Comments Generally, liabilities of an entity do represent variable interests in the entity. However, trade accounts payable that are short-term, fixed in amount, not junior to any other liability, and not concentrated with a small number of vendors generally should not be treated as a variable interest in the entity because such types of trade accounts payable are routine and have little variability. A trade accounts payable that does not fit this description may be a variable interest in the entity. A debt holder’s interest absorbs the variability in the value of an entity’s assets because the debt holder is exposed to that entity’s ability to pay (i.e., credit risk) and may be exposed to interest rate risk, depending on the design of the entity. If the equity interest is equity investment at risk pursuant to ASC 810-10-15-14(a), it is a variable interest that absorbs the variability associated with changes in the entity’s NAV. If the equity interest is not at risk pursuant to ASC 810-10-15-14(a), it is usually a variable interest if it exposes the equity owner to the VIE’s variability.

Long-term liabilities of an entity (e.g., fixed-rate debt, floating-rate debt, mandatorily redeemable preferred stock). Equity of an entity (e.g., mezzanine equity, preferred stock, common stock, partnership capital).

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Table 1 — Examples of Variable Interests (continued) Financial Instruments or Other Contracts Guarantees held by an entity.* Comments The guarantee agreement transfers all or a portion of the risk of specified assets (or liabilities) of the entity to the guarantor, resulting in the guarantor’s absorbing the variability in values of those specified assets (or liabilities). See ASC 810-10-25-21 through 25-36 for more information. For a discussion of implicit variable interests, see Q&As 2.12 and 2.13. Same as guarantees held by an entity. The put option writer is exposed to the variability in the values of the assets held by the entity. However, whether a derivative or a contract with the characteristics of a derivative is a variable interest in an entity depends on the design of the entity and the characteristics of that instrument. See ASC 810-10-25-21 through 25-36 for more information. The holder of such a stand-alone call option absorbs positive variability in the value of the specified assets under that call option agreement in scenarios in which the call option would be exercised. However, whether a derivative or a contract with the characteristics of a derivative is a variable interest in an entity depends on the design of the entity and the characteristics of that instrument. See ASC 810-10-25-21 through 25-36 for more information. The counterparty to the forward contract absorbs variability in the fair value of the entity’s specified assets underlying the forward contract. However, whether a derivative or a contract with the characteristics of a derivative is a variable interest in an entity depends on the design of the entity and the characteristics of that instrument. See ASC 810-10-25-21 through 25-36 for more information. The total return swap transfers all or a portion of the risk of specified assets (or liabilities) of the entity to the swap counterparty, resulting in the counterparty absorbing the variability created by those specified assets (or liabilities). Whether a derivative is a variable interest in an entity depends on the design of the entity and the characteristics of that instrument. ASC 810-10-25-21 through 25-36 provide additional guidance on determining whether other derivatives are variable interests. These fees would be considered variable interests if they fail to meet one or more of the six conditions in ASC 810-10-55-37 through 37A. These fees would be considered variable interests if they fail to meet one or more of the six conditions in ASC 810-10-55-37 through 37A. These contracts transfer all or a portion of the risk of specified assets of the entity to the guarantor, resulting in the guarantor absorbing the variability of those specified assets. Because the embedded guarantee and purchase option are not clearly and closely related to the cash flows of the operating lease, the operating lease (i.e., the host contract) and the embedded items should be evaluated separately. The embedded items result in a variable interest,* as explained above. However, the host contract, an economic equivalent of an account receivable, creates variability for the entity and therefore is not a variable interest. See Q&A 2.13 for a discussion of an implicit variable interest. An operating or capital lease represents an economic liability of the lessee entity (the potential VIE). That is, the lessor is exposed to the lessee entity’s ability to pay under the terms of the agreement; therefore, a lessor’s interest in a lease generally is a variable interest in the lessee entity. See Q&A 2.04 for more information. For supply agreements designed to reimburse all or a portion of actual costs incurred, the counterparty to the supply agreement absorbs variability in the entity. Investors in the entity are partially protected from absorbing losses because the counterparty is reimbursing the entity for actual costs incurred.

Put options held by an entity and similar arrangements on specified assets owned by the entity.*

Stand-alone call options written by an entity on specified assets owned by that entity.*

Fixed-price forward contracts to sell specified assets owned by an entity.*

Total return swaps on specified assets owned by an entity.* Other derivatives.

Fees paid to a decision maker. Fees paid to a service provider. Stand-alone residual value guarantees of an entity’s leased assets, written call options covering such leased assets, or both.* Operating leases (in which the entity is the lessor) with an embedded residual value guarantee, a non-fair-value-based purchase option (a lessee call option), or both.*

Operating leases (in which the entity is the lessee).

Supply agreements with a variable cost component (when the entity is the supplier/seller).

* ASC 810-10-25-55 and 25-56 indicate that variable interests in a specified asset whose value is less than half of the total fair value of a VIE’s assets are not considered variable interests in that entity.

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Table 2 below lists examples (not all-inclusive) of financial instruments and other contracts with an entity that generally would not be considered variable interests in that entity. As in Table 1, note that determining whether a particular interest is a variable interest depends on the design of the entity and the role of that interest. Also note that “entity” means the potential VIE in which the reporting entity holds an interest.
Table 2 — Examples of Nonvariable Interests Financial Instruments or Other Contracts Assets of an entity. Comments Assets typically are the major source of an entity’s variability and are therefore not considered variable interests. However, see Table 1 for purchased guarantees, put options, and similar items that may be assets but are considered variable interests in the entity or in specified assets pursuant to ASC 810-10-25-55 and 25-56. When the entity writes (sells) an option, a guarantee, or a similar contract, those contracts normally create variability (e.g., an entity writes a put option on an asset owned by another party). Therefore, they are normally nonvariable interests to the counterparty, except for stand-alone call options written by an entity on specified assets owned by that entity, as discussed in Table 1. Whether a derivative is a variable interest in an entity depends on the design of the entity and the characteristics of that instrument. ASC 810-10-25-21 through 25-36 provide additional guidance on determining whether other derivatives are variable interests. Typically, forward contracts that relate to assets the entity does not own create variability because they expose the entity to changes in the fair value of the assets underlying the forward purchase or sale contracts. The operating lease is the economic equivalent of an account receivable; therefore, it exposes the entity to variability (e.g., lessee performance). See Q&A 2.03 for more information.

Options, guarantees, and similar financial instruments or contracts written by an entity.

Other derivatives.

Fixed-price forward contracts to purchase assets not owned by an entity, fixed-price contracts to sell assets not owned by an entity. Operating leases in which an entity is the lessor, in the absence of a residual value guarantee, a non-fair-value-based purchase option (i.e., a lessee call option), or other similar provisions.

2.02 Identifying Whether a Reporting Entity Holds a Variable Interest Requiring Analysis Under the VIE Model in ASC 810-10
The VIE model in ASC 810-10 indicates that the investments or other interests that are variable interests will absorb or receive portions of a VIE’s variability. ASC 810-10-55-19 explains that the identification of a variable interest involves determining which assets, liabilities, or contracts create the entity’s variability and which assets, liabilities, or contracts absorb or receive the entity’s variability. The latter are the entity’s variable interests. ASC 810-10-55-17 states, in part:
The identification of variable interests requires an economic analysis of the rights and obligations of a legal entity’s assets, liabilities, equity, and other contracts. Variable interests are contractual, ownership, or other pecuniary interests in a legal entity that change with changes in the fair value of the legal entity’s net assets exclusive of variable interests.

Generally, assets and operations of an entity create its variability, while its liabilities and equity interests absorb that variability. Other contracts or arrangements entered into by the entity may appear both to create and to absorb variability (e.g., interest rate swaps) because they can be assets or liabilities depending on prevailing market conditions. In addition, a contract or arrangement may absorb many different types of risks (e.g., credit risk, interest rate risk, foreign currency exchange risk). ASC 810-10-25-22 discusses the “by-design” approach to determining which variability to consider in the evaluation of whether an interest is a variable interest (i.e., an interest that absorbs variability in the entity). Therefore, the determination of whether a particular interest is a variable interest will be affected by which variability is considered in performing the analysis. The by-design approach requires analysis of (1) the entity’s design, including the nature of the risks in the entity; (2) why the entity was created; and (3) the variability that the entity is designed to create and pass along to its interest holders. In performing this analysis, a reporting entity should review in detail the terms of the contracts that the entity has entered into, including the original formation documents, governing documents, marketing materials, and other contractual arrangements entered into by the entity and provided to potential investors or other parties associated with the entity. ASC 810-10-55-55 through 55-86 provide additional guidance, including indicators and examples, to help reporting entities apply this approach.
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Question
What steps should a reporting entity perform to determine whether it (1) holds a variable interest in an entity and (2) needs, therefore, to evaluate whether it is the “primary beneficiary” of a VIE under ASC 810-10-25-38A?

Answer
A holder of a variable interest must evaluate its interest in an entity under the VIE model in ASC 810-10 unless it meets one of the scope exceptions in ASC 810-10-15-12 or ASC 810-10-15-17. The following steps can help a reporting entity that holds an interest (this interest can take many forms, including a financial instrument or other contract) in an entity determine whether that interest is a variable interest. Note that under certain circumstances, it may be apparent that the entity is not a VIE. In such cases, the reporting entity need not determine whether it holds a variable interest. Step 1: Does the entity or reporting entity qualify for one of the scope exceptions in ASC 810-10-15-12 or ASC 810-10-15-17? If yes, the reporting entity should not apply the VIE model in ASC 810-10. If no, proceed to step 2. Step 2: Does the reporting entity (the holder of an interest in the entity) performing the evaluation have either an explicit arrangement or an implicit arrangement (for more information, see Q&A 2.09) that absorbs or receives variability of the entity? (See also ASC 810-10-55-16 through 55-41 and ASC 810-10-25-21 through 25-36.) If no, the reporting entity should not apply the VIE model in ASC 810-10. If yes, the reporting entity holds a variable interest and should determine whether its interest represents an interest in specified assets or an interest in the entity, and whether a silo exists. (See Q&A 5.01 for additional guidance.)

2.03 Determining When a Lease Represents a Variable Interest — Potential VIE Is a Lessor
Question
Does a lessee’s interest in a lease constitute a variable interest in the lessor entity?

Answer
ASC 810-10-55-39 states, in part:
Receivables under an operating lease are assets of the lessor entity and provide returns to the lessor entity with respect to the leased property during that portion of the asset’s life that is covered by the lease. Most operating leases do not absorb variability in the fair value of a VIE’s net assets because they are a component of that variability. Guarantees of the residual values of leased assets (or similar arrangements related to leased assets) and options to acquire leased assets at the end of the lease terms at specified prices may be variable interests in the lessor entity if they meet the conditions described in paragraphs 81010-25-55 through 25-56. Alternatively, such arrangements may be variable interests in portions of a VIE as described in paragraph 810-10-25-57. The guidance in paragraphs 810-10-55-23 through 55-24 related to debt instruments applies to creditors of lessor entities.

Accordingly, a leasing arrangement accounted for as an operating lease that does not include a residual value guarantee (or similar arrangement) or a fixed-price purchase option, and that is consistent with prevailing market terms at the inception of the lease, generally does not represent a variable interest because the arrangement is akin to a receivable of the lessor entity (the potential VIE). However, as noted in ASC 810-10-55-39, a residual value guarantee or a fixed-price purchase option are not the only provisions within a lease that may represent a variable interest in the lessor entity. All relationships and contractual arrangements between the lessee, lessor, and variable interest holders of the lessor should be evaluated to determine whether those relationships or arrangements result in the lessee’s absorbing expected losses or receiving expected residual returns, even if the lessee has not entered into an arrangement that would be an explicit variable interest in the entity. See Q&A 2.13 for a discussion of when an implicit guarantee may exist in a related-party lease. Also see Q&A 2.04 for a discussion of whether a lessor’s interest in a lease constitutes a variable interest in the lessee entity.

Example — Standard Operating Lease
Company A leases property from an unrelated party, Company B. The lease requires fixed monthly payments and contains no residual value guarantees or fixed-price purchase options. At the inception of the lease, the terms were consistent with fair market rentals. The lease meets the classification for an operating lease under ASC 840. The operating lease is the only contractual relationship between A, B, and variable interest holders of B. Company A’s operating lease would not be considered a variable interest in B.
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2.04 Determining When a Lease Represents a Variable Interest — Potential VIE Is a Lessee
Q&A 2.03 states that, from a lessee’s perspective, an operating lease that does not include a residual value guarantee (or similar arrangement) or a fixed-price purchase option generally does not represent a variable interest in the lessor entity.

Question
Does a lessor’s interest in a lease constitute a variable interest in the lessee entity?

Answer
An operating or capital lease represents an economic liability of the lessee entity (the potential VIE). That is, the lessor is exposed to the lessee entity’s ability to pay under the terms of the lease agreement. Therefore, a lessor’s interest in a lease generally is a variable interest in the lessee entity. Contingent rentals may increase the lessor’s exposure to variability in the results of the entity. For example, contingent rentals based on the lessee entity’s sales would result in the lessor’s absorbing or receiving additional variability in the results of the entity.

2.05 Determining Variable Interests Under the VIE Model in ASC 810-10 in a Synthetic CDO Structure When Decision-Maker Fees Are Not Treated as a Variable Interest
A typical synthetic CDO is structured as follows: An entity (the “vehicle”) acquires high-credit-quality debt securities (a credit default on these securities is considered remote). The entity finances the acquisition by issuing several classes of beneficial interests. Each class has a different claim on the available cash flows of the entity — for example, a senior class (usually highly rated), a subordinated class, and a junior class. The junior class often is unrated and bears the first risk of shortfalls in available cash flows. The stipulated rate of return on each class increases as its priority in the entity’s cash flows decreases. Assume that the entity has an asset manager who is a decision maker but that its fees are not considered variable interests in accordance with ASC 810-10-55-37 through 37A. In addition, assume that the entity is neither a voting interest entity nor a QSPE. Note that this structure has little credit risk because the vehicle’s assets are high quality. However, at inception, the entity writes a credit derivative, indexed to a specific portfolio of debt instruments (such as commercial loans or corporate bonds). The derivative counterparty is senior in priority to the beneficial interest holders. The portfolio may or may not be held by the derivative counterparty — the performance of the reference assets is used to determine the cash flows between the vehicle and the purchaser of the credit derivative (usually a financial intermediary, such as a bank, broker-dealer, or insurance company).1 If credit events occur on the reference assets (e.g., a default or bankruptcy), the vehicle may be required to purchase the actual reference assets at a price of par, even though their value is much less. Alternatively, the vehicle may have to pay the derivative holder an amount equal to the decline in value. If there are no losses on the reference assets, the vehicle fully earns a premium for taking on credit risk. This premium, plus the yield on the vehicle’s assets, pays interest on the various classes of beneficial interests that the vehicle issued. However, if there are credit losses on the reference assets, the vehicle pays the counterparty the amount of the losses or acquires the reference assets for an amount greater than their fair value. In such circumstances, the vehicle could be required to sell all or a portion of its high-quality debt securities. Consequently, the funds available to the vehicle to service its obligations would decrease. These events may result in the vehicle’s inability to pay interest, principal, or both on some or all of the beneficial interests it issues. Because of credit tranching, the junior debt bears the initial risk of losses. If losses are greater than the amount of junior debt, a reasonably possible scenario, the subordinated debt class would be next in line to absorb loss. In the unlikely event of severe losses on the reference assets, the senior class also bears a risk of loss. Because synthetic CDOs can vary substantially in their structure and complexity, the reporting entity should carefully consider all relevant facts and circumstances. Note also that risks other than those described in this question are possible. For example, other derivatives, such as interest rate swaps, may manage a risk between fixed-rate assets and floating-rate beneficial interests, or vice versa.
1

Whether the credit derivative is an ASC 815 derivative, or is exempt from the requirements of ASC 815 because it qualifies as a financial guarantee, is beyond the scope of this question.
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In this question, assume that the only interest rate risk is attributable to the effect of interest rates on the fair value of the vehicle’s assets if the vehicle must sell some or all of these assets to fund its obligation under the written credit derivative.

Question
In a synthetic CDO (sometimes referred to as a credit-linked note structure) in which the decision-maker fees are not treated as a variable interest, which interests are variable interests under the VIE model in ASC 810-10?

Answer
The fundamental objective is to distinguish interests that create variability, and thus are not variable interests, from those that absorb variability, and thus are variable interests. ASC 810-10-55-26 states:
If the VIE is the writer of a guarantee, written put option, or similar arrangement, the items usually would create variability. Thus, those items usually will not be a variable interest of the VIE (but may be a variable interest in the counterparty).

Further, ASC 810-10-55-29 states, in part:
Derivative instruments held or written by a VIE should 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.

In addition, ASC 810-10-25-35 states, in part:
The following characteristics, if both are present, are strong indications that a derivative instrument is a creator of variability: a. Its underlying is an observable market rate, price, index of prices or rates, or other market observable variable (including the occurrence or nonoccurrence of a specified market observable event). The derivative counterparty is senior in priority relative to other interest holders in the legal entity.

b.

The credit derivative, written by the vehicle described in this Q&A, is strongly indicated as a creator of variability on the basis of the design of the entity and because its underlying is based on observable market variables and is senior in priority to other interest holders (see Case E in ASC 810-10-55-71 through 55-74). Because the credit derivative creates variability, it is not a variable interest in the vehicle. The assets of the vehicle also are a source of variability because they expose it to credit risk — but usually to a lesser extent than the credit derivative, since the assets are highly rated. All the beneficial interests, to a different degree, are available to absorb the variability created by the credit derivative. The credit tranching, however, indicates that the junior class and the subordinated class absorb the reasonably possible losses on the credit derivative, as indicated in part by the high credit rating on the senior class.2, 3 Thus, all the beneficial interests represent the variable interests in the entity. As discussed in this Q&A, the asset manager’s fees are not variable interests in this case because it has been assumed that the conditions in ASC 810-10-55-37 through 37A are satisfied. However, the determination of whether such fees should be considered variable interests will be based on facts and circumstances. See Q&A 2.06 for an example in which decision-maker fees are considered variable interests.

2

ASC 810-10-55-24 discusses senior interests, stating that “senior beneficial interests and senior debt instruments with fixed interest rates or other fixed returns normally would absorb little of the VIE’s expected variability.” Note that this paragraph analyzes losses within the vehicle, primarily those that are attributable to the credit derivative. Actual losses incurred on the reference assets will vary according to the impact these losses have on the vehicle (i.e., the losses on the credit derivative, not the losses on the reference assets, create variability in the vehicle).
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3

2.06 Determining Variable Interests Under the VIE Model in ASC 810-10 in a Synthetic CDO Structure When Decision-Maker Fees Are Treated as a Variable Interest
Asset managers often will be decision makers in synthetic CDOs. Unlike the structure described in Q&A 2.05, the fees paid to the asset manager/decision maker frequently will be considered variable interests in the entity in accordance with ASC 810-10-55-37 through 37A. Reasons for this include: • • All or a portion of the fees is subordinated (see ASC 810-10-55-37(b)). The asset manager/decision maker holds more interests that, in the aggregate, would absorb more than an insignificant amount of the entity’s expected losses or would receive more than an insignificant amount of the entity’s expected residual returns (see ASC 810-10-55-37(c)).

For example, in a structure similar to the one described in Q&A 2.05, the asset manager/decision maker often will hold more than an insignificant amount of the junior classes, which violates the second bullet above. Asset managers may hold such interests because rating agencies prefer to see the manager’s economic interests aligned with those of independent investors in the vehicle; the asset manager may also believe the risk/return profile is attractive. When an asset manager/decision maker’s fees are considered variable interests, all of its fees (whether fixed or variable, senior or subordinate) constitute a variable interest in the entity.

Question
Assume that the asset manager is a decision maker and that its fee must be considered a variable interest in the vehicle. How does this change in assumption affect the determinations discussed in Q&A 2.05?

Answer
When an asset manager/decision maker’s fees are accounted for as variable interests, the asset manager will have to qualitatively determine whether it is the primary beneficiary of the VIE under ASC 810-10-25-38A. This qualitative analysis should include whether: • • It has the power to direct the activities of the VIE that most significantly affect the VIE’s performance. Its variable interests, including all asset management fees and other interests (e.g., owning a percentage of junior class bonds) give it the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. See Q&A 6.29 for a discussion of how the holdings of any related parties or de facto agents should be considered in this analysis.

If both of the above characteristics are met, the asset manager is the primary beneficiary and should consolidate the VIE.

2.07

Netting of Instruments Other Than Equity
Equity investments in a VIE are variable interests to the extent they are at risk. . . . 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 investor’s 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.

ASC 810-10-55-22 states, in part:

Q&A 3.06 describes an equity instrument that would not be at risk because of this netting concept. At times, a subordinated beneficial interest or debt holder, as described in ASC 810-10-55-23, of a potential VIE also will be the counterparty to an asset of that entity (e.g., it also borrowed money from the entity).

Question
In the determination of a reporting entity’s exposure to expected losses, does the same netting described in ASC 810-10-55-22 apply to subordinated beneficial interests or subordinated debt instruments?

Answer
Generally, a reporting entity should net its variable interests against contracts or other agreements in which the reporting entity is the counterparty that the VIE treats as assets. The netting concept applies to any variable interest holder that has another interest with the potential VIE. However, if the contract with the investor is not the only asset of the entity, the investor must consider whether the combination of its rights and interests economically
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exposes the investor to risks of the entity. For example, while an investor’s investment in the entity may not be greater than the asset of the entity to which it is the counterparty, the subordination of its investment may economically be equivalent to a guarantee of the entity’s other assets. While the netting concept applies primarily to the determination of whether a reporting entity has a variable interest, it also affects the determination of the primary beneficiary of a VIE. ASC 810-10-25-38A(b) notes that the second condition for determining whether a reporting entity has a controlling financial interest is whether it has the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant. This assessment should be based on facts and circumstances but should generally not take into account the probability that the absorption of losses or the receipt of benefits from the VIE will occur. See Q&A 6.09 for a further discussion of whether a reporting entity should contemplate probability when determining whether it has the characteristic in ASC 810-10-25-38A(b).

Example
Entity X is funded as follows: • • Enterprise A: subordinated preferred stock — $100. Enterprise B: senior debt — $100.

Entity X uses the $200 to invest in a $100 note from A and to invest $100 in “other debt securities” issued by parties unrelated to A, B, or X. The above facts indicate that A has two relationships with X: (1) the subordinated preferred stock, an absorber of variability (i.e., a variable interest), and (2) a note receivable due to X, a creator of variability. Entity X should net these two interests when considering A’s exposure to expected losses/residual returns because a portion of A’s risk stems from its ability to pay on the note. In this example, A has indirectly guaranteed the “other debt securities” by subordinating its interest. That is, if the “other debt securities” are not paid when due (or otherwise decrease in value if X does not plan to hold them until maturity), A will absorb that loss by paying on its $100 note payable to X and receiving the residual amount in X through its preferred stock investment. Enterprise A should determine whether its exposure to the expected variability of X could potentially be significant. Note that in certain circumstances, netting a variable interest with an asset in which the reporting entity is the counterparty will result in minimal or no risk to the variable interest holder. (For more information, see Example 1 of Q&A 3.06.) The variable interest holder would still need to assess whether the interest represents an obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant. (For more information, see Q&A 6.09.)

2.08 Applying the VIE Model in ASC 810-10 to Trust Preferred Security Arrangements and Similar Structures
Many companies (“sponsors”) use trusts or other legal entities (“vehicles”) as issuers of trust preferred securities. The structures are marketed under a variety of names, including trust originated preferred securities, monthly income preferred securities, and quarterly income preferred securities. A conventional trust preferred arrangement is structured as follows: • • • • • The sponsor invests a nominal amount of cash in exchange for common stock in a new entity (“trust”). The trust issues preferred securities to outside investors in exchange for cash (for an amount much larger than the cash invested by the sponsor). The proceeds received from the issuance of the common and preferred securities are loaned to the sponsor in exchange for a note (the note’s terms are identical to those of the trust preferred securities). The sponsor’s parent provides a guarantee to the trust for the repayment of the note payable. The interest paid on the note by the sponsor to the trust is used by the trust to pay dividends on the preferred securities to outside investors.

In a conventional trust preferred arrangement, the trust has a contract (note receivable) with the sponsor, which is the trust’s only asset. The common stock’s absorption of expected losses depends solely on the sponsor’s ability to repay the note. That is, the trust was designed to create and pass along only the credit risk of sponsor to the
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sponsor. As a result, the common stock is not equity at risk and not a variable interest. Therefore, the sponsor would not consolidate the trust under the provisions of the VIE model in ASC 810-10 (see ASC 810-10-55-22). The following diagram illustrates a typical conventional trust preferred arrangement:
#1 Cash #1 Common Stock Sponsor #3 Note Payable #3 Cash Trust

#2 Issues Preferred Securities

#2 Cash Proceeds

Outside Investors

Question
Should a reporting entity analogize to a conventional trust preferred security arrangement in determining whether it holds a variable interest in a similar type of arrangement?

Answer
It depends. Trust preferred arrangements can be structured in many ways and can result in different conclusions under the VIE model in ASC 810-10. The FASB staff has informally indicated that the reporting entity (sponsor) should consider whether the arrangement is designed such that the sponsor’s interest in the trust constitutes an obligation to the trust or an investment in the trust. The risks the trust was designed to create and pass along to the sponsor should be considered in the evaluation of the design of the entity. For example, in a conventional trust preferred security arrangement, the trust was designed to create and pass along the credit risk of the sponsor to the sponsor. The only asset of the trust is an obligation of the sponsor, and the sponsor controls the payment on its obligation. In a situation in which the trust holds the common stock of the sponsor, the trust is designed to create and pass along equity price risk to the sponsor. The sponsor does not necessarily control its own equity price because it is subject to a myriad of economic factors. To illustrate this concept, the FASB staff has expressed the following views on two scenarios similar to conventional trust preferred arrangements:

Example 1 — Reverse Trust Preferred Structure
In this example, the trust receives preferred stock, redeemable at the sponsor’s option, instead of holding a note receivable. The preferred stock is treated as debt in the financial statements of the sponsor under ASC 480-10. The investors have no recourse to the assets of the sponsor. The FASB staff’s view is that, similarly to a conventional trust preferred arrangement, the common stock is not equity at risk and is not a variable interest because the contract (preferred stock) with the sponsor represents the only asset of the trust and the preferred stock represents an obligation of the sponsor to the trust; therefore, the only asset of the trust is an obligation of the sponsor.

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#1 Cash #1 Common Stock Sponsor #3 Preferred Stock #3 Cash Trust

#2 Debt

#2 Cash Proceeds

Investors

Example 2 — Treasury Stock Financing Arrangement
In this example, the sponsor seeks to reduce the amount of its common stock held by third-party investors by establishing an SPE. The proceeds received by the SPE from the sponsor and the investment bank (from the issuance of the SPE’s common stock and debt, respectively) are used to purchase the common stock of the sponsor on the open market. The SPE makes interest payments on the debt with the dividend proceeds from the sponsor’s common stock. The investment bank is entitled to additional returns from the SPE if the share price of the sponsor’s common stock exceeds specified thresholds. The FASB staff’s view is that the sponsor has a variable interest in the SPE because the SPE was designed to create and pass along equity price risk to the sponsor. Unlike the sponsor in Example 1, the sponsor in this example does not have an obligation to the SPE. Conversely, the sponsor has an investment in the SPE that absorbs variability because the common stock of the sponsor, purchased on the open market, is subject to economic factors not limited to the credit risk of the sponsor.
#1 Cash Sponsor #1 Common Stock SPE #3 Cash #3 Sponsor Common Stock #2 Cash Proceeds Open Market

#2 Debt

Investment Bank

ASC 810-10
Implicit Variable Interests 25-48 Implicit variable interests commonly arise in leasing arrangements among related parties, and in other types of arrangements involving related parties and unrelated parties. [FSP FIN 46(R)-5, paragraph Note] 25-49 The following guidance addresses whether a reporting entity should consider whether it holds an implicit variable interest in a VIE or potential VIE if specific conditions exist. [FSP FIN 46(R)-5, paragraph 1] 25-50 a. b. c. The identification of variable interests (implicit and explicit) may affect the following: The determination as to whether the potential VIE shall be considered a VIE The calculation of expected losses and residual returns The determination as to which party, if any, is the primary beneficiary of the VIE.

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. [FSP FIN 46(R)-5, paragraph 2]
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ASC 810-10 (continued)
25-51 An implicit variable interest is an implied pecuniary interest in a VIE that changes with changes in the fair value of the VIE’s net assets exclusive of variable interests. Implicit variable interests may arise from transactions with related parties, as well as from transactions with unrelated parties. [FSP FIN 46(R)-5, paragraph 3] 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. [FSP FIN 46(R)-5, paragraph 4] 25-53 The significance of a reporting entity’s 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 entity’s related party holds a variable interest in the same VIE or potential VIE. A reporting entity’s 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. [FSP FIN 46(R)-5, paragraph 5] 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. [FSP FIN 46(R)-5, paragraph 6]

Implicit Variable Interests 2.09 Implicit Variable Interests and “Activities Around the Entity” — Illustration

Question
What is an implicit variable interest, and how does a reporting entity determine whether it holds one?

Answer
Table 1 in Q&A 2.01 provides examples of contracts or arrangements that may result in a reporting entity’s holding a variable interest in a VIE. Variable interests held by a reporting entity may be explicit, implicit, or both. ASC 81010-25-48 through 25-54 clarify that a reporting entity should consider whether it holds an implicit variable interest in a potential VIE. The identification of explicit variable interests involves determining which contractual, ownership, or other pecuniary interests in an entity directly absorb or receive the variability of the entity. An implicit variable interest acts the same as an explicit variable interest except that it involves the absorbing, receiving, or both of variability indirectly, rather than directly, from the 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 entity. At the 2004 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff used the phrase “activities around the entity.” This expression refers to certain transactions and relationships between a direct interest holder in a potential VIE and other enterprises that indirectly alter the holder’s exposure to the risks-andrewards profile of the direct interest holder’s investment.

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The SEC staff stated:
We have seen a number of questions about whether certain aspects of a relationship that a variable interest holder has with a variable interest entity (VIE) need to be considered when analyzing the application of FIN 46R [codified in ASC 810-10]. These aspects of a relationship are sometimes referred to as “activities around the entity.” It might be helpful to consider a simple example. Say a company (Investor A) made an equity investment in a potential VIE and Investor A separately made a loan with full recourse to another variable interest holder (Investor B). We have been asked whether the loan in this situation can be ignored when analyzing the application of FIN 46R. The short answer is no. First, FIN 46R specifically requires you to consider loans between investors as well as those between the entity and the enterprise in determining whether equity investments are at risk, and whether the at risk holders possess the characteristics . . . defined in paragraph 5 of FIN 46R [codified as ASC 810-10-15-14]. It is often difficult to determine the substance of a lending relationship and its impact on a VIE analysis on its face. You need to evaluate the substance of the facts and circumstances. The presence of a loan between investors will bring into question, in this example, whether Investor B’s investment is at risk and depending on B’s ownership percentage and voting rights, will influence whether the at risk equity holders possess the characteristics of a controlling financial interest. Other “activities around the entity” that should be considered when applying FIN 46R include equity investments between investors, puts and calls between the enterprise and other investors and noninvestors, service arrangements with investors and non-investors, and derivatives such as total return swaps. There may be other activities around the entity that need to be considered which I have not specifically mentioned. These activities can impact the entire analysis under FIN 46R including the assessment of whether an entity is a VIE as well as who is the primary beneficiary. In another situation involving activities around the entity, investors became involved with an entity because of the availability of tax credits generated from the entity’s business. Through an arrangement around the entity, the majority of the tax credits were likely to be available to one specific investor. Accordingly, the staff objected to an analysis by this investor that 1) did not include the tax credits as a component of the investor’s variable interest in the entity and 2) did not consider the impact of the tax credits and other activities around the entity on the expected loss and expected residual return analysis.

At the 2005 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff emphasized that although FSP FIN 46(R)-5 (codified in ASC 810-10-25-48 through 25-54) focuses on noncontractual interests in a leasing transaction between related parties, implicit interests can also result from contractual arrangements between a reporting entity and unrelated variable interest holders. The SEC staff provided the following questions for reporting entities to consider in determining whether an implicit variable interest exists:
• • • • Was the arrangement entered into in contemplation of the entity’s 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 [VIE]?

Implicit variable interests and “activities around the entity” may affect the determination of: 1. 2. 3. 4. 5. Whether an investor has provided additional financial support (see Q&A 1.28). Whether a reporting entity holds a variable interest (see Q&As 2.10–2.13 for examples of transactions and relationships that are not directly with an entity that require consideration). Whether an investor’s equity is at risk, as described in ASC 810-10-15-14(a) (see Q&As 3.10 and 3.14). Whether the entity is a VIE, as described in ASC 810-10-15-14. Whether the reporting entity’s obligation to absorb losses or right to receive benefits of the VIE could potentially be significant to the VIE, as described in ASC 810-10-25-38A(b).

In many cases, an implicit arrangement in the design of an entity protects a variable interest holder from absorbing losses in a VIE, limits the holder’s ability to receive residual returns in a VIE, or both. Entities can also be designed to enable a reporting entity to circumvent the provisions of the VIE model in ASC 810-10 by placing a party (often a related party) between the reporting entity and a VIE. In all cases, the role of a contract or arrangement in the design of an entity must be carefully evaluated, with a focus on its substance rather than on its legal form or accounting designation. ASC 810-10-15-13A states:
For purposes of applying the Variable Interest Entities Subsections, only substantive terms, transactions, and arrangements, whether contractual or noncontractual, shall be considered. Any term, transaction, or arrangement shall be disregarded when applying the provisions of the Variable Interest Entities Subsections
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if the term, transaction, or arrangement does not have a substantive effect on any of the following: a. b. c. A legal entity’s status as a VIE A reporting entity’s power over a VIE A reporting entity’s obligation to absorb losses or its right to receive the benefits of the entity. [Emphasis added]

In the following diagram, anything within the circle represents arrangements that are potential explicit variable interests in Entity X. Arrangements between the investors and other enterprises outside the circle represent “activities around the entity” and are potential implicit variable interests in Entity X .
D Fixed-Price Put Option E Total Return Swap

C FixedPrice Call Option

F Back-toBack Asset Guarantee

Investor A ($1 million) 50% Owned Entity X

Investor B ($1 million) 50% Owned Asset Guarantee

Investors A and B hold the only potential explicit variable interests in Entity X as a result of their equity investments of $1 million and Investor B’s asset guarantee. However, a reporting entity must consider whether any arrangements outside the circle represent an implicit variable interest in Entity X — i.e., Reporting Entities C, D, E, and F should “look through” the counterparty to determine whether the role of their interest is to absorb variability of Entity X. ASC 810-10-55-87 through 55-89 include an example illustrating the determination of when an implicit variable interest may exist in a leasing arrangement. (For more information, see Q&A 2.13.) In addition to the questions discussed at the December 2005 AICPA Conference, questions for a reporting entity to consider in determining whether it holds an implicit variable interest include the following: • Does a related party, through an ownership interest or by virtue of holding a significant role in the operations, have the ability to require (or have substantial influence over a decision to require) the reporting entity to reimburse the related party for its losses? Is there an economic motivation for the reporting entity to protect the related party or its variable interest holders from potential losses? Does the related-party relationship lack the following: (1) conflict-of-interest policies, (2) significant regulatory requirements that create disincentives, (3) fiduciary responsibilities clauses, or (4) other similar restrictions that would prevent or deter a reporting entity from forcing a related party to absorb losses? Are there situations in which losses have been sustained in the past and, though not contractually required to be, were absorbed by the reporting entity? Are the unrelated parties (e.g., creditors, legal advisers) unaware of the relationships between the parties? Do other parties (e.g., a lender) involved with the reporting entity believe that there are implicit variable interests (e.g., guarantees)? Have implicit variable interests existed in past relationships that are similar to the current arrangement?

• •

• • • •

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The determination of whether an interest is an implicit variable interest will depend on the role of that interest in the design of the entity and should be based on facts and circumstances. The following Q&As may help a reporting entity determine whether an interest represents an implicit variable interest: • • • • Investor C (purchased call option): Q&A 2.10. Investor D (written put option): Q&A 2.10. Investor E (total return swap): Q&A 2.11. Investor F (back-to-back asset guarantee): Q&A 2.12.

2.10

Implicit Variable Interests — Call and Put Options

Investor A has a variable interest in Entity X. Investor A writes a call option to Enterprise C, an unrelated enterprise, that allows C to call A’s variable interest in X. In addition, A purchases a put option from Enterprise D, an unrelated enterprise, that allows A to put its variable interest in X to D.

Question
Is C deemed to have a variable interest in X by virtue of the call option between A and C, and is D deemed to have a variable interest in X by virtue of the put option between A and D? (For another example, see the diagram in Q&A 2.09.)

Answer
Neither C nor D holds an explicit variable interest in X. However, the arrangements (call and put options) C and D have with A (a holder of an explicit variable interest in X) require them to consider whether they hold an implicit variable interest in X. (For a discussion of implicit and explicit variable interests, see Q&A 2.09.) Thus, C and D should consider the following: • • • • • Whether the call and put options were entered into in contemplation of X’s formation. Whether the call and put options were entered into contemporaneously with the issuance of the variable interest held by A. The reason the call and put options were entered into with A and not X. Whether the call and put options concern specified assets of X. The specific terms and conditions of the call and put options (e.g., whether the strike price is fixed).

Whether an implicit variable interest exists will ultimately depend on individual facts and circumstances.

2.11

Implicit Variable Interests — Total Return Swap

Investor B holds an equity interest in Entity X that is a variable interest pursuant to the VIE model in ASC 810-10. Investor B enters into a total return swap agreement (the “swap”) with Enterprise E, an unrelated enterprise, with the following terms and conditions: • • • • • • • Investor B pays E any dividends it receives as a result of its equity interest in X. Investor B pays E the appreciation in the value of its equity interest in X, if any, on certain predetermined dates, including the maturity date of the swap. Enterprise E pays B the depreciation in the value of B’s equity interest in X, if any, on those same dates. Enterprise E pays B a fixed periodic amount. Investor B must vote its interest in accordance with E’s instructions. The swap matures in five years, a date in advance of the expected liquidation of X. Both B and E are constrained; that is, neither enterprise can transfer or assign its rights under the swap and B cannot sell or transfer its variable interest in X. In the absence of such constraints, certain qualified parties would engage in those transactions. The likelihood that either B or E will fail to perform on any of the swap terms is remote. Investor B’s variable interest is collateral for its obligation to E.
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• •

For another example, see the diagram in Q&A 2.09.

Question
Is E deemed to have a variable interest in X by virtue of the total return swap agreement described above?

Answer
Enterprise E does not have an explicit variable interest in X. However, the total return swap arrangement between E and B (a holder of an explicit variable interest in X) requires E to consider whether it holds an implicit variable interest in X. (For a discussion of implicit and explicit variable interests, including factors to consider in determining whether a reporting entity holds an implicit variable interest in an entity, see Q&A 2.09.) Enterprise E must therefore consider whether the total return swap protects B by absorbing variability in X. Although E does not legally own the assets of X, the total return swap generally protects B by transferring the risks and rewards of the assets in X from B to E. Therefore, E would probably conclude that it holds an implicit variable interest in X. This conclusion is consistent with ASC 810-10-25-31, which addresses interests that transfer all or a portion of the risk of specified assets (or liabilities) of a VIE (total return swaps are examples of such an arrangement). This risk transfer strongly indicates a variability that X was designed to create and pass along to its interest holders. Therefore, under ASC 810-10-25-21 through 25-36, if E had entered into the total return swap agreement directly with X, E would most likely conclude that it holds a variable interest in X. For a discussion of the factors an entity should consider in determining whether an implicit variable interest exists, including those discussed by the SEC staff at the 2005 AICPA National Conference on Current SEC and PCAOB Developments, see Q&A 2.09. Note that in the example above, a principal-agency relationship exists between E and B, respectively, because B is required to vote its interest in X, as directed by E. When applying the provisions of the VIE model in ASC 810-10, B should attribute its interest to E. For another example, see Q&A 3.14.

2.12

Implicit Variable Interests — Back-to-Back Asset Guarantee

Investor B holds an equity interest in Entity X and provides an asset guarantee (guarantee of value) to X. The equity interest and guarantee of value are both variable interests pursuant to the VIE model in ASC 810-10. Investor B enters into a guarantee contract with Enterprise F, an unrelated enterprise, that requires F to pay B for any decrease in value of the assets held by X. (For another example, see the diagram in Q&A 2.09.)

Question
Is F deemed to have a variable interest in X by virtue of the guarantee agreement described above?

Answer
Enterprise F does not have an explicit variable interest in X. However, the guarantee arrangement between F and B (a holder of an explicit variable interest in X) requires F to consider whether it holds an implicit variable interest in X. For a discussion of the factors an entity should consider in determining whether an implicit variable interest exists, including those discussed by the SEC staff at the 2005 AICPA National Conference on Current SEC and PCAOB Developments, see Q&A 2.09. Note that whether an implicit variable interest exists will depend on individual facts and circumstances. In situations in which F guarantees the fair value of less than a majority of the entity’s assets, the guarantee would not be considered a variable interest in a VIE.

2.13 Determining When an Implicit Guarantee (Variable Interest) Exists in a RelatedParty Transaction
Q&A 2.03 notes that an arrangement accounted for as an operating lease that does not include a guarantee (or similar arrangement) or fixed-price purchase option, and that is consistent with prevailing market terms at the inception of the lease, generally does not represent a variable interest to the lessee because the arrangement is a receivable of the lessor entity (the potential VIE). As a “receivable,” the arrangement creates, rather than absorbs, variability for the entity. However, ASC 810-10-55-25 states, in part, the following:

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Guarantees of the value of the assets or liabilities of a VIE . . . or similar obligations such as . . . agreements (explicit or implicit) to replace impaired assets held by the VIE are variable interests if they protect holders of other interests from suffering losses. [Emphasis added]

Note that ASC 810-10-25-48 through 25-54 clarify that a reporting entity should consider whether it holds an implicit variable interest in a potential VIE resulting from a related-party relationship, as well as from unrelated parties.

Question
In a related-party lease, what factors should an entity consider in determining whether the lessee has a variable interest in the lessor entity through an implicit guarantee of the assets of the lessor entity?4

Answer
In situations in which a lessee does not have an explicit contract with a potential VIE (lessor entity) that qualifies as a variable interest, the lessee still may have a variable interest in the entity through an implicit guarantee. Whether an implicit guarantee exists depends on the relationship between the related parties and the nature of their variable interests in the lessor entity. Since an operating lease is generally not a variable interest under ASC 810-10-55-39, there may be no explicit variable interests between the related-party lessor (potential VIE) and lessee. However, in some related-party relationships (e.g., when the holder of a variable interest in the lessor entity has the ability to exert its influence on the lessee enterprise), even those without an explicit guarantee or purchase option, the lessee may protect the lessor5 entity from losses on the leased property, thereby creating an “implicit guarantee,” as described in ASC 810-10-55-25. Determining whether an implicit guarantee exists is important to the analysis of a potential VIE because (1) any implicit guarantee may cause the lessor entity to be a VIE under ASC 810-10-15-14(b)(2) since such a guarantee protects the holders of equity from the expected losses of the entity and (2) if an implicit guarantee exists, the lessee (or its related parties) may hold a variable interest in the lessor VIE and should determine whether it is the lessor VIE’s primary beneficiary. A reporting entity should consider all facts and circumstances in determining whether a related-party lessee (and its related parties) has provided an implicit guarantee of the lessor entity’s property. This determination should include the following steps: Step 1: This step involves the determination of whether a party that has an ownership interest in — or that holds a significant role in the operations of — the lessee can require (or have substantial influence over a decision to require) the lessee to reimburse the lessor entity for losses it incurs in holding the leased asset. An implicit guarantee, for example, could manifest in a decision to renew the lease at above-market rents or in compensation paid directly to the variable interest holder. The guarantee is not limited to an outright reimbursement of the lessor for incurred losses. Some examples of possible substantial influence under step 1 include the following: • • • The lessee and the lessor are both controlled by a common parent. The lessor is wholly or substantially owned by a stockholder or group of stockholders who also own a stake in, and can exercise substantial influence over, the lessee entity. The lessor is wholly or substantially owned by a stockholder or group of stockholders who hold a significant role in the operations of the lessee entity (e.g., holding a senior officer or director position in the lessee or a controlling parent company).

If step 1 is met, an implicit guarantee may exist; proceed to step 2. Step 2: In this step, a reporting entity should consider all factors in assessing whether an implicit guarantee exists, including the following: • Whether there is an apparent economic motivation for the lessee to protect the lessor entity or holders of variable interests in the lessor entity (ASC 810-10-55-25 indicates that a guarantee cannot exist unless it protects holders of other interests from suffering losses). For example, if the lessee and the lessor are

4

Although this Q&A focuses on whether an implicit guarantee exists in a leasing arrangement between related parties, whether an implicit guarantee exists should be analyzed in any arrangement. In the determination of whether the lessor entity is protected, payments made to the lessor entity by the lessee, as well as payments made directly to an interest holder of the lessor, should be considered to protect the lessor entity.
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5

both wholly owned subsidiaries of a common parent, the parent (as the shareholder in the lessor) would probably not benefit (on a net basis) from an implicit guarantee. Additional factors (not all-inclusive) to consider include whether (1) a tax strategy exists that creates an economic motivation or (2) parent financing is secured by assets of the lessee. • Whether the lessee (or its ultimate parent) has a fiduciary responsibility. For example, if the lessee has minority shareholders who would be disadvantaged by an implicit guarantee, the lessee may have a fiduciary responsibility that would prevent or significantly deter an implicit guarantee. Whether the lessee (or its ultimate parent) has clear conflict-of-interest policies that would preclude the existence of an implicit guarantee, and whether the policies are effectively monitored and violations are reported to a level within the organization that has authority over the violator. Whether the lessee is subject to regulatory requirements that create significant disincentives or preclude transactions that result in an implicit guarantee, or would raise a question about the legality of an implicit guarantee. Whether similar transactions have occurred in the past in which a loss has been sustained and whether there has been no performance constituting an implicit guarantee. Whether other unrelated parties (e.g., creditors, legal advisers) are aware of the existence of any implicit guarantee between the related parties to the transaction.

• •

In addition, at the 2005 AICPA National Conference on Current SEC and PCAOB Developments, Mr. Mark Northan, a professional accounting fellow in the Office of the Chief Accountant of the SEC, indicated that the SEC staff believes preparers should consider the following questions (not all-inclusive) in identifying implicit variable interests: • • • • Was the arrangement entered into in contemplation of the entity’s 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 [VIE]?

Example 1 — Implicit Guarantee Exists
Operating Company (Operating) is a nonpublic entity that leases real estate from a related party, Real Estate Company (Real Estate), which is wholly owned by the majority shareholder of Operating. Real Estate (a VIE) was capitalized with $30,000 of equity from the majority shareholder and $970,000 of bank debt, with recourse to the assets of Real Estate and to the personal assets of the majority shareholder. Real Estate owns no assets other than the real estate asset leased to Operating. The lease contains no explicit guarantees of the residual value of the real estate or fixed-price purchase options. At the inception of the lease, the terms were consistent with fair market rentals. The lease meets the criteria for classification as an operating lease under ASC 840. The operating lease is the only contractual relationship between Operating and Real Estate. The following diagram depicts the relationship described above:
Personal Guarantee Shareholder 100% Owned Majority Owned Potential Implicit Guarantee

Real Estate

Operating Lease

Operating

Loan Bank Minority Shareholder

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ASC 810-10-55-25 indicates that guarantees of the value of the assets or liabilities of a VIE may be explicit or implicit. Although the operating lease itself does not contain a contractual guarantee of the value of Real Estate’s leased asset, the related-party relationship between the two entities requires an analysis of whether Operating has provided an implicit guarantee of Real Estate’s leased asset to protect the majority shareholder’s investment in Real Estate and the majority shareholder’s personal guarantee of Real Estate’s debt. Step 1 Analysis: The majority shareholder can require Operating to reimburse it or Real Estate for losses incurred through its controlling interest. Therefore, a step 2 analysis must be performed. Step 2 Analysis: The majority shareholder has an economic motivation to require Operating to reimburse it for losses incurred by Real Estate because the minority interest holder will incur a portion of the losses pushed to Operating. If no other factors indicate that the majority shareholder is unable to require performance, an implicit guarantee exists. The implicit guarantee would result in Operating’s holding a variable interest in Real Estate (this implicit guarantee of Real Estate’s leased asset exists whether the guaranteed payment is made directly to Real Estate or directly to the majority shareholder). Although Operating and the majority shareholder are related, both Operating (i.e., through its implicit guarantee of the assets of Real Estate) and the majority shareholder (i.e., through its equity interest and personal guarantee of the debt) must first follow the guidance in ASC 810-1025-38A to determine whether either entity individually meets both characteristics and should consolidate Real Estate. If neither Operating nor the majority shareholder individually meets both characteristics, they must follow the guidance in ASC 810-10-25-43 and 25-44 to determine whether, as a related-party group, they meet both characteristics in ASC 810-10-25-38A, and which of them should then consolidate Real Estate. This analysis would most likely result in Operating’s consolidation of Real Estate as the primary beneficiary because it appears that Operating has both (1) the power to direct the activities of Real Estate that most significantly affect Real Estate’s economic performance and (2) the obligation to absorb losses of Real Estate that could potentially be significant to Real Estate. The economic performance of Real Estate is significantly affected by the value of its sole real estate asset at the end of the long-term lease with Operating. Operating’s ability to control the real estate asset over the lease term gives it the power to direct the activities that have the most significant impact on Real Estate’s economic performance. In addition, by virtue of the implicit guarantee, Operating would have the obligation to absorb losses that could potentially be significant if it has to reimburse the majority shareholder for Real Estate’s losses.

Example 2 — Implicit Guarantee Does Not Exist
Enterprise H is a public holding company with two wholly owned subsidiaries, Entity R and Enterprise O. Enterprise O is a regulated operating entity that must file stand-alone financial statements with its regulator. The regulator requires that all related-party transactions entered into by O be on market terms and imposes certain restrictions on dividends that O can pay. Entity R is a real estate company whose only asset is a building leased to O. The lease is a long-term, market-rate operating lease with no explicit residual value guarantee or purchase option. Entity R is funded by 20 percent equity issued to H and an 80 percent intercompany loan from H. Since an operating lease is generally not a variable interest under ASC 810-10-55-39 and since O and R are related parties, O must consider whether it has provided an implicit guarantee to R because of H’s potential ability to require O to fund any losses of R. Step 1 Analysis: Enterprise H, because of its 100 percent ownership in O, can control O. Therefore, a step 2 analysis must be performed. Step 2 Analysis: The following analysis is performed: • • Enterprise O and Entity R are both wholly owned subsidiaries of Enterprise H. Therefore, the parent would not benefit (on a net basis) from an implicit guarantee. Enterprise O is subject to regulatory requirements that require transactions with related parties to be conducted at market terms. In addition, there are significant disincentives within the regulatory requirements for capital transactions.

If no other overriding factors indicate that H is able to require O to protect it from losses incurred on its investment in R, an implicit guarantee does not exist.

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2.14

Implicit Variable Interests — Waiving of a Management Fee

MMFs are investment funds that attempt to maintain a constant per-share NAV by adjusting the periodic interest rates paid to investors. In return for their management services, investment managers typically receive a fee that is calculated as a percentage of the fair value of the assets that they manage. Managers generally do not have any explicit interests in the mutual fund entity other than the right to receive a fee. As a result of the credit crisis, certain MMFs incurred significant decreases in the fair value of their investments. This caused some funds to “break the buck” when the NAV fell below the anticipated constant per-share amount (usually set at $1 per share). With money market funds experiencing declines in fair value as a result of deterioration in the creditworthiness of their assets and general illiquidity conditions, as well as low rates of interest on investments held by the fund, many MMF managers chose to provide financial support to their funds. Such support included, but was not necessarily limited to, capital contributions, standby letters of credit, guarantees of principal and interest, and agreements to purchase troubled securities at amortized cost or par. Many mutual fund managers also chose to waive all or a portion of their management fee for a limited period.

Question
Is an implicit variable interest created solely as a result of a mutual fund manager’s waiving its management fee for a limited period?

Answer
No. Informal discussions with the FASB staff have indicated that an implicit variable interest would not be created solely as a result of a mutual fund manager’s waiving its management fee for a limited period. This conclusion is consistent with ASC 810-10-25-52, which states, in part:
[T]he 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.

The manager’s waiving of the fee for a limited period is a business decision that the manager makes because of the poor performance of the fund; this decision changes neither the design of the fund nor the manager’s role in its operation. However, a reporting entity would need to further evaluate other financial support intended to protect investors (e.g., the manager’s guarantee of the fund’s performance) to determine whether it represents an implicit variable interest (or an explicit variable interest) and whether it changes the role of the fund manager from a fiduciary to a principal.

The By-Design Approach to Determining Variability
ASC 810-10
25-20 This Subsection addresses various transactional considerations in determining whether a legal entity is a variable interest entity (VIE) and would need to be consolidated by the reporting entity, specifically: a. b. c. Determining the variability to be considered Initial involvement with a legal entity Consolidation based on variable interests 1. 2. 3. 4. The effect of related parties Sufficiency of equity at risk Implicit variable interests Variable interest and interests in specific assets of a VIE.

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ASC 810-10 (continued)
25-21 The variability that is considered in applying the Variable Interest Entities Subsections affects the determination of all of the following: a. b. c. Whether the legal entity is a VIE Which interests are variable interests in the legal entity Which party, if any, is the primary beneficiary of the VIE.

That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. [FSP FIN 46(R)-6, paragraph 2] 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. 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). [FSP FIN46(R)-6, paragraph 5]

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. [FSP FIN 46(R)-6, paragraph 5] 25-24 a. b. c. d. e. f. The risks to be considered in Step 1 that cause variability include, but are not limited to, the following: Credit risk Interest rate risk (including prepayment risk) Foreign currency exchange risk Commodity price risk Equity price risk Operations risk. [FSP FIN 46(R)-6, paragraph 6]

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 entity’s interests issued How the legal entity’s interests were negotiated with or marketed to potential investors Which parties participated significantly in the design or redesign of the legal entity. [FSP FIN 46(R)-6, paragraph 7]

25-26 Typically, assets and operations of the legal entity create the legal entity’s 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. [FSP FIN 46(R)-6, paragraph 8] 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. [FSP FIN 46(R)-6, paragraph 9] 25-28 Example 3 (see paragraph 810-10-55-55) is intended to demonstrate how to apply the provisions of this guidance on determining the variability to be considered, including whether arrangements (such as derivative instruments or guarantees of value) create variability (and are therefore not variable interests) or absorb variability (and are therefore variable interests). [FSP FIN 46(R)-6, paragraph 14] 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. [FSP FIN 46(R)-6, paragraph 15]
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ASC 810-10 (continued)
25-30 a. b. c. d. The following addresses various considerations related to determination of variability, specifically: Terms of interests issued Subordination Certain interest rate risk Certain derivative instruments.

Terms of Interests Issued 25-31 An analysis of the nature of the legal entity’s interests issued shall include consideration as to whether the terms of those interests, regardless of their legal form or accounting designation, transfer all or a portion of the risk or return (or both) of certain assets or operations of the legal entity to holders of those interests. The variability that is transferred to those interest holders strongly indicates a variability that the legal entity is designed to create and pass along to its interest holders. [FSP FIN 46(R)-6, paragraph 10] Subordination 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 entity’s 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. [FSP FIN 46(R)-6, paragraph 11] Certain Interest Rate Risk 25-33 Periodic interest receipts or payments shall be excluded from the variability to consider if the legal entity was not designed to create and pass along the interest rate risk associated with such interest receipts or payments to its interest holders. However, interest rate fluctuations also can result in variations in cash proceeds received upon anticipated sales of fixed-rate investments in an actively managed portfolio or those held in a static pool that, by design, will be required to be sold prior to maturity to satisfy obligations of the legal entity. That variability is strongly indicated as a variability that the legal entity was designed to create and pass along to its interest holders. [FSP FIN 46(R)-6, paragraph 12] Certain Derivative Instruments 25-34 A legal entity may enter into an arrangement, such as a derivative instrument, to either reduce or eliminate the variability created by certain assets or operations of the legal entity or mismatches between the overall asset and liability profiles of the legal entity, thereby protecting certain liability and equity holders from exposure to such variability. During the life of the legal entity those arrangements can be in either an asset position or a liability position (recorded or unrecorded) from the perspective of the legal entity. [FSP FIN 46(R)-6, paragraph 4] 25-35 The following characteristics, if both are present, are strong indications that a derivative instrument is a creator of variability: a. b. Its underlying is an observable market rate, price, index of prices or rates, or other market observable variable (including the occurrence or nonoccurrence of a specified market observable event). The derivative counterparty is senior in priority relative to other interest holders in the legal entity. [FSP FIN 46(R)-6, paragraph 13]

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 legal 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 legal 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. [FSP FIN 46(R)-6, paragraph 13]

2.15

Overview of the Guidance in ASC 810-10-25-21 Through 25-36

ASC 810-10-25-21 through 25-36 provide guidance on determining whether an interest in an entity is a variable interest. ASC 810-10-25-22 discusses the “by-design” approach to determining which variability to consider in evaluating whether an interest is a variable interest. A reporting entity that holds a variable interest in a VIE must determine whether it is the primary beneficiary of the VIE under ASC 810-10-25-38A.
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ASC 810-10-25-21 through 25-36 require reporting entities to perform the following two-step analysis in evaluating which variability to consider when determining whether an interest is a variable interest: Step 1: Analyze the nature of the risks in the legal entity. Step 2: Determine the purpose(s) for which the legal entity was created and the variability (created by the risks identified in step 1) the legal entity is designed to create and pass along to its interest holders. In step 1, examples of risks that may cause variability include, but are not limited to, credit risk, interest rate risk, foreign currency exchange risk, commodity price risk, equity price risk, and operations risk. In applying step 2, the reporting entity should consider the following factors: • • • • • The activities of the legal entity. The terms of the contracts the legal entity has entered into. The nature of the legal entity’s interests issued. How the legal entity was marketed to potential investors. Which parties participated significantly in the design or redesign of the legal entity.

Regarding the terms of the contracts, a reporting entity may wish to review original formation documents, governing documents, any amendments to the original formation or governing documents, marketing materials, or other contractual arrangements entered into by the VIE and provided to potential investors or other parties associated with the VIE. ASC 810-10-15-13A states:
For purposes of applying the Variable Interest Entities Subsections, only substantive terms, transactions, and arrangements, whether contractual or noncontractual, shall be considered. Any term, transaction, or arrangement shall be disregarded when applying the provisions of the Variable Interest Entities Subsections if the term, transaction, or arrangement does not have a substantive effect on any of the following: a. b. c. A legal entity’s status as a VIE A reporting entity’s power over a VIE A reporting entity’s obligation to absorb losses or its right to receive the benefits of the entity.

ASC 810-10-25-30 through 25-33 provides the following strong indicators of the variability that the VIE was designed to create and pass along to its interest holders: • When the terms of the interests transfer all or a portion of the risk or return (or both) of certain assets or operations to the interest holder, the variability that is transferred strongly indicates a variability that the VIE is designed to create and pass along to its interest holders (see ASC 810-10-25-31). Interests that absorb this risk or return are likely to be variable interests. Variability that is absorbed by a substantively subordinated interest strongly indicates a particular variability that the VIE was designed to create and pass along to its interest holders (ASC 810-10-25-32). Interests that absorb this variability are likely to be variable interests. Variability associated with periodic interest receipts or payments on fixed-rate investments that may or will be sold before maturity strongly indicates variability that the VIE was designed to create and pass along to its interest holders (ASC 810-10-25-33). Interests that absorb this variability are likely to be variable interests.

ASC 810-10-25-34 through 25-36 provide guidance on determining whether certain derivative instruments are creators of variability or variable interests (see Certain Derivative Instruments).

Interest Rate Variability
Interest rate variability associated with a VIE’s assets is generally not a risk a VIE is designed to create and pass along to its interest holders when a derivative instrument (e.g., an interest rate swap) is used to hedge such a risk. Therefore, interest rate variability that is hedged, or that arises from assets that will be held by the VIE until maturity, should generally not be considered in the determination of whether an interest is a creator or absorber of variability.

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However, certain circumstances strongly indicate that a VIE was designed to create and pass along interest rate risk to its interest holders, including the following: • • • Variations in cash proceeds to be received upon anticipated sales of fixed-rate investments in an actively managed investment portfolio. Variations in the cash proceeds a VIE will receive when it holds investments in a static pool that, by design, the VIE will be required to sell before maturity to satisfy its obligations. Variations in fair value resulting from an “interest rate mismatch.” ASC 810-10-55-55 through 55-86 give an example in which a VIE holds fixed-rate assets and floating-rate debt. The interest rate mismatch is not hedged; thus, the VIE was designed to expose the debt and equity investors to changes in fair value of the investments. Therefore, interest rate risk associated with changes in the fair value of fixed-rate periodic interest rate payments received must be considered.

Therefore, interests that absorb interest rate variability associated with any of these three circumstances generally would be considered variable interests.

Certain Derivative Instruments
According to ASC 810-10-25-35, while certain derivative instruments (see Q&A 2.23) absorb the variability an entity was designed to create and pass along to its interest holders, a derivative that has both of the following characteristics is generally considered a creator of variability (not a variable interest): (1) its underlying is an observable market rate, price, index of prices or rates, or other market-observable variable (including the occurrence or nonoccurrence of a specified market-observable event) and (2) the derivative counterparty is senior in priority to other interest holders in the legal entity. Therefore, it is likely that most “plain vanilla” interest rate or currency swaps that possess these characteristics will not be variable interests if the swap counterparty is not otherwise a holder of a variable interest in the entity. ASC 810-10-25-36 provides an exception to this indicator, stating, in part, “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 legal entity will need to be analyzed further to determine whether that instrument should be considered a creator of variability or a variable interest.” Therefore, many total return swaps, put options, and call options related to a majority of the entity’s assets or operations would probably be considered variable interests even if they possess the characteristics in ASC 810-10-25-35.

Examples
ASC 810-10-55-55 through 55-86 give examples illustrating the application of the “by-design” approach. Each example illustrates how to (1) analyze the nature of the risks in the entity, (2) determine the purpose for which the entity was created, and (3) determine the variability the entity was designed to create and pass along to its interest holders.

2.16 Applying the Guidance in ASC 810-10-25-21 Through 25-36 to Purchase and Supply Arrangements
In applying the guidance of ASC 810-10-25-21 through 25-36 to purchase and supply arrangements in which a reporting entity enters into a contract either to purchase products from, or to sell products or services to, another entity, the reporting entity must first determine whether that contract should be evaluated under ASC 810-10-2535 and 25-36. If the contract does not possess the necessary characteristics to be evaluated under ASC 810-1025-35 and 25-36, the reporting entity should apply the other provisions in ASC 810-10-25-21 through 25-36 to determine what variability to consider and, ultimately, whether the contract is a variable interest. See Q&As 2.22– 2.25 for more information about applying ASC 810-10-25-35 and 25-36. If the contract is not deemed a creator of variability under ASC 810-10-25-35 and 25-36, the determination of whether a purchase or supply contract is a variable interest will be based on what risks the entity is designed to be subject to and whether the role of the contract is to transfer a portion of any of those risks from the equity, debt investors, or both to the counterparty of the purchase or supply agreement. This is consistent with the guidance in ASC 810-10-25-31, which states:

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An analysis of the nature of the legal entity’s interests issued shall include consideration as to whether the terms of those interests, regardless of their legal form or accounting designation, transfer all or a portion of the risk or return (or both) of certain assets or operations of the legal entity to holders of those interests. The variability that is transferred to those interest holders strongly indicates a variability that the legal entity is designed to create and pass along to its interest holders.

To determine whether the role of the contract is to transfer all or a portion of the risk or return (or both) of the assets or operations of the entity to the forward counterparty, the reporting entity must understand (1) the pricing of the contract, including whether the contract is fixed, variable, at market value, or off-market; (2) the predominant risks in the entity; and (3) any other involvement the counterparty may have with the entity. For example, a purchase or supply agreement that is off-market, when entered into, will always be a variable interest because the pricing terms of the contract result in a reallocation of expected losses between the interest holders. See Q&A 2.18 for a further discussion of off-market contracts. The table below illustrates the application of ASC 810-10-25-21 through 25-36 to certain types of purchase and supply contracts. Determining whether a contract is a variable interest will ultimately depend on individual facts and circumstances. Assume that an entity is created to hold a manufacturing facility and is funded by two unrelated equity holders (Investor 1 and Investor 2). An unrelated enterprise enters into either a purchase contract or a supply contract with the entity, as described in the table below. The contract is priced at market terms as of its inception date. The enterprise has no other involvement with the entity. Assume that ASC 810-10-25-35 and 25-36 do not apply because no observable market is associated with the contract. The enterprise has identified three potential risks in the entity: operating risk, credit risk, and product price risk.
Type of Contract Fixed-price purchase contract in which the enterprise purchases 100 percent of the manufactured product from the entity. Variable Interest? No. The entity is designed to be subject to operating risk, credit risk, and raw material price risk. The role of the fixed-price purchase contract is not to transfer a portion of those risks from the equity investors to the enterprise since the price paid under the contract does not change as a result of changes in operating costs, raw material costs, or default by the purchaser. The variability associated with those risks is designed to be absorbed by the equity investors. Yes. The entity is designed to be subject to operating risk, credit risk of the counterparty, and raw material price risk. The role of the variable-price purchase contract is to transfer raw material price risk and some portion of operating risk from the equity investors to the enterprise. Risk of changes in raw material prices and a portion of operating costs will be borne by the purchaser. No. The entity is designed to be subject to operating risk and product price risk. The role of the fixed-price supply contract is not to transfer the product price risk from the equity investors to the enterprise. Rather, the fixed-price supply contract creates variability since the entity has fixed its raw material price. Risk of changes in product prices and operating risk will be borne by the equity investors. No. The entity is designed to be subject to raw material price risk, operating risk, and product price risk. The role of the variable-price supply contract is not to transfer raw material price risk from the equity investors to the enterprise. Risk of changes in raw material costs will be borne by the equity investors.

Variable-price purchase contract in which the enterprise purchases 100 percent of the manufactured product from the entity. The contract reimburses the entity for actual costs incurred in manufacturing the product. Fixed-price supply contract in which the enterprise supplies the raw materials to the entity.

Variable-price supply contract in which the enterprise supplies the raw materials to the entity.

2.17 Applying ASC 810-10-25-21 Through 25-36 to PPAs, Tolling Agreements, and Similar Arrangements
Reporting entities that purchase output under PPAs, tolling agreements, or similar arrangements may not be able to apply the provisions of ASC 810-10-25-35 and 25-36. Some features of these agreements that would not allow a reporting entity to apply ASC 810-10-25-35 and 25-36 include the following: 1. 2. There is no explicit or implicit notional amount in the PPA. The output under the PPA (power) does not meet the net settlement criteria in ASC 815-10-15-110 and ASC 815-10-15-119.

The following example illustrates how ASC 810-10-25-21 through 25-36 are applied to PPAs, tolling agreements, or similar arrangements that cannot be evaluated under ASC 810-10-25-35 and 25-36: • An entity (PowerCo) is created to hold a power plant and is funded by two unrelated equity holders and one unrelated debt holder.
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• • •

PowerCo uses the proceeds from the equity contributions and debt to purchase the power plant. As a condition of lending, the debt holder requires PowerCo to enter into a 20-year forward contract to sell 100 percent of its output to a third party. PowerCo holds the title to the plant, which has a useful life of 40 years.

Although PowerCo is a business, as defined in ASC 805, the equity holders, debt holder, and purchaser of the electricity participated significantly in the design of the entity. Therefore, they should analyze PowerCo to determine whether it is subject to the VIE model in ASC 810-10.
Equity 1 Equity 2

Utility — Electricity (Purchaser)

PowerCo (Seller)

Debt

Raw Materials (Fuel)

In applying the provisions of ASC 810-10-25-21 through 25-36 to PPAs, tolling agreements, or similar arrangements, the reporting entity (counterparty to the contract) should assess risks to which the entity was designed to be exposed, such as raw material price risk, operations risk, credit risk, and electricity price risk. Factors to consider during this assessment include the activities of the entity, the terms of the contracts the entity has entered into, the nature of the entity’s interest issued, how the entity’s interests were negotiated with or marketed to potential investors, and which parties participated significantly in the design or redesign of the entity. Furthermore, it is important to consider all contracts held by a reporting entity, as well as those held by its relatedparty group. The following table illustrates the application of ASC 810-10-25-21 through 25-36 to PPAs, tolling agreements, or similar arrangements. These contracts are analyzed from the purchaser’s perspective (first column). The contracts described in the second column are other arrangements entered into between the entity (PowerCo) and either a third party or the purchaser. Assume that ASC 810-10-25-35 and 25-36 do not apply to the contracts below. Ultimately, whether a contract is a variable interest will depend on individual facts and circumstances.
Type of Contract (Purchaser) Fixed-price forward to purchase electricity. Existing Contracts for Fuel and Other Materials Market-price forward to purchase fuel from a third-party provider. Is the Purchaser’s Contract a Variable Interest?

No. The entity is designed to be subject to operating risk, credit risk of the purchaser, and fuel price risk. The role of the fixed-price forward contract is not to transfer any portion of those risks from the equity and debt investors to the purchaser since the price paid under the forward does not change as a result of changes in operating costs, fuel prices, or default by the purchaser. Those risks are designed to be borne by the equity and debt investors. No. The entity is designed to be subject to operating risk and credit risk of the purchaser. The role of the fixed-price forward contract is not to transfer any portion of these risks from the equity and debt investors to the purchaser since the price paid under the forward does not change as a result of changes in operating costs or default by the purchaser. Those risks are designed to be borne by the equity and debt investors. Yes. The entity is designed to be subject to operating risk, credit risk of the purchaser, and fuel price risk. The role of the fixed-price forward contracts held by the purchaser, when these contracts are evaluated together, transfers the fuel price risk from the equity and debt investors to the purchaser. Changes in the fuel prices will be borne by the purchaser. This arrangement is equivalent to the purchaser entering into a variable-price forward that is designed to reimburse the entity for changes in fuel prices.

Fixed-price forward to purchase electricity.

Fixed-price forward to purchase fuel from a third-party provider.

Fixed-price forward to purchase electricity.

Fixed-price forward to purchase fuel from the purchaser.

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Type of Contract (Purchaser) Tolling arrangement in which the purchaser provides fuel to the entity at no cost or transfer of title and purchases 100 percent of the output at a specified charge per unit (conversion cost). Variable-price forward to purchase electricity — reimburses entity for costs of fuel and O&M. Variable-price forward to purchase electricity — reimburses entity for costs of fuel and O&M.

Existing Contracts for Fuel and Other Materials Agreement to provide fuel included in the tolling arrangement.

Is the Purchaser’s Contract a Variable Interest?

Yes. The entity is designed to be subject to operating risk, credit risk of the purchaser, and fuel price risk.* The role of the tolling arrangement transfers the fuel price risk from the equity and debt investors to the purchaser. Changes in the fuel prices will be borne by the purchaser. This arrangement is equivalent to the purchaser entering into a variable-price forward that is designed to reimburse the entity for changes in fuel prices.

Market-price forward to purchase fuel from a third-party provider.

Yes. The entity is designed to be subject to operating risk, credit risk of the purchaser, and fuel price risk. The role of the variable-price forward contract is to transfer the fuel price risk and some portion of operating risk from the equity and debt investors to the purchaser. Changes in the fuel prices and O&M costs will be borne by the purchaser.

Market-price forward to Yes. The entity is designed to be subject to operating risk, credit risk of the purchase fuel from the purchaser, and fuel price risk. The role of the variable-price forward contract purchaser. is to transfer the fuel price risk and some portion of operating risk from the equity and debt investors to the purchaser. Changes in the fuel prices and O&M costs will be borne by the purchaser. Yes. The entity is designed to be subject to operating risk, credit risk of the purchaser, and fuel price risk. Although a component of the variableprice forward is considered an operating lease, the role of the remaining, non-lease components of the arrangement is to transfer fuel price risk and some portion of operating risk from the equity and debt investors to the purchaser. Changes in the fuel prices and O&M costs will be borne by the purchaser.

Market-price forward Variable-price forward to purchase fuel from a to purchase electricity — reimburses the entity third-party provider. for costs of fuel and O&M. A component of the variable-price forward is considered an operating lease under ASC 840. Purchaser enters into a fixed-price forward contract that qualifies as an operating lease under ASC 840. Market-price forward to purchase fuel from a third-party provider.

No. The forward contract to buy the electricity is an operating lease. Under ASC 810-10-55-39, operating leases are generally not variable interests in situations in which the lease is contracted at fair value and the purchaser provides no guarantee or holds no purchase option on the leased assets.

* Although the entity does not take title to the fuel in a tolling arrangement, the entity must produce electricity, which requires fuel. By supplying the entity with fuel at no cost, the reporting entity is implicitly absorbing fuel price risk associated with producing the electricity. This concept is consistent with the SEC speech on "activities around the entity" — see Q&A 2.09.

2.18

Off-Market Supply Agreements

Investor A and Investor B (unrelated parties) each hold a 50 percent equity interest in an entity. The entity owns a manufacturing facility that makes a product sold into the marketplace. Investor A enters into an agreement to supply the entity with the raw materials it needs to manufacture its product. The pricing of the supply agreement is off-market as of the inception date of the contract. Assume that A and B have no other interests in the entity.

Question
Is the supply agreement between A and the entity a variable interest?

Answer
Yes. The off-market supply agreement reallocates expected losses between A and B; therefore the contract absorbs expected losses and residual returns. For example, if the selling price of the raw materials were below market, A would absorb expected losses beyond its 50 percent equity interest because it is not receiving the normal profit on the sale. If the selling price of the raw materials were above market, A would receive, in the form of a premium, residual returns beyond its 50 percent equity interest. This conclusion would not change if a nonequity investor were to enter into the off-market supply agreement with the entity. The off-market contract would reallocate expected losses from the equity investors to the counterparty to the supply agreement.
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In evaluating whether a supply contract is a variable interest, a reporting entity must consider all relevant facts and circumstances, including (1) the terms of all contracts the entity has entered into (see Q&A 2.16 for examples) and (2) the entity’s overall design and purpose. Reporting entities should refer to the guidance in ASC 810-10-25-21 through 25-36. Step 2 in ASC 810-10-25-22 requires interest holders to “[d]etermine 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 also Example 3 in Q&A 3.36, which addresses the role of an off-market supply contract in an analysis under ASC 810-10-15-14(b)(2).) ASC 810-10
Subordination 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 entity’s 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. [FSP FIN 46(R)-6, paragraph 11]

2.19

Determining Whether a Variable Interest Is Subordinated Financial Support

Understanding which variable interests constitute subordinated financial support is important to evaluating an entity under the VIE model in ASC 810-10. For example, ASC 810-10-15-17(d)(3) requires a reporting entity to assess whether it has provided more than half of a potential VIE’s subordinated financial support when determining whether the potential VIE meets the business scope exception. Further, ASC 810-10-15-14 requires a reporting entity to assess the design of the potential VIE’s subordinated financial support when determining whether a potential VIE is a VIE. Subordinated financial support, as defined in ASC 810-10-20, is “[v]ariable interests that will absorb some or all of a [VIE’s] expected losses.”

Question
Under the VIE model in ASC 810-10, would all variable interests also be considered subordinated financial support?

Answer
No. Interests in an entity that are considered variable interests because they absorb expected losses of the entity are not necessarily subordinated financial support. Variable interests, as defined in ASC 810-10-20, are “contractual, ownership, or other pecuniary interests in a VIE that change with the changes in the fair value of the VIE’s net assets exclusive of variable interests” (see Q&A 4.02). ASC 810-10-55-19 further indicates that variable interests absorb or receive the expected variability created by assets, liabilities, or contracts of a VIE that are not, themselves, variable interests. The determination of whether a variable interest is subordinated financial support will be based on how that interest absorbs expected losses compared with other variable interests in the entity. The determination will be based on all facts and circumstances. If the terms of the arrangement cause the variable interest to absorb expected losses before or at the same level as the most subordinated interests (e.g., equity, subordinated debt), or the most subordinated interests are not large enough to absorb the entity’s expected losses, the variable interest would generally be considered subordinated financial support. For example, investment-grade debt and trade accounts payable are variable interests that would generally not be considered subordinated financial support. (See also Q&A 2.01, which addresses whether an interest is a variable interest.)

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Example
An investor holds a common-stock investment of $50 and a debt instrument of $60 in an entity. The only other variable interest is $40 of preferred stock held by an unrelated third party. The common and preferred stock are considered equity at risk in accordance with ASC 810-10-15-14(a), and the expected losses of the entity are $80. The entity is designed so that common and preferred stock absorb expected losses before the debt. The investors are evaluating whether the entity is a VIE under ASC 810-10-15-14(a). In this example, the equity, preferred stock, and debt are all considered variable interests because they are expected to absorb some of the potential VIE’s variability. However, because the common and preferred stock ($90) are expected to absorb 100 percent of the expected losses ($80), the debt is not considered subordinated financial support. ASC 810-10
Certain Interest Rate Risk 25-33 Periodic interest receipts or payments shall be excluded from the variability to consider if the legal entity was not designed to create and pass along the interest rate risk associated with such interest receipts or payments to its interest holders. However, interest rate fluctuations also can result in variations in cash proceeds received upon anticipated sales of fixed-rate investments in an actively managed portfolio or those held in a static pool that, by design, will be required to be sold prior to maturity to satisfy obligations of the legal entity. That variability is strongly indicated as a variability that the legal entity was designed to create and pass along to its interest holders. [FSP FIN 46(R)-6, paragraph 12]

2.20

Analyzing a MMF for Consolidation

Note: ASU 2010-10 indefinitely defers the amendments in ASU 2009-17 for a reporting entity’s interest in certain entities, including a reporting entity’s 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 or the Investment Company Act of 1940 for registered money market funds. See Q&A 1.01 for guidance on determining which consolidation model to apply. Rule 2a-7 of the Investment Company Act of 1940 regulates MMFs. The rule places certain restrictions on MMFs to help minimize the credit risk of their underlying asset portfolio, including requiring that they: 1. 2. 3. Invest only in highly rated securities with a maturity of 397 days or less. Maintain an asset portfolio with a dollar-weighted maturity of 90 days or less. Establish a board of directors that elects the investment adviser controlled by the fund’s shareholders.

Accordingly, regulated MMFs generally invest in short-term investments, including certificates of deposit, commercial paper and government securities, and pay dividends to shareholders that generally reflect short-term interest rates. Although credit losses in the underlying portfolio of an MMF are possible, they are typically managed with the goal of keeping losses to a minimum. Part of the perceived security of an investment in an MMF is that it is managed with the intent of retaining an NAV of $1 per share. Within certain parameters established by Rule 2a-7, an MMF is allowed to retain its $1 NAV. However, if the market value of the fund assets deviates from amortized cost by more than 50 basis points, the fund is required to record its investments at fair value. If fair value is less than book value, an MMF would be forced to report an NAV of less than $1 (referred to as “breaking the buck”). Some MMFs have sought to increase yields by investing in highly rated short-term debt issued by SIVs, which issue such debt to buy higher-yielding securities. Debt issued by SIVs may decline in value when the SIV securities default or are downgraded by rating agencies. The realized (or, in the event of downgraded but nondefaulted securities, the unrealized) losses may then cause the MMF to report an NAV of less than $1. To prevent NAV from falling below $1, an MMF sponsor (that is also the fund’s adviser) may step in and provide credit support to the MMF. This support may include, but is not necessarily limited to, capital contributions, standby letters of credit, guarantees of principal and interest, and agreements to purchase troubled securities at par. Such support is almost never contractually required and, if provided, is given at the sole discretion of the sponsor. See Q&A 2.14 for further discussion. Historically, an MMF has not been considered a VIE within the scope of the VIE model in ASC 810-10 because (1) the fund was deemed to have sufficient equity investment at risk to finance its activities without additional subordinated financial support and (2) the fund’s group of at-risk equity investors (i.e., the shareholders) had the requisite characteristics of a controlling financial interest. However, the act of providing credit support is a
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modification of the MMF’s contractual arrangements that may require the sponsor, as well as the other variable interest holders, to reconsider whether the fund is a VIE (see ASC 810-10-35-4(a)). Often, a sponsor’s support protects the holders of equity at risk (i.e., the shareholders) from the obligation to absorb the expected losses of the MMF that are associated with credit risk (see Q&A 3.36). If the MMF is ultimately determined to be a VIE, each variable interest holder (including the sponsor) would need to determine whether it should consolidate the fund as its primary beneficiary. ASC 810-10-25-21 through 25-36 address how a reporting entity should determine the variability to be considered in applying the VIE model in ASC 810-10. The VIE model requires the following two-step analysis of the design of the entity: • • Step 1: Analyze the nature of the risks in the legal entity. Step 2: Determine the purpose for which the legal entity was created and the variability (on the basis of the risks identified in step 1) the legal entity is designed to create and pass along to interest holders.

In the step 1 analysis, interest rate risk and credit risk are generally identified as the two main risks in an MMF. In the step 2 analysis, credit risk is usually considered a source of variability that an MMF is designed to create and pass along to its interest holders. However, although the interest earned by an MMF is passed along to its shareholders, there is some question about whether an MMF is designed to create and pass along interest rate risk to its interest holders (see Q&A 2.15).

Question
Should interest rate risk be included in the analysis of a regulated MMF when an entity applies the provisions of the VIE model in ASC 810-10?

Answer
Yes. Interest rate risk is one of the risks a regulated MMF is designed to create and pass along to its interest holders. ASC 810-10-25-25 includes factors a reporting entity should consider when making this determination, including (1) how the legal entity’s interests were negotiated with and marketed to potential investors and (2) the nature of the legal entity’s interests issued. As stated in its prospectus, a regulated MMF’s interests are negotiated with and marketed to investors as an investment that exposes investors to credit risk (in the form of the risk that the obligor of the fund’s assets will fail to pay interest or principal on the obligations) and interest rate risk (in the form of reinvestment risk associated with the continual need to replace maturing short-term assets at then-current market interest rates). Further, by virtue of their regulatory requirements, MMFs are designed to have minimal credit risk. Including variability in cash flows associated with interest and reinvestment risk is consistent with the stated purpose of a regulated MMF and with the decision that most investors make when becoming involved with a regulated MMF, which is to compare regulated MMF yields with those offered by comparable bank products (i.e., savings accounts and interest-bearing checking accounts). In addition, the explicit, single-class nature of the interests issued by a regulated MMF exposes the fund’s investors to the variability in net income or losses of the fund. The net income of the fund includes the impact of both credit and interest rate risk. Because a regulated MMF does not have any explicit subordinate class of interest issued that is designed to absorb variability, all variability in net income and variability of the MMF’s assets is, by the passthrough nature of the fund, intended to be passed along to its single class of interest holders. In informal discussions, the staff of the SEC’s Office of the Chief Accountant has stated that it would not object to registrants applying the view that regulated MMFs are designed to create and pass along interest rate risk to their interest holders. Although not specifically mentioned by the SEC staff, the above guidance would also apply when a registrant analyzes an unregulated MMF that is designed and marketed to be operated in accordance with Rule 2(a)-7. However, the SEC staff did state that this guidance “should not be analogized” to structures other than MMFs.6 If an MMF’s sponsor concludes that it is not a primary beneficiary of an MMF on the basis of the above guidance, it should determine the appropriate accounting for and disclosure of the credit support provided to the fund under other applicable GAAP (e.g., ASC 460-10 or ASC 815).

6

This issue was included in the January 10, 2008, EITF Agenda Committee Request. The EITF Agenda Committee, however, did not add this Issue to its March 2008 agenda. For more background on the Issue and the various views considered by the EITF Agenda Committee, see the January 10, 2008, Agenda Committee meeting minutes on the FASB’s Web site.
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ASC 810-10
Certain Derivative Instruments 25-34 A legal entity may enter into an arrangement, such as a derivative instrument, to either reduce or eliminate the variability created by certain assets or operations of the legal entity or mismatches between the overall asset and liability profiles of the legal entity, thereby protecting certain liability and equity holders from exposure to such variability. During the life of the legal entity those arrangements can be in either an asset position or a liability position (recorded or unrecorded) from the perspective of the legal entity. [FSP FIN 46(R)-6, paragraph 4]

2.21 How to Determine Whether an Embedded Derivative Is Clearly and Closely Related Economically to Its Asset or Liability Host
ASC 810-10-55-31 states:
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.

Question
If an embedded derivative is determined not to require separation from its related asset or liability host in accordance with ASC 815-15-25-1, can it be assumed that the embedded derivative does not need to be evaluated separately from its host asset or liability pursuant to the VIE model in ASC 810-10?

Answer
Not necessarily. The analysis of whether an embedded derivative should be separately evaluated is different under the VIE model in ASC 810-10. ASC 815-15-25-1 lists three criteria for separation of an embedded derivative from the host contract:
a. b. c. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract. The hybrid instrument is not remeasured at fair value under otherwise applicable [GAAP] with changes in fair value reported in earnings as they occur. A separate instrument with the same terms as the embedded derivative would, pursuant to ASC 815-10-15, be a derivative instrument subject to the requirements of this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

If the embedded derivative meets criterion (a) but not criterion (b) or (c), it should not be separated from its host contract under ASC 815. However, because the embedded derivative is not clearly and closely related to the host contract, a reporting entity should evaluate the derivative separately to determine whether there is a variable interest under ASC 810-10. In other words, the VIE model in ASC 810-10 only requires an analysis of whether the derivative is clearly and closely related economically to its asset or liability host (i.e., ASC 815-15-25-1(a)). For additional guidance on deciding whether the embedded derivative is clearly and closely related economically to the asset or liability host in accordance with the VIE model in ASC 810-10, see ASC 815-15-25-16 through 25-29, ASC 815-15-55-165 through 55-226, and any other relevant guidance on the phrase “clearly and closely related.”

Example
Enterprise A leases equipment (the only asset of Entity B) from B for a monthly payment of $10,000 for 36 months. The lease agreement includes a residual value guarantee provision in which A guarantees that the fair value of the leased equipment will be no less than $25,000 at the end of the 36-month term. The lease is an operating lease pursuant to ASC 840. The hybrid instrument embodies a host contract (the operating lease) and an embedded derivative (the residual value guarantee provision). The residual value guarantee provision is not clearly and closely related to the operating lease because the economic characteristics and risks of the guarantee are different from those related to the cash flows of the operating lease. Therefore, the hybrid instrument meets the criterion in ASC 815-15-25-1(a). As a result, the residual value guarantee must be evaluated separately from the host operating lease (a nonvariable interest) pursuant to paragraph ASC 810-10-55-31.

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The operating lease host, an equivalent of an account receivable, creates variability and therefore is not a variable interest in B. As discussed in ASC 810-10-25-21 through 25-36, the residual value guarantee transfers the risk of certain of the entity’s assets to the lessee and accordingly is deemed a variable interest in B. That the instrument should not be separated from the operating lease host pursuant to ASC 815 because it fails to meet the criterion in ASC 815-15-25-1(c) does not change the analysis under the VIE model in ASC 810-10. ASC 810-10
25-35 The following characteristics, if both are present, are strong indications that a derivative instrument is a creator of variability: a. b. Its underlying is an observable market rate, price, index of prices or rates, or other market observable variable (including the occurrence or nonoccurrence of a specified market observable event). The derivative counterparty is senior in priority relative to other interest holders in the legal entity. [FSP FIN 46(R)-6, paragraph 13]

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 legal 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 legal 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. [FSP FIN 46(R)-6, paragraph 13]

2.22

Applying the Guidance in ASC 810-10-25-35 and 25-36

ASC 810-10-25-35 and 25-36 provide guidance on determining whether a derivative instrument is a variable interest, stating:
The following characteristics, if both are present, are strong indications that a derivative instrument is a creator of variability: a. Its underlying is an observable market rate, price, index of prices or rates, or other market observable variable (including the occurrence or nonoccurrence of a specified market observable event). The derivative counterparty is senior in priority relative to other interest holders in the legal entity.

b.

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 legal 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 legal 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.

Under ASC 810-10-25-35 and 25-36, even if an instrument absorbs variability, it may be considered a creator of variability (i.e., not a variable interest) as long as it possesses specified characteristics and does not absorb all or essentially all of the variability in the entity. The guidance is intended to be narrow in scope, applying only to certain types of derivative contracts that possess specified characteristics (see Q&As 2.23 and 2.24 for further discussion of those characteristics). A reporting entity should not apply the guidance in ASC 810-10-25-35 and 25-36 when it has other involvement with the entity (e.g., when it holds equity, debt, or other contractual arrangements) and should not apply it to other types of contracts that do not possess the specified characteristics. Rather, a reporting entity should apply the other provisions in ASC 810-10-25-21 through 25-36 to all of its interests in assessing which variability to consider in determining which interests are variable interests.

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The following decision tree illustrates how a reporting entity should apply the guidance in ASC 810-10-25-35 and 25-36 :
Does the reporting entity have involvement with the entity other than the derivative instrument? No Does the instrument meet the definition of a derivative under ASC 815-10-15-83 through 15-139? Q&A 2.23 Yes Is the derivative’s underlying a marketobservable variable? Q&A 2.24 Yes Is the derivative counterparty senior in priority relative to other interest holders in the entity? Yes Are changes in the fair value or cash flows of the derivative insturment 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 entity? Q&A 2.25 No In the absence of evidence to the contrary, the derivative instrument is not a variable interest. The derivative instrument should not be evaluated under ASC 810-10-25-35 through 25-36. The design of the entity should be analyzed further to determine whether the instrument is a creator of variability or a variable interest. No No No Yes

Yes

The examples below illustrate the application of ASC 810-10-25-35 and 25-36 in certain situations. However, each transaction must be evaluated on the basis of its own facts and circumstances.

Example 1
An entity is created and financed with equity and variable-rate debt. The entity uses the proceeds to purchase BB-rated, fixed-rate securities. In addition, the entity enters into a “plain vanilla” interest rate swap with an unrelated third party (swap counterparty) that economically converts the fixed-rate securities to a variable rate. The notional amount of the swap relates to a majority of the assets in the entity. The swap counterparty has no other involvement with the entity. Assume that the interest rate swap possesses the following characteristics necessary to apply ASC 810-10-25-35 and 25-36: • • • The interest rate swap meets the definition of a derivative, as described in ASC 815-10-15-83. The interest rate swap’s underlying is an observable market rate. The swap counterparty is senior in priority to the entity’s other interest holders.

The interest rate swap would probably be considered a creator of variability even though that swap absorbs interest rate variability. Although the notional amount of the swap relates to a majority of the assets of the entity, changes in the cash flows or fair value of the swap are not expected to offset all, or essentially all, of the risk or return (or both) related to the investments because the fair value and cash flows of the entity’s investments are expected to be affected by risk factors other than changes in interest rate risk (e.g., credit risk of the fixed-rate securities). The swap is designed to offset only interest rate risk, which does not constitute essentially all of the overall risk in the entity.

Example 2
An entity is formed to construct and hold a single plant that will produce electricity. The plant has an estimated useful life of 40 years and is financed with equity (10 percent) and nonrecourse debt (90 percent). During the formation of the entity, an enterprise enters into a forward contract to buy 100 megawatts of the electricity
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produced by the plant (this is not contingent on the output of the entity) for 20 years. The forward contract is at a variable price, reimbursing the entity for a portion of operating and maintenance costs. The enterprise has no other involvement with the entity. The entity can choose to purchase the raw materials needed to produce the electricity on the spot market either at the time needed or before needed. Assume the forward contract possesses the following characteristics necessary to apply ASC 810-10-25-35 and 25-36: • • • The forward contract meets the definition of a derivative, as described in ASC 815-10-15-83 (see Q&A 2.17 for a discussion of power purchase arrangements). The forward contract’s underlying (electricity) has an observable market price. The enterprise is senior in priority to the entity’s other interest holders.

The enterprise has identified construction risk, raw material price risk, electricity price risk, operating risk, and credit risk as risks to which the entity is designed to be exposed. The forward contract would probably be considered a creator of variability even though the contract absorbs variability associated with electricity price risk and a portion of operating risk. Although the forward contract relates to a majority of the operations of the entity, changes in the cash flows or fair value of the forward contract are not expected to offset all, or essentially all, of the risk or return (or both) related to the output of the entity because the fair value and cash flows of the entity’s asset are expected to be affected by risk factors other than changes in electricity price risk and operating risk (i.e., construction risk, raw material price risk, credit risk). The forward contract is designed to absorb electricity price risk and a portion of operating risk, which does not constitute essentially all of the risk in the entity.

Example 3
An entity is created solely to hold common stock in a public company. The entity enters into a total return swap agreement with an unrelated third party in which the (1) entity pays the third party the return on common stock held by the entity as of certain predetermined dates and (2) third party pays to the entity a fixed periodic amount. The enterprise has no other involvement in the entity. Assume the swap possesses the following characteristics necessary to apply ASC 810-10-25-35 and 25-36: • • • The swap meets the definition of a derivative in ASC 815-10-15-83. The swap’s underlying (common stock of the entity) is publicly traded and therefore has an observable market price. The swap counterparty is senior in priority to the other interest holders.

While the total return swap possesses the characteristics described above, it offsets all, or essentially all, of the risk or return (or both) related to the majority of the assets (common stock) held by the entity because the fair value and cash flows of the entity’s investment will vary solely with changes in the price of the common stock and are not expected to be affected by other risk factors. Under the swap agreement, the third party is absorbing all of that price risk and the entity’s residual interest holders are receiving a fixed return. Further analysis of the entity’s design indicates that the total return swap would most likely be considered a variable interest (see also Q&A 2.11).

2.23

Meaning of the Term “Derivative Instrument” in ASC 810-10-25-35 and 25-36

ASC 810-10-25-36 states that the presence of both of the characteristics described in (a) and (b) of ASC 810-1025-35 in a derivative instrument strongly indicates that the derivative is a creator of variability and therefore not a variable interest.

Question
What is the meaning of the term “derivative instrument,” as used in ASC 810-10-25-35 and 25-36, and how does it compare with the same term used in ASC 810-10-55-16 through 55-41?

Answer
The term derivative instrument, as used in ASC 810-10-25-35 and 25-36, refers only to instruments that meet the definition of a derivative in ASC 815-10-15-83. This conclusion was confirmed through discussions with the FASB staff. Such derivative instruments would also include those instruments that might not otherwise be subject to the requirements of ASC 815, in accordance with ASC 815-10-15-13. Therefore, only a reporting entity holding an instrument that meets the ASC 815 definition of a derivative may apply ASC 810-10-25-35 and 25-36 to determine whether that instrument is a variable interest.
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If a reporting entity cannot apply the guidance in ASC 810-10-25-35 and 25-36, the reporting entity should further analyze the design of the entity under the VIE model in ASC 810-10 to determine whether the instrument is a creator of variability or a variable interest. ASC 810-10-55-16 through 55-41 give examples of variable interests that are subject to the provisions of the VIE model in ASC 810-10. These examples include instruments that have derivative-like features, including guarantees, written put options, liquidity agreements, and forward contracts (see ASC 810-10-55-25 through 55-31). While these instruments may or may not meet the definition of a derivative under ASC 815, they are still subject to the provisions of the VIE model in ASC 810-10. However, only those instruments that meet the definition of a derivative under ASC 815 can apply ASC 810-10-25-35 and 25-36.

2.24

Meaning of the Term “Market-Observable Variable” in ASC 810-10-25-35

For a reporting entity that has no other involvement with an entity to determine whether it can apply ASC 810-1025-35 and 25-36 to a derivative instrument, it must first evaluate whether the instrument meets the definition of a derivative in ASC 815-10-15-83. If so, the reporting entity must determine whether the instrument possesses the following characteristics: • The derivative instrument’s underlying is an observable market rate, price, index of prices or rates, or other market-observable variable (including the occurrence or nonoccurrence of a specified marketobservable event). The derivative counterparty is senior in priority to other interest holders in the entity.

Question
What is the meaning of the term “market-observable variable,” as used in ASC 810-10-25-35?

Answer
To be a market-observable variable, the market price, index, rate, or other variable underlying a derivative must be verifiable through an active, liquid market. A derivative with an underlying variable that is entity-specific (such as an entity’s sales or service revenues) or that is not based on market events (such as the occurrence of a hurricane or an earthquake) would not meet the conditions in ASC 810-10-25-35 even if the contract met the definition of a derivative in ASC 815-10-15-83. This conclusion was confirmed through discussions with the FASB staff. For example, commodities that trade on an active market, such as a commodities exchange, would be deemed to have an observable market price. However, a manufactured product that is sold by a reporting entity and its competitors in the marketplace, but not through an active, liquid market, would not be deemed to have an observable market price. Another example is an interest rate index such as LIBOR, which would be considered a market observable interest rate index. Conversely, a bank’s prime rate would not be considered a market observable interest rate index because it is determined by the bank and not in an active, liquid market. The concept of “market observable variable” used in ASC 810-10-25-35 is not analogous to the notion of “observable inputs” used in ASC 820. Under ASC 820, “observable inputs” are not limited to variables that are verifiable in active, liquid markets.

2.25

Meaning of the Term “Essentially All” in ASC 810-10-25-36

An instrument that possesses characteristics specified in ASC 810-10-25-35 but that is expected to offset all, or “essentially all,” of the risk or return (or both) related to the majority of the assets or operations of the entity must be further analyzed to determine whether the instrument is a creator of variability or a variable interest.

Question
How does a reporting entity determine whether an instrument offsets “essentially all” of the risk in an entity?

Answer
A reporting entity must consider whether the instrument offsets “essentially all” of the overall risk in the entity. The magnitude of the total risk should be considered, not whether a reporting entity offsets some of each type of risk in the entity. The determination of whether an instrument offsets “essentially all” of the risk or return (or both) is a

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matter of judgment — there are no strict quantitative guidelines. All facts and circumstances should be considered. These conclusions were confirmed through discussions with the FASB staff. For example, assume that two types of risk are created in an entity: operating risk and credit risk. Operating risk accounts for 98 percent of the total risk in the entity. The reporting entity holds a derivative instrument in the entity that offsets all of the operating risk but none of the credit risk. There are no other arrangements between the entity and the reporting entity. In this example, although the derivative instrument does not absorb each type of risk in the entity, it does offset essentially all of the overall risk in the entity because operating risk represents essentially all of the risk in the entity. Therefore, the reporting entity must further analyze the design of the entity to determine whether the derivative instrument is considered a creator of variability or a variable interest. If there is no evidence to the contrary, the derivative instrument is a variable interest.

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Section 3 — Determination of Whether an Entity Is a VIE
ASC 810-10-20
Variable Interest Entity A legal entity subject to consolidation according to the provisions of the Variable Interest Entities Subsections of Subtopic 810-10. [FIN 46(R), paragraph 2]

ASC 810-10
15-14 A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a variable interest entity [VIE] does not become one because of operating losses. [Paragraph 5] The design of the legal entity is important in the application of these provisions.): [FSP FIN 46(R)-6, footnote 2 of paragraph 5] a. The total equity investment (equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements) at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. For this purpose, the total equity investment at risk has all of the following characteristics: 1. 2. 3. Includes only equity investments in the legal entity that participate significantly in profits and losses even if those investments do not carry voting rights Does not include equity interests that the legal entity issued in exchange for subordinated interests in other VIEs Does not include amounts provided to the equity investor directly or indirectly by the legal entity or by other parties involved with the legal entity (for example, by fees, charitable contributions, or other payments), 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 Does not include amounts financed for the equity investor (for example, by loans or guarantees of loans) directly by the legal entity or by other parties involved with the legal 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.

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 entity’s 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). 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.

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ASC 810-10 (continued)
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 810-10-55-42) 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 entity’s 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. 2. 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 entity’s 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).

For purposes of applying this requirement, reporting entities shall consider each party’s obligations to absorb expected losses and rights to receive expected residual returns related to all of that party’s interests in the legal entity and not only to its equity investment at risk. [Paragraph 5] 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. [Paragraph 3]

Determination of Whether Equity Investment at Risk Is Sufficient Under ASC 810-1015-14(a)
ASC 810-10
15-14 A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a variable interest entity [VIE] does not become one because of operating losses. [Paragraph 5] The design of the legal entity is important in the application of these provisions.): [FSP FIN 46(R)-6, footnote 2 of paragraph 5] a. The total equity investment (equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements) at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. For this purpose, the total equity investment at risk has all of the following characteristics: 1. 2. 3. Includes only equity investments in the legal entity that participate significantly in profits and losses even if those investments do not carry voting rights Does not include equity interests that the legal entity issued in exchange for subordinated interests in other VIEs Does not include amounts provided to the equity investor directly or indirectly by the legal entity or by other parties involved with the legal entity (for example, by fees, charitable contributions, or other payments), 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

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ASC 810-10 (continued)
4. Does not include amounts financed for the equity investor (for example, by loans or guarantees of loans) directly by the legal entity or by other parties involved with the legal 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.

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. [Paragraph 5(a)]

3.01 Determination of Equity Investment at Risk When the Investor’s Initial Accounting Basis of Its Equity Differs From Fair Value
Under U.S. GAAP, a reporting entity must sometimes use carryover historical cost to record initial equity contributions made in the form of nonmonetary assets (e.g., formation of a joint venture or a contribution of nonmonetary assets pursuant to SAB Topic 5.G ).

Question
How should a reporting entity value an equity contribution in determining the amount of the equity investment at risk under ASC 810-10-15-14(a)?

Answer
A reporting entity should use the fair value of the asset (e.g., fixed asset, intellectual property) as of the contribution date, not the carrying value of the asset in the contributor’s books before the transfer, as the amount of the equity investment.

3.02

Including Mezzanine Equity Instruments in Total Equity Investment at Risk

An issuer of a security that is redeemable at the holder’s option, or upon a contingent event or other contingency outside the control of the issuer, may be subject to ASR 268 (FRR Section 211), SAB Topic 3.C, and EITF Topic D-98 (codified through ASU 2009-04), which require the issuer to present such a security outside of permanent equity on its balance sheet (i.e., classify the security as temporary or mezzanine equity).

Question
May a security that is classified outside of permanent equity (i.e., as temporary or mezzanine equity) qualify for inclusion in total equity investment at risk under ASC 810-10-15-14(a)?

Answer
Yes. ASC 810-10-15-14(a) states that equity investments in an entity are interests that must be reported as equity in that entity’s financial statements. Instruments accounted for as mezzanine or temporary equity would qualify for inclusion in an entity’s total equity investment at risk if those instruments meet the conditions in ASC 810-10-1514(a). This guidance is consistent with ASC 815-10-15-76, which indicates that “[t]emporary equity is considered stockholders’ equity for purposes of the scope exception in paragraph ASC 815-10-15-74(a) even if it is required to be displayed outside of the permanent equity section.” However, interests classified as temporary equity typically do not significantly participate in the profits and losses of the entity and thus fail to meet the requirement in ASC 810-10-15-14(a)(1) for inclusion in equity investment at risk. In addition, ASC 480-10 requires that certain instruments previously classified as temporary or mezzanine equity under ASR 268 (FRR 211), SAB Topic 3.C, and ASC 480-10-S99 be reclassified as liabilities (or assets in certain circumstances). Instruments classified as assets or liabilities do not qualify for inclusion in total equity investment at risk under ASC 810-10-15-14(a).

3.03 Determination of Whether a Personal Guarantee Provided by an Equity Holder Represents Equity Investment at Risk
Question
If an entity’s equity holder provides a personal guarantee of the entity’s debt, does this personal guarantee count as equity investment at risk under ASC 810-10-15-14(a)?
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Answer
No. If the amount has only been guaranteed (and not funded) by the equity holder as of the date of the VIE analysis, neither the amount guaranteed nor the fair value of the guarantee is considered equity investment at risk.

3.04 Determining Whether an Instrument With a Risks-and-Rewards Profile Similar to That of an Equity Investment Qualifies as Equity
Question
An entity may be capitalized with equity as well as with other instruments that cannot be reported as equity under U.S. GAAP in the entity’s financial statements (e.g., participating subordinated debt, subordinated intercompany debt). Sometimes the risks-and-rewards profile of such an instrument is similar to that of an equity investment. Is it appropriate to include these other instruments in total equity investment at risk under ASC 810-10-15-14(a)?

Answer
No. Whether interests in an entity qualify as equity investment at risk depends, in part, on their form. ASC 810-1015-14(a) states, in part, that “equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements.” Therefore, instruments that cannot be reported as equity in an entity’s financial statements cannot qualify as equity investment at risk. ASC 810-10-25-47 includes the following example illustrating that subordinated debt does not qualify as equity investment at risk:
[I]f 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.

3.05 Impact of ASC 810-10-15-14(a) on the Determination of Total Equity Investment at Risk When the Investee Is a Foreign Entity
Question
A reporting entity holds a variable interest in a foreign entity that prepares its financial statements in accordance with its home-country GAAP. Can that reporting entity consider an investment that is classified as equity under the investee’s foreign GAAP, but that does not qualify as equity under U.S. GAAP, as part of the equity investment at risk under ASC 810-10-15-14(a)?

Answer
No. Even though the foreign entity reports the instrument as equity under its home-country GAAP, the financial instruments in the foreign entity still must qualify for recognition as equity under U.S. GAAP in the determination of total equity investment at risk under ASC 810-10-15-14(a).

3.06

Non-At-Risk Equity Investment as a Variable Interest

Question
ASC 810-10-15-14(a) provides guidance on when an equity investment is considered at risk. If an equity investment is considered not to be at risk, is it a variable interest?

Answer
Generally, equity that is disqualified as equity investment at risk under ASC 810-10-15-14(a) is a variable interest unless the equity does not absorb or receive any of the entity’s variability. In certain circumstances, however, an equity investment would not be a variable interest (e.g., see Example 1 below).

Example 1
A commercial bank sponsors a trust. The trust raises $97 by issuing redeemable preferred stock to investors unrelated to the commercial bank. The commercial bank invests $3 for the common stock of the trust, which in turn lends $100, in the form of a note, to the commercial bank. The terms of the note, if satisfied, will service the dividend on the preferred stock and provide funds for its redemption. The trust is a VIE.
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ASC 810-10-55-22 states, in part:
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 investor’s 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.

The commercial bank designed the entity so that its equity investment is not at risk by obtaining the funds for its common-stock investment from the trust through the note. Therefore, the commercial bank is not exposed to the VIE’s variability. The preferred shareholders bear the losses borne by the trust if the commercial bank defaults on its obligation. Any loss the commercial bank suffers on its common-stock investment is recouped by the “gain” it experiences by defaulting on the note. Therefore, the commercial bank’s “investment” is not a variable interest in the trust-preferred vehicle. Since the commercial bank does not have a variable interest in the trust, it cannot be the VIE’s primary beneficiary and cannot consolidate the trust.

Example 2
A VIE issues notes to third parties for $75 and common stock to a sponsor for $25. The common stock receives a return only after the notes have been redeemed. The VIE invests $25 in a senior debt obligation of the sponsor (highly creditworthy) and $75 in a portfolio of debt securities issued by unrelated third parties. The sponsor’s investment in common stock is not an equity investment at risk because it is effectively funded by the VIE through its purchase of the sponsor’s debt obligation. However, the VIE was designed to pass along the risk related to the debt securities; therefore, the sponsor is exposed to the variability of the VIE. The sponsor’s note will fund losses that the VIE incurs on its portfolio of debt securities for the benefit of the VIE’s noteholders. In effect, the common-stock investment (net of the sponsor’s obligation to the VIE) acts as a guarantee by the sponsor of the portfolio of debt securities, capped at $25. Since guarantees are often variable interests, the sponsor should treat its common-stock “investment” as a variable interest in the entity and evaluate whether it is the VIE’s primary beneficiary.

Equity Investments That Participate in Profits and Losses
ASC 810-10
15-14 A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a variable interest entity [VIE] does not become one because of operating losses. [Paragraph 5] The design of the legal entity is important in the application of these provisions.): [FSP FIN 46(R)-6, footnote 2 of paragraph 5] a. The total equity investment (equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements) at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. For this purpose, the total equity investment at risk has all of the following characteristics: 1. Includes only equity investments in the legal entity that participate significantly in profits and losses even if those investments do not carry voting rights [Paragraph 5(a)(1)]

3.07

Definition of “Profits and Losses,” as Used in ASC 810-10-15-14(a)(1)

Question
Does the term “profits and losses,” as used in ASC 810-10-15-14(a)(1), refer to profits and losses under GAAP?

Answer
Yes. Whether an entity participates significantly in profits and losses should be based on an entity’s profits and losses under GAAP, not the entity’s variability in returns (i.e., expected losses and expected residual returns).

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3.08 Including Fixed-Rate, Nonparticipating Preferred Stock in the Total Equity Investment at Risk
Question
Is a fixed-rate, nonparticipating preferred-stock instrument (i.e., one that does not participate with common stock in dividends or liquidation) or other equity instrument that provides a fixed rate of return considered part of an entity’s equity investment at risk?

Answer
Generally, no. ASC 810-10-15-14(a)(1) requires that equity investment at risk participate significantly in the entity’s profits and losses (i.e., the fluctuations of an entity’s profits and losses). Therefore, fixed-rate, nonparticipating preferred-stock or other fixed-return instruments classified in equity typically would not participate significantly in the profits and losses of the entity. (Note that the term “profits and losses,” as used in ASC 810-10-15-14(a)(1), differs from the definitions of expected losses and expected residual returns in ASC 810-10-20 — see Q&A 3.07 for more information). Occasionally, the entity may have very little expected variability in profits and losses (e.g., the entity holds fixed-rate assets that have little risk). In such cases, a reporting entity may determine, upon evaluating all the facts and circumstances, that a fixed-rate instrument participates significantly in the profits and losses of the entity.

3.09 Determining Whether an Equity Interest Participates Significantly in the Profits and Losses of an Entity
ASC 810-10-15-14(a) states that an entity is a VIE subject to the requirements of the VIE model in ASC 810-10 if its “total equity investment . . . at risk is not sufficient to permit the . . . entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders.” In addition, ASC 81010-15-14(a) lists four criteria that an equity interest in an entity must meet to be considered equity investment at risk. The first criterion states that equity investment at risk includes only those equity investments (classified in equity) that participate significantly in the profits and losses of the entity, “even if those investments do not carry voting rights.”

Question
How does a reporting entity determine whether a class of equity participates significantly in profits and losses of a potential VIE?

Answer
A reporting entity must determine whether an equity instrument participates significantly in the profits and losses of the potential VIE as a whole on the basis of the design of the potential VIE as of the date of the evaluation under ASC 810-10-15-14(a). Generally, instruments that participate on a pro rata basis in the profits and losses, based on GAAP (see Q&A 3.07), of all the potential VIE’s assets and liabilities are considered to participate significantly in the profits and losses of the potential VIE as a whole. In contrast, instruments that participate in the profits and losses of specified assets are not considered to participate significantly in the profits and losses of the potential VIE as a whole and therefore would not qualify as equity investment at risk.

Example 1
A limited partnership is formed in which the GP holds a 2 percent interest; the LPs hold the remaining equity interests. Profits and losses of all assets and liabilities of the partnership are distributed according to ownership interests. There are no other arrangements between the entity and the GP/LPs. In this scenario, even though the GP only absorbs and receives 2 percent of the profits and losses of the limited partnership, its equity interest participates in the profits and losses of the limited partnership as a whole. Therefore, the GP’s equity interest participates significantly in the profits and losses of the limited partnership. See also Q&A 3.22, which discusses nonsubstantive equity of a GP.

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Example 2
Two unrelated parties, Enterprise A and Enterprise B, each contribute $10 million for equity investments in an entity. The entity uses the proceeds from the equity issuance, along with another $80 million obtained from the issuance of debt to invest in two buildings, each worth $50 million. The common stock is classified in equity. Enterprise A contractually absorbs only the profits and losses of Building 1, and B contractually absorbs only the profits and losses of Building 2. In this example, even though the common stock is classified in equity, none of the equity qualifies as equity investment at risk. Neither the equity of A nor that of B qualifies as equity investment at risk because neither significantly participates in the profits and losses of the entity as a whole. In this example, the parties involved that hold variable interests should evaluate their interest under the “silo” provisions in ASC 810-1025-57 to determine whether silos exist.

3.10 Impact of Put Options, Call Options, and Total Return Swaps on Equity Investment at Risk
ASC 810-10-15-14(a) states that an entity is a VIE subject to the requirements of the VIE model in ASC 810-10 if its “total equity investment . . . at risk is not sufficient to permit the . . . entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders.” In addition, ASC 81010-15-14(a) lists four criteria an equity interest in an entity must meet to be considered equity investment at risk.

Question
If an equity holder in a potential VIE purchases a put option, writes a call option, or enters into a total return swap on its equity interest, does the equity interest subject to the put, call, or total return swap qualify for inclusion in total equity investment at risk?

Answer
To qualify for inclusion in total equity investment at risk, the equity interest must meet all four criteria in ASC 81010-15-14(a). An equity interest subject to a put option, call option, or total return swap in which the counterparty is a party unrelated to the entity would not disqualify the equity investment from being at risk. Depending on the terms, a purchased put, a written call, or a total return swap entered into by an equity investor with the potential VIE or a party involved with the potential VIE may result in the disqualification of the investor’s equity from being considered equity investment at risk under ASC 810-10-15-14(a)(1) or ASC 810-10-15-14(a)(4). (See Q&A 3.11 for guidance on determining whether an equity interest participates significantly in the profits and losses of a potential VIE and Q&A 2.09 for the SEC staff’s views on “activities around the entity.”) The following table includes an analysis of whether an equity interest subject to a purchased put, a written call, or a total return swap qualifies as equity investment at risk under ASC 810-10-15-14(a)(1) or ASC 810-10-15-14(a)(4).
Original Reporting Entity Holds Equity in a Potential VIE and: Purchases a physically settled, fixed-price put on its equity investment. Writes a physically settled, fixed-price call on its equity.

Counterparty Is:

Compliant With ASC 810-10-15-14(a)(1)?

Compliant With ASC 810-10-15-14(a)(4)? Yes. The counterparty is not the potential VIE or another party involved with the potential VIE.

Additional Comments

Unrelated to Yes. Although the original reporting the potential entity is protected from losses via VIE. its fixed-price put option, the equity interest itself will remain outstanding even if the put is exercised; thus, the equity interest participates in both the profits and losses of the potential VIE. Unrelated to Yes. Although the counterparty can the potential obtain some of the original reporting VIE. entity’s upside, the equity interest itself will remain outstanding even if the counterparty exercises its call; thus, the equity interest participates in both the profits and losses of the potential VIE.

Yes. The counterparty is not the potential VIE or another party involved with the potential VIE.

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Original Reporting Entity Holds Equity in a Potential VIE and: Enters into a net-cashsettled total return swap indexed to the all-in return on its equity investment.* Purchases a physically settled, fixed-price put on its equity investment. Writes a physically settled, fixed-price call on its equity investment.

Counterparty Is:

Compliant With ASC 810-10-15-14(a)(1)?

Compliant With ASC 810-10-15-14(a)(4)? Yes. The counterparty is not the potential VIE or another party involved with the potential VIE.

Additional Comments Note that a principalagent relationship may exist (see Q&A 2.11).

Unrelated to Yes. The equity interest itself the potential participates in both the profits and VIE. losses of the potential VIE.

The potential VIE.

No. The fixed-price put option purchased from the potential VIE allows the original reporting entity to simply put its equity instrument to the potential VIE to protect it from incurring losses. Thus, the equity interest does not participate significantly in the potential VIE’s losses. No. The fixed-price call option written to the potential VIE results in the significant participation of the original reporting entity only in the potential VIE’s losses but not its profits (provided that the potential VIE acts rationally by exercising the call option when the fair value of the original reporting entity’s equity interest exceeds the fixed strike price). Yes. Although the original reporting entity is protected from losses via its fixed-price put option, the equity interest itself will remain outstanding even if the put is exercised; thus, the equity interest participates in both the profits and losses of the potential VIE. Yes. Although the counterparty can obtain some of the original reporting entity’s upside, the equity interest itself will remain outstanding even if the counterparty exercises its call; thus, the equity interest participates in both the profits and losses of the potential VIE.

No. The fixed-price put option purchased from the potential VIE is economically equivalent to the original reporting entity’s receiving a loan from the potential VIE to finance the original reporting entity’s investment in the potential VIE. Yes. The equity interest was not “financed” by the potential VIE.

The potential VIE.

Purchases a physically settled, fixed-price put on its equity investment. Writes a physically settled, fixed-price call on its equity investment.

A party related to the potential VIE.

No. The fixed-price put option purchased from the party related to the potential VIE is economically equivalent to the original reporting entity’s receiving a loan from the counterparty to finance the original reporting entity’s investment in the potential VIE. Yes. The equity interest was not “financed” by the party related to the potential VIE, except for deep in-themoney call options.

See example below for further explanation of this concept.

A party related to the potential VIE.

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Original Reporting Entity Holds Equity in a Potential VIE and: Enters into a net-cashsettled total return swap indexed to the all-in return on its equity investment.*

Counterparty Is:

Compliant With ASC 810-10-15-14(a)(1)?

Compliant With ASC 810-10-15-14(a)(4)? Generally, no. The total return swap entered into with a party related to the potential VIE is economically equivalent to the original reporting entity’s receiving a loan from the counterparty to finance the original reporting entity’s investment in the potential VIE. However, the equity investment may be at risk if the original reporting entity that holds the equity is acting solely as an agent for the other party related to the potential VIE. For guidance on determining whether the arrangement between the two equity investors is essentially a principal-agent relationship, see Q&A 2.11.

Additional Comments Note that a principalagent relationship may exist (see Q&A 2.11).

A party Yes. The equity interest itself related to participates in both the profits and the potential losses of the potential VIE. VIE.

* A total return swap on the equity interest is an arrangement in which the (1) original reporting entity will receive a fixed return (or variable interest rate return) and an amount equal to the decline in value of the equity interest and (2) counterparty will receive all the cash returns on the equity interest and the appreciation in value of the equity interest. In effect, a total return swap transfers substantially all of the risk and return related to the equity interest in the potential VIE without necessarily transferring the equity interest. See Q&A 2.11 for considerations related to whether a counterparty to a total return swap has a variable interest in the underlying entity.

Example
Enterprise A and Enterprise B are both equity investors. A put option purchased by A from B on A’s equity interest is economically equivalent to A borrowing all or a portion of the amount invested in the equity of the entity. Enterprise A receives upside but has no downside risk in the entity because the downside will be absorbed by B. An equity investment that was financed by a loan from a party involved with the entity does not qualify as equity investment at risk under ASC 810-10-15-14(a)(4). Likewise, this put option is economically equivalent to a “financing” of A’s interest by B (another party involved with the VIE); thus, the equity interest subject to the put option does not qualify as equity investment at risk.

3.11 Impact of Contracts and Instruments That Protect an Equity Investor on Equity Investment at Risk
ASC 810-10-15-14(a)(1) states that equity investment at risk “[i]ncludes only equity investments in the legal entity that participate significantly in profits and losses even if those investments do not carry voting rights” (emphasis added). Sometimes, an equity investor could be protected from incurring losses or its ability to obtain profits could be capped because of a contract or instrument that is separate from its equity interest and entered into with a party other than the investee. Examples of these arrangements include, but are not limited to: • • • • Guaranteed returns by another party involved or not involved with the legal entity. Put rights to another investor in the legal entity or an unrelated third party. Call rights granted to another investor in the legal entity or an unrelated third party. Total return swap on the equity investor’s equity written by another party involved or not involved with the legal entity.

Question
Do contracts or instruments that are separate from the equity interest and entered into with a party other than the investee cause the equity not to be at risk under ASC 810-10-15-14(a)(1)?
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Answer
Generally, no. Whether an equity interest participates significantly in the profits and losses of a legal entity generally is only based on the terms of the contracts or instruments with the investee entity. Therefore, a contract or instrument entered into with a party other than the investee that is separate from the equity interest itself does not disqualify the equity investment from being at risk. In the examples in the bulleted list above, the equity interest itself participates significantly in the profits and losses. The contracts and instruments may affect the holder’s total return but do not directly affect returns from the legal entity on the equity investment. Therefore, the equity investment would be at risk as long as it meets the other conditions in ASC 810-10-15-14(a). Put rights, total return swaps, guarantees, etc., with parties related to the legal entity may cause the equity interest to be considered not at risk under ASC 810-10-15-14(a)(4). See Q&A 3.09 and 3.10 for additional guidance on determining whether an equity investment is at risk. Note that if the direct holder of the equity interest is acting solely as an agent for the counterparty to the other instrument or contract, a reporting entity should attribute the direct holding to the counterparty in evaluating the accounting requirements under the VIE model in ASC 810-10. See ASC 810-10-25-42 and 25-43 and Q&A 2.11 for additional guidance on principal-agent relationships.

Equity Investments Provided Directly or Indirectly by the Entity
ASC 810-10
15-14 A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a variable interest entity [VIE] does not become one because of operating losses. [Paragraph 5] The design of the legal entity is important in the application of these provisions.): [FSP FIN 46(R)-6, paragraph 5, footnote 2] a. The total equity investment (equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements) at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. For this purpose, the total equity investment at risk has all of the following characteristics: 3. Does not include amounts provided to the equity investor directly or indirectly by the legal entity or by other parties involved with the legal entity (for example, by fees, charitable contributions, or other payments), 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 [Paragraph 5(a)(3)]

3.12 Qualification of Equity Investments Issued in Exchange for Promises to Perform Services as Equity Investment at Risk
Question
If an equity investor acquires equity investments issued by a potential VIE in exchange for performing or promising to perform services, can these investments be included in equity investment at risk?

Answer
No. Equity investments acquired by an equity investor in exchange for promising to perform services cannot be included in equity investment at risk under ASC 810-10-15-14(a)(3), which states that equity investment at risk does not include amounts that the potential VIE provides to the equity investor, such as fees or other payments. Similarly, equity investments acquired as a result of past services performed are not considered equity investment at risk.

Example
Three investors form Entity 1 to conduct R&D activities. Entity 1 issues equity with a par amount of $15 million, $5 million to each investor. Investor A contributes $5 million in cash. Investor B issues a guarantee that the fair value of the completion of the R&D activities will be at least $90 million. Investor C enters into an agreement with Entity 1 to provide research scientists who will each work for 500 hours to complete the activities. Only Investor A’s $5 million in equity is considered equity at risk because Investors B and C received their equity as payment from Entity 1 for the guarantee (promise to stand ready) and the performance of services, respectively.
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3.13 Determining Whether Fees Received by an Equity Investor for Services Performed at Inception or in the Future Reduce Equity Investment at Risk
Question
Should equity investment at risk be reduced for the fees paid or expected to be paid to an equity investor for prior or future services?

Answer
It depends. Fees paid or incurrence of an obligation to pay fees to the equity investor at the inception of the potential VIE (e.g., a developer or structuring fee) typically reduces the potential VIE’s equity investment at risk. The amount of the fee represents a return of the investor’s equity at risk. Since the equity investment is returned (or will be returned over time in the form of a payable), the portion of the investor’s equity investment returned in fees is not at risk. In contrast, if the fees expected to be paid/incurred in the future to the investor are commensurate with a service to be provided (at market rates), the equity investment at risk should not be reduced for these future fees. If future fees are in excess of market rates and the equity investor is unconditionally entitled to the fees, the present value of the excess should reduce the potential VIE’s equity investment at risk because the above-market fees received are, in substance, a guaranteed return of equity.

Equity Investments Financed by the Entity
ASC 810-10
15-14 A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a variable interest entity [VIE] does not become one because of operating losses. [Paragraph 5] The design of the legal entity is important in the application of these provisions.): [FSP FIN 46(R)-6, paragraph 5, footnote 2] a. The total equity investment (equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements) at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. For this purpose, the total equity investment at risk has all of the following characteristics: 4. Does not include amounts financed for the equity investor (for example, by loans or guarantees of loans) directly by the legal entity or by other parties involved with the legal 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. [Paragraph 5(a)(4)]

3.14 Determining Whether Funds Borrowed by a Reporting Entity Qualify as Equity Investment at Risk
Question
If an equity investor borrows funds to finance its equity investment in a legal entity, is the equity investment considered at risk if the financing is provided by a party that is both (1) unrelated to the legal entity and (2) not involved with the legal entity?

Answer
Yes. According to ASC 810-10-15-14(a)(4), amounts loaned to the equity holder are only disqualified if they are provided by “the legal entity or by other parties involved with the legal entity, unless that party . . . is required to be included in the same set of consolidated financial statements as the investor.” Therefore, if financing of the equity investment is provided to the equity investor by an unrelated third party that is not involved with either the legal entity or other parties involved with the legal entity, the investment can be included as equity investment at risk as long as the other criteria in ASC 810-10-15-14(a) are also met. Conversely, if one equity investor provides financing to another equity investor, the investment made by the equity investor who received the financing generally would be excluded from equity investment at risk. (For more information, see Q&A 2.09, which provides the SEC staff’s views on “activities around the entity.”)

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In unusual circumstances, the equity investment may be at risk when (1) one equity investor provides financing to another equity investor and (2) the borrowing equity investor is acting solely as an agent for the other equity investor (see Example 3 below).

Example 1
Enterprises A, B, and C each contribute $100 to form Entity D. Enterprise A’s $100 contribution was funded by a loan from Bank Z (an unrelated enterprise). Therefore, A’s equity does not fail to meet the criterion in ASC 810-1015-14(a)(4) because its loan was from an unrelated party that is not involved with either the legal entity or other parties involved with the legal entity.

Example 2
Enterprises A, B, and C each contribute $100 to form Entity D. Enterprise A’s $100 contribution was funded by a loan from Enterprise B (a bank), another party that is involved with the entity. Assume that A is not acting as an agent for B. Enterprise A has financed its equity investment by obtaining a loan directly from another party that is involved with D. In addition, B does not have to be included in A’s consolidated financial statements. Therefore, A’s $100 contribution would not qualify as equity investment at risk.

Example 3
Enterprises B and C each contribute $50 to form an entity. Enterprise B funds its equity investment by obtaining a $50 loan from C. Under a separate agreement, B is required to vote its interest in the entity (in all matters) in accordance with C’s instructions; therefore, a principal-agent relationship exists. Assume that B and C are not included in the same set of consolidated financial statements. In this example, all of B’s equity is considered equity investment at risk. Even though B obtained its equity through a loan from C (a party involved with the entity), B’s equity is still considered equity investment at risk because B is merely acting as C’s agent.

Sufficiency of Equity Investment at Risk
ASC 810-10
25-45 An equity investment at risk of less than 10 percent of the legal entity’s total assets shall not be considered sufficient to permit the legal entity to finance its activities without subordinated financial support in addition to the equity investment unless the equity investment can be demonstrated to be sufficient. The demonstration that equity is sufficient may be based on either qualitative analysis or quantitative analysis or a combination of both. Qualitative assessments, including, but not limited to, the qualitative assessments described in (a) and (b), will in some cases be conclusive in determining that the legal entity’s equity at risk is sufficient. If, after diligent effort, a reasonable conclusion about the sufficiency of the legal entity’s equity at risk cannot be reached based solely on qualitative considerations, the quantitative analyses implied by (c) shall be made. In instances in which neither a qualitative assessment nor a quantitative assessment, taken alone, is conclusive, the determination of whether the equity at risk is sufficient shall be based on a combination of qualitative and quantitative analyses. a. b. c. The legal entity has demonstrated that it can finance its activities without additional subordinated financial support. 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. The amount of equity invested in the legal entity exceeds the estimate of the legal entity’s expected losses based on reasonable quantitative evidence. [Paragraph 9]

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. [Paragraph 10]

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ASC 810-10 (continued)
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. [Paragraph D31]

3.15 Determining Whether a Quantitative Assessment of Equity Investment at Risk Is Necessary
ASC 810-10-25-45 presumes that an equity investment of less than 10 percent of the legal entity’s total assets is not sufficient to permit the legal entity to finance its activities without subordinated financial support in addition to the equity investment. That presumption can be overcome by a qualitative analysis, a quantitative analysis, or a combination of both.

Question
Is a reporting entity always required to perform a quantitative analysis (i.e., a calculation of expected losses) in determining whether a legal entity has sufficient equity investment at risk?

Answer
In the determination of whether the legal entity’s equity at risk is sufficient, a quantitative analysis may be unnecessary if a qualitative assessment is deemed conclusive. ASC 810-10-25-45(a) and 25-45(b) give the following two examples of qualitative assessments in which a reporting entity can reasonably conclude that the equity investment at risk is sufficient under ASC 810-10-15-14(a):
a. b. The legal entity has demonstrated that it can finance its activities without additional subordinated financial support. 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.

Further, the VIE model in ASC 810-10 permits a qualitative assessment to be based on factors other than those cited above. ASC 810-10-25-47 cites the following additional qualitative considerations: design of the legal entity, apparent intentions of the parties that created the legal entity, debt ratings, interest rates, and other financing terms. If a qualitative assessment of the sufficiency of the equity investment at risk has been performed and is conclusive, a quantitative approach to analyzing ASC 810-10-15-14(a) is unnecessary. The VIE model in ASC 810-10 indicates that the qualitative analysis should be the first step in determining whether a legal entity’s equity investment at risk is sufficient. A reporting entity must perform a quantitative assessment only if, after making a diligent effort, it cannot reach a reasonable conclusion about the sufficiency of the legal entity’s equity investment at risk solely on the basis of qualitative considerations. The quantitative analysis discussed in ASC 810-10-25-45(c) requires that the amount of equity invested in the legal entity exceed the estimate of the legal entity’s expected losses on the basis of reasonable quantitative evidence. If a quantitative assessment does not produce conclusive evidence (see Q&A 3.16), a reporting entity must perform a combination of qualitative and quantitative assessments. Also see Q&A 3.17.

Example 1
An entity is formed with (1) a $50 million equity investment that meets the conditions in ASC 810-10-15-14(a) for being “at risk” and (2) $950 million in high-credit-quality senior debt (e.g., AAA-rated). The high credit rating of the debt suggests the independent rating agency’s belief that entities other than the debt holders will absorb the entity’s expected losses. If the only variable interest besides the debt is the equity, the equity is considered to be sufficient to finance the entity’s activities without additional subordinated financial support.

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Although the reporting entity has reached a conclusion about the sufficiency of the legal entity’s equity at risk, the reporting entity must still analyze the legal entity to determine whether it fails to meet any of the characteristics in ASC 810-10-15-14(b) and 15-14(c) before concluding that the entity is not a VIE.

Example 2
An entity is formed with (1) a 1 percent equity investment that meets the conditions in ASC 810-10-15-14(a) for being “at risk” and (2) 99 percent debt, which contractually receives a high rate of return in relation to the interest rate of an investment-grade instrument with similar terms. Since the entity only has 1 percent equity and has issued subordinated debt in exchange for agreeing to pay a high rate of return, a qualitative analysis would demonstrate that the entity is a VIE.

3.16

Qualitative Versus Quantitative Analysis of Whether an Entity Is a VIE

ASC 810-10-25-45 states, in part, “The demonstration that equity is sufficient may be based on either qualitative analysis or quantitative analysis or a combination of both.” ASC 810-10-25-45 requires that a reporting entity undertake the qualitative analysis first. Only if, after making a diligent effort, a reasonable conclusion cannot be reached should a quantitative assessment be performed. ASC 810-10-25-45 further indicates that “[i]n instances in which neither a qualitative assessment nor a quantitative assessment, taken alone, is conclusive, the determination of whether the equity at risk is sufficient shall be based on a combination of qualitative and quantitative analyses.”

Question
Will a quantitative analysis always override a qualitative analysis?

Answer
No. While ASC 810-10-25-45 could require a qualitative, a quantitative, or a combined approach (see Q&A 3.15), the VIE model in ASC 810-10 raises the prominence of undertaking a qualitative assessment in lieu of an expected losses calculation. The FASB noted two reasons for why a qualitative assessment is the preferred method: • • The qualitative approach may help a reporting entity avoid the detailed estimates and computations of the quantitative approach (which could require significant effort and costs). While a quantitative approach may appear more precise and less subjective, the reporting entity may lack objective evidence on which to base the estimates and assumptions used to make the computation, resulting in imprecision and subjectivity.

Therefore, reasoned professional judgment that considers all facts and circumstances (including qualitative and quantitative considerations) is often as good as, or even better than, mathematical computations based on estimates and assumptions.

Example
Enterprise A contributes $1,000 in return for an equity investment in a joint venture. Assume that, in accordance with ASC 810-10-15-12 and ASC 810-10-15-17, the joint venture is not outside the scope of the VIE model in ASC 810-10. To determine whether the joint venture is a VIE, A must assess whether the entity’s equity at risk is sufficient to finance its activities without additional subordinated financial support. In accordance with the criteria in ASC 810-10-15-14(a), A determines that the entity’s equity at risk is $1,000. Enterprise A initially determines that the available qualitative evidence regarding the sufficiency of the entity’s equity at risk is not conclusive. Therefore, A performs an expected losses calculation and determines that the entity’s expected losses are $995. Although the entity’s $1,000 equity at risk exceeds the calculated expected losses of $995, the relatively insignificant difference between the two amounts provides little comfort that the quantitative approach alone is an adequate assessment of the sufficiency of the equity at risk. In this case, A must consider this quantitative analysis as well as the qualitative evidence to conclude that the entity’s equity at risk is sufficient under the ASC 810-10-1514(a) test.

3.17

Quantitative Expected-Loss Calculation — After Adoption of ASU 2009-17

Question
Could a reporting entity ever be required to perform a quantitative expected-loss calculation to support its conclusion that equity of the VIE is sufficient?
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Answer
Although ASU 2009-17 eliminates the requirement that a reporting entity perform a quantitative analysis to identify the primary beneficiary of a VIE, the reporting entity may still be required to perform a quantitative analysis when determining whether an entity is a VIE. It may need to perform a quantitative analysis to determine whether the total equity investment at risk is insufficient to permit the entity to finance its activities without additional subordinated financial support, which would indicate that the entity is a VIE. However, the quantitative analysis is only required when a reasonable conclusion about the sufficiency of the entity’s equity at risk cannot be reached solely on the basis of a qualitative analysis. Note also that while the primary-beneficiary analysis is no longer based on a quantitative expected-loss computation, the VIE model in ASC 810-10 indicates that a party’s economic exposure to an entity may provide information helpful to assessing the reasonableness of the conclusion about which party has control of the entity. See Q&A 4.16 for a discussion of methods for performing a quantitative calculation under ASC 810-10-55-37 through 37A when deemed necessary. Also see Q&A 3.15.

3.18 Consideration of Subordinated Debt in a Qualitative Assessment of Sufficiency of Equity at Risk
ASC 810-10-15-14(a) indicates that an entity is a VIE if the “total equity investment . . . at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders.” According to ASC 810-10-25-45, demonstration that equity is sufficient may be based on a qualitative analysis, quantitative analysis, or both. The qualitative analysis should be the first step in determining whether a legal entity’s equity investment at risk is sufficient. A reporting entity should only perform a quantitative assessment if qualitative considerations alone do not allow the reporting entity to reach a reasonable conclusion about the sufficiency of the legal entity’s equity at risk.

Question
Is the existence of subordinated debt a qualitative factor indicating that a legal entity’s equity investment at risk is not sufficient?

Answer
Yes. In a qualitative assessment, the existence of subordinated debt is a factor indicating that a legal entity’s total equity investment at risk may not be sufficient to absorb expected losses. That is, by virtue of its subordination, subordinated debt is expected to absorb expected losses beyond a legal entity’s equity investment at risk. However, the existence of subordinated debt should not be considered determinative in itself; an evaluation of the sufficiency of equity at risk should be based on all facts and circumstances. ASC 810-10-25-47 cites the following additional qualitative considerations: design of the legal entity, apparent intentions of the parties that created the legal entity, debt ratings, interest rates, and other financing terms. See also Q&A 3.16, which discusses the qualitative and quantitative assessment of whether an entity is a VIE.

Example 1
Entity D is formed with $50 of equity and $50 of long-term debt. The long-term debt consists of two issuances: Debt A, $45, and Debt B, $5. Debt B is subordinate to Debt A. Because D was recently formed, it could not obtain senior debt (Debt A) in an investment-grade form. In a qualitative assessment, the existence of subordinated debt is a factor indicating that D does not have sufficient equity at risk. A reporting entity should consider this factor, along with all other facts and circumstances, in making such an assessment. When an analysis of all other facts and circumstances results in an inconclusive qualitative assessment, a reporting entity should perform a quantitative analysis (i.e., calculation of expected losses/residual returns) to determine whether D is a VIE.

Example 2
Assume that in Example 1, D is a VIE. Two years later, D engages in additional business activities beyond those that were considered at formation and is an established, profitable business. Given its desire to further expand its business, D issues a new tranche of debt (Debt C) whose rank is identical in seniority (e.g., priority in liquidation) to that of Debt B. Because of its improved financial condition, the tranche of debt is rated investment-grade. Given the identical priority in liquidation of Debt B and Debt C, one can infer that Debt A (which is senior to Debt B) and Debt B would be rated investment-grade as well. No other debt securities are outstanding and no other evidence
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of subordinated financial support (e.g., guarantees) is noted. Assume that a reconsideration event under ASC 810-10-35-4(c) has occurred because the additional business activities increase D’s expected losses. Therefore, the variable interest holders must determine whether D is still a VIE. In a qualitative assessment, D’s ability to issue investment-grade debt that has the same priority in liquidation as Debt A and Debt B is one factor indicating that D, as of the reconsideration date, has sufficient equity at risk. In other words, in the absence of other forms of subordinated financial support, D would not have been able to obtain an investment-grade rating on the new debt if its existing equity at risk was not sufficient. However, a reporting entity should consider all other facts and circumstances existing as of the reconsideration date. If a qualitative assessment is not conclusive, the reporting entity should perform a quantitative analysis to determine whether D is a VIE as of the reconsideration date.

Example 3
Entity M is formed with equity and three issuances of debt. One of the debt instruments is investment-grade, while the other two are unrated debt. At formation, a qualitative assessment provides conclusive evidence that M has sufficient equity at risk. There are no other factors that would cause M to be a VIE. Five years later, M has incurred losses in several periods and disposes of two significant lines of business. Entity M also obtains additional financing in the form of subordinated debt that is rated as below investment grade. Entity M continues to maintain an investment grade rating on its other tranches of debt. Assume that a reconsideration event has occurred because M has curtailed its activities in a way that decreases its expected losses (ASC 810-1035-4(d)). Therefore, the variable interest holders must determine whether M is a VIE as of the reconsideration date. While M continues to have investment-grade debt outstanding, the subsequent issuance of subordinated debt is one factor, in a qualitative assessment, indicating that M does not have sufficient equity at risk (in other words, if M had sufficient equity at risk to finance its activities, the issuance of below investment grade subordinated debt would be unnecessary). However, a reporting entity should evaluate all other facts and circumstances existing as of the reconsideration date. If a qualitative assessment is inconclusive, the reporting entity should perform a quantitative analysis to determine whether M is a VIE as of the reconsideration date.

Determining Whether, as a Group, the Holders of the Equity Investment at Risk Lack Any of the Characteristics in ASC 810-10-15-14(b)
ASC 810-10
15-14 A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a variable interest entity [VIE] does not become one because of operating losses. [Paragraph 5] The design of the legal entity is important in the application of these provisions.): [FSP FIN 46(R)-6, footnote 2 of paragraph 5] 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 entity’s 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). Legal entities that are not controlled by the holder of a majority voting interest because of minority 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. 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 810-10-55-42) for a discussion of expected losses.

2.

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ASC 810-10 (continued)
3. 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 entity’s 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.

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. [Paragraph 5(b)]

3.19 Characteristics in ASC 810-10-15-14(b) Held Within the Group of At-Risk Equity Investors
Question
If some, but not all, of the at-risk equity investors in a potential VIE lack any of the three characteristics in ASC 81010-15-14(b), would that potential VIE automatically be a VIE?

Answer
No. To be a VIE pursuant to ASC 810-10-15-14(b), the at-risk equity investors as a group must lack any of the three characteristics listed in that paragraph. That is, as long as the group of equity investors possesses these three characteristics, the failure of any one at-risk equity investor to meet the conditions would not make the entity a VIE. See Q&A 3.20 for guidance on the meaning of the phrase “as a group.”

Example
Entity A is formed by two equity investors, one with voting rights (Investor 1) and one without any voting rights (Investor 2). Both equity investments are considered equity investment at risk under ASC 810-10-15-14(a). As long as one of the equity investors (Investor 1) has the power through its voting rights to direct the activities of the entity that most significantly affect the entity’s economic performance, the group does not lack the characteristic in ASC 810-10-15-14(b)(1). Note that the investors must also analyze the entity under ASC 810-10-15-14(c) because of Investor 1’s disproportionate voting rights.

3.20

Meaning of the Phrase “As a Group” in ASC 810-10-15-14(b)

ASC 810-10-15-14(b) specifies that if the holders of the equity investment in an entity “as a group” lack any one of the paragraph’s three characteristics, the entity is subject to the provisions of the VIE model in ASC 810-10.

Question
What is the relevance of the phrase “as a group”?

Answer
The phrase “as a group” means that all three characteristics in ASC 810-10-15-14(b) must be attributable solely to the equity investments at risk. If the equity investments at risk “as a group” do not possess all the characteristics in ASC 810-10-15-14(b), the entity will be a VIE even if there is sufficient equity at risk. Each individual equity investment at risk need not possess all three characteristics in ASC 810-10-15-14(b), but the total equity investments at risk must possess all three characteristics. The following are situations in which an entity is a VIE because the equity investors “as a group” lack one or more characteristics in ASC 810-10-15-14(b): • Holders of variable interests other than equity (e.g., debt holders, providers of guarantees, counterparties on derivative transactions that represent variable interests, providers under service contracts that represent variable interests) have sufficient voting rights or contractual rights to prevent the holders of the equity “at risk” from having the power to direct the activities of the entity that most significantly affect the entity’s economic performance.

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Holders of variable interests other than equity (e.g., debt holders, providers of guarantees, counterparties on derivative transactions that represent variable interests, providers under service contracts that represent variable interests) protect the equity investment at risk from expected losses or cap the return on the equity investment at risk. Holders of equity that is not considered to be at risk under ASC 810-10-15-14(a) have the power to direct the activities of the entity that causes the entity not to meet the characteristic in ASC 810-10-15-14(b)(1). See the ASC 810-10-15-14(a) Q&As for examples of equity instruments that are not considered to be at risk.

See Q&A 3.21 for additional guidance.

Example 1
The financing of Entity 1 consists of $100 million in equity (two investors each hold $50 million of the equity) and $200 million in convertible debt held by a single unrelated investor. The convertible debt carries 66 percent of the voting rights on all matters subject to shareholder vote (including those activities that most significantly affect the entity’s economic performance). Because the convertible debt is not considered equity at risk under ASC 810-1015-14(a) and the convertible debt holder can exercise power through voting on the activities that most significantly affect the entity’s economic performance, the equity investors, as a group, fail to meet the power-to-direct criterion in ASC 810-10-15-14(b)(1). Therefore, Entity 1 is a VIE.

Example 2
In many affordable housing partnerships, the GP receives a development fee, paid up front or over time, which typically exceeds the amount of the GP’s interest and is not commensurate with the ongoing services provided. The amount of the fee received represents a return of the GP’s equity at risk. This arrangement is economically equivalent to the entity’s providing the equity to the investor in exchange for fees, which does not meet the condition in ASC 810-10-15-14(a)(3). (For more information, see Q&A 3.13.) The GP typically has the power to direct the entity’s activities that most significantly affect the entity’s economic performance (i.e., the LP has very limited power). Because the GP’s investment is returned (or will be returned over time) in the form of developer fees, the GP’s investment is not at risk. If the GP has the power to direct, the at-risk equity holders (the LPs) will not, as a group, meet the condition in ASC 810-10-15-14(b)(1); thus, the partnership is a VIE.

3.21 Impact of ASC 810-10-15-14(b) on Determining Characteristics of Control or Lack of Control by the Group of Holders of Equity Investment at Risk
Question
Assume that the characteristics in ASC 810-10-15-14(b) are provided by a combination of equity and nonequity instruments. Further assume that the nonequity instruments are entirely held by the holders of the at-risk equity. Would an entity be a VIE under these circumstances?

Answer
It depends on the extent to which the nonequity interests participate in the power to direct the activities that most significantly affect the entity’s economic performance. If the characteristics identified in ASC 810-10-15-14(b)) are provided to the holder(s) by any interest of an entity other than the equity investment at risk, the entity is a VIE. However, if only the equity-investment-at-risk instruments provide the holders as a group with all of the characteristics listed, the entity is not a VIE (as long as the criteria in ASC 810-10-15-14(a) and ASC 810-10-15-14(c) are satisfied).

Example 1
Assume that an entity is formed by the issuance of equity and debt, both with voting rights proportional to the amount invested. Investor 1 contributes $20 in return for equity with a 20 percent vote. Investor 2 contributes $80 — $20 for equity with a 20 percent vote and $60 for debt with a 60 percent vote. Decisions are based on a simple majority of all voting rights. Although the holders of equity investment at risk have the power to direct, as a group, the equity does not convey the power to direct the activities of the entity that most significantly affect the entity’s economic performance. That conclusion is reached because 60 percent of the voting rights are attached to Investor 2’s debt instrument.
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The voting ability attached to the debt is so significant that it prevents the equity from conveying the power to direct (as discussed in ASC 810-10-15-14(b)(1)). Therefore, the holders of the at-risk equity investments fail to meet the criterion in ASC 810-10-15-14(b)(1); thus, the entity would be deemed a VIE. Alternatively, if Investor 2 contributes $80 — $60 for equity with a 60 percent vote and $20 for debt with a 20 percent vote, the criterion in ASC 810-10-15-14(b)(1) would be met because the equity conveys to the equity holders as a group the power (i.e., an 80 percent majority vote) to direct the activities of the entity that most significantly affect the entity’s economic performance.

Example 2
Assume that the sole asset of Entity A is a building that it leases to Company Z. Company Z owns 20 percent of the at-risk equity of A. Pursuant to the lease agreement, Z has provided a residual value guarantee on the building, which protects all the equity investors from any losses resulting from the decline of value in the building. It appears that the at-risk equity participants would have the obligation to absorb the expected losses of the entity in accordance with ASC 810-10-15-14(b)(2). However, although the exposure of the at-risk equity holders to losses is not limited directly by the terms of the at-risk equity, the at-risk equity investors are protected from losses that arise from declines in value of the building. The residual value guarantee absorbs those losses. Therefore, the holders of the at-risk equity investments fail to meet the criterion in ASC 810-10-15-14(b)(2) and the entity would be deemed a VIE.

Example 3
Assume that one of the at-risk equity investors in an investment fund serves as the fund’s investment manager. Pursuant to the fund’s governing documents, the investment manager is entitled to all of the fund’s annualized returns of more than 10 percent in any annual period. The at-risk equity participants as a group appear to have the right to receive the expected residual returns of the entity (which are not capped by the terms of the equity itself or by any governing documents), in accordance with ASC 810-10-15-14(b)(3). However, the rights of the investment manager to the entity’s returns must be considered. Therefore, as a group, the holders of the at-risk equity investments would fail to meet the criterion in ASC 810-10-15-14(b)(3); thus, the entity would be deemed a VIE.

3.22

Minimum Amount of Equity Held By an Investment Manager or GP

Question
Under ASC 810-10-15-14(b), does an investment manager or GP need to hold a minimum amount of equity for its interest to be considered part of the equity at risk?

Answer
For the equity investment of an investment manager or GP to be considered at risk, it must be determined to be more than “inconsequential.” In making this assessment, a reporting entity may consider the following: • The investment manager’s or GP’s investment in the entity relative to the value of other investments providing a similar return. For example, if the investment manager or GP invests $1,000 in a $10 million fund and the minimum investment required for all other participants is $500,000, the investment manager’s or GP’s investment may be considered inconsequential. The design of the entity. If the entity appears to be designed (or redesigned) to produce a desired accounting result (e.g., to specifically avoid the provisions of the VIE model in ASC 810-10 or to cause an entity or reporting entity to be within the scope of the VIE model in ASC 810-10), a reporting entity should use additional skepticism in arriving at a conclusion. Other factors, such as the legal and tax implications and the extent to which they affect the amount invested by an investment manager’s or GP’s interest, as well as whether the investment manager or GP is a related party of other investors in the entity.

Example
A GP and various LPs form a limited partnership with $100 million of equity, all of which meets the definition of equity at risk under ASC 810-10-15-14(a). The sole GP makes all day-to-day investment decisions. When the partnership is formed, the GP makes an initial equity investment of $1,000. Assume that the LPs have no kickout rights.
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In this example, (1) the GP’s equity is inconsequential when compared with the total amount of equity at risk and therefore does not constitute equity at risk under ASC 810-10-15-14(a) and (2) there is no substantive difference between an investment of $0 and an investment of $1,000.

3.23

Ability of Holders of Equity Investment at Risk to Remove a Decision Maker

ASC 810-10-15-14(b)(1) states that for an entity not to be a VIE, the holders of equity investment at risk, as a group, must have the power to direct the activities of an entity that most significantly affect the entity’s economic performance. Assume that the collateral manager of a CDO structure makes day-to-day decisions about the investments held, purchased, and sold. Those decisions must be made within certain guidelines established at inception of the structure, but they are the decisions that will most significantly impact the economic performance of the entity. (See Q&As 2.05 and 2.06 for more information about synthetic CDO structures.)

Question
If the holders of equity investment at risk as a group can vote to remove that collateral manager, are the equity holders considered to have the power to direct described in ASC 810-10-15-14(b)(1)? Assume that other variable interest holders of the CDO do not have rights to participate in the firing of the current collateral manager and the hiring of a new collateral manager.

Answer
It depends. A reporting entity must evaluate the fees paid to the collateral manager under ASC 810-10-55-37 through 37A to determine whether the management agreement represents a variable interest in the entity. If the fees paid to the collateral manager meet all of the conditions in ASC 810-10-55-37 through 37A, the agreement does not represent a variable interest in the entity. Provided that the agreement does not represent a variable interest in the entity, the management agreement would not prevent the equity holders from having the characteristic in ASC 810-10-15-14(b)(1). However, if, after evaluating the management agreement under ASC 810-10-55-37 through 37A, a reporting entity determines that the collateral manager does have a variable interest in the entity, the equity holders may lack the characteristic in ASC 810-10-15-14(b)(1) and, if so, the CDO entity would be a VIE. Under ASC 810-10-15-14(b) (1), kickout rights would prevent the collateral manager from having the power if the kickout rights were held by a single equity holder (including its related parties and de facto agents) that has the unilateral ability to exercise such rights. If the kickout rights are held collectively by the equity holders, they would not prevent the collateral manager from having the power, and the equity holders would not have the characteristic in ASC 810-10-1514(b)(1).

3.24 Decision-Making Rights Granted to an Equity Holder Separately From Its Equity Investment at Risk
Question
If the power to direct the activities that most significantly affect the entity’s economic performance is granted to an equity holder separately from a substantive equity investment at risk and the decision-making contracts meet the definition of a variable interest in ASC 810-10-55-37 through 37A, does the entity lack the characteristic in ASC 810-10-15-14(b)(1) (i.e., the equity at risk has the power to direct the activities of an entity that most significantly affect the entity’s economic performance)?

Answer
Yes. A separate management agreement that grants the power to direct the activities that most significantly affect the entity’s economic performance (as described in Q&A 3.23) that is a variable interest under ASC 810-10-55-37 through 37A would cause the equity holders to lack the power to direct under ASC 810-10-15-14(b)(1) even if the manager, under the management agreement, also holds an equity investment in the entity. According to ASC 810-10-15-14(b)(1), a reporting entity must evaluate a management agreement under ASC 81010-55-37 through 37A to determine whether it represents a variable interest in the entity. If the fees paid to the decision maker under the management agreement meet all of the conditions in ASC 810-10-55-37 through 37A, the agreement does not represent a variable interest in the entity. Provided that the management agreement does not represent a variable interest in the entity, it would not prevent the equity holders from having the characteristic in ASC 810-10-15-14(b)(1).
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However, if, after evaluating the management agreement under ASC 810-10-55-37 through 37A, the reporting entity determines that the decision maker does have a variable interest in the entity, the equity holders lack the characteristic in ASC 810-10-15-14(b)(1) unless a single entity holder has the substantive, unilateral ability to remove the decision maker. Note that when determining whether the management agreement is separate from the equity investment, a reporting entity must evaluate all relevant facts and circumstances, including both the form of the management agreement and the substance of the arrangement. If the reporting entity can dispose of the management agreement without disposing of the equity investment (or vice versa) or if the equity investment at risk is not substantive, then the management agreement would generally be considered a separate arrangement that should be evaluated under ASC 810-10-55-37 through 37A. If, however, the reporting entity (or a related party) is required to have a substantive equity investment at risk in order to perform the management activities, then the management agreement would generally not be considered a separate arrangement (i.e., the power to direct the activities that most significantly affect the entity’s economic performance would be derived through the equity investment), and therefore the management agreement would not be subject to an evaluation under ASC 810-10-55-37 through 37A. For example, if a GP (with a substantive equity interest and a separate management agreement) cannot dispose of its equity interest and still maintain its decision-making rights under the management agreement, the management agreement and the equity interests are unlikely to be considered substantively separate. Also, the absence of valid and compelling business reasons for documenting decisionmaking rights separately from equity interests may indicate that the arrangement was designed solely or principally to achieve an accounting result.

3.25

Nonsubstantive Equity Investment of a GP

A GP and various LPs form a limited partnership with $100 million of equity, all of which meets the definition of equity at risk under ASC 810-10-15-14(a). The sole GP makes all day-to-day investment decisions. When the partnership is formed, the GP makes an initial equity investment of $1,000. Assume that the LPs have no kickout rights. In this example, (1) the GP’s equity is inconsequential when compared with the total amount of equity at risk and therefore does not constitute equity at risk under ASC 810-10-15-14(a) and (2) there is no substantive difference between an investment of $0 and an investment of $1,000. See Q&A 3.22 for more information.

Question
In the above scenario, how does the conclusion that the GP’s initial investment is not equity at risk affect whether, under ASC 810-10-15-14(b)(1), the holders of equity at risk, as a group, are able to direct the activities of the partnership that most significantly affect the partnership’s economic performance?

Answer
According to ASC 810-10-15-14(b)(1), a reporting entity must evaluate the fees paid to the GP under ASC 810-1055-37 through 37A to determine whether the GP has a variable interest in the partnership. If the fees paid to the GP meet all of the conditions in ASC 810-10-55-37 through 37A, the GP does not have a variable interest in the partnership. If the GP does not have a variable interest in the partnership, the decision-making power held by the GP would not prevent the equity holders from having the characteristic in ASC 810-10-15-14(b)(1). However, if, after evaluating the fees paid to the GP under ASC 810-10-55-37 through 37A, a reporting entity determines that the GP does have a variable interest in the entity, the equity holders lack the characteristic in ASC 810-10-15-14(b)(1) and the partnership is a VIE. If only the form of the transaction were considered, the partnership would not be considered a VIE because the equity holders as a group (GP and LPs combined) would be perceived to have the ability to make decisions about the partnership’s activities.

3.26 Determining Whether a GP Interest Should Be Aggregated With an LP (or Other) Interest in the Evaluation of a Legal Entity Under ASC 810-10-15-14
ASC 810-10-15-14(b)(1) indicates that an entity is considered a VIE if the holders of equity at risk, as a group, lack the “power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance.”

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At the 2006 AICPA National Conference on Current SEC and PCAOB Developments, a member of the SEC staff described a limited partnership arrangement in which the GP is a related party to at least one of the LPs and the GP has made either no equity investment or a nonsubstantive equity investment in the legal entity. Consequently, the reporting entity may conclude that the LPs are the only holders of equity at risk. In evaluating this structure under ASC 810-10-15-14(b)(1), the reporting entity may further conclude that because the GP is not an equity investor but has decision-making ability, the group of at-risk equity holders (LPs) lacks the characteristic in ASC 810-10-1514(b)(1) and the entity is therefore a VIE. However, according to the SEC staff member, although the GP is not an equity investor, the GP could be so “closely associated” with one or more of the LPs that the interests of the GP and one or more LPs should be considered in the aggregate under ASC 810-10-15-14(b)(1). Q&A 3.24 also needs to be considered when analyzing the examples discussed below.

Question
What factors should be considered in the determination of whether to aggregate the interests of two or more reporting entities under ASC 810-10-15-14(b)(1)?

Answer
In general, the determination of whether two or more reporting entities’ interests should be aggregated under ASC 810-10-15-14(b)(1) depends heavily on the facts and circumstances and requires judgment. For example, a reporting entity should carefully evaluate the significance of the relationship between separate entities that qualify as related parties under ASC 850-10 and ASC 810-10-25-42 and 25-43 to determine whether those reporting entities are so closely associated that aggregation of their interests is warranted. In particular, if two or more reporting entities are under common control, this strongly supports a presumption that their interests should be evaluated in the aggregate. Other factors to consider in evaluating the significance of related-party relationships include (1) the design or redesign of the legal entity, (2) the level of influence one related party may have over the operations and financial policies of another related party, and (3) the extent to which aggregation of the entities’ interests might lead to a different conclusion under the VIE model in ASC 810-10 if their interests were viewed separately. However, the mere existence of a related-party relationship under ASC 850-10 and ASC 810-10-25-42 and 25-43 does not automatically result in a conclusion that two or more reporting entities are so closely associated that their interests should be viewed in the aggregate. A reporting entity may need to perform further analysis to determine whether the decision-making rights are distinct from the equity investment. Accordingly, a reporting entity should also consider the guidance in Q&A 3.24 when determining whether the holders of equity investment at risk have the decision-making abilities described in ASC 810-10-15-14(b)(1). The following three examples illustrate this concept:

Example 1
A GP and several LPs form a partnership. Assume that the GP makes no or a nonsubstantive equity investment, the LPs hold equity at risk, and no other arrangements would cause the partnership to be a VIE under ASC 810-10. The GP and one of the LPs (LP1) are controlled by the same parent. Because the GP and LP1 are controlled by the same parent, they are related parties under ASC 850-10. This related-party relationship is also presumptively so significant that the interests of the parties should be viewed in the aggregate because the common parent can make decisions for both the GP and LP1. Therefore, in the absence of evidence to the contrary, the GP and LP1 interests should be considered in the aggregate under ASC 810-10-15-14(b)(1). As a result, the group of equity holders (GP and LPs) may not lack the characteristic described in ASC 810-10-15-14(b)(1); thus, the partnership may not be a VIE. An entity should consider the guidance in Q&A 3.24 in making this assessment.

Example 2
A GP and several LPs form a partnership. Assume that the GP makes no or a nonsubstantive equity investment, the LPs hold equity at risk, and no other arrangements would cause the partnership to be a VIE under ASC 810-10. The GP and LPs are restricted from selling their interests without the prior approval of the other partners. The existence of a “lock-up” provision does not, in and of itself, indicate a significant related-party relationship because it is a customary part of a partnership arrangement. Therefore, in the absence of evidence to the contrary, the GP and LP interests should not be considered in the aggregate under ASC 810-10-15-14(b)(1). Accordingly, the group of equity holders (LPs) would lack the characteristic in ASC 810-10-15-14(b)(1) and the partnership would be a VIE.
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Example 3
A GP and several LPs form a partnership. In this example, the GP and the LPs all make substantive equity investments that qualify as equity investment at risk. However, the GP has irrevocably transferred all of its decision-making ability by contract to Enterprise A, which cannot be kicked out without cause. Enterprise A does not hold any equity in the partnership. However, A and the GP are both wholly owned by a common parent. Because the GP and A are controlled by the same parent, they are related parties under ASC 850-10. This related-party relationship is also presumptively so significant that the parties’ interests should be viewed in the aggregate because the common parent can make decisions for both the GP and A. In the absence of evidence to the contrary, interests of the GP and A should be considered in the aggregate under ASC 810-10-15-14(b)(1). Therefore, the group of equity holders (GP and LPs) may not lack the characteristic described in ASC 810-10-1514(b)(1); thus, the partnership may not be a VIE. A reporting entity should consider the guidance in Q&A 3.24 in making this assessment.

Analysis of Fees Paid to a Decision Maker or Service Provider 3.27 Meaning of “Insignificant” in the Analysis of Fees Paid to a Decision Maker or Service Provider
ASC 810-10-55-37 lists six conditions that must be met for a reporting entity to determine that fees paid to a decision maker or a service provider do not represent a variable interest. In particular, ASC 810-10-55-37(c), 37(e), and 37(f) state, in part:
c. The decision maker or service provider does not hold other interests in the VIE that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE’s expected losses or receive more than an insignificant amount of the VIE’s expected residual returns. [Emphasis added] The total amount of anticipated fees are insignificant relative to the total amount of the VIE’s anticipated economic performance. [Emphasis added] The anticipated fees are expected to absorb an insignificant amount of the variability associated with the VIE’s anticipated economic performance. [Emphasis added]

e. f.

Further, ASC 810-10-55-37A states:
For purposes of evaluating the conditions in [ASC 810-10-55-37], 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 of [ASC 810-10-55-37], any interest in the entity that is held by a related party of the entity’s decision maker(s) or service provider(s) should be treated as though it is the decision maker’s or service provider’s 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.

Question
What is the meaning of “insignificant,” as used in ASC 810-10-55-37?

Answer
ASC 810-10 does not define the term “insignificant.” The Basis for Conclusions of Statement 167 indicates that the conditions in ASC 810-10-55-37 regarding whether decision-maker fees and service-provider fees represent a variable interest were sufficient for determining whether a reporting entity is acting in a fiduciary (agency) role as opposed to acting as a principal. Therefore, the principle underlying the guidance in ASC 810-10-55-37 is whether a decision maker or service provider is acting as a principal or as an agent. Although the FASB does not define the term “insignificant” in ASC 810-10, paragraph A75 in the Basis for Conclusions of Statement 167 indicates that the FASB used the term “insignificant” instead of the term “more than trivial” because “more than trivial” has been interpreted in practice to be a very small amount (i.e., anything
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other than zero) and “no evaluation of the facts and circumstances related to the interest or the [reporting entity’s] involvement with the [VIE] is considered when making this determination.” Paragraph A75 further indicates that a reporting entity should consistently apply the term “insignificant” when evaluating an individual fee arrangement under ASC 810-10-55-37(c), 37(e), and 37(f). Although application of the term “insignificant” to individual fee arrangements will require significant judgment, a reporting entity should apply this term consistently when evaluating similar types of fee arrangements. As a general guideline, if the variability1 absorbed through the fee arrangement or other variable interests in the VIE exceeds, either individually or in the aggregate, 10 percent of the variability of the VIE, the conditions in ASC 81010-55-37(c) and 37(f) are not met and the decision-maker or service-provider fee would therefore be considered a variable interest. The same general guideline can be applied to the evaluation under ASC 810-10-55-37(e) of the total amount of anticipated fees to be received by a decision maker or service provider in comparison to the total anticipated economic performance of the VIE. However, 10 percent should not be viewed as a bright-line or safe harbor definition of “insignificant.” That is, facts and circumstances may cause a reporting entity to conclude that the conditions in ASC 810-10-55-37 are not met even if the variability absorbed by the reporting entity’s interests in the VIE is less than 10 percent and the anticipated fees in relation to the anticipated economic performance of the VIE are less than 10 percent. Likewise, when applying ASC 810-10-55-37, a reporting entity should not necessarily view 10 percent as a cap with respect to the definition of “insignificant.” Depending on the facts and circumstances, it may be possible for a reporting entity to conclude that the conditions in ASC 810-10-55-37 are met even if the variability absorbed by the reporting entity’s interests in the VIE is more than 10 percent and the anticipated fees in relation to the anticipated economic performance of the VIE are more than 10 percent. These considerations will require the application of professional judgment and an assessment of the nature of the reporting entity’s involvement with the VIE. The analysis under ASC 810-10-55-37(c), 37(e), and 37(f) deals with the expected (or anticipated) outcome of the VIE. Therefore, when analyzing a decision-maker or service-provider fee under these paragraphs, a reporting entity would identify and weigh the probability of the various possible outcomes in determining the expected losses, expected residual returns, and anticipated economic performance of the VIE. However, as noted in ASC 810-1055-37A, a reporting entity will not always need to prepare a detailed quantitative analysis to reach a conclusion under ASC 810-10-55-37. Moreover, such a detailed analysis should also not be the sole determinant of whether a reporting entity meets the conditions in ASC 810-10-55-37. For example, if a decision maker holds 100 percent of the residual interest in an entity (and the residual interest is substantive), a reporting entity may conclude that it does not need to perform a quantitative test to assess condition (c) (i.e., the reporting entity could qualitatively conclude, on the basis of specific facts and circumstances, that holding all of a substantive residual interest would represent a more than insignificant amount of the entity’s expected losses or expected residual returns). The evaluation under ASC 810-10-55-37 should focus on a qualitative consideration of all the conditions in ASC 810-10-55-37 in the context of all the relevant facts and circumstances associated with the reporting entity’s involvement with the VIE. In addition to considering the reporting entity’s interests in a VIE, the reporting entity should consider the nature of the VIE’s activities, the risks the VIE was designed to pass along to its variable interest holders, and the nature of the variable interests issued by the VIE. Note that although the consideration of the probabilities of various outcomes is important to determining whether a decision-maker or service-provider fee is a variable interest under ASC 810-10-55-37, the condition in ASC 810-10-25-38A(b) (i.e., whether a reporting entity has an obligation to absorb losses or a right to receive the returns of an entity) generally does not permit consideration of probabilities. (For more information, see Q&A 6.09.)

3.28

Meaning of the Term “Same Level of Seniority”

ASC 810-10-55-37 states that one of the conditions for concluding that a fee paid to an entity’s decision maker or service provider is not a variable interest is that “[s]ubstantially all of the fees are at or above the same level of seniority as other operating liabilities of the VIE that arise in the normal course of the VIE’s activities, such as trade payables.”

Question
What does the term “same level of seniority” in ASC 810-10-55-37 mean?

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Conditions (c) and (f) require a consideration of the variability absorbed by the reporting entity’s interest(s). Therefore, if a reporting entity performs a quantitative calculation to evaluate these conditions, the variability absorbed by the reporting entity’s other interests and anticipated fees should be calculated and compared, both individually and in the aggregate, with the entity’s total expected variability.
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Answer
“Same level of seniority” should be based on the priority of payment upon liquidation of the VIE (or as of the distribution date for securitization structures). That is, this condition would be met if, upon liquidation (or distribution), substantially all of the fees have the same level of priority as, or a higher level of priority than, other operating liabilities. Therefore, if such a condition is to be met, substantially all of the fees cannot be subordinate to other operating liabilities. The calculation of the fee generally should not affect whether the payment priority of that fee is subordinate to other operating liabilities of the VIE in liquidation. That is, in this assessment, what is important is whether the fee is subordinate to the other operating liabilities once the fee is earned. Therefore, a performance fee that is calculated after other expenses are calculated would not violate this condition to the extent that its payment priority in the event of liquidation (or distribution) is not subordinate to other operating liabilities of the entity. However, if more than an insignificant amount of the fees has a payment priority that is subordinate to other operating liabilities, this condition would not be met and the fee would generally be considered a variable interest under ASC 810-10-55-37.

3.29 Whether a Fee Paid to a Decision Maker or Service Provider That Represents a Variable Interest Could Potentially Not Be Significant to a VIE
Question
If a reporting entity determines that a fee paid to a decision maker or service provider represents a variable interest after evaluating the conditions in ASC 810-10-55-37 through 37A, is it possible for the reporting entity to conclude, under ASC 810-10-25-38A(b), that it does not have an obligation to absorb losses, or a right to receive benefits, that could potentially be significant to the entity?

Answer
It depends. If a reporting entity determines that a fee paid to a decision maker or service provider is a variable interest after considering the conditions in ASC 810-10-55-37 through 37A, the decision maker’s or service provider’s interest will usually represent an obligation to absorb losses of the VIE or a right to receive benefits from the VIE that could potentially be significant to the VIE. When a decision-maker or service-provider fee is considered a variable interest under ASC 810-10-55-37 through 37A it is usually because the reporting entity concludes that its fee and its other variable interests in the entity represent a more than insignificant economic interest in the entity. If a reporting entity concludes it has a more than insignificant economic interest in the entity (that is, the fee and other interests do not meet conditions (c), (e), and (f) in ASC 810-10-55-37), that interest will usually represent an obligation to absorb losses or a right to receive benefits that could potentially be significant to the entity. However, see Q&A 6.29 for situations where a reporting entity determines that a fee paid to a decision maker or service provider represents a variable interest and the reporting entity’s related parties also have variable interests in the VIE. If the reporting entity concludes the decision-maker or service-provider fee represents a variable interest, the reporting entity should consider the guidance in Q&A 6.09 when determining whether its interest represents an obligation to absorb losses of the VIE or a right to receive benefits from the VIE that could potentially be significant.

3.30 Determining Whether a Decision Maker or Service Provider Must Evaluate ASC 810-10-25-38A If the Fees Paid to the Decision Maker or Service Provider Do Not Represent a Variable Interest
Question
If a fee paid to a decision maker or service provider does not represent a variable interest on the basis of the conditions in ASC 810-10-55-37 through 37A, must a reporting entity perform further analysis under ASC 810-1025-38A to determine whether the decision maker is the primary beneficiary of the VIE?

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Answer
Generally, no. Paragraph A76 of Statement 167’s Basis for Conclusions states, in part:
[T]he Board expects that the fees paid to an enterprise that acts solely as a fiduciary or agent should typically not represent a variable interest in a variable interest entity because those fees would typically meet the conditions in [ASC 810-10-55-37]. If an enterprise’s fee did not meet those conditions, the Board reasoned that an enterprise is not solely acting in a fiduciary role. . . . The Board observed that the conditions in [ASC 810-10-55-37] would allow an enterprise to hold another variable interest in the entity that would absorb an insignificant amount of the entity’s expected losses or receive an insignificant amount of the entity’s expected returns. The Board concluded that an enterprise holding such an interest would still be acting in a fiduciary role as long as the other conditions in [ASC 810-10-55-37] were met and that enterprise would not be the primary beneficiary of the entity.

On the basis of the guidance in paragraph A76, if a decision maker or service provider concludes that its fee does not represent a variable interest (after consideration of all the criteria in ASC 810-10-55-37 through 37A, including an evaluation of its other variable interests in the entity under ASC 810-10-55-37(c)), the reporting entity is not required to further evaluate its interest under ASC 810-10-25-38A. A decision maker or service provider whose fee does represent a variable interest will need to consider whether it is the primary beneficiary of the VIE under ASC 810-10-25-38A. This guidance applies to decision makers or other service providers who are given the right to make decisions in exchange for a fee. If a reporting entity with a variable interest has decision-making ability outside of a fee-based arrangement (e.g., if power is conveyed through other variable interests), ASC 810-10-55-37 through 37A is not applicable and the reporting entity would be required to consider those arrangements under ASC 810-10-25-38A. In addition, see Q&A 3.24.

3.31

Reassessment of Fees Paid to a Decision Maker or Service Provider

Question
Is a decision maker or service provider required to continually reassess whether its fees represent a variable interest under the VIE model in ASC 810-10?

Answer
No. Paragraph A76 in the Basis for Conclusions of Statement 167 indicates that the fees paid to a decision maker or service provider acting in a fiduciary capacity should typically not represent a variable interest under ASC 810-10-55-37. An entity’s design dictates whether a decision maker or service provider’s role is that of a fiduciary or principal. Because the decision maker or service provider’s role is so closely tied to the entity’s design, the decision maker or service provider is not required to reconsider its previous conclusions under ASC 810-10-55-37 through 37A unless (1) there has been a change in the design of the entity or (2) there is a significant change in the economic performance of the entity and that change is expected to continue throughout the life of the entity. The reconsideration events in ASC 810-10-35-4(a) through 4(d) focus on changes in the entity’s design. Therefore, if one of those events occurs, a decision maker or service provider would need to reassess, concurrently with its reconsideration of the entity’s status as a VIE and on the basis of facts and circumstances that existed as of the date of the reconsideration event, whether its fee met the conditions in ASC 810-10-55-37 through 37A. ASC 810-10-35-4 also indicates that “[a] legal entity that previously was not subject to the Variable Interest Subsections shall not become subject to them simply because of losses in excess of its expected losses that reduce the equity investment.” Therefore, a reporting entity would typically not be required to reassess whether its fee met the conditions in ASC 810-10-55-37 through 37A as a result of changes in general market conditions or changes in the economic performance of the entity. However, if a significant change in the economic performance of the entity that is expected to continue throughout the life of the entity occurs, the decision maker or service provider may no longer be serving in a fiduciary capacity (or, alternatively, the decision maker or service provider may no longer be serving as a principal). This may represent a reconsideration event under ASC 810-1035-4(e), which would require a decision maker or service provider to reassess, concurrently with its reconsideration of the entity’s status as a VIE and on the basis of facts and circumstances that existed as of the date of the reconsideration event, whether its fee met the conditions in ASC 810-10-55-37 through 37A. In order for a decision maker or service provider to conclude that it is no longer serving as a principal, the reporting entity would also need to conclude that it no longer has the characteristic in ASC 810-10-25-38A(b). Otherwise, it would not be
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clear that the reporting entity is no longer serving as a principal. The reporting entity should consider the guidance in Q&A 6.09 when determining whether its interest(s) meets the characteristic in 810-10-25-38A(b). Temporary changes in the economic performance of an entity and most changes in market conditions, in isolation, would not require a reassessment of a decision maker’s or service provider’s fee under ASC 810-10-55-37 through 37A. If a decision maker or service provider acquires or disposes of variable interests in the entity, the decision maker or service provider would need to reassess the condition in ASC 810-10-55-37(c). Although the acquisition or disposal of variable interests, in isolation, would not require a reconsideration of the other conditions in ASC 810-10-55-37 through 37A, a reporting entity should also consider the condition in ASC 810-10-55-37(f) for determining whether, in the aggregate, the decision maker’s or service provider’s exposure to the entity is more than insignificant. In addition, all facts and circumstances should be considered. For example, if a decision maker or service provider protects the holders of equity at risk by purchasing variable interests at amounts in excess of fair value, this may represent a modification of the entity’s contractual arrangements (i.e., an ASC 810-1035-4 reconsideration event) that would require a reporting entity to reassess whether its fee met the conditions in ASC 810-10-55-37 through 37A on the basis of facts and circumstances that existed as of the date of the reconsideration event. If a decision maker’s or service provider’s fee no longer met the conditions in ASC 810-10-55-37 through 37A, the decision maker or service provider would no longer be acting solely in a fiduciary role. Therefore, the decision maker or service provider would need to apply ASC 810-10-25-38A to determine whether it is the primary beneficiary of the VIE.

Obligation to Absorb the Expected Losses of the Legal Entity 3.32 Determining Whether a Reporting Entity Lacks the Obligation to Absorb Expected Losses of the Entity
Question
If a legal entity is determined to have a total equity investment at risk in excess of expected losses under ASC 81010-15-14(a), can it be assumed that the equity holders as a group have the obligation to absorb the expected losses of the entity under ASC 810-10-15-14(b)(2)?

Answer
No. Although the variable interest holders of an entity may determine (under ASC 810-10-15-14(a)) that the total equity investment at risk exceeds expected losses, ASC 810-10-15-14(b)(2) focuses on whether the holders of the equity investment at risk are actually the sole group exposed to those expected losses before other parties involved with the entity. If the holders of the equity investment at risk are protected (e.g., because another party has provided a limited guarantee on assets that comprise more than half the total fair value of the entity’s assets) or are guaranteed a return, the entity is a VIE because it does not meet the criterion in ASC 810-10-15-14(b)(2).

Example 1
Assume that Enterprises A and B form a joint venture (Entity C) that does not qualify for any of the scope exceptions in ASC 810-10-15-12 and ASC 810-10-15-17. The joint venture consists mostly of three assets (all real estate assets), each with a fair value representing 33 percent of the entity’s total assets. Each of the real estate assets has been guaranteed by different third parties, each unrelated to A and B. Each guarantor is required to absorb decreases in the value of the real estate asset specific to the guarantor’s respective guarantee up to a stipulated amount. The guarantor’s loss absorption occurs before any absorption by the equity holders. In this example, the equity holders (A and B) as a group meet the characteristic of ASC 810-10-15-14(b)(2) to qualify as a voting interest entity because each of the guarantors is considered to hold a variable interest in a specific asset under ASC 810-10-25-55 and 25-56 rather than a variable interest in the entity as a whole. ASC 810-10-25-56 states, in part, “Expected losses related to variable interests in specified assets are not considered part of the expected losses of the legal entity for purposes of . . . identifying the primary beneficiary unless the specified assets constitute a majority of the assets of the legal entity” (emphasis added). Therefore, since the guarantees are not considered variable interests in the entity, the equity holders are not considered protected by these guarantees in the context of ASC 810-10-15-14(b)(2).

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Note that the third-party guarantors need to consider the “silo” guidance in ASC 810-10-25-57. See Section 5 — Interests in Specified Assets of the VIE and Silo Provisions.

Example 2
Assume the same facts as in Example 1 except that the guarantor guaranteed two or three of the real estate assets. The guarantor must aggregate its interests in determining whether it has a variable interest in the entity under ASC 810-10-25-55 and 25-56. The variable interest in specific assets represents a majority of the fair value of the entity’s total assets; therefore, the guarantor would have a variable interest in the entity and thus, the expected losses of the assets, excluding the guarantee, would be considered part of the expected losses of the entity. Because the equity holders as a group would be protected from such expected losses by the guarantee variable interest, they would lack the characteristic in ASC 810-10-15-14(b)(2). Note that if this example were changed to reflect that the equity holders absorbed the first risk of loss up to the amount of their equity investments before the performance under the guarantee, the entity would not lack the characteristic in ASC 810-10-15-14(b)(2).

Example 3
Assume the same facts as in Example 1 except that the guarantors of the real estate assets are related parties. As in Example 2, the guarantees must be aggregated, which represents a majority of the fair value of the entity’s total assets; thus, the guarantors would hold variable interests and the entity would lack the characteristic in ASC 81010-15-14(b)(2).

Example 4
Assume the same facts as in Example 1 except that one of the joint venture’s real estate assets constitutes the majority of the fair value of the entity’s total assets. As in Examples 2 and 3, the guarantee relates to a majority of the entity’s total assets; thus, the guarantors would hold a variable interest and the entity lacks the characteristic in ASC 810-10-15-14(b)(2).

3.33 Use of a Qualitative Approach to Determine Whether a Reporting Entity Has the Obligation to Absorb Expected Losses
Under two of the three conditions in ASC 810-10-15-14, an entity is deemed a VIE if, by design, (1) the equity at risk is insufficient (ASC 810-10-15-14(a)) or (2) the holders of equity investment at risk lack certain characteristics (ASC 810-10-15-14(b)). One of the characteristics in ASC 810-10-15-14(b) is that the holders of the equity investment at risk have the obligation to absorb the expected losses of the entity (ASC 810-10-15-14(b)(2)). ASC 810-10-25-45 indicates that the sufficiency of equity may be based on either a qualitative or quantitative assessment (i.e., calculation of expected losses) or a combination of both.

Question
If it is conclusively determined that the equity investment at risk is sufficient on a qualitative basis (i.e., no calculation of expected losses was made), how would a reporting entity determine whether the equity at risk has the obligation to absorb the expected losses under ASC 810-10-15-14(b)(2)?

Answer
The characteristics under ASC 810-10-15-14(b), including the obligation to absorb expected losses, may be determined qualitatively. A reporting entity should consider the contractual arrangements that it and other interest holders have with each other and with the potential VIE that may protect one or more holders of equity investment at risk from the expected losses or guarantee them a return (e.g., a guarantee of the residual value of the majority of the fair value of the potential VIE’s assets, a contractual arrangement that guarantees a 5 percent return). In addition, a reporting entity should consider the contractual allocation of cash flows in determining whether the equity investment at risk absorbs the first risk of loss of a potential VIE to the extent of its equity invested. If a qualitative analysis indicates that no interests (1) are subordinate to the equity investment at risk, (2) protect the equity investors at risk, or (3) guarantee the equity investors a return, such an analysis is sufficient for analyzing the equity investment at risk under ASC 810-10-15-14(b). Conversely, it may be qualitatively evident that the equity investors are being protected and that they therefore fail to meet the criterion in ASC 810-10-15-14(b)(2).

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3.34 Determining Whether a Put Option on an Equity Interest Causes the Holders of the Equity Investment at Risk to Lack the Obligation to Absorb the Expected Losses of the Entity
ASC 810-10-15-14(b)(2) stipulates that the group of holders of the equity investment at risk lacks a characteristic outlined in that paragraph if it does not have:
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. [Emphasis added]

Question
If equity holders (individually or as a group) have the right to put their equity interest to another party not otherwise involved with the legal entity at a fixed price, would the holders of the equity investment at risk, as a group, lack the obligation to absorb the expected losses of the legal entity under ASC 810-10-15-14(b)(2)?

Answer
No. Although the fixed-price put (whether physically or cash settled) protects the individual equity holder(s) from the expected losses of the legal entity, the put is with a party not otherwise involved with the legal entity. That is, the equity holder or holders purchase the put from an unrelated third party outside the legal entity. Therefore, the put option does not cause the legal entity to be a VIE under ASC 810-10-15-14(b)(2) because the counterparty to the put, if exercised, will become an equity investor and will be exposed to the expected losses and residual returns of the entity. Note that a put option on an equity investment to the legal entity or another party involved with the legal entity would disqualify the equity from being at risk. (For more information, see Q&A 3.10).

3.35 Determining Whether a Put Option on a Potential VIE’s Assets Causes the Holders of the Equity Investment at Risk to Lack the Obligation to Absorb the Expected Losses of the Potential VIE
Question
If the potential VIE has the right to put, at a fixed price, a majority of its assets (based on fair values) to a specified third party that does not hold equity in the potential VIE, would the holders of the equity investment at risk, as a group, lack the obligation to absorb the expected losses of the potential VIE under ASC 810-10-15-14(b)(2)?

Answer
Yes. The holders of the equity investment at risk lack the obligation to absorb the expected losses of the potential VIE because the purchased put protects the equity holders from the expected losses related to the decrease in value of the assets. Conversely, if the put option was on less than a majority of the potential VIE’s assets (based on fair values), the counterparty to the put option would hold an interest in specified assets as opposed to a variable interest in the entity (as long as the counterparty does not have another variable interest in the entity — see ASC 810-10-25-55 and 25-56). Therefore, the equity investment at risk would not fail to meet the criterion in ASC 810-10-15-14(b)(2). (For more information, see Q&A 3.32.)

3.36 Determining the Effect of Other Arrangements on the Ability of the Equity Group to Absorb Expected Losses or Receive Residual Returns
For a legal entity not to be considered a VIE, the holders of the equity investment at risk must possess the characteristics outlined in ASC 810-10-15-14(b). ASC 810-10-15-14(b) further states, “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.” Under ASC 810-10-15-14(b)(2) and 15-14(b)(3), a legal entity is considered a VIE if the holders of the equity investment at risk, as a group, do not have the obligation to absorb the expected losses or the right to receive the residual returns of the legal entity.

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Question
Does the existence of other arrangements (i.e., other than the equity investment at risk) between the equity investors or other parties and the legal entity that either absorb expected losses or receive residual returns of the legal entity cause that entity to be a VIE?

Answer
It depends. If the terms of the arrangement cause the first dollar of expected losses to be absorbed before the equity investment at risk, the arrangement protects the holders of equity at risk from some portion of the expected losses. In these instances, the holders of the equity investment at risk lack the characteristic in ASC 810-10-1514(b)(2) and the entity is a VIE. This same conclusion applies whether the legal entity enters into an arrangement with the equity investor or with another related or unrelated party. See Q&A 3.32. A reporting entity should also apply this conclusion in determining whether an arrangement limits the rights of the holders of equity investment at risk to receive residual returns of the legal entity (see ASC 810-10-15-14(b)(3)).

Example 1
Investor B and Investor C each have a 45 percent equity interest in a joint venture, all of which qualifies as equity at risk. Investor D has a 10 percent equity interest in the joint venture that does not qualify as equity at risk. Profits and losses are allocated between the investors according to their ownership interests after payments are made to all other interests in the joint venture. In this scenario, while D’s equity interest is not considered equity at risk, it still absorbs expected losses and receives residual returns at the same level as the equity at risk. That is, D is not protecting the other equity investors from absorbing the first-dollar risk of loss. Therefore, the equity at risk does not lack the characteristics in paragraph ASC 810-10-15-14(b)(2) or ASC 810-10-15-14(b)(3).

Example 2
Investor B and Investor C each have a 45 percent equity interest in a joint venture, all of which qualifies as equity at risk. Investor D has a 10 percent equity interest in the joint venture that does not qualify as equity at risk. Profits and losses are allocated according to ownership interests after payments are made to all other interests in the joint venture. Investor D is also entitled to an additional 5 percent of profits (not losses) above a specified threshold. In this scenario, while D is entitled to additional profits above a specified threshold, D’s equity interest shares losses and residual returns at the same level as the equity interest (pari passu) of B and C. Although D’s interest has a beneficial feature, its equity investment is not senior to the equity interests of B and C. Therefore, the returns to the holders of equity at risk are not capped and the equity at risk does not lack the characteristics in ASC 810-10-1514(b)(2) or ASC 810-10-15-14(b)(3). (For guidance on determining whether an investor’s return is capped, see Q&A 3.37.)

Example 3
Investor B and Investor C each have a 50 percent equity interest in a joint venture, all of which qualifies as equity at risk. Investor C has also entered into a contract to supply raw materials to the joint venture at prices below those that could be obtained through sales with unrelated third parties (supply contract). The supply contract is considered a variable interest because the equity holders are protected from the losses associated with that contract. That is, the supply contract is reallocating expected losses associated with the below-market pricing from the equity interests directly to C. (See also Q&A 2.18 for guidance on off-market supply agreements.) In examining how the supply contract absorbs losses before the equity investment at risk, assume that there are no other variable interest holders. The expected losses of the entity are $110 and are allocated as follows: • • • Below-market supply contract — Investor C = $10. 50 percent equity — Investor B = $50. 50 percent equity — Investor C = $50.

In this scenario, the design of the entity is such that the supply contract absorbs $10 of expected losses before the equity investment at risk. Although C is an equity holder, the supply contract is not part of the equity investment at risk. Therefore, the equity at risk lacks the characteristic in ASC 810-10-15-14(b)(2) and the entity would be considered a VIE.

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Example 4
An investor owns 100 percent of the equity issued by an entity, all of which is considered equity at risk. An unrelated enterprise enters into a contract to purchase finished product from the entity at a price equal to the actual costs of production (including costs of raw materials, labor, etc.) plus a 2 percent fixed margin. The purchase agreement is designed so that the purchaser absorbs all variability associated with the production of the finished product. There are no other variable interest holders in the entity. In this example, because the purchaser absorbs all of the variability related to the manufacturing of the products under the purchase agreement, the investor is protected from some portion of expected losses. Therefore, the equity at risk lacks the characteristic in ASC 810-10-15-14(b)(2) and the entity would be considered a VIE. (For guidance on purchase and supply agreements, see Q&A 2.16.)

Right to Receive the Expected Residual Returns of the Legal Entity 3.37 Determining Whether an Investor Has the Right to Receive the Expected Residual Returns of a Legal Entity and Whether the Investor’s Return Is Capped
ASC 810-10-15-14(b)(3) states that the investors (i.e., as a group, the holders of the equity investment at risk) do not have the right to receive the expected residual returns of a legal entity if their return is capped by the legal entity’s governing documents or by arrangements that the legal entity may have with other variable interest holders.

Question
How does an investor evaluate whether it has the right to receive the expected residual returns of a legal entity?

Answer
ASC 810-10-20 describes the calculation of a legal entity’s expected losses and expected residual returns, which will result in a dollar amount representing the expected losses and expected residual returns specific to that entity. Although the first sentence of ASC 810-10-15-14(b)(3) indicates that the investors need to have the right to receive the expected residual returns of the legal entity, the second sentence states, “The investors do not have that right if their return is capped by the legal entity’s governing documents or arrangements with other variable interest holders or the legal entity” (emphasis added). The use of the term “return” instead of “expected residual returns” indicates that the right to the entity’s return under GAAP must not be capped under ASC 810-10-15-14(b)(3). In determining whether returns are capped under ASC 810-10-15-14(b)(3), a reporting entity must use significant judgment and evaluate all relevant facts and circumstances. Investors should not be considered to have the right to receive the expected residual returns of the legal entity if their participation in the return of a legal entity is trivial beyond a specified amount. The following are examples of situations in which residual returns generally would be considered capped under ASC 810-10-15-14(b)(3): • • The investment manager receives a performance-based fee equal to all investment returns above 15 percent in any annual period. The legal entity is designed to serve as a profit-sharing vehicle for employees of a sponsoring reporting entity at which all returns on assets of more than 6 percent are allocated to the employees.

The following are examples of situations in which holders of the equity investment at risk generally would not be considered capped: • • The investment manager receives a performance-based fee equal to 10 percent of all investment returns up to 15 percent and thereafter shares in investment returns 30-70 with the equity investors. The legal entity is designed to serve as a profit-sharing vehicle for employees of a sponsoring reporting entity at which 50 percent of returns on assets of more than 6 percent are allocated to the employees.

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3.38

Impact of an Outstanding Equity Call Option on Whether a Return Is Capped

ASC 810-10-15-14(b)(3) states that the investors (i.e., as a group, the holders of the equity investment at risk) do not have the right to receive the expected residual returns of a legal entity if their return is capped by the legal entity’s governing documents or by arrangements with other variable interest holders or the legal entity.

Question
If the only at-risk equity investor writes a fixed-price call option on its equity to an unrelated party not involved with the legal entity, would the at-risk equity holder lack the characteristic in ASC 810-10-15-14(b)(3)?

Answer
ASC 810-10-15-14(b)(3) indicates that “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.” Similarly, a return to an at-risk equity investor is not capped by an outstanding fixed-price call option on the investor’s equity because the holder of the option would become an equity investor if the option is exercised. See Q&A 3.10.

3.39

Impact of a Call Option on an Entity’s Assets on Whether a Return Is Capped

ASC 810-10-15-14(b)(3) states that the equity investors (i.e., as a group, the holders of the equity investment at risk) do not have the right to receive the expected residual returns of a legal entity if their return is capped by the legal entity’s governing documents or by arrangements with other variable interest holders or the legal entity.

Question
If a third party holds a fixed-price call option on all or a majority of the assets of a legal entity, would the equity holders lack the right to receive the expected residual returns of the legal entity, thereby causing the entity to be a VIE?

Answer
A fixed-price call option written by the legal entity on specified assets of the legal entity that represent more than 50 percent of the total fair value of a legal entity’s assets would be considered a cap on the equity holders’ right to receive the expected residual returns of the legal entity. However, if the aggregate amount of call options with a counterparty and its related parties is on assets constituting 50 percent or less of the total fair value of a legal entity’s assets, it would not represent a cap on the residual returns of the equity holders. See Section 5 — Interests in Specified Assets of the VIE and Silo Provisions.

Example
An entity leases equipment to several unrelated lessees under operating leases. The lessees hold fixed-price purchase options on the leased equipment that are exercisable upon expiration of the lease terms. The initial fair value of equipment under one of the leases is more than 50 percent of the fair value of the lessor’s total assets. Therefore, that lessee’s purchase option under that lease would be a variable interest in the entity. Because the purchase option would cap the equity holder’s right to receive residual returns pursuant to ASC 810-10-15-14(b)(3) (i.e., the lessor entity does not participate in the appreciation in value of the related equipment), the lessor would be a VIE.

Determining When the Equity Investors as a Group Are Considered to Lack the Characteristics in ASC 810-10-15-14(b)(1)
ASC 810-10
15-14 A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a variable interest entity [VIE] does not become one because of operating losses. The design of the legal entity is important in the application of these provisions.): 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.
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ASC 810-10 (continued)
2. Substantially all of the legal entity’s 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).

For purposes of applying this requirement, reporting entities shall consider each party’s obligations to absorb expected losses and rights to receive expected residual returns related to all of that party’s interests in the legal entity and not only to its equity investment at risk. [Paragraph 5(c)]

3.40

Application of the VIE Test Under ASC 810-10-15-14(c)

Question
How should a reporting entity apply ASC 810-10-15-14(c) to determine whether the equity investors as a group lack the characteristics described in ASC 810-10-15-14(b)(1), resulting in an entity’s being a VIE?

Answer
To be a VIE, the entity must possess both characteristics in ASC 810-10-15-14(c). That is, (1) at least one of the variable interest holders (see Q&A 3.41) would need to have voting rights that are not proportional to its share of the expected losses/residual returns of the potential VIE and (2) substantially all of the potential VIE’s activities (see Q&A 1.26 for further guidance on the meaning of “substantially all”) would need to be conducted on behalf of the variable interest holder that has disproportionately few voting rights. At the 2003 AICPA National Conference on Current SEC Developments, the SEC staff stated the following:
In the event that a registrant concludes that it has disproportionately few voting rights compared to its economics, there must be an assessment of whether substantially all of the activities of the entity either involve or are conducted on behalf of the registrant. There is no “bright-line” set of criteria for making this assessment. All facts and circumstances, qualitative and quantitative, should be considered in performing the assessment.

Here the term “activities” denotes the business activities of the potential VIE under evaluation but does not necessarily refer to the economic interests (i.e., the obligation of the interest holders to absorb expected losses or the right of the interest holders to receive expected residual returns). In addition, it is important to understand the business reason why an investor chooses to accept voting rights that are not proportionate to its investment. The provision in ASC 810-10-15-14(c) is intended to prevent a reporting entity from circumventing the consolidation of a VIE by forming the VIE primarily for its own use with voting rights that do not equate to the allocation of the underlying economic gains and losses of holders of interests in the formed VIE. See Q&A 1.26 for conditions to consider in the determination of whether a potential VIE’s activities are conducted substantially on behalf of a reporting entity and its related-party group.

Example 1
Two investors, Enterprise A and Enterprise B, form a joint venture (JV 1) solely to manufacture steel. Enterprises A and B contribute cash of $80 million and $20 million, respectively, to fund the entity. Each investor has 50 percent of the voting rights. In addition, 90 percent of the manufactured steel of the entity is sold to A and 10 percent to third parties. In this scenario, JV 1 meets the first characteristic in ASC 810-10-15-14(c) because A’s share in losses of JV 1 is disproportionate to its voting rights (80 percent share of losses compared with 50 percent voting rights). JV 1 also qualifies for the second characteristic because substantially all of JV 1’s activities (90 percent of the output) are conducted on behalf of A, the investor with disproportionately few voting rights. Therefore, JV 1 would be a VIE because it lacks the characteristics in ASC 810-10-15-14(b)(1). In contrast, if the entity were to sell 50 percent or more of its manufactured steel to unrelated third parties, the entity would not be a VIE. If sales to A are greater than 50 percent but less than 90 percent, a reporting entity should use judgment in determining whether the entity meets both criteria in ASC 810-10-15-14(c) if no other activity besides sales is relevant to the evaluation.
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Example 2
An investment hedge fund (Entity 1) is established by a 99 percent LP (Enterprise A) and a 1 percent GP (Enterprise B). Enterprise B manages the hedge fund and makes all decisions. Enterprise A cannot remove B except for cause. Therefore, the voting rights are not proportional to the share of expected losses and expected residual returns of Entity 1. In this example, substantially all of the entity’s activities would be considered to be on behalf of A because Entity 1 is established to invest its money and provide a return to A. Therefore, because Entity 1 meets both conditions in ASC 810-10-15-14(c), it would be deemed a VIE. In contrast, if LP interests were held equally by a larger number of LPs, Entity 1 would not be considered a VIE under ASC 810-10-15-14(c).

Example 3
Entity X is formed by Enterprise A and Enterprise B via equity contributions of $80 million and $20 million, respectively. Each investor has a 50 percent voting interest. Entity X’s activities consist solely of purchasing merchandise from A and selling and distributing it to third-party customers. Entity X meets the first criterion in ASC 810-10-15-14(c) because the voting rights of the investors are not proportional to their obligation to absorb the expected losses of the entity. Therefore, the investors of X must consider the second criterion in ASC 810-10-15-14(c). While the “outputs” of X are not transactions with A or B, the business of X represents another distribution or sales channel for A’s merchandise. Entity X appears to be an extension of A’s business because it is so closely aligned in appearance and purpose. Entity X has been designed so that substantially all of its activities either involve or are conducted on behalf of A (the investor that has disproportionately few voting rights). Therefore, the second criterion in ASC 810-10-15-14(c) is met and X is a VIE.

Example 4
Enterprise A and Enterprise B form Entity Y with equity contributions of $80 million and $20 million, respectively. Each investor has a 50 percent voting interest. Entity Y has contracted to purchase all of its raw materials from A. Entity Y is one of several customers of A. Entity Y uses these raw materials to manufacture products to sell to thirdparty customers identified by Y. Entity Y meets the first criterion in ASC 810-10-15-14(c) because the voting rights of the investors are not proportional to their obligation to absorb the expected losses of the entity. Therefore, the investors of Y must consider the second criterion in ASC 810-10-15-14(c). Entity Y sells its products directly to third parties. That is, the “outputs” of Y are not transactions conducted directly with A or B. Even though all of the raw materials of Y are provided by A, Y does not appear to be an extension of A’s business and would not be considered to be designed so that substantially all of its activities either involve or are conducted on behalf of the investor that has disproportionately few voting rights. (This is different from the situation in Example 3 above.) Therefore, the second criterion in ASC 810-10-15-14(c) is not met and Y is not a VIE under ASC 810-10-15-14(c). Note that a reporting entity must also consider the criteria in ASC 810-10-15-14(a) and 15-14(b) before determining that Y is not a VIE.

3.41 Considering a Reporting Entity’s Obligations to Absorb Expected Losses and Rights to Receive Expected Residual Returns Other Than Those Provided Through Equity Interests When Applying ASC 810-10-15-14(c)
Question
What is the meaning of the last sentence in ASC 810-10-15-14(c), which states, “For purposes of applying this requirement, reporting entities shall consider each party’s obligations to absorb expected losses and rights to receive expected residual returns related to all of that party’s interests in the legal entity and not only to its equity investment at risk”?

Answer
This provision is specifically referring to the first criterion for considering an entity a VIE pursuant to ASC 810-10-1514(c) — that “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.” In other
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words, when determining whether a reporting entity’s voting rights are proportional to its obligations to absorb the expected losses of the legal entity, its rights to receive the expected residual returns of the legal entity, or both, a reporting entity must consider all of the variable interests issued by the entity, including those held by reporting entities that do not also hold equity investment at risk. The FASB staff has indicated that ASC 810-10-15-14(c) requires a reporting entity to consider each possible scenario in determining whether its voting rights are proportionate to its obligations to absorb the expected losses or rights to receive the expected residual returns of the legal entity. Therefore, a reporting entity that holds a voting equity investment at risk and any other variable interest not proportionately held by other equity interest holders (e.g., debt, service contract that is a variable interest, guarantee) will always meet the first condition in ASC 81010-15-14(c). Note that the reporting entity must also meet the second condition in ASC 810-10-15-14(c)(2) to be deemed a VIE.

Example
Two enterprises, X and Y, each contribute $1 million (aggregate equity of $2 million) in exchange for a 50 percent equity interest in an entity. This entitles each enterprise to equal voting rights. Enterprise Y, but not X, also provides subordinated debt. The criterion in ASC 810-10-15-14(c)(1) is met because Y’s total variable interests, as a percentage of the total of all variable interests of holders of equity investment at risk, are greater than its voting rights (50 percent). This is true even if the entity’s specific amount of expected losses and expected residual returns is less than the $2 million equity investment at risk. In other words, although subordinated debt is not expected to absorb any of the expected losses, Y could experience losses or returns that are disproportionate to its 50 percent voting interest. Note that ASC 810-10-15-14(c) has a second requirement, in addition to disproportionate voting rights, that an entity must meet to be deemed a VIE.

Initial Determination of Whether an Entity Is a VIE
ASC 810-10
25-37 The initial determination of whether a legal entity is a VIE shall be made on the date at which a reporting entity becomes involved with the legal entity. For purposes of the Variable Interest Entities Subsections, involvement with a legal entity refers to ownership, contractual, or other pecuniary interests that may be determined to be variable interests. That determination shall be based on the circumstances on that date including future changes that are required in existing governing documents and existing contractual arrangements. [Paragraph 6]

3.42

Anticipated Changes in the Assessment of Whether an Entity Is a VIE

Under ASC 810-10-25-37, a reporting entity should initially determine whether an entity is a VIE “on the date at which a reporting entity becomes involved with the legal entity.” Further, the initial determination “shall be based on the circumstances on that date including future changes that are required in existing governing documents and existing contractual arrangements” (emphasis added).

Question
Can a reporting entity consider anticipated, but not contractually required, future changes in determining whether an entity is a VIE?

Answer
In general, the assumptions used to determine whether an entity is a VIE are limited by the design of the entity as of the assessment date. Anticipated, but not required, contractual changes to the design of the entity should not be considered. The design of the entity is established by the existing governing documents and contractual arrangements and usually gives insight into why the entity was formed and the primary activities it is expected to perform. However, a reporting entity must make assumptions regarding future events or transactions in calculating expected losses of the entity if these future events or transactions are (1) a creator (not absorber) of variability for the entity and (2) are expected to be incurred in the entity’s course of business as a result of the entity’s design.

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For example, it would be appropriate to assume the entity’s future entrance into sales and purchase contracts as part of the ordinary course of business because the entity’s ability to enter into these contracts affects the variability in the designed operations. A reporting entity must use judgment when determining whether an assumption is within the scope of the entity’s design. (For more information, see Q&A 4.10.)

Example 1
Entity X is formed by Enterprise A (equity investment) and Enterprise B (loan to entity). The entity is designed solely for constructing and leasing one commercial real estate building. All equity and debt financing are invested at the inception of the entity and are sufficient to complete the building. Enterprises A and B must assess whether X is a VIE as of the inception date (i.e., the date each holder became involved). The assessment should only include scenarios that are possible in accordance with X’s current design. The assessment should not include assumptions of additional financings or construction of other buildings that currently are not contemplated in the existing governing documents and contractual arrangements of X, but should include assumptions about contracts that are expected to be entered into in X’s ordinary course of business. For example, cash flow scenarios should reflect occupancy rates, market leasing rates, etc., even if X does not have any current leasing agreements in place.

Example 2
Assume the same facts as in Example 1 except that the entity was designed to construct and lease several buildings with the financing it received from Enterprises A and B. The assessment should include possible outcomes that reflect the construction and leasing of more than one building in accordance with X’s current design. (For guidance on anticipated and contractually required future sources of financing, see Q&A 3.43.)

3.43

Future Sources of Financing to Include in a Potential VIE’s Expected Cash Flows

Q&A 3.42 states that a reporting entity must make assumptions regarding future events affecting the potential VIE’s cash flows in calculating expected losses. It further states that cash flow scenarios should include changes within the nature of the potential VIE’s business that are a source of the potential VIE’s variability.

Question
How should future financings (e.g., equity and debt) of a potential VIE be included in the determination of the potential VIE’s expected cash flows?

Answer
It depends. If the future financings are currently required by the governing or contractual arrangements existing as of the evaluation date (or are contemplated by the involved parties in a manner consistent with the design of the potential VIE), the future financings and resulting activities should be included in the determination of the potential VIE’s expected cash flows. Only financings and activities associated with the current design of the potential VIE can be considered. (For more information, see Q&A 3.42.) Note that the calculation of a potential VIE’s expected cash flows differs from its calculation of expected losses and residual returns. The process for calculating expected losses and residual returns often begins with cash flow statements under GAAP (representing expected cash flows), with adjustments made to reflect only cash flows from nonvariable interest holders. (For guidance on use of the indirect method to calculate estimated cash flows, see Q&A 4.06.) Because all financings (including future financings) are generally variable interests, the calculation of expected losses and residual returns will include the cash flows associated with the resulting activities from future financings but will exclude the cash flows directly related to those financings (e.g., cash from debt issuances and the related interest and principal payments). In the examples below, the cash inflows and outflows directly associated with the equity and debt financings should be considered in the potential VIE’s expected cash flows; however, if those financings are variable interests, the cash flows would be excluded from the potential VIE’s calculation of expected losses and residual returns. Further, the determination of which party is the primary beneficiary of a VIE only includes parties that have an existing variable interest as of the evaluation date.

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Example 1
Entity X is formed by the issuance of equity to Enterprise A and debt to Enterprise B. The entity was designed solely to construct and lease one commercial real estate building. However, A and B only provided enough funding to finance the first three months of construction. The governing documents require quarterly capital and debt investments from the investors for the two remaining years of construction. In this example, the cash flow associated with the activities resulting from the quarterly investments made by the investors should be considered in the determination of expected cash flows because the quarterly investments are contractually required to be made.

Example 2
Entity Y is formed by the issuance of equity to Enterprises A and B. The entity was designed to own and operate retail stores in the United States, and A and B provided enough funding to finance the first two years of operations. The governing documents identify the planned expansion after five years into international locations and allow for additional capital and debt financings as the source for such expansions. In this example, although the future financings are not required by Y’s governing documents, the international expansion is contemplated in the design of the potential VIE. Therefore, the cash flows associated with the activities resulting from the additional capital and debt financings associated with the international expansion may be considered in Y’s expected cash flows. Note that any future commitment to fund equity cannot be included in the analysis of the sufficiency of equity investment at risk under ASC 810-10-15-14(a) because the equity is not funded as of the assessment date. However, each additional contribution of equity investment at risk requires the variable interest holders to reconsider whether an entity is a VIE under ASC 810-10-35-4(d). Development-stage entities have special rules for determining sufficiency at risk. (For more information, see Q&A 3.50.)

Reconsideration of Whether the Entity Is a VIE
ASC 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. d. e. The legal entity’s governing documents or contractual arrangements are changed in a manner that changes the characteristics or adequacy of the legal entity’s 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 entity’s 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 entity’s economic performance. [Paragraph 7]

3.44

Guidance on Reconsideration of Whether an Entity Is a VIE

ASC 810-10-35-4(a)–(e) requires that the initial determination of whether an entity is a VIE be reconsidered if certain types of events (“reconsideration events”) occur. If one or more reconsideration events occur, the holder of a variable interest in a previously determined VIE must reconsider whether that entity continues to be a VIE. Likewise, the holder of a variable interest in an entity that previously was not a VIE must reconsider whether the entity has become a VIE.

Question
What are some examples of reconsideration events under ASC 810-10-35-4?

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Answer
ASC 810-10-35-4 identifies five specific types of events that lead to reconsideration of VIE status, each of which is illustrated below with an example. ASC 810-10-35-4 also provides guidance on the circumstances in which the entity has incurred operating losses since the initial determination date, stating, “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” (emphasis added). Consequently, if the amount of the equity investment at risk at the entity’s inception (or when a reporting entity first became involved with the entity) was determined to be sufficient, losses later incurred by that entity do not by themselves require a reporting entity to reconsider whether the entity has sufficient equity in accordance with ASC 810-10-15-14(a). A reporting entity must consider all pertinent facts and circumstances in assessing whether an event that meets the criteria in ASC 810-10-35-4(a) through 35-4(e) has occurred. Insignificant events do not always result in a reconsideration of an entity’s VIE status. An event’s significance depends on whether the event appears to have changed the sufficiency of equity investment at risk or on whether the characteristics of the holders of equity investment at risk have changed. (For guidance on isolating the impact of a change under ASC 810-10-35-4(a) through 35-4(e), see Q&A 3.46.) It is also important to emphasize that ASC 810-10-35-4 applies to both of the following: • • Entities that were not determined previously to be a VIE. Entities that were determined previously to be a VIE.

That is, an entity could become a VIE or cease being a VIE as a result of a reconsideration event under ASC 810-1035-4. Such an event could also cause a reporting entity to no longer qualify for one of the scope exceptions in ASC 810-10-15-12 and ASC 810-10-15-17. Note that a reporting entity cannot elect to reconsider the status of an entity at times other than those in ASC 810-10-35-4. Upon reconsideration, the variable interest holders would need to consider all of the requirements of ASC 810-1015-14 in determining whether the entity is a VIE. Each of the specific events cited is illustrated by examples in ASC 810-10-35-4:

Analysis Under ASC 810-10-35-4(a)
ASC 810-10-35-4(a) states:
The legal entity’s governing documents or contractual arrangements are changed in a manner that changes the characteristics or adequacy of the legal entity’s equity investment at risk.

Example 1
A privately held partnership was formed with a contribution of capital from the partners in equal portions to their ownership interests. At inception, the partnership was deemed not to be a VIE because it had sufficient equity investment at risk and the group of holders of the equity investment at risk possessed the characteristics in ASC 810-10-15-14(b). After inception, the partners wanted to protect their loss on the decline in value of the partnership’s sole asset, a rental property. Therefore, the partners paid a premium to a third party for a first-loss residual value guarantee on the partnership’s building. In this situation, the residual value guarantee has changed the characteristics of the partnership’s equity investment at risk. This causes the entity to reconsider whether the partnership is a VIE (specifically, it appears that the partnership no longer meets the characteristic in ASC 810-1015-14(b)(2)) because the equity group does not absorb the expected losses related to the decline of the rental property.

Analysis Under ASC 810-10-35-4(b)
ASC 810-10-35-4(b) states:
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.

Upon the return of the equity investment at risk, or some part thereof, each potential variable interest holder must determine whether other interests (whether new or preexisting) have become exposed to expected losses of the entity. Other interest holders become exposed to expected losses if the equity, at the time of the reconsideration, would not be sufficient to permit the entity to finance its activities without subordinated financial support, as described in ASC 810-10-15-14(a), given the circumstances and conditions at the time of the reconsideration.

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This determination may be based on a qualitative evaluation, a quantitative evaluation, or a combination of both, as discussed in ASC 810-10-25-45.

Example 2
Enterprise A owns 49 percent of the common voting shares of Entity B, a voting interest entity, as well as B’s nonvoting preferred stock. Enterprise A does not control B and does not consolidate B’s accounts under the voting interest model in ASC 810-10. Entity B finances its operations by issuing equity and debt (rated investment-grade by a nationally recognized rating agency). When A first became involved with B, A concluded that B was a voting interest entity partly on the basis of a conclusive qualitative assessment of the sufficiency of B’s equity investment at risk. One year after A made its investments in B, B makes a partial return of the common shareholders’ investment. Therefore, A needs to reassess whether other interest holders have become exposed to expected losses of B. Enterprise A makes a qualitative assessment, noting that the rating agency has reaffirmed its investment-grade rating of B’s debt. This and other pertinent factors lead to a conclusive qualitative assessment that B continues to be a voting interest entity that is not subject to the VIE model in ASC 810-10.

Analysis Under ASC 810-10-35-4(c)
ASC 810-10-35-4(c) states:
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 entity’s expected losses.

Example 3
A real estate entity, initially determined not to be a VIE, purchases five rental properties by issuing equity and debt instruments. At inception, the equity and debt holders determine that the equity investment at risk is sufficient under ASC 810-10-15-14(a) and ASC 810-10-25-45. Subsequently, the entity issues subordinated debt to purchase additional rental properties. The debt issuance, in and of itself, is not a reconsideration event. However, because the entity acquired additional assets with the proceeds, which potentially increases the entity’s expected losses, the enterprises involved must reconsider whether the entity has become a VIE. These transactions were not anticipated when the entity was formed. Note that had these transactions been anticipated, the sufficiency of the equity would have required consideration of the variability associated with the substantial uncertainty regarding the acquisition of unidentified real estate.

Example 4
A development-stage entity is considered to be undertaking additional activities when the entity comes out of the development stage; therefore, in accordance with ASC 810-10-35-4(c), such an entity should be reevaluated as a potential VIE at that time. (See ASC 810-10-15-16 for a discussion of development-stage entities. Also see Q&A 3.50 for a discussion of when to assess whether a development-stage entity is a VIE.)

Analysis Under ASC 810-10-35-4(d)
ASC 810-10-35-4(d) states:
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.

Example 5
Three investors form Entity 1 to purchase real estate property. Each of the three investors contributes $5 million in equity investment at risk and $45 million in subordinated debt. The entity was deemed a VIE because of insufficient equity investment at risk. The original governing documents stipulate that, 12 months after Entity 1’s formation, each investor must contribute an additional $25 million in equity investment at risk. When that additional equity investment is made, the entity’s VIE status is reconsidered, even though the original governing documents required the subsequent equity investment.

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Analysis Under ASC 810-10-35-4(e)
ASC 810-10-35-4(e) states:
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 entity’s economic performance.

Example 6
Investors X and Y form Entity Z to purchase and operate real estate properties. Each investor contributes $25 million in equity at risk. In addition, Investor D loans $5 million to Z. The loan agreement between D and Z includes a clause stipulating that if there is an adverse change that materially impairs the ability of Z to pay back the loan, D can take possession of all the assets of Z and direct the activities that most significantly affect Z’s economic performance. An independent third party must objectively determine whether a material adverse change has occurred on the basis of the terms of the loan agreement (an example of a material adverse change under the loan agreement would be the bankruptcy of Z). At inception, Z is deemed a voting interest entity (the rights of D are considered protective rights in accordance with ASC 810-10-25-38C). The occurrence of a material adverse change under the debt agreement would trigger a reconsideration event, since the holders of the equity investment at risk as a group would have lost the power to direct the activities that most significantly affect Z’s economic performance.

3.45

Valuation of Equity Investment at Risk When a Reconsideration Event Occurs

Question
How should a reporting entity measure equity investment at risk in determining its sufficiency upon a reconsideration event under ASC 810-10-35-4?

Answer
A reporting entity should use the fair value of the equity investment at risk as of the reconsideration date, not the carrying value of the equity investments, in determining the sufficiency of equity investment at risk. (For more information, see Q&A 3.01.) See Q&A 3.46 for guidance on isolating the impact of a change under ASC 810-10-35-4(a) and ASC 810-1035-4(c).

3.46 Isolating the Impact of a Change in the Entity’s Governing Documents or Contractual Arrangements and the Impact of Undertaking Additional Activities or Acquiring Additional Assets
The initial determination of whether an entity is a VIE must be reconsidered upon the occurrence of one of the events in ASC 810-10-35-4. Q&A 3.44 gives some examples of triggering events under ASC 810-10-35-4.

Question
In determining whether a reconsideration event has occurred, how should a reporting entity assess changes in the adequacy of the equity investment at risk (ASC 810-10-35-4(a)) and an increase in expected losses (ASC 810-1035-4(c))?

Answer
Under ASC 810-10-35-4(a), the adequacy of the entity’s equity investment at risk, as defined in ASC 810-1015-14(a), should be considered immediately before and immediately after the change in the entity’s governing documents or contractual arrangements occurs. Similarly, under ASC 810-10-35-4(c), the expected losses of the entity should be considered immediately before and immediately after the entity undertakes additional activities or acquires additional assets that are beyond those initially anticipated (i.e., not included in a reporting entity’s initial assessment of the VIE model in ASC 810-10). ASC 810-10-35-4 states, in part, “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.” Therefore, by performing these evaluations immediately before and after the reconsideration event, the reporting entity is identifying whether the potential reconsideration event itself gave rise to a change in expected losses.
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Example
Entity X was formed on January 15, 2005. As of that date, all variable interest holders determined that X had sufficient equity investment at risk (i.e., X is not a VIE). Entity X incurred significant operating losses for its first two years of operations. On January 15, 2007, X had insufficient equity investment at risk. However, no event causing reconsideration under ASC 810-10-35-4 has occurred. On January 16, 2007, the governing documents of X were changed. The variable interest holders determined that the change in the governing documents did not cause a change in the amount of the equity investment at risk. Even though X has insufficient equity investment at risk on January 16, 2007, the insufficiency was caused by operating losses, not by the change in governing documents. Therefore, a reconsideration event has not occurred.

3.47

Entering Into Bankruptcy

ASC 810-10-35-4 requires that the initial determination of whether an entity is a VIE be reconsidered if one or more of the following events (“reconsideration events”) occur:
a. b. c. The legal entity’s governing documents or contractual arrangements are changed in a manner that changes the characteristics or adequacy of the legal entity’s 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 entity’s 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 entity’s economic performance.

d. e.

If one or more of the reconsideration events above occur, the holder of a variable interest in a previously determined VIE must reconsider whether that entity continues to be a VIE. Likewise, the holder of a variable interest in an entity that previously was not determined to be a VIE must reconsider whether that entity has become a VIE.

Question
Is the act of filing for bankruptcy a reconsideration event under ASC 810-10-35-4?

Answer
Generally, yes. ASC 810-10-35-4 states, ”A legal entity that previously was not subject to the Variable Interest Entities Subsections [of ASC 810-10] shall not become subject to them simply because of losses in excess of its expected losses that reduce the equity investment.” However, the act of entering into bankruptcy will often result in the loss of the equity investors’ ability to direct the activities of the entity that most significantly affect the entity’s economic performance (generally, this ability would reside with the bankruptcy court) which is a reconsideration event (see ASC 810-10-35-4(e)).

3.48

Emerging From Bankruptcy

ASC 810-10-35-4 requires that the initial determination of whether an entity is a VIE be reconsidered if one or more of the following events (“reconsideration events”) occur:
a. b. c. The legal entity’s governing documents or contractual arrangements are changed in a manner that changes the characteristics or adequacy of the legal entity’s 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 entity’s 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.
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d.

e.

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 entity’s economic performance.

If one or more of the reconsideration events above occur, the holder of a variable interest in a previously determined VIE must reconsider whether that entity continues to be a VIE. Likewise, the holder of a variable interest in an entity that previously was not determined to be a VIE must reconsider whether that entity has become a VIE.

Question
Is emergence from bankruptcy a reconsideration event under ASC 810-10-35-4?

Answer
Generally, yes. When an entity emerges from bankruptcy, its governing documents generally establish new equity and other contractual arrangements that change the characteristics of the entity’s equity investment at risk. In this situation, a reporting entity that holds a variable interest in an entity must reconsider its original conclusion related to that entity’s VIE status.

Development-Stage Entities
ASC 810-10
15-16 Because reconsideration of whether a legal entity is subject to the Variable Interest Entities Subsections is required only in certain circumstances, the initial application to a legal entity that is in the development stage is very important. Guidelines for identifying a development stage entity appear in paragraph 915-10-05-2. A development stage entity is a VIE if it meets any of the conditions in paragraph 810-10-15-14. A development stage entity does not meet the condition in paragraph 810-10-1514(a) if it can be demonstrated that the equity invested in the legal entity is sufficient to permit it to finance the activities it is currently engaged in (for example, if the legal entity has already obtained financing without additional subordinated financial support) and provisions in the legal entity’s governing documents and contractual arrangements allow additional equity investments. However, sufficiency of the equity investment should be reconsidered as required by paragraph 810-10-35-4, for example, if the legal entity undertakes additional activities or acquires additional assets. [Paragraph 11]

3.49

Determining Whether a Development-Stage Entity Is a Business

Question
Can a development-stage entity be considered a business, as defined in ASC 805, to qualify for the scope exception under ASC 810-10-15-17(d)?

Answer
It depends. To qualify as a business under ASC 805, a set of activities and assets does not have to be selfsustaining; it only has to be capable of producing outputs. Therefore, certain development-stage entities may qualify as businesses under ASC 805.

3.50 Risk

Development Stage Entities — Assessing the Sufficiency of Equity Investment at

ASC 810-10-15-16 indicates that a development-stage entity, as described in ASC 915, would be considered to have sufficient equity at risk under ASC 810-10-15-14(a) “if it can be demonstrated that the equity invested in the legal entity is sufficient to permit it to finance the activities it is currently engaged in (for example, if the legal entity has already obtained financing without additional subordinated financial support) and provisions in the legal entity’s governing documents and contractual arrangements allow additional equity investments.” Note that these rules are specific to entities that meet the definition of a development-stage entity and should not be applied by other entities. (For a discussion of anticipated and contractually required future sources of financing when assessing whether an entity is a VIE, see Q&A 3.43.)

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Question
If a development-stage entity does not qualify for any of the scope exceptions in ASC 810-10-15-12 or ASC 81010-15-17, including the scope exception for businesses (see Q&A 3.49), when and how should a reporting entity assess a development-stage entity’s equity investment at risk?

Answer
A reporting entity must evaluate a development-stage entity that does not meet any of the scope exceptions in ASC 810-10-15-12 and ASC 810-10-15-17 to determine whether the entity meets the definition of a VIE in ASC 810-10-15-14. A development-stage entity is deemed to have sufficient equity investment at risk if the equity is sufficient to fund its current activities (i.e., to fund the expected losses associated with the current “phase” of the entity’s development) and the entity’s governing documents and contractual arrangements allow the use of additional equity investments to fund future activities or “phases.” A reporting entity should initially assess whether the entity is a VIE on the date it first becomes involved with the development-stage entity. This assessment must be reconsidered upon the occurrence of any of the events in ASC 810-10-35-4. For a development-stage entity, this would include, but not be limited to: • • Funding of additional equity. Commencement of additional activities (e.g., entering a subsequent “phase” of development).

Example
Entity D is a development-stage entity as defined in ASC 915. Investor A and Investor B each contributed $1 million of equity financing to D. Entity D’s current activities consist of product development and marketing surveys (“phase I”). Upon successful completion of phase I, D plans to commence test marketing (i.e., selling these products in selected areas) (“phase II”). During the final phase of D’s development stage, it plans to engage in limited-scale production and selling efforts (“phase III”). Entity D’s bylaws allow A and B to fund additional equity upon the completion of phase I and phase II. When assessing the sufficiency of equity at risk under ASC 810-10-15-14(a), D need only consider the current “phase” of its development. Thus, if, at inception, the $2 million of equity capital is deemed sufficient to finance phase I, D would be considered to have sufficient equity investment at risk. This determination should be reassessed at the commencement of phase II and phase III, upon the funding of additional equity financing, or upon the occurrence of any of the events in ASC 810-10-35-4.

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Section 4 — Expected Variability and the Calculation of Expected Losses and Expected Residual Returns
ASC 810-10-20
Expected Losses A legal entity that has no history of net losses and expects to continue to be profitable in the foreseeable future can be a variable interest entity (VIE). A legal entity that expects to be profitable will have expected losses. A VIE’s expected losses are the expected negative variability in the fair value of its net assets exclusive of variable interests and not the anticipated amount or variability of the net income or loss. [FSP FIN 46(R)-2, paragraphs 1–2 and 8] Expected Residual Returns A variable interest entity’s (VIE’s) expected residual returns are the expected positive variability in the fair value of its net assets exclusive of variable interests. [Paragraph 8] Expected Variability Expected variability is the sum of the absolute values of the expected residual return and the expected loss. [Paragraph 2] Expected variability in the fair value of net assets includes expected variability resulting from the operating results of the legal entity. [Paragraph 8]

4.01

Definitions of Expected Losses and Expected Residual Returns

ASC 810-10-20 states that expected losses and expected residual returns “refer to amounts derived from expected cash flows discounted and otherwise adjusted for market factors and assumptions rather than to undiscounted cash flow estimates.” Furthermore, ASC 810-10-20 separately defines expected losses and expected residual returns as follows:
A VIE’s expected losses are the expected negative variability in the fair value of its net assets exclusive of variable interests and not the anticipated amount or variability of the net income or loss. A [VIE’s] expected residual returns are the expected positive variability in the fair value of its net assets exclusive of variable interests.

Note the difference in the above definitions of expected losses and expected residual returns — one refers to cash flows and the other to fair value.

Question
What are expected losses and expected residual returns?

Answer
The terms “expected losses” and “expected residual returns” both refer to amounts derived from the unique calculation of “expected cash flows of a VIE” incorporated into the VIE model in ASC 810-10. This calculation is based broadly on the techniques for developing cash flow estimates under the expected cash flow approach in Concepts Statement 7. However, although both Concepts Statement 7 and the VIE model prescribe a cash flow scenario technique and require the discounting of cash flows, calculations of expected cash flows under the two are not the same. To apply the expected cash flow approach in Concepts Statement 7, a reporting entity must calculate expected values to develop estimated cash flow scenarios. In general — as with any traditional expected value calculation — a “pure” (unadjusted) Concepts Statement 7 calculation would include, for each scenario, all cash flows into and out of the VIE, regardless of the source of those cash flows.
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Although the VIE model in ASC 810-10 also requires a cash flow scenario technique, it mandates that certain cash flows (those stemming from nonvariable interests) be included in, and certain cash flows (those stemming from variable interests) be excluded from, the cash flows that otherwise would be used to calculate the expected value of the VIE under Concepts Statement 7. For example, cash flow amounts representing distributions to holders of variable interests are not included as cash outflows of the VIE in the determination of the VIE’s expected losses or expected residual returns. Similarly, cash flow amounts that represent receipts from holders of variable interests are not considered cash inflows to the VIE. By excluding those amounts, the VIE model’s calculation of expected cash flows attempts to isolate changes (variability) in the fair value of the VIE’s existing net assets that are attributable to nonvariable interests. The objective of the expected cash flows calculation under the VIE model is to arrive at a single estimate resulting from the probability-weighted, discounted cash flows generated by the VIE that variable interest holders are expected to ultimately receive (as returns) or absorb (as losses) from the VIE. As with all expected value calculations, the final product (expected cash flows of the VIE) is a mean or average value associated with a group of possible probability-weighted outcomes. In calculating that mean or average, a reporting entity should develop a number of cash flow scenarios to reflect different possible outcomes. Some cash flow scenarios will represent outcomes that are lower than the mean amount, and some will represent outcomes higher than the mean amount. Each outcome reflects a variance from the mean — those that are lower than the mean represent negative variability (these are “expected loss” scenarios), and those that are higher than the mean represent positive variability (those are the “expected residual return” scenarios). The actual calculation of expected losses and expected residual returns requires that the outcome under each scenario be subtracted from the mean. The “expected losses of the VIE” are equal to the sum of the differences from the mean of all the expected loss scenarios, while the “expected residual returns of the VIE” are equal to the sum of the differences from the mean of all the expected residual return scenarios. The calculation of expected cash flows under Concepts Statement 7 or the VIE model in ASC 810-10 is not equivalent to the amounts that are reported in a cash flow statement prepared under GAAP. In addition, the expected losses and expected residual returns of the VIE do not represent actual gains or losses of the VIE. Those calculations represent the variability in the VIE’s mean cash flows. For example, if the expected cash flows of a VIE are calculated to be $800,000 (this is the average of all scenarios), an amount of $40,000 would be included in the expected losses of the VIE for a single scenario that results in cash flows of $760,000. Note that although this is considered an expected loss, the actual outcome for the VIE under that scenario is a positive cash flow of $760,000. See Q&A 4.04 for further guidance on calculating the expected cash flows of a potential VIE. In addition, ASC 810-10-55-42 through 55-54 illustrate the calculation of variability for both expected losses and expected residual returns.

4.02

The Meaning of “Net Assets” Under the VIE Model in ASC 810-10
A VIE’s expected losses are the expected negative variability in the fair value of its net assets exclusive of variable interests. A [VIE’s] expected residual returns are the expected positive variability in the fair value of its net assets exclusive of variable interests.

ASC 810-10-20 defines expected losses and expected residual returns as follows:

Furthermore, ASC 810-10-55-17 states, in part:
The Variable Interest Entities Subsections use the terms expected losses and expected residual returns to describe the expected variability in the fair value of a legal entity’s net assets exclusive of variable interests.

Question
Does the term “net assets exclusive of variable interests” under ASC 810-10 mean net assets as identified on the entity’s balance sheet under GAAP?

Answer
No. Under the VIE model in ASC 810-10, the term “net assets exclusive of variable interests” represents the nonvariable interests in the entity. That is, the objective of the net asset calculation is to include only the estimated cash flows stemming from nonvariable interests. Net assets under the VIE model differ from those described elsewhere in GAAP (i.e., the excess of assets over liabilities). For example, net assets under the VIE model in ASC 810-10 may include unrecognized firm commitments, contractual arrangements with service providers or decision makers, and supply contracts that are not recorded under GAAP. Conversely, a derivative under GAAP
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that is deemed a variable interest would not be part of net assets exclusive of variable interests, as used in the calculations. See Q&As 4.05 and 4.06 for examples illustrating the calculation of the expected losses and expected residual returns of an entity, including consideration of the calculation of the net assets under the VIE model. In addition, net assets exclusive of variable interests include interests in specific assets, as described in ASC 810-1025-55 and 25-56, because those interests are not variable interests in the entity. Note that this treatment has the same effect as excluding the variability in the asset (or portion of the asset) and excluding the interest in that asset.

4.03 Purpose of Calculating the Expected Losses and Expected Residual Returns of the Entity
Question
What is the purpose of calculating expected losses and expected residual returns under the VIE model in ASC 81010?

Answer
Under the VIE model in ASC 810-10, a reporting entity may need to calculate the “expected losses of the entity” to determine whether an entity is a VIE because it lacks sufficient equity investment at risk to absorb expected losses (if a qualitative assessment of the adequacy of equity investment at risk is not conclusive). In determining whether an entity is a VIE, the reporting entity compares the entity’s expected losses with the total equity investment at risk under ASC 810-10-15-14(a) to determine whether the entity has sufficient equity investment at risk to finance its activities without additional subordinated financial support. The reporting entity may also need to perform a quantitative calculation to assess fees paid to decision makers or service providers under ASC 810-10-55-37(c) or 37(f), or to determine which related-party group is most closely associated with a VIE under ASC 810-10-25-44.

4.04 How to Determine the Expected Losses and Expected Residual Returns of the Entity
Question
How does a variable interest holder determine the expected losses and expected residual returns of the entity under the VIE model in ASC 810-10?

Answer
As noted in Q&A 4.01, a reporting entity determines expected losses and expected residual returns by calculating the “expected cash flows of the entity” under the VIE model in ASC 810-10. To determine the expected cash flows of the entity under the VIE model, a reporting entity must develop a number of estimated cash flow scenarios, each with its own cash flow result. Concepts Statement 7 and Q&A 4.10 contain general guidance on developing estimates of cash flows for expected present value calculations. That guidance is useful for developing estimated cash flow scenarios under the VIE model in ASC 810-10. However, estimated cash flow scenarios under the VIE model exclude certain cash inflows and outflows that occur between the entity and its variable interest holders, which would be included in a traditional calculation of expected cash flows under Concepts Statement 7. Once the cash flow scenarios are developed, they are probability-weighted and summed to arrive at the expected cash flows of the entity under the VIE model. By comparing that amount to each outcome in each estimated cash flow scenario, a reporting entity can identify positive variability (expected residual return scenarios) and negative variability (expected loss scenarios). Finally, the reporting entity discounts the expected loss and expected residual return scenarios and totals each set of scenarios to determine the expected losses of the entity (the sum of the discounted cash flow scenarios giving rise to negative variability) and the expected residual returns (the sum of the discounted cash flow scenarios giving rise to positive variability). The following steps outline an approach to determining the expected losses and expected residual returns of the entity under the VIE model in ASC 810-10: • • Step 1: Distinguish the nonvariable interests from the variable interests in the entity. Step 2: Develop the scenarios of estimated cash flows attributable to nonvariable interests under the VIE model.

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• •

Step 3: Calculate the expected cash flows of the entity under the VIE model. Step 4: Calculate the expected variability (i.e., expected losses and expected residual returns) in expected cash flows for each scenario.

The paragraphs below provide guidance on applying these steps. For an example illustrating the steps’ application, see Q&A 4.05.

Step 1: Distinguish the nonvariable interests from the variable interests in the entity.
Under the VIE model in ASC 810-10, each of the entity’s assets, liabilities, contracts, and equity items represents an “interest,” some of which are considered “variable interests” and some of which are not. The first step in calculating the expected cash flows of the entity (and, consequently, the expected losses and expected residual returns) is to distinguish the variable and nonvariable interests from among the entity’s assets, liabilities, equity, and other contractual arrangements. This step is important for a number of reasons. First, each holder of a variable interest in the entity (unless otherwise exempt from the provisions of the VIE model in ASC 810-10) could be deemed the primary beneficiary under ASC 810-10-25-38A. Further, each holder of a variable interest in the entity is subject to the disclosure requirements in ASC 810-10. Conversely, a reporting entity that does not hold a variable interest (either directly or indirectly through its related parties or de facto agents) cannot be the primary beneficiary of a VIE. Second, as noted in Q&A 4.01, a reporting entity does not include cash flows to or from variable interests as cash outflows or inflows of the entity in developing cash flow scenarios. Consequently, it is important to distinguish nonvariable interests from variable interests to ensure that (1) the calculation of the entity’s expected cash flows appropriately represents the amount of cash flows that would be expected to be allocated to variable interest holders, (2) the primary beneficiary (if any) can be properly identified, and (3) reporting entities involved with the entity can determine whether they are subject to the disclosure requirements in ASC 810-10. Recall that the determination of whether an entity is a VIE is sometimes based, in part, on the calculation of expected losses, which is expected negative variability from the amount identified as the entity’s expected cash flows, and the calculation of expected residual returns, which represents positive variability from the amount identified as the entity’s expected cash flows. (For more information about the definitions of expected losses and expected residual returns, see Q&A 4.01.) Under the VIE model in ASC 810-10, the basis for the distinction between the entity’s asset, liability, contract, and equity items that are variable interests and those that are not is that interests that create positive or negative variability are not variable interests and those that receive positive or absorb negative variability are variable interests. (For further guidance on determining whether an interest is a variable interest in an entity, see Q&A 2.01 and ASC 810-10-55-16 through 55-41.) In other words, if the returns of the entity are less than expected (negative variability or expected losses), an item that is a variable interest typically would receive a lower return than expected, thus “absorbing” expected losses. Conversely, if the returns of the entity are more than expected, an item that is a variable interest would typically receive a return that is greater than expected, thus “receiving” expected residual returns. Any item that either absorbs expected losses or receives expected residual returns is considered a variable interest in the entity. Once the variable interests have been distinguished from the nonvariable interests, a reporting entity must further evaluate the variable interests. Under ASC 810-10-25-55 and 25-56, a reporting entity treats some interests that otherwise would be considered variable interests under ASC 810-10-55-16 through 55-41 as nonvariable interests in deriving the expected cash flows of the entity under the VIE model. ASC 810-10-25-55 states, in part:
A variable interest in specified assets of a VIE (such as a guarantee or subordinated residual interest) shall be deemed to be a variable interest in the VIE only if the fair value of the specified assets is more than half of the total fair value of the VIE’s assets or if the holder has another variable interest in the VIE as a whole (except interests that are insignificant or have little or no variability).

Step 2: Develop the scenarios of estimated cash flows attributable to nonvariable interests under the VIE model.
In step 2, the reporting entity must develop estimated (non-probability-weighted) cash flows under a number of different scenarios. To calculate an entity’s expected losses, a reporting entity’s management will need to develop various scenarios, each of which estimates the entity’s cash flows from nonvariable interests under different assumptions about future conditions and circumstances. Each scenario will represent an estimate of one possible future cash flow outcome of the net assets, exclusive of variable interests in the entity, and will incorporate different expectations and uncertainties about the amount or timing of those cash flows. Concepts Statement 7 states that “present value should attempt to capture the elements that taken together would comprise
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a market price if one existed.” Thus, the assumptions that management uses to develop the entity’s estimated cash flow scenarios should be those that marketplace participants would use and should not be based solely on management’s own perspective. Note that management should consider distributions-in-kind in estimating cash flows. (For more information, see Q&A 4.07.) As a result of considering the entity’s “cash drivers” (i.e., key factors that affect the cash flows associated with the entity’s assets and liabilities), management will develop differing expectations about cash flows for each scenario. Cash drivers can vary from entity to entity and include such factors as credit risk, price risk, interest rate risk, currency risk, technological innovation and obsolescence, competition, supply and demand for products and services, and general economic conditions. Management must use judgment in developing market-based assumptions about changes in cash drivers and their effects on the timing and amount of estimated cash flows and should document its conclusions and the basis for those conclusions. Management should develop cash flow scenarios on the basis of all the possible variations in the operating results of the entity. (For more information, see Q&A 4.10.) The cash flow scenarios must incorporate a reasonable period. At the end of the forecast period, the cash flows should reflect the outcome of all assets being sold at fair market value with the proceeds used to settle all liabilities that are not variable interests (e.g., trade payables and accrued expenses that are not variable interests). In other words, each cash flow scenario must incorporate a terminal value into its cash flow estimate if the life of the entity could extend beyond a period subject to reasonable estimation. A reporting entity may develop its scenarios by starting with either GAAP net income or cash flows (see Q&A 4.06 for an example illustrating the development of scenarios by starting with GAAP cash flows) or by using other methods to develop the cash flow amounts. Starting with cash flows will be easier than starting with net income because, as part of calculating the entity’s expected losses and expected residual returns, a reporting entity must calculate an amount for the expected cash flows of the entity by using an approach based on the techniques in Concepts Statement 7 for calculating expected present value. However, if GAAP-based projections are used, the cash inflows and outflows must be adjusted to reverse the cash inflows and outflows related to items identified as variable interests. That is, the cash flows incorporated into the scenarios used to develop the entity’s expected cash flows do not incorporate cash flows that would be paid to or received from a holder of a variable interest (identified in step 1). (See the guidance on the definitions of expected losses and expected residual returns in Q&A 4.01.) The result of each scenario should represent the estimated cash flows to be absorbed or received by the collective variable interest holders if that scenario were to occur.

Step 3: Calculate the expected cash flows of the entity under the VIE model.
Whereas each scenario provides a single estimate of an amount to be paid or received in the future, the VIE model’s expected cash flows of the entity is the sum of the probability-weighted outcomes of those scenarios. Thus, each scenario outcome identified in step 2 must be probability-weighted (in a manner consistent with the approach to calculating expected cash flows under Concepts Statement 7). A reporting entity assigns probabilities on the basis of the likelihood of occurrence of that scenario in relation to all scenarios. The selection of probabilities should be based on all facts and circumstances and requires judgment (the sum of the probabilities assigned to the scenarios must equal 100 percent). (For more information, see Q&A 4.10.) The sum of the expected (probability-weighted) cash flows for all scenarios is equal to the expected cash flows of the entity under the VIE model.

Step 4: Calculate the expected variability (i.e., expected losses and expected residual returns) in the VIE model’s expected cash flows for each scenario
A reporting entity determines expected losses and expected residual returns under the VIE model by first using the risk-free rate to discount the outcomes under each relevant scenario and then summing the discounted amounts (see Q&A 4.11 for guidance on the use of the risk-free rate). The mean of the discounted amounts can be calculated from the sum; the results of the calculations for all the scenarios can be compared against this mean. The sum of the discounted amounts is the expected cash flows to be received/absorbed by the variable interest holders. ASC 810-10-55-42 through 55-49 refer to this amount as “fair value.” Under certain circumstances, one important check of the reasonableness of the calculation of discounted expected cash flows is a comparison of the result to the fair value of all the variable interests. Under ASC 820-10-20, fair value is “[t]he price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

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The scenarios giving rise to negative variability result in expected losses, and the scenarios giving rise to positive variability result in expected residual returns. For each scenario, the reporting entity calculates the expected variability in the expected cash flows under the VIE model by subtracting the discounted expected cash flows of the entity from the estimated cash flows and multiplying the difference by the relevant probability. When the result of that calculation is positive (i.e., estimated cash flows associated with a scenario are greater than the expected cash flows of the entity), the result is positive variability, indicating that the scenario is an expected residual return scenario. When the cash flows associated with a scenario are less than the expected cash flows, the result is negative variability, indicating that the scenario is an expected loss scenario. The sum of the negative variability scenarios is the expected losses of the entity. The sum of the positive variability scenarios is the expected residual returns of the entity.

4.05 How to Determine the Expected Losses and Expected Residual Returns of the Entity — Example
Q&A 4.04 describes the steps involved in the determination of an entity’s expected losses and expected residual returns.

Question
How would those steps be applied to an example?

Answer
The following example illustrates the steps in the determination of an entity’s expected losses and expected residual returns.

Example
Assume the following: An entity (PowerCo) is created to hold a power plant with a fair market value of $10 million at inception. PowerCo is funded by two unrelated equity holders, each contributing $1 million, and the issuance of $8 million of debt as follows: • • • $5 million in senior fixed-rate bonds with a 5 percent interest rate to a single unrelated party. $3 million in subordinated fixed-rate bonds with a 7.5 percent interest rate to a single unrelated party. The two bondholders are unrelated to each other or to the equity holders. The senior and subordinated bonds are due in a lump sum payment (“bullet maturity”) at the end of 25 years. PowerCo uses $9.95 million of the proceeds from equity contributions and debt to purchase a power plant. The other $50,000 of proceeds is used to pay a guarantee premium on the subordinated bond, as discussed below. As a condition of lending, the subordinated debt holder requires PowerCo to obtain a credit guarantee. The guarantee will cover any shortfall of the subordinated debt principal payments up to $1 million. PowerCo pays a third-party guarantor a premium of $50,000 for the guarantee. PowerCo enters into a forward contract to sell its output at market value to an unrelated third party. PowerCo retains a significant amount of the operating risk associated with the power plant. An unrelated party, ManageCo, runs the plant and makes the day-to-day operating decisions. ManageCo has a five-year contract and receives a fixed fee of $90,000 per year, plus an additional 1 percent of net income before this fee, impairment expense, depreciation expense, and guarantor premiums or proceeds. During its five-year term, ManageCo cannot be fired or relieved of its duties except for breach of contract.

Further assume the following: •

• •

Although PowerCo is a “business” as defined in ASC 805, the equity holders, the bond holders, and ManageCo participated significantly in the design of the entity. Therefore, they are not exempt from analyzing PowerCo to determine whether it is subject to the VIE model in ASC 810-10. See Q&A 1.20 for further discussion of the business scope exception. This example assumes that a qualitative assessment was completed in accordance with ASC 810-10-25-45 but was not conclusive in the determination that PowerCo had sufficient equity investment at risk.
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Step 1: Distinguish the nonvariable interests from the variable interests in the entity.
The following table analyzes interests in PowerCo to determine which are variable interests:
PowerCo’s equity does not create losses or residual returns. The equity is the most subordinated interest in PowerCo. If returns of PowerCo are less than expected, it absorbs losses (negative variability) first, and if returns of PowerCo are greater than expected, it will receive returns (positive variability) greater than those provided to more senior interests (i.e., the senior bond holder and the subordinated bond holder receive their principal and interest before the equity absorbs any residual returns of PowerCo). Thus, the equity interests are variable interests. The subordinated bond does not create losses or returns for PowerCo. Instead, it is a variable interest in PowerCo because it is subordinated to the senior bond and therefore would have to absorb losses (after the equity) if PowerCo does not generate enough cash to pay interest or principal on the bond. The analysis is the same as that for the subordinated bond above (i.e., the senior bond is a variable interest in PowerCo). Although the equity and subordinated bond would absorb PowerCo’s expected losses first, scenarios are possible in which returns are less than expected and for which the senior bond also will absorb losses. Therefore, the senior bond is a variable interest in PowerCo. The subordinated bond guarantee is a variable interest in PowerCo because it must absorb losses if PowerCo does not generate enough cash to pay interest or principal on the subordinated bond. ASC 810-10-55-25 states, in part, “[t]o the extent the counterparties of guarantees . . . will be called on to perform in the event expected losses occur, those arrangements are variable interests, including fees or premiums to be paid to those counterparties.” Although the guarantee gives rise to future cash flows of the entity, those cash flows are triggered by, and are intended to make up for, returns that are less than expected. Note that although the guarantor is a variable interest holder, the guarantor need not analyze its interest under the VIE model in ASC 810-10 because PowerCo meets the definition of a business in ASC 805 (provided that the guarantor was not significantly involved in the design of the entity). Power Plant The power plant is PowerCo’s primary asset. The operations of the power plant create variability because it will generate and incur cash flows related to the operation of the business. Thus, the power plant creates variability in cash flows that will be absorbed by the variable interest holders and the power plant is not a variable interest. The design of PowerCo is important to the determination of whether the third-party customer holds a variable interest in PowerCo. According to ASC 810-10-25-35, the determination of whether a forward contract to sell electricity is a variable interest is based, in part, on whether (1) its “underlying is an observable market rate, price, index of prices or rates, or other market observable variable” and (2) the “counterparty is senior in priority relative to other interest holders in the legal entity.” In addition, if changes in the cash flows or fair value of the forward contract are expected to offset all, or essentially all, of the electricity price risk and operating risk related to the power plant, further analysis of the design of PowerCo would be required. Criteria (1) and (2) above are met in this instance, and although PowerCo sells the electricity at market value, it still retains a significant amount of operations risk associated with the power plant; therefore, the forward contract is considered a creator of variability and is not a variable interest. This conclusion would change if the forward contract was designed to reimburse PowerCo for all or essentially all of the costs related to operating the power plant. (For more information, see ASC 810-10-55-81 through 55-86.) The ManageCo service contract is a variable interest. The VIE model in ASC 810-10 provides guidance on determining whether the fee stream paid to a decision maker or service provider is a variable interest. In this case, the ManageCo contract is a variable interest in accordance with ASC 810-10-55-37 through 37A. After consideration of all relevant facts and circumstances, the ManageCo contract fails to meet all the conditions of a nonvariable interest in ASC 810-10-55-37 through 37A.

Equity

Subordinated Bond

Senior Bond

Subordinated Bond Guarantee

Third-Party Customers

ManageCo Service Contract

On the basis of the above analysis, the following assets and contracts create variability in PowerCo (and are not variable interests): • • The estimated cash flows from the operations of the power plant (including the sales to third parties). The estimated changes in the fair value of the power plant not reflected in net income or loss.

The following liabilities, contracts, and equity absorb or receive the variability created by the above (and are variable interests in the entity): • • • The equity. The senior bond. The subordinated bond.

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• •

The subordinated bond guarantee. ManageCo (through its fees).

As stated in the table above, only the holders of the equity, the senior bond, the subordinated bond, and ManageCo will analyze whether PowerCo is a VIE and whether any of them is the primary beneficiary. The guarantor of the subordinated debt does not need to analyze its interest held because PowerCo meets the definition of a business in ASC 805 and none of the conditions in ASC 810-10-15-17(d) are met with respect to its variable interest in PowerCo. However, the variable interest holders will treat all of the interests that absorb or receive variability as variable interests within the scope of the VIE model in ASC 810-10 when calculating the expected cash flows of the entity.

Step 2: Develop the scenarios of estimated cash flows attributable to nonvariable interests under the VIE model.
Cash flow scenarios must be developed on the basis of all of the possible variations in the operating results of PowerCo. PowerCo uses the “indirect method” (as illustrated in Q&A 4.06) to calculate the estimated cash flows for each scenario. Note that the calculation of expected cash flows for each scenario only should include the cash flows created by the entity. That is, as noted in Q&A 4.01, the result for each cash flow scenario should reflect the cash flows available to variable interest holders for that scenario, as identified in step 1 above. In this case, PowerCo only will consider cash flows related to the operations of the plant and the changes in fair value of the power plant that otherwise are not reflected in net income or loss (i.e., the estimated termination value of the power plant at the end of the estimated cash flow period). PowerCo starts its calculation with amounts derived under GAAP; therefore, it must adjust its cash flow estimates to exclude the impact on GAAP amounts of cash flows related to the variable interests (i.e., any cash flow to or from the holders of equity, debt, the guarantee, or the management contract). For simplicity, this example assumes only three possible scenarios for PowerCo — best case (Scenario 1), most likely case (Scenario 2), and worst case (Scenario 3). However, in practice, a reporting entity will need to consider many more scenarios. See Q&A 4.10 for guidance on the number of scenarios needed to calculate the expected cash flows of an entity under the VIE model. In addition, for simplicity, this example assumes that the cash flows of PowerCo have been estimated over a fiveyear period. However, in practice, a reporting entity must use judgment to determine the appropriate period over which cash flows reasonably can be estimated. At the end of the five-year period, the assets of the entity (e.g., the power plant) are assumed to be sold at fair market value under each scenario and the proceeds from the sale are incorporated into the estimated cash flow scenarios. In other words, the termination value of the entity must be considered in each cash flow scenario. For each scenario, assume that the power plant is depreciated over 20 years. Q&A 4.06 illustrates the calculations of cash flow scenarios for PowerCo under Scenario 3. The following table shows the results for all three scenarios:
Table 1 — Undiscounted Cash Flows Undiscounted Cash Flows to Be Received From or Paid to the Entity by Variable Interests Scenario 1 Scenario 2 Scenario 3

Year 1 $ 1,485,000 1,435,000 785,000

Year 2 $ 1,755,000 1,255,000 755,000

Year 3 $ 1,420,000 1,320,000 720,000

Year 4 $ 1,238,000 1,038,000 588,000

Year 5 $ 9,552,000 8,172,000 5,866,400

Total $15,450,000 13,220,000 8,714,400

Step 3: Calculate the expected cash flows of the entity under the VIE model.
To arrive at the expected cash flows of the entity under the VIE model in ASC 810-10, a reporting entity must weigh the probability of each cash flow outcome associated with each of the three scenarios (this approach is consistent with the approach to calculating expected cash flows under Concepts Statement 7). Probabilities are assigned on the basis of the likelihood of the occurrence of that scenario compared with that of all other scenarios. The selection of probabilities should be based on all facts and circumstances (the sum of the probabilities assigned to the scenarios must equal 100 percent). (For more information, see Q&A 4.10.) Table 2 below shows the calculation of the expected cash flows of PowerCo under the VIE model. The calculation of the discounted cash flows is shown in step 4.

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Table 2 — Undiscounted Expected Cash Flows Undiscounted Estimated Cash Flows (A) $ 15,450,000 13,220,000 8,714,400 Probability (B) 25% 50 25 100% Probability-Weighted Expected Cash Flows (A × B) $ 3,862,500 6,610,000 2,178,600 $ 12,651,100

PowerCo Scenario 1 Scenario 2 Scenario 3 Undiscounted expected cash flows under the VIE model in ASC 810-10

Step 4: Calculate the expected variability (i.e., expected losses and expected residual returns) in expected cash flows for each scenario.
Expected losses and expected residual returns under the VIE model in ASC 810-10 are determined by first using the risk-free rate to discount the outcomes under each relevant scenario and then summing the discounted amounts. The mean of the discounted amounts can be calculated from the sum; the results of the calculations for all three scenarios can be compared against this mean. The following table illustrates the calculation of the discounted expected cash flows for the three scenarios:
Table 3 — Discounted Expected Cash Flows Discounted Estimated Cash Flows (A)* $ 12,735,519 10,902,195 7,134,616 Probability-Weighted Discounted Expected Cash Flows (A × B) $ 3,183,880 5,451,098 1,783,654 $ 10,418,632

PowerCo Scenario 1 Scenario 2 Scenario 3 Discounted expected cash flows under the VIE model in ASC 810-10

Probability (B) 25% 50 25 100%

* Table 4 below illustrates the calculation of discounted estimated cash flows for Scenario 3. Table 4 — Undiscounted Cash Flows (Scenario 3) Discounted Cash Flows Attributable to Nonvariable Interests Cash flows to be received from or paid to the entity by nonvariable interests Discount rate* Discounted cash flows $

Year 1

Year 2

Year 3

Year 4

Year 5

Total

$

785,000 5% 747,619

$ $

755,000 5% 684,807

$ $

720,000 5% 621,963

$ $

588,000 5% 483,749

$ 5,866,400 5% $ 4,596,478

$ 8,714,400 $ 7,134,616

* The discount rate used was held constant at 5 percent for all years for simplicity. However, a reporting entity should use the implied yield currently available on zero-coupon U.S. government issues, with a remaining term equal to the term associated with the cash flows being valued (see Q&A 4.11 for further discussion of discount rates). The same forward interest rate curve should be used for each scenario. That is, one of the variables in each scenario cannot be a fluctuation in the discount rate (i.e., use of a different yield curve).

In Table 3 above, the discounted expected cash flows were calculated to be $10,418,632. ASC 810-10-55-44 and 55-45 refer to this amount as “fair value.” Under certain circumstances, the fair value of all the variable interests is one check of the reasonableness of the calculation of discounted expected cash flows. In this example, fair value is assumed to be the sum of what the variable interest holders paid or contributed for their interests. However, since the analysis may need to be performed at many times other than inception (e.g., reconsideration events under ASC 810-10-35-4), a readily observable market value or transaction price may not be available but should be estimated.

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The approximate fair value of the variable interests is as follows:
Table 5 — Fair Value of the Variable Interests Variable Interest Holder Equity holders Senior bond holder Subordinated bond holder Third-party guarantor ManageCo Total fair value $ Fair Value 2,000,000 5,000,000 3,000,000 –* 417,048 ** $ 10,417,048

* The third-party guarantor has a fair value of zero because the entity gave up value of $50,000 in the form of a premium for a promise to pay in the future. The discounted probability-weighted cash flows are ($50,000) for honoring the guarantee. ** ManageCo has a fair value based on its discounted probability-weighted fees to be received from the VIE.

Because the discounted expected cash flows of $10,418,632 approximate the fair value of the variable interests in the entity of $10,417,048, the underlying assumptions used in developing the estimated cash flows appear to be appropriate. A reporting entity can also compare the discounted expected cash flows of each variable interest with its fair value at inception to determine whether the assumptions and probabilities used appear proper. The next step in determining the expected losses and expected residual returns is to calculate the expected variability in expected cash flows for each scenario in accordance with the VIE model. The following table illustrates the calculation of the variability for the three scenarios:
Table 6 — Calculation of Expected Losses and Expected Returns ProbabilityWeighted Discounted Expected Cash Flows $ 3,183,880 5,451,098 1,783,654 $ 10,418,632

PowerCo Scenario 1 Scenario 2 Scenario 3

Probability 25% 50 25 100% $

Variability* 579,222 241,782 (821,004)

Expected Losses

Expected Residual Returns $ 579,222 241,782

(821,004) $ (821,004) $ 821,004

* Variability is calculated as follows (example for Scenario 1): Expected cash flows above $ 10,418,632 Multiply by probability of scenario 25% Probability-weighted amount 2,604,658 Probability-weighted discounted expected cash flows in Scenario 1 3,183,880 Less probability-weighted amount (2,604,658) Variability 579,222

Negative variability results in an expected loss scenario, and positive variability results in an expected residual return scenario. The term “expected losses” does not refer to what an entity or variable interest holder expects to lose but to the variability in the cash flows to be absorbed by the variable interest holder. All entities, therefore, have expected losses (as indicated in ASC 810-10-55-50 through 55-54, even profitable entities have expected losses). Typically, the more risk involved in the activities of the entity, the larger its expected losses and expected residual returns.

Conclusion
The expected losses are compared with the total equity investment at risk under ASC 810-10-15-14(a) to determine whether the entity is a VIE because it lacks sufficient equity. In Table 6 above, the expected losses of the entity are $821,004. Because PowerCo has equity investment at risk of $2 million, its equity is sufficient to cover the expected losses of the entity.
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Note that sufficient equity investment at risk is just one of the characteristics that must be met for a reporting entity to conclude that an entity is not a VIE; the conditions in ASC 810-10-15-14(b) and 14(c) are additional obstacles an entity must clear. For instance, under ASC 810-10-15-14(b)(1), the equity investment at risk must allow the group of equity investors to have the “power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance.” In the example in this Q&A, if a conclusion was reached that ManageCo had the power to direct the most significant activities, PowerCo would be deemed a VIE because the equity group would lack the power to direct the activities that most significantly affect the entity’s economic performance, as described in ASC 810-10-15-14(b)(1).

4.06

Use of the Indirect Method to Calculate Estimated Cash Flows

The VIE model in ASC 810-10 requires that a reporting entity develop estimated cash flow scenarios in calculating expected losses and expected residual returns, as these terms are defined in ASC 810-10-20. Q&A 4.04 indicates that a reporting entity may use various approaches to develop estimated cash flows.

Question
How is the “indirect method” used to estimate cash flows?

Answer
This indirect method is similar to the indirect method used in preparing cash flow statements under GAAP. The process involves adjusting GAAP net income to a cash basis and further adjusting the cash flows to reflect only those resulting from nonvariable interest holders. (Alternatively, a reporting entity could start with GAAP cash flows, adjusted to reflect only those resulting from nonvariable interest holders — i.e., the direct method). The example of PowerCo in Q&A 4.05 illustrates the indirect method. As in that example, in the example below, the cash flows will be estimated over five years for simplicity even though, in practice, a reporting entity must use judgment to determine the appropriate period over which cash flows reasonably can be estimated. The only scenario that will be illustrated is Scenario 3 (the worst-case scenario). For this worst-case scenario, the power plant is depreciated over 20 years and has a termination value of $5.5 million at the end of the five years. The five-year income statement is estimated for Scenario 3 as follows:
Table 7 — Scenario 3 Income Statement Income Statement Power sales income Operating expenses Third-party guarantor fees* Depreciation expense ManageCo fees** Interest expense — senior debt Interest expense — subordinated debt Impairment loss† Guarantee proceeds‡ Gain on extinguishment of debt^ Net income (loss) $ – (431,100) $ – (282,600) $ – (480,600) $ – (431,100) $ Year 1 $ 3,300,000 (2,650,000) (2,000) (497,500) (91,600) (250,000) (240,000) Year 2 $ 3,350,000 (2,550,000) (2,000) (497,500) (93,100) (250,000) (240,000) Year 3 $ 3,350,000 (2,750,000) (2,000) (497,500) (91,100) (250,000) (240,000) Year 4 $ 3,250,000 (2,600,000) (2,000) (497,500) (91,600) (250,000) (240,000) Year 5 $ 3,000,000 (2,535,600) (42,000) (497,500) (90,000) (250,000) (240,000) (1,962,500) 243,000 2,000,000 (374,600)

* The $50,000 guarantee premium is amortized over the term of the subordinated bond (i.e., 25 years). Year 5 includes the remaining expense, since the VIE is liquidated at the end of the five years in this cash flow scenario. ** According to the facts in Q&A 4.05, ManageCo receives fees of a fixed amount of $90,000 per year, plus an additional 1 percent of net income before such fees, impairment expense, depreciation expense, and guarantor proceeds.

In accordance with ASC 360-10, an impairment loss is calculated at the end of five years on the basis of the carrying value in excess of fair value. The termination value at the end of five years in this scenario is estimated to be $5,500,000 and the carrying value is $7,462,500 ($9,950,000 purchase, less $2,487,500 of depreciation). Accordingly, an impairment charge of $1,962,500 is made in year 5.

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Table 7 — Scenario 3 Income Statement (continued)

The subordinated bond holder has required the VIE to obtain a third-party guarantee that would cover a shortfall of the subordinated bond principal payments up to $1,000,000. The guarantee would be triggered in year 5 if cash flows are not available to make the guaranteed principal payments on the subordinated bond. In this scenario, the cash flows available to the subordinated bond holder before any guarantor proceeds is $757,000. Therefore, the guarantor must pay the VIE $243,000 because the subordinated bond holder is guaranteed $1,000,000 of its principal payments. The $243,000 of guarantee proceeds is reflected as an increase in net income for the entity in year 5. The subordinated bond holder only received $1,000,000 of its $3,000,000 of principal. Therefore, the VIE would record a gain on extinguishment of debt of $2,000,000 in year 5.

^

The table below illustrates the adjustments PowerCo would need to make to use the indirect method to develop the estimated cash flows. Note that these adjustments would be the same if the direct method were used. The principle is to adjust the cash flows to those that create variability. Said another way, the result should be those cash flows that will be absorbed by or paid to the entity by variable interest holders:
Table 8 —Illustration of Indirect Method Indirect Method Net income (loss) Non-cash items: Depreciation expense Amortization expense of premium Impairment loss Gain on extinguishment of debt Change in working capital accounts Net operating positive (negative) cash flows Other adjustments: Fair value of power plant at the end of five years Fair value of other assets less assumed settlement of liabilities Payments by a variable interest holder reflected in net income (loss): Guarantee proceeds Payment to variable interest holders reflected in net income (loss): Senior bond interest expense Subordinated bond interest expense ManageCo fees paid Cash flows to be (received from) or paid to the entity by variable interests (E) (E) (G) 250,000 240,000 91,600 250,000 240,000 93,100 250,000 240,000 91,100 250,000 240,000 91,600 250,000 240,000 90,000 (D) (243,000) (A) 135,000 203,400 (45,000) 171,900 120,000 138,900 (62,000) 6,400 (F) 497,500 2,000 497,500 2,000 497,500 2,000 497,500 2,000 497,500 42,000 1,962,500 (2,000,000) (150,000) (22,600) Year 1 Year 2 Year 3 Year 4 Year 4 Total $ (431,100) $ (282,600) $ (480,600) $ (431,100) $ (374,600)

(B)

5,500,000

(C)

52,000

$

785,000

$

755,000

$

720,000

$

588,000

$ 5,866,400

$ 8,714,400

(A) Change in working capital accounts reflects the changes in balance sheet accounts (e.g., prepaid accounts, accounts receivable, accounts payable, and accrued expenses), excluding the payment of the prepaid premium to adjust to a cash basis.
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Table 8 —Illustration of Indirect Method (continued) (B) The estimated fair value of the power plant at the end of five years must be included in cash flows to be absorbed by variable interests, because all assets must be assumed to be sold or distributed at fair value at the end of the period in the estimation of terminal value. (C) Adjustment reflects the accumulation of the change in working capital accounts reflected in (A) above. Because the estimated cash flows is for five years, all assets are assumed to be received at fair value and liabilities paid at carrying value at the end of this period. (D) Because the guarantor of the subordinated bond is a variable interest holder in the VIE, any payments made by the guarantor to the VIE in honoring its guarantee must be adjusted, since the payment is a reduction to net income above. In other words, any payment received from a variable interest holder by the VIE that is reflected in net income must be adjusted to create a zero impact on cash flows. This adjustment is made so that those cash flows can be allocated to the guarantor, as illustrated in Q&A 4.09. (E) Consistent with the guarantor in (D) above, interest payments on the senior and subordinated bond are payments from the VIE to a variable interest holder that are deducted in net income above. It is assumed that all interest is received in each period presented. However, when an accrual is made at year-end and reflected in interest expense, only the actual cash paid to the bond holders would be adjusted. This adjustment is made so that those cash flows can be absorbed by the senior and subordinated bond holder, as illustrated in Q&A 4.09. (F) The premium of $50,000 is amortized over the life of the subordinated bond (i.e., 25 years). (G) In addition, the fees, which are deducted from net income, must be adjusted so that ManageCo’s variable interest can absorb those cash flows.

4.07 Noncash Receipts or Distributions in the Determination of an Entity’s Estimated Cash Flow Scenarios
Question
In developing an entity’s estimated cash flow scenarios, a variable interest holder could receive noncash assets (e.g., real estate, other tangible assets, investments) from the entity in one or more scenarios. How does a reporting entity treat noncash distributions (e.g., dividends-in-kind, distributions of real estate or investments) to variable interest holders and noncash receipts from variable interest holders (e.g., contributions of fixed assets, real estate, identifiable intangible assets) when developing an entity’s estimated cash flow scenarios to calculate expected losses or expected residual returns?

Answer
The receipt or distribution of assets other than cash should be treated as if a receipt or distribution (respectively) of cash equal to the fair value of the assets was received or distributed. For example, if a variable interest holder has agreed to provide assets other than cash to settle its obligations to the entity or if the entity is required to settle an obligation to a variable interest holder with noncash assets, those receipts or distributions of noncash assets must be considered receipts from, or distributions to, variable interests holders on the same basis as a cash receipt or distribution.

Example
Assume that BigLessor holds all of the equity in SpecialLeaseCo, an entity established solely to finance the purchase of property that is then leased under an operating lease with LesseeCo, an unrelated third party. The lease term is 20 years. At the end of the lease term, SpecialLeaseCo will dissolve and title to the property will be distributed to BigLessor. In the calculation of the entity’s estimated cash flows under this scenario, the property (an asset of the entity) would be considered a nonvariable interest. (See Q&A 4.02 for guidance on the meaning of “net assets” under the VIE model in ASC 810-10.) Thus, each scenario would include an amount equal to the fair value of the property as part of the entity’s cash flows (a positive cash flow to the entity that is available under that estimated scenario for distribution to a holder of a variable interest in the entity) at the end of the 20-year lease term.

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4.08 Inclusion of Low-Income Housing or Similar Tax Credits in a Calculation of Expected Losses and Expected Residual Returns
A reporting entity with a variable interest in a VIE may be required to calculate expected losses and residual returns under the VIE model in ASC 810-10. (See Q&A 4.03 for more information about when a calculation of expected losses and expected residual returns may be necessary under the VIE model in ASC 810-10.) ASC 810-10-20 defines expected losses and expected residual returns of a VIE as the expected negative and positive variability, respectively, in the fair value of the VIE’s net assets, exclusive of variable interests. The term “expected losses and expected residual returns” refers to “amounts derived from expected cash flows . . . discounted and otherwise adjusted for market factors and assumptions rather than to undiscounted cash flow estimates.” (For more information, see Q&A 4.01.) However, some entities, such as affordable housing projects, are designed to provide all or a significant portion of the return to certain investors through pass-through tax credits.

Question
Should tax credits be considered in a calculation of expected losses and expected residual returns?

Answer
Expected cash flow scenarios developed for calculating expected losses and expected residual returns generally should not include the effect of the variable interest holder’s income taxes (i.e., the income tax effect on the variable interest holder). However, the estimated income taxes to be paid by the potential VIE should be considered because the entity’s payment of income taxes affects the amount of cash flows available to the variable interest holders. Occasionally, the economics of the entity and the fair value of a variable interest necessitate consideration of the effects of noncash tax credits that may be passed through the entity to variable interest holders. In such cases, the incremental cash flow equivalent from income tax credits should be included in the expected cash flow calculation at its fair value. For example, an enterprise may invest in an entity that receives tax incentives in the form of tax credits (e.g., affordable housing projects, projects that produce energy or fuel from alternative sources). Depending on the structure of the entity, the tax credits may pass through to the investors in the entity rather than benefit the entity itself. Regardless of whether the tax credits will be used by the entity or the investors in the entity, because the tax credits affect the fair value of the entity and the amount that an investor would be willing to pay for an interest in the entity, a reporting entity should include these credits in the expected cash flows (in a manner similar to noncash distributions) at fair value when calculating expected losses and expected residual returns. (See Q&A 4.07 for guidance on noncash distributions.)1 At the 2004 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff supported this position, stating the following:
In another situation involving activities around the entity, investors became involved with an entity because of the availability of tax credits generated from the entity’s business. Through an arrangement around the entity, the majority of the tax credits were likely to be available to one specific investor. Accordingly, the staff objected to an analysis by this investor that 1) did not include the tax credits as a component of the investor’s variable interest in the entity and 2) did not consider the impact of the tax credits and other activities around the entity on the expected loss and expected residual return analysis.

4.09 Effect of Options on Specific Assets in the Determination of the Entity’s Estimated Cash Flows
Question
How are the cash flows associated with an option to purchase an asset of the entity (a call option written by the entity) or a residual value guarantee on an asset of the entity (a put option purchased by the entity) reflected in the development of an entity’s estimated cash flow scenarios?

1

This conclusion is consistent with the conclusion reached in ASC 360-10-35 (Q&A 23) in Deloitte’s FASB Accounting Standards Codification Manual.
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Answer
It depends on whether the option (or the guarantee) is determined to be a variable interest in the entity under ASC 810-10-25-55 and 25-56. If the fair value of the asset is less than 50 percent of the total fair value of the entity’s assets, the option (or guarantee) on the asset would not be considered a variable interest in the entity. However, if the option is considered a variable interest in the entity, the “cash flows” in all scenarios do not include the cash flows of variable interests.

Example
Assume that SpecialLeaseCo holds five properties, each with the same fair value and each leased to a different unrelated lessee. Further assume that LesseeCo, unrelated to SpecialLeaseCo, holds an option to purchase its leased property, Property A, at the end of its lease term for $1 million and that LesseeCo holds no other interest in the entity. The purchase option relates to specific assets whose fair value is less than 50 percent of the total fair value of the entity’s assets. LesseeCo does not have a variable interest in the entity and would need to consider whether its interest is part of a “silo” that may need to be consolidated under ASC 810-10-25-57. The existence of the purchase option effectively limits the terminal value associated with Property A in the determination of SpecialLeaseCo’s cash flow scenarios. That is, the VIE model’s expected cash flows from Property A for SpecialLeaseCo would be $1 million in any scenario under which the fair value of Property A exceeded $1 million, because the variable interest holders will only be able to receive up to $1 million in cash flows (any reasonable lessee will exercise its purchase option if the fair value of the property is greater than the purchase price). Assume that there are five possible scenarios at the end of 20 years and that the fair value of Property A under each scenario is as follows:
Amount Included as “Cash Flows” to the Entity’s Variable Interest Holders When the Option Is Not a Variable Interest in the Entity $ 1,000,000 1,000,000 1,000,000 750,000 500,000

Scenario 1 2 3 4 5

Probability 20% 20 20 20 20

Fair Value of Property A at End of Lease $ 2,000,000 1,500,000 1,100,000 750,000 500,000

In Scenarios 1, 2, and 3, LesseeCo would be expected to exercise its option to purchase Property A for $1 million because the fair value of Property A is more than $1 million. In Scenarios 4 and 5, LesseeCo would not be expected to exercise this option because the fair value of Property A is less than $1 million. Note that if Property A were the only property (or represented more than 50 percent of the total fair value of assets) in SpecialLeaseCo, the option held by LesseeCo would be considered a variable interest in SpecialLeaseCo. In that case, the effect of the option would not be considered in developing the entity’s cash flows. Amounts identified in the column “Fair Value of Property A at End of Lease” would be the amounts included as “cash flows” to the entity’s variable interest holders. When those cash flows are allocated to variable interest holders to determine who is the primary beneficiary, LesseeCo will receive the excess of fair value over $1 million and the other variable interest holders will receive the $1 million purchase price in each scenario (e.g., $2 million in Scenario 1 — $1 million to LesseeCo and $1 million to the other variable interest holders).

4.10 Developing Estimated Cash Flow Scenarios and Assigning Probabilities for Expected Loss and Expected Residual Return Calculations
Question
In calculating expected losses or expected residual returns, a reporting entity must develop estimated cash flow scenarios. What is the minimum number of scenarios required, and how are probabilities assigned to those scenarios?

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Answer
There is no set number of scenarios that a reporting entity must develop in calculating expected losses and expected residual returns. However, the number of scenarios should be sufficient for the expected cash flows of the entity under the VIE model, discounted at the risk-free rate, to approximate the fair value of the entity’s net assets, exclusive of variable interests (also to approximate the fair value of the entity’s variable interests), as of the determination date. (For guidance on using a market risk premium to calculate expected losses and expected residual returns, see Q&A 4.11.) When developing the inputs used to calculate expected losses and expected residual returns, management must use judgment to determine the number of scenarios and assign probabilities. For complex entities or entities with a large number of dissimilar assets and liabilities affected by various risk factors, a reporting entity may need to develop and aggregate cash flow estimates for individual asset or liability groups or for categories of risks to arrive at an appropriate estimate of the cash flows in any given scenario. Note that it may be helpful for a reporting entity to use a Monte Carlo simulation approach, or another similar approach, in calculating expected losses and expected residual returns. In this approach, a reporting entity considers thousands of scenarios on the basis of primary factors that affect the cash flows and variability of the entity. Such an approach may be especially useful if there are multiple drivers of expected losses in the entity. Management should keep in mind the following guidelines regarding the number of cash flow estimates/scenarios: • • • The best-case scenario and worst-case scenario provide upper and lower boundaries on the estimated cash flows. The sum of the probabilities associated with each scenario must equal 100 percent. The most likely scenario (if there is one) will have the highest probability relative to the others.

In addition, a reporting entity should consider the following in developing scenarios and assigning probabilities (this list is not all-inclusive): • The scenarios should reflect the effects of possible changes in key drivers of cash flows (e.g., interest rate risk, credit risk, risk of changes in market price of assets, supply and demand for products, technological innovation and obsolescence) on the entity’s asset values that can result in variations in expected losses and expected residual returns. (A scenario that does not address assumptions about the critical cash flow drivers should be viewed with skepticism.) Scenarios should not include changes to the design of an entity’s business that are not required by existing governing documents and contractual arrangements. (For more information, see Q&A 3.42.) For example, scenarios used for an entity that is designed to hold and operate a manufacturing facility with installed machinery should not include a change, whether planned or unplanned, to remove the machinery and convert the building into a rental property, unless that change is specified in the entity’s governing documents or contractual arrangements. However, scenarios should include changes within the design of the entity’s business that are a source of the entity’s variability. For example, assume that an entity is designed to hold investment securities that it plans to actively manage within defined parameters, resulting in changes in the mix of securities held. For that entity, scenarios should include the cash flow effects of potential acquisitions and dispositions of securities within the defined parameters. It is not appropriate to include scenarios that only reflect a static pool of securities for such an entity. The calculations of the entity’s expected losses and expected residual returns include those associated with variable interests in the entity. Some variable interest holders may hold interests in specified assets of the entity that are not considered variable interests in the entity. (For more information, see ASC 81010-25-55 and 25-56 and Q&A 4.09.) When discounted at the risk-free rate, the sum of probability-weighted cash flows from all scenarios should generally approximate the fair value of the entity’s nonvariable interests (net assets exclusive of variable interests) as well as the fair value of the entity’s variable interests as of the determination date. (For guidance on using a market risk premium to calculate expected losses and expected residual returns, see Q&A 4.11.) Management of a reporting entity analyzing the potential VIE or VIE should be able to justify the assignment of a probability to a particular scenario. Market-based assumptions are used to develop probabilities. Market participants’ perspectives on the ability to realize asset values and related cash
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flows may differ from management’s perspective for various reasons, such as management’s possession of information that is not available to market participants or management’s intent to use an asset in a different or innovative way that is not incorporated into the assumptions used by market participants (paragraphs 25–38 of Concepts Statement 7 contain additional discussion). For the expected losses/ residual returns calculation, management should develop probabilities from the perspective of market participants and the information that would be available to them. • Concepts Statement 7 provides general guidance on developing estimates of cash flows for expected present value calculations. Recall that ASC 820-10 defines fair value and establishes a framework for measuring it. Although ASC 820-10 did not amend Concepts Statement 7, it clarifies Concept Statement 7’s guidance on determining fair value.

Note that the calculations of expected cash flows under the VIE model in ASC 810-10 and Concepts Statement 7 are not exactly the same. (For more information, see Q&A 4.01.)

4.11 Discount Rate to Use in the Calculation of Expected Losses and Expected Residual Returns
Question
What is the appropriate discount rate to apply to the individual, probability-weighted cash flows in each scenario developed for calculating expected losses and expected residual returns?

Answer
The risk-free rate should be used. Regarding the expected cash flow approach to computing present value, paragraph 40 of Concepts Statement 7 states that only the time value of money is included in the discount rate because other risk factors that cause adjustments to the cash flows are reflected in the cash flow estimates in each of the scenarios and the probabilities associated with them. For U.S. entities, the risk-free interest rate is the rate currently available on zero-coupon U.S. government issues. Thus, for each cash flow scenario, a reporting entity should use the implied yield currently available on zero-coupon U.S. government issues, with a remaining term equal to the term associated with the cash flows being valued. For example, the five-year zero-coupon U.S. government rate should be used for cash flows projected five years from the date the cash flow analysis began (see the discussion of the cash flow and fair value approaches below). This approach is different from traditional present value techniques, in which a single scenario is developed (in many cases, the contractual cash flows or the most probable cash flows). Under such approaches, the scenario is discounted by a rate that incorporates risks (e.g., a 12 percent discount rate is used to adjust for risks that are not considered in the single scenario). The risk-free rate is appropriate under the VIE model calculation in ASC 810-10 because, similarly to the Concepts Statement 7 approach, the VIE model in ASC 810-10 requires a probabilityweighted cash flow approach that incorporates these risks into the various scenarios, as opposed to adjusting for risks in its discount rate. If a rate higher than the risk-free rate is used, a reporting entity would understate the variability in cash flows in accordance with the calculation of “expected losses” and “expected residual returns” required by the VIE model in ASC 810-10. Paragraph 62 of Concepts Statement 7 also provides the following guidance on use of a risk adjustment for calculating fair value and expected cash flows (see also Q&A 4.15, which discusses the impact of ASC 820-10 on an expected losses/residual returns calculation):
An estimate of fair value should include the price that marketplace participants are able to receive for bearing the uncertainties in cash flows — the adjustment for risk — if the amount is identifiable, measurable, and significant. An arbitrary adjustment for risk, or one that cannot be evaluated by comparison to marketplace information, introduces an unjustified bias into the measurement. On the other hand, excluding a risk adjustment (if it is apparent that marketplace participants include one) would not produce a measurement that faithfully represents fair value. There are many techniques for estimating a risk adjustment, including matrix pricing, option-adjusted spread models, and fundamental analysis. However, a reliable estimate of the market risk premium often may not be obtainable or the amount may be small relative to potential measurement error in the estimated cash flows. In such situations, the present value of expected cash flows, discounted at a risk-free rate of interest, may be the best available estimate of fair value in the circumstances.

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4.12 Cash Flow and Fair Value Approaches to Calculating Expected Losses and Expected Residual Returns
Question
What are the cash flow and fair value approaches to calculating expected losses and expected residual returns?

Answer
Under both the cash flow and fair value approaches, a reporting entity should develop multiple cash flow scenarios that result from all potential outcomes. There are no differences in these gross projected cash flows under either the cash flow or fair value approach. The differences, as described below, arise only from the discount rates applied to each of the cash flow scenarios.

Cash Flow Approach
The underlying principle of the cash flow method approach is that a VIE’s variability arises from fluctuations in its cash flows. The cash flow method does not anticipate changes in future interest rates. In an expected losses/ residual returns calculation, the only variations in the risk-free rates used are within each cash flow scenario — to reflect the time value of money for varying periods.

Example — Cash Flow Approach
Entity X (a U.S. legal entity) is created with cash contributions from various equity investors. Entity X’s governing documents state that its life is five years. Assume that there are three cash flow scenarios for X’s expected losses/ residual returns calculation. At inception, the zero-coupon bond rates for U.S. Treasury bonds maturing between one and five years are 5.0 percent, 5.15 percent, 5.25 percent, 5.5 percent, and 5.75 percent, respectively. Under the cash flow approach, the first year of cash flows in each of the three scenarios would be discounted at 5.0 percent, the second year’s cash flows at 5.15 percent, etc. The discount rates applied to the various scenarios do not anticipate increases or decreases in future interest rates. In other words, a static yield curve is used.

Fair Value Approach
The underlying principle of the fair value approach is that the source of a VIE’s variability is fluctuations in the fair value of the VIE’s net assets. In contrast to the cash flow approach, the fair value approach of calculating expected losses and residual returns incorporates anticipated changes in interest rates into each cash flow scenario. In other words, multiple yield curves are used to reflect the different interest rate environments the VIE may encounter. The different yield curves used under the fair value approach should be consistent with the assumptions used in the related scenario.

Example — Fair Value Approach
Entity X (a U.S. legal entity) is created with cash contributions from various equity investors. Entity X’s governing documents state that its life is five years. Assume that there are three cash flow scenarios for X’s expected losses/ residual returns calculation. At inception, the zero-coupon bond rates for U.S. Treasury bonds maturing between one and five years are 5.0 percent, 5.15 percent, 5.25 percent, 5.5 percent, and 5.75 percent, respectively. In the calculation of expected losses, the discount rates applied in each of the three scenarios should incorporate the changes in interest rates that X may encounter and should be consistent with the assumptions used in each of the three scenarios. Therefore, in contrast to the cash flow method, the discount rate applied to the first year of cash flows may be different in each of the three scenarios to reflect an anticipated increase or decrease in interest rates (and not a single yield curve).

4.13 Appropriateness of Using Either the Cash Flow Approach or Fair Value Approach to Calculate Expected Losses and Expected Residual Returns
Question
When is it appropriate for a reporting entity to use either the cash flow method or the fair value method in calculating expected losses and residual returns?

Answer
It depends. ASC 810-10-25-21 through 25-36 provide guidance on determining whether an interest in an entity is a variable interest. These paragraphs introduce the “by-design” approach to determining which variability to consider in the evaluation of whether an interest is a variable interest. A reporting entity that holds a variable
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interest in a VIE should consider the guidance in ASC 810-10-25-21 through 25-36 in determining the variability that an entity is designed to create and pass along to its interest holders. In many instances, the VIE may be designed to create and pass along cash flow variability to its variable interest holders. Therefore, in such cases, it would be appropriate for a reporting entity to use a cash flow approach. However, a VIE may be designed primarily to pass along fair value variability, in which case it would be appropriate to apply the fair value approach. Although ASC 810-10-25-21 through 25-36 do not provide specific guidance on when either of these methods should be used to calculate expected losses and residual returns, ASC 810-10-55-55 through 55-86 give examples of when using these methods would be appropriate. Case D in ASC 810-10-55-68 through 55-70 describes a VIE that is designed to create and pass along fair value variability attributable to changes in interest rates. In this example, the VIE holds fixed-rate assets and floating-rate debt (no interest rate swap is used); therefore, an interest rate mismatch exists. The interest rate mismatch was designed to expose the debt investors to changes in the fair value of the investments. Therefore, Case D concludes that a reporting entity must consider interest rate risk associated with changes in the fair value of fixed-rate periodic interest payments received. In this example, it is reasonable to use a fair value method of calculating expected losses and residual returns. If a reporting entity is applying different approaches to different VIEs, it should ensure that (1) different methods are not used for VIEs that have similar structures and (2) there is a reasonable basis supporting the use of different methods based on the reporting entity’s specific facts and circumstances.

4.14 Determining Whether Decision-Maker and Service-Provider Fees Are Included in Expected Losses and Expected Residual Returns
Question
When are decision-maker and service-provider fees included in the cash flows of the VIE in the computation of expected losses and expected residual returns under the VIE model in ASC 810-10?

Answer
The treatment of decision-maker and service-provider fees depends on whether the fees have to be treated as a variable interest. If it is determined that decision-maker and service-provider fees are variable interests, the fees would be excluded from the expected losses/residual returns calculation (i.e., excluded from the VIE’s cash flows). Accordingly, the amount determined to be expected losses would be allocated to the variable interest holders, including decision makers and service providers deemed to hold a variable interest. In general, decision-maker and service-provider fees are variable interests unless the conditions in ASC 810-10-55-37 through 37A are met.

4.15

Whether ASC 820-10 Affects an Expected Losses/Residual Returns Calculation

A reporting entity with a variable interest in a VIE may be required to calculate expected losses and residual returns under the VIE model in ASC 810-10. See Q&A 4.03 for further discussion of when an expected losses and residual returns calculation may be necessary under the VIE model in ASC 810-10. ASC 810-10-20 states that expected losses and expected residual returns ”refer to amounts derived from expected cash flows . . . discounted and otherwise adjusted for market factors and assumptions rather than to undiscounted cash flow estimates.” Recall that ASC 820-10 defines fair value and establishes a framework for measuring it. Although ASC 820-10 did not amend Concepts Statement 7, it clarifies Concepts Statement 7’s guidance on determining fair value. ASC 820-10-55-13 through 55-20 discuss a risk premium in the context of an expected present value calculation used to determine fair value. The risk premium is an adjustment to an expected present value calculation to convert the expected cash flows to certainty-equivalent cash flows. That is, the effect of the adjustment results in an indifference to trading a certain cash flow for an expected cash flow. ASC 820-10 describes two methods of adjusting an expected present value technique used to calculate fair value for a risk premium. In the first method, the expected cash flows are adjusted by subtracting out a cash risk premium; in the second method, the risk premium is a percentage adjustment to the risk-free interest rate.

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Question
How does ASC 820-10 affect the calculation of expected losses and expected residual returns, as defined in 81010-20?

Answer
Although ASC 820-10 is not intended to amend the provisions of the VIE model in ASC 810-10, reporting entities should be mindful of a market risk premium in developing an expected loss calculation. ASC 810-10-55-42 through 55-49 refer to the sum of the discounted probability-weighted amounts for each scenario under the expected present value technique as fair value. Therefore, ASC 820-10’s guidance should be considered in the calculation of expected losses and expected residual returns under the VIE model in ASC 810-10. In practice, determining adjustments for such risk premiums may require considerable judgment. As an alternative to including an adjustment for a risk premium in the expected loss/residual return calculation, a reporting entity may consider the risk premium during the reasonableness check discussed in Q&A 4.05. This Q&A indicates that one method of checking the overall reasonableness of the cash flows used in the expected loss/residual return calculation is to compare the total of the probability-weighted discounted cash flows with the fair value of the net assets of the VIE, exclusive of its variable interests. A reporting entity should also perform this reasonableness check for each of its variable interests. When performing this reasonableness check, a reporting entity may discover a difference between the transacted or known fair value and the probability-weighted discounted cash flows. This difference may partially or entirely represent the risk premium described above. When evaluating the reasonableness of an expected loss calculation under the VIE model in ASC 810-10, a reporting entity should understand the potential causes of this difference, including the portion that can reasonably be attributed to the risk premium. Errors in the calculation should not be attributed to the effect of the risk premium. Because the primary drivers of the risk inherent in the VIE’s operations are reflected in the probability weighting of the different scenario’s projected cash flows, the risk premium adjustment should generally be smaller relative to the expected cash flows or risk-free interest rate. In addition, when the risk-free rate is adjusted, the resulting interest rate will probably be lower than the risk-adjusted rate used in the discount rate adjustment technique. Note that the discount rate adjustment technique (described in ASC 820-10-55-10 through 55-12) uses a single set of cash flows from the range of possible outcomes. The discount rate used is derived from observed rates of return for comparable assets and liabilities traded in the market.

4.16 Allocation Methods That May Be Used to Determine Whether Fees Paid to Decision Makers or Service Providers Are Variable Interests
ASC 810-10-55-37 lists conditions that must be met for a reporting entity to determine that fees paid to a decision maker or a service provider do not represent a variable interest. The following two conditions (ASC 810-10-5537(c) and 37(f)) require consideration of the amount of variability in the entity’s anticipated economic performance that will be absorbed by the decision maker or service provider:
c. The decision maker or service provider does not hold other interests in the VIE that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE’s expected losses or receive more than an insignificant amount of the VIE’s expected residual returns. The anticipated fees are expected to absorb an insignificant amount of the variability associated with the VIE’s anticipated economic performance.

f.

ASC 810-10-55-37 does not specify any particular approach that a reporting entity should use to determine whether these two conditions are met. Further, ASC 810-10-55-37A states, “For purposes of evaluating the conditions in [ASC 810-10-55-37], any interest in the entity that is held by a related party of the entity’s decision maker(s) or service provider(s) should be treated as though it is the decision maker’s or service provider’s own interest.”

Question
What are some acceptable approaches that a reporting entity may use to determine whether the conditions in ASC 810-10-55-37(c) and 37(f) are met?

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Answer
A decision maker or service provider will generally be able to use a qualitative analysis to determine whether the conditions in ASC 810-10-55-37(c) and 37(f) are met; a quantitative analysis would not typically be necessary. ASC 810-10-55-37A states, in part, “For purposes of evaluating the conditions in [ASC 810-10-55-37], the quantitative approach . . . is not required and should not be the sole determinant as to whether a reporting entity meets such conditions.” However, if a reporting entity determines that a quantitative analysis is necessary, the decision maker or service provider generally should apply a variation of the “top-down” allocation method (described below) to all VIEs evaluated. Before ASU 2009-17’s amendments to the VIE model in ASC 810-10, there were two fundamental allocation methods for identifying the primary beneficiary of a VIE: the top-down method and the “bottoms-up” method. These methods were based on the allocation of expected losses and expected residual returns to the variable interests. Several variations of the top-down method were developed in practice. Under each method, a reporting entity must use the contractual cash inflow and outflow provisions between the VIE and the variable interest holders in allocating expected losses and expected residual returns to the variable interests. The following table summarizes the top-down and bottoms-up methods and their variations.
Method Top-Down Comments The top-down method has many variations. Fundamentally, however, each variable interest holder calculates its expected losses and expected residual returns on the basis of the cash flows that would be allocated to it under each scenario.2 That is, the cash flows that are used to calculate the aggregate expected losses and aggregate expected residual returns of the VIE are allocated to each variable interest holder on the basis of the contractual provisions of its interests and the underlying assumptions used for each scenario. In practice, variations in applying the top-down method are due to how the expected losses and expected residual returns are assigned to each variable interest holder when one party absorbs an expected loss while another receives an expected residual return in a single cash flow scenario. Although there may be more than one acceptable approach to applying the top-down method when expected losses and expected residual returns are allocated to multiple variable interest holders under a single cash flow scenario (i.e., one party absorbs an expected loss and another party receives an expected residual return in a single cash flow scenario), under any potential approach the total amount of the expected losses and expected residual returns allocated to each variable interest holder must equal the aggregate expected losses and aggregate expected residual returns of the VIE. Bottoms-Up Under the bottoms-up method, the aggregate expected losses (and aggregate expected residual returns, if necessary) of the VIE are treated as a single cash flow scenario that is assumed to occur. That amount of expected losses and expected residual returns is allocated to each variable interest holder on the basis of the calculated fair value of each variable interest holder (i.e., the probability-weighted discounted expected cash flows) in the VIE, starting with the most subordinate variable interest to the most senior variable interest. The bottoms-up method is limited by the fact that it does not consider the timing or causes of the expected losses and expected residual returns of the VIE when those amounts are allocated to the variable interest holders. Therefore, the bottoms-up method is not operational when different variable interest holders have different rights (obligations) regarding the receipt (absorption) of different risks that cause the variability of the VIE or when the timing of the occurrence of the risks that the entity was designed to pass on to the variable interest holders has a significant impact on the overall variability of the VIE that will be absorbed by the variable interest holders.

Although the calculation of expected losses and expected residual returns is not expected to be prevalent under the VIE model in ASC 810-10 (as amended), the top-down method may continue to be appropriate in the assessment of the conditions in ASC 810-10-55-37(c) and 37(f) if a reporting entity determines that a quantitative analysis is necessary for such evaluations. When a quantitative analysis is deemed necessary, a decision maker or service provider can select any reasonable top-down method of allocating a VIE’s expected losses and expected residual returns to the variable interest holders. However, given that the application of different variations of the top-down method could result in different conclusions under ASC 810-10-55-37(c) and 37(f), a reporting entity should apply a consistent variation of the “top down” method to all VIEs for which a quantitative analysis of ASC 810-10-55-37(c) and 37(f) is deemed necessary.

2

A “scenario” is a single cash flow outcome that is developed on the basis of the potential variability in the economic performance of a VIE, exclusive of cash flows received from or distributed to the variable interests in the VIE. Multiple cash flow scenarios are determined and probability-weighted in the calculation of the aggregate expected losses and aggregate expected residual returns of a VIE. See Q&A 4.10 for a discussion of the number of cash flow scenarios used in calculating the expected losses and expected residual returns of a VIE and Q&A 4.05 for an example illustrating the calculation of expected losses and expected residual returns of a VIE.
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Because the bottoms-up method assumes that only the aggregate expected losses and aggregate expected residual returns of the VIE will occur, this method is appropriate only when (1) there is only one type of risk that is designed to be passed on to the variable interest holders or (2) the subordination of classes of variable interests to other variable interests is the same for all types of risks designed to be passed on to the variable interest holders, regardless of the timing of when those risks are absorbed by the variable interest holders. That is, no matter what type of risk causes the VIE’s loss or the timing of that loss, the loss must be absorbed in the ascending order of the various classes of variable interests’ priority claims.3 Because neither of the conditions necessary to apply the bottoms-up method will be expected to exist for decision-making or servicing contracts (because a decision maker or service contract generally will not absorb all the elements of the variability of a VIE, because the timing of the variability will affect the absorption, or both), the bottoms-up method is generally not appropriate when a quantitative analysis is deemed necessary to the evaluation of the conditions in ASC 810-10-55-37(c) and 37(f).

3

The aggregate expected losses of a VIE result from the probability weighting of numerous possible scenarios that could occur. The cause of each potential loss scenario is not known under the bottoms-up method because the expected losses of the VIE that are being allocated are treated as a single “hypothetical” scenario that is assumed to occur.
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Section 5 — Interests in Specified Assets of the VIE and Silo Provisions
ASC 810-10
25-55 A variable interest in specified assets of a VIE (such as a guarantee or subordinated residual interest) shall be deemed to be a variable interest in the VIE only if the fair value of the specified assets is more than half of the total fair value of the VIE’s assets or if the holder has another variable interest in the VIE as a whole (except interests that are insignificant or have little or no variability). This exception is necessary to prevent a reporting entity that would otherwise be the primary beneficiary of a VIE from circumventing the requirement for consolidation simply by arranging for other parties with interests in certain assets to hold small or inconsequential interests in the VIE as a whole. The expected losses and expected residual returns applicable to variable interests in specified assets of a VIE shall be deemed to be expected losses and expected residual returns of the VIE only if that variable interest is deemed to be a variable interest in the VIE. [Paragraph 12] 25-56 Expected losses related to variable interests in specified assets are not considered part of the expected losses of the legal entity for purposes of determining the adequacy of the equity at risk in the legal entity or for identifying the primary beneficiary unless the specified assets constitute a majority of the assets of the legal entity. For example, expected losses absorbed by a guarantor of the residual value of leased property are not considered expected losses of a VIE if the fair value of the leased property is not a majority of the fair value of the VIE’s total assets. [Paragraph 12] 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. [Paragraph 13] 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. [FSP FIN 46(R)-1, paragraphs 1–2] 25-59 Acquisition, development, and construction loan structures may be VIEs subject to the guidance in the Variable Interest Entities Subsections. [EITF Issue 84-04, paragraph STATUS] Guidance on determining whether a lender should account for an acquisition, development, and construction arrangement as a loan or as an investment in real estate or a joint venture is presented in Subtopic 310-10.

5.01

Accounting for Interests in Specified Assets and Silos

ASC 810-10-25-55 through 25-58 provide guidance on how to consider interests in specified assets in the determination of the expected losses of a legal entity. Depending on the terms of an interest in specified assets, the expected losses and expected residual returns associated with the assets underlying that interest may be (1) included in the expected losses and expected residual returns of the legal entity as a whole if the interest relates to assets with a fair value that exceeds 50 percent of the total fair value of the assets of the legal entity, (2) excluded from the expected losses and expected residual returns of the legal entity as a whole if the interest relates to assets whose fair value is less than 50 percent of the total fair value of the assets of the legal entity, or (3) considered separately from the legal entity and instead considered as part of a deemed entity called a “silo.” The outcome of this evaluation will affect the determination of what cash flows would be included in the calculation of expected losses and expected residual returns of the legal entity, which may affect whether the legal entity is a VIE under ASC 810-10-15-14 and whether the reporting entity is the primary beneficiary under ASC 81010-25-38A. Note, however, that a quantitative analysis is not required, and may not be the sole determinant, in the assessment of whether the reporting entity is the primary beneficiary.
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If a silo exists, expected losses and expected residual returns of the silo are excluded from the expected losses and expected residual returns of the host entity. Similarly, potential benefits or losses related to the activities of the silo (and the activities that gave rise to those benefits or losses) are excluded from the determination of the primary beneficiary of the host VIE. See Q&A 5.09 for further discussion. If a silo does not exist but there is a variable interest in specified assets, a reporting entity would continue to include the expected losses, the expected residual returns, or both (if any) that are associated with the specified assets, but not absorbed by the variable interest in those specified assets, in the expected losses and expected residual returns of the legal entity as a whole. Similarly, potential benefits or losses (and the activities that gave rise to those benefits or losses) related to the specified assets that do not inure to the benefit of the interest in the specified assets would continue to be included in the determination of the primary beneficiary of the VIE as a whole. As a result, and as discussed in Q&As 5.02 and 5.04, the determination of whether a legal entity is a VIE and the identification of the primary beneficiary of that VIE will be affected by the determination of whether certain interests constitute variable interests in specified assets and whether those assets (and the related liabilities and equity) represent silos within a larger entity.

Question
How should a reporting entity account for variable interests in specified assets and silos in accordance with ASC 810-10-25-55 through 55-58?

Answer
A reporting entity can use the following flowchart when analyzing interests in specified assets and silos:
Does the reporting entity have a variable interest in specified assets of an entity? (See Q&As 5.02, 5.03, 5.04, and 5.05.) Yes Is the fair value of the specified assets more than 50 percent of the fair value of all assets? No Does the reporting entity have another variable interest in the VIE as a whole (unless that interest is insignificant or has little or no variability)? No Does a silo exist? For guidance on determining whether a silo exists, see Q&A 5.06. Yes Is the silo a VIE under ASC 810-10-15-14? (See Q&A 5.08.) Yes In the absence of the silos, is the host entity a VIE under ASC 810-10-15-14? (See Q&A 5.07.) No Evaluate the entire entity under the voting interest model in ASC 810-10. Yes Separately determine the primary beneficiary of the silo VIE and the primary beneficiary of the host entity. (See Q&A 5.09.) No Is the fair value of the specified assets more than 50 percent of the fair value of all assets? No Reporting entity has a variable interest in specified assets — exclude expected losses and expected residual returns absorbed by the variable interest in specified assets from the expected loss/expected residual returns calculation in the determination of whether the entity is a VIE and, if so, who is the primary beneficiary. (See Q&A 5.04.)
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No

Yes

Yes

Yes Apply the VIE model in ASC 810-10 to the entity as a whole to determine whether the entity is a VIE (including a consideration of whether other reporting entities have a variable interest in specified assets) and, if so, whether the reporting entity is the primary beneficiary.

5.02

Consideration of Interests in Specified Assets
A variable interest in specified assets of a VIE (such as a guarantee or subordinated residual interest) shall be deemed to be a variable interest in the VIE only if the fair value of the specified assets is more than half of the total fair value of the VIE’s assets or if the holder has another variable interest in the VIE as a whole (except interests that are insignificant or have little or no variability). . . . The expected losses and expected residual returns applicable to variable interests in specified assets of a VIE shall be deemed to be expected losses and expected residual returns of the VIE only if that variable interest is deemed to be a variable interest in the VIE.

ASC 810-10-25-55 states, in part:

See Q&A 5.04 for further discussion of the terms “insignificant” and “little or no variability.”

Question
What is an interest in specified assets?

Answer
An interest in specified assets is a contractual, ownership, or other pecuniary interest whose value changes according to changes in the value of selected assets of the potential VIE. In other words, the risks and returns that are associated with the interest are tied to a specific asset or group of assets and not to the risks and returns of the entity as a whole. Interests that typically are considered interests in specified assets include the following: • A fixed-price purchase option or residual value guarantee on a leased asset. Consider an example in which a reporting entity leases equipment from a potential VIE and the terms of the lease allow the reporting entity to purchase the equipment at the end of the lease term for a fixed price. In this case, the reporting entity has a variable interest in specified assets (i.e., the leased equipment) of the potential VIE. Nonrecourse debt. Consider an example in which a reporting entity provides a loan to a potential VIE and the loan is repaid solely from the cash flows that come from specified securities held by the potential VIE. In this case, if the securities do not fully repay the loan or if the potential VIE goes bankrupt, the reporting entity has no recourse to other assets of the potential VIE and the loan is an interest in specified assets (the specified securities). Credit guarantees and put options held by the potential VIE. Consider an example in which a potential VIE holds a portfolio of receivables and purchases a credit guarantee from a third-party entity. In this case, the third-party entity has an interest in specified assets (the portfolio of receivables). Certain types of equity or other residual interests. Consider an example in which a reporting entity holds preferred stock, such as so-called target stock, that pays a return on the basis of specified activities of the potential VIE. A forward contract to purchase or sell an asset at a price other than fair value.

Once a reporting entity has identified that it has an interest in specified assets, such as in the examples above, it must further evaluate the interest under ASC 810-10-25-55 through 25-57 to determine whether it should be considered an interest in specified assets under the VIE model in ASC 810-10, an interest in the potential VIE as a whole, or an interest in a silo. The outcome of that evaluation will, in turn, affect the determination of what cash flows must be included in the calculation of expected losses of the potential VIE. Factors a reporting entity should consider in performing that evaluation include: • • • • • The design of the potential VIE. The existence of silos. The proportion of fair value represented by the assets underlying the interest. Legal recourse available to the interest holder in bankruptcy. Whether the reporting entity has other interests in the potential VIE that are not interests in specified assets.

See Q&A 5.01 for a description of the evaluation described above.

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5.03 Guarantees That Represent a Variable Interest in the Entity Versus a Variable Interest in Specified Assets of the Entity
Question
Does a provider of a guarantee always hold a variable interest in the guaranteed entity?

Answer
Not always. Any guarantee of any portion of an entity’s liabilities is generally considered a variable interest in the entity. However, for guarantees of the entity’s assets (e.g., a residual value guarantee of a leased asset), only guarantees on assets that represent more than half the total fair value of the entity’s assets are considered variable interests in the entity. Note that a holder, including its related parties, of a variable interest in specified assets must combine all of its interests in specified assets to determine whether the aggregate interest is more than 50 percent of the fair value of the entity’s total assets. In addition, if a guarantor holds a separate variable interest in the entity as a whole, the guarantee is a variable interest in the entity even if it covers less than 50 percent of the total fair value of the entity’s assets, unless the other interest is insignificant or has little or no variability (see Q&A 5.04). If the guarantee is on assets whose fair value is not more than 50 percent of the total fair value of the entity’s assets, the guarantee is considered a variable interest in specified assets rather than a variable interest in the entity (as long as the guarantor has no other variable interest in the entity). If the holder, including its related parties and de facto agents, of a variable interest in specified assets holds no other variable interest in the entity as a whole, it generally cannot be the primary beneficiary of the entity. However, the holder of an interest in specified assets must consider the “silo” (a portion of an entity) provisions of ASC 810-10-25-57 to determine whether a silo exists and whether the reporting entity should consolidate the silo.

5.04 Considering a Party’s Other Interests in the Analysis of a Variable Interest in Specified Assets of an Entity
ASC 810-10-25-55 explains that if a reporting entity has (1) a variable interest in specified assets of the VIE and (2) another variable interest in the VIE as a whole, the reporting entity’s interest in specified assets is considered a variable interest in the entity as a whole. However, if the holder’s interest in the entity as a whole is insignificant or deemed to have little or no variability, the holder’s interest in specified assets would not be considered a variable interest in the entity.

Question
What do the terms “insignificant” and “little or no variability” mean with respect to the determination of whether the holder’s interest in specified assets represents a variable interest in the VIE as a whole?

Answer
A reporting entity should consider all facts and circumstances associated with its interests in the VIE in determining whether its interest in the VIE as a whole is significant or will absorb more than little or no variability in the VIE’s cash flows. When determining significance, the reporting entity should consider quantitative factors (e.g., the fair value of the “non-guarantee” interest in relation to the fair value of other assets in the VIE) and qualitative factors (e.g., specific rights or obligations borne by the interest in the entity and the purpose served by this interest in the design of the VIE). Little or no variability would be expected to be a lower threshold than “insignificant,” as used in ASC 810-10-55-37. The objective is to determine whether the other interest held by the party with an interest in specified assets is a substantive interest in the entity as a whole or whether the interest was designed to circumvent a consolidation conclusion that would otherwise be reached under the VIE model in ASC 810-10. A reporting entity will make this determination by considering all the interests in the entity and the risks that the entity was designed to pass along to its interest holders. ASC 810-10-25-55 explains that when a party holds an interest in specified assets and another interest, the provision requiring that the other interest be a substantive interest in the entity as a whole is necessary to prevent a variable interest holder that might otherwise be required to consolidate the VIE from circumventing the consolidation requirement by arranging for another party with interests in specified assets (e.g., a guarantor of less than 50 percent of the VIE’s assets) to hold small or inconsequential interests in the VIE as a whole. ASU 2009-17 amended the VIE model in ASC 810-10 with respect to the determination of the primary beneficiary of a VIE from a risks-and-rewards analysis to an assessment of the power to direct the activities of the VIE that most significantly
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affect the VIE’s economic performance. However, the guidance in ASC 810-10-25-55 is still relevant after the amendments by ASU 2009-17 because it serves to prevent one party that meets the conditions for being a VIE’s primary beneficiary under ASC 810-10-25-38A from avoiding consolidation of the VIE through nonsubstantive structuring opportunities. In addition to potentially affecting the determination of the primary beneficiary of a VIE, identifying whether an interest in specified assets is an interest in the entity as a whole could influence the determination of whether the entity is a VIE. This is because the expected losses and expected residual returns that would be attributable to the interest holder in specified assets are excluded from the calculation of the expected losses and expected residual returns of the entity as a whole. Expected losses and expected residual returns arising from specified assets that are not attributable to the interest holder in specified assets continue to be included in that calculation (see Q&A 4.09). Therefore, ASC 810-10-25-55 prevents a reporting entity from structuring the terms of the interests issued by an entity to achieve a desired accounting result regarding whether the entity is a VIE and whether the reporting entity is the primary beneficiary of the VIE.

Example
Enterprise A owns 99.97 percent of the equity in Entity X. Entity X is a lessor of three commercial real estate assets that each approximate 33 percent of the fair value of X. The assets are individually leased to three unrelated enterprises. Each lease contains a residual value guarantee of the asset at the end of the lease term. Further, it was concluded that a silo does not exist in X. Entity X requires, in conjunction with entering into the lease, that each lessee invest in 0.01 percent of the equity of X. Since the equity held by each lessee is insignificant, the residual value guarantees would be considered interests in specified assets under ASC 810-10-25-55. Therefore, before the evaluation of the design of X and the risks that X was designed to create and pass along to its variable interest holders, the expected losses absorbed by the residual value guarantees are excluded from the expected losses of X, the VIE. The expected residual returns relating to the three buildings continue to be included in the expected residual returns of the VIE because those returns accrue to other variable interest holders in X. After the expected losses and expected residual returns associated with the buildings are properly allocated between the variable interest in specified assets and the variable interests in the entity as a whole, A can evaluate X’s design, including the risks that X was designed to create and pass along to the variable interest holders in X as a whole. Enterprise A is now the only variable interest holder in X as a whole. (The lessees have been identified as having a variable interest in specified assets but not a variable interest in X as a whole.) If A has the power to direct the activities of the VIE that most significantly affect the economic performance of the VIE, the fact that all expected residual returns and expected losses that are not attributable to the residual value guarantors accrue to A would cause A to meet both conditions in ASC 810-10-25-38A and therefore be the primary beneficiary of X. Thus, A’s requirement that each lessee hold a nonsubstantive interest in X would not affect the conclusion that A is the primary beneficiary (or the conclusion that X is a VIE).

5.05 Considering a Related Party’s Interest in the Analysis of a Variable Interest in Specified Assets of an Entity
ASC 810-10-25-55 explains that if a variable interest holder has (1) a variable interest in specified assets of the VIE and (2) another variable interest in the VIE as a whole, its interest in specified assets is considered a variable interest in the entity as a whole.

Question
Enterprises A and B are related parties (see ASC 810-10-25-42 and 25-43). Individually, A has a variable interest in VIE X. Individually, B does not have a variable interest in X because B’s arrangement with X consists of a guarantee of less than 50 percent of X’s assets. Should A and B consider their combined interests to be a variable interest in X?

Answer
Yes. ASC 810-10-25-42 states, “For purposes of determining whether it is the primary beneficiary of a VIE, a reporting entity with a variable interest shall treat variable interests in that same VIE held by its related parties as its own interests” (emphasis added). Otherwise, a variable interest holder could avoid having a variable interest in the entity as a whole simply by having a related party hold the other variable interest. See Q&A 5.04 for more information about this provision.
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5.06

Determining Whether a Silo Exists

ASC 810-10-25-57 explains that, in certain instances, a reporting entity with a variable interest in specified assets of a VIE should treat those assets and the related liabilities and equity as a distinct VIE that is separate and apart from the larger host VIE. The separate VIE is referred to as a “silo.” ASC 810-10 includes guidance on identifying silos as separate VIEs because it is possible for an entity to be designed so that portions of the entity essentially operate economically as distinct legal entities even though they do not have a separate legal identity for financial reporting, tax, or legal purposes. The VIE model in ASC 810-10 requires that once a silo is identified, it be evaluated separately from the larger legal entity if the larger legal entity, excluding the silo, is determined to be a VIE. Therefore, determining that a silo exists directly affects the calculation of expected losses, which in turn affects whether the entity is a VIE and which party should consolidate the larger host VIE. See Q&A 5.01 for a description of the process for identifying variable interests in specified assets and whether a silo exists. A reporting entity that holds an interest in the host entity when a silo exists must determine whether that interest is a variable interest in the host entity and, if so, whether the reporting entity is the primary beneficiary of the host entity.

Question
How should a reporting entity determine whether any silos exist in a larger host entity?

Answer
In identifying whether a silo exists, a reporting entity should first look to ASC 810-10-25-57 and 25-58. According to ASC 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.” Thus, not all variable interests in specified assets will give rise to a silo. A silo typically exists when the obligations or claims of the holder of an interest in the specified assets are not effectively commingled with the obligations or claims of the holders of interests in the VIE as a whole. ASC 810-1025-58 elaborates on the guidance in ASC 810-10-25-57, stating that a portion of a VIE should be treated as a silo if essentially all of the assets, liabilities, and equity of the entity that is deemed a silo are separate from the larger host entity and specifically identifiable. That is, a portion of a VIE should be treated as a silo if essentially none of the returns on the assets of the entity that is deemed a silo can be used by the remaining VIE and essentially none of the liabilities of the entity that is deemed a silo are payable from the assets of the remaining VIE. “Essentially all” is not specifically defined but should be interpreted as meaning that 95 percent or more of the assets, liabilities, and equity of the potential silo entity are separate from the host entity and that the related expected losses and expected residual returns inure to the interest holders in the potential silo entity. Under ASC 810-10-25-58, two characteristics must exist for a silo to be present. First, the risks or returns associated with the interest in specified assets must be legally limited to changes in fair value or cash flows associated with a specifically identified asset or group of assets within the larger legal entity. (For more information, see Q&A 5.02.) That is, the first condition that must be met for a silo to be present is that the holder of a liability or other interest in those assets cannot have the ability to look to the entity as a whole for compensation if it has a loss in value or cash flows, and the holder’s risk and return exposure must be limited to the specifically identified asset or group of assets. Second, the larger entity as a whole must not have a significant legal claim on the specified assets or group of assets and must not depend on the returns of the silo assets to satisfy other claims on the entity as a whole. That is, the second condition that must be met for a silo to be present is that the assets are segregated from the general claims of the entity as a whole and the entity as a whole essentially does not participate in changes in fair value or cash flows associated with those assets. This second characteristic distinguishes interests in specified assets that should be viewed as silos from other interests in specified assets that would be analyzed under ASC 810-10-25-55 and 25-56 as part of the larger legal entity.1 However, only the variability in this latter subset of specified assets that does not accrue to the holder of a variable interest in specified assets would be included in the evaluation of the larger legal entity.
A silo’s assets may be more than 50 percent of the fair value of an entity’s total assets. Therefore, in determining whether a silo exists, a reporting entity should disregard the requirement in ASC 810-10-25-55 that interests in specified assets must be 50 percent or less of the total fair value of the entity’s assets.
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1

Example 1
Assume that a lessor entity is formed and capitalized with $10 of equity from two unrelated investors. The entity obtains third-party financing in the form of two $95 loans (Loans A and B) that have recourse to the entity (the loans are cross-collateralized) and uses the proceeds to purchase two $100 buildings. The entity leases each of the buildings to unrelated lessees. Each lease includes a fixed-price purchase option and provides a residual value guarantee to the lessor entity. In this example, no silos exist because each building is not essentially the only source of payment for the entity’s debt. The expected losses and expected residual returns of each of the buildings do not inure to a specified liability (the debt absorbs expected losses of the whole entity) or to specified other interests. Note that the fixed-price purchase option and residual value guarantees could still be considered interests in specified assets even though a silo does not exist. For more information, see Q&A 5.02.

Example 2
Assume that a lessor entity is formed and capitalized with $10 of equity from two unrelated investors. The entity obtains third-party financing in the form of two $95 nonrecourse loans (Loans A and B) and uses the proceeds of Loan A to purchase Building A for $100 and Loan B to purchase Building B for $100. The rental cash flows from Building A can only be used to repay Loan A, and the rental cash flows from Building B can only be used to repay Loan B. The equity is separate from the overall entity, specifically identifiable, and linked to each building and loan of the entity. The entity leases each of the buildings to unrelated lessees. Each lease includes a fixed-price purchase option and provides a residual value guarantee to the lessor entity. In this example, two separate silos exist because essentially all (95 percent or more) of the expected losses and expected residual returns of each building inure to a specified liability (the nonrecourse debt) or to specified other interests. Each silo consists of a building, its related nonrecourse debt, and an allocation of equity. The equity and debt holders must determine whether their specific silo is a VIE.

5.07

Determining Whether a Host Entity Is a VIE When a Silo Exists

Question
How should a reporting entity determine whether the host entity is a VIE if a silo exists?

Answer
If a silo exists, a reporting entity must apply the VIE model in ASC 810-10 to the host entity as if the silo were a separate legal entity and not part of the VIE as a whole. The reporting entity must apply the VIE model to the host entity to determine whether it is a VIE (exclusive of the assets, liabilities, and residual interests associated with the silo). This analysis includes determining whether the host entity’s equity is sufficient to absorb expected losses under ASC 810-10-15-14(a) and evaluating the host entity under the other provisions of ASC 810-10-15-14. In performing the analysis under ASC 810-10-15-14, the reporting entity should only consider the expected losses (excluding the silo’s expected losses) and at-risk equity (excluding the at-risk equity, if any, of the silo) of the host entity. That is, to determine whether the host entity has sufficient equity, the reporting entity should compare the host entity’s equity at risk with its expected losses. If, in the absence of the silos, the remaining host entity is a “shell entity,” it is likely that the host entity is a VIE. In making this determination, the reporting entity should be mindful of whether it has a variable interest in specified assets of the host entity that are not part of the silo. Such variable interests may affect the expected loss calculation of the host entity because: • If certain conditions are met, the variable interest in specified assets will be considered a variable interest in the host entity as a whole and the variability in cash flows associated with the specified assets will therefore be included in the expected loss calculation of the host entity. If the variable interest in specified assets is not considered a variable interest in the host entity, any expected losses and expected residual returns associated with the specified assets, but not absorbed by the variable interest in those specified assets, would continue to be included in the expected loss calculation of the host entity.

Specifically, as described in ASC 810-10-25-55, a variable interest in specified assets of a VIE is a variable interest in the VIE as a whole (and therefore should not be treated as an interest in specified assets but as a variable interest in the entity) “only if the fair value of the specified assets is more than half of the total fair value of the VIE’s assets or if the holder [of the variable interest in the specified assets] has another variable interest in the VIE as a whole.”
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When a silo exists, a reporting entity should apply the guidance in ASC 810-10-25-55 to the host entity, exclusive of the silo — that is, the fair value of the silo’s assets should be deducted from the fair value of the host entity’s total assets. Further, if a variable interest in specified assets does not create a silo and is not considered a variable interest in the host entity as a whole, expected losses and expected residual returns (if any) associated with the specified assets, but not absorbed by the variable interest in those specified assets, would continue to be included in the expected losses of the host entity. (For more information, see Q&As 5.04 and 5.02.)

Example 1
Assume that an entity is formed and capitalized with $30 of equity from three unrelated investors (Investor A contributed $5, Investor B contributed $10, and Investor C contributed $15). The equity of Investor A is separate from the overall entity, specifically identifiable, and linked to a specific asset and loan of the entity. The entity obtains third-party financing in the form of two loans and uses the proceeds to purchase two assets. Further assume that one separate silo exists and that it consists of an asset, its related loan, and the equity from Investor A. Further assume that Investors B and C do not have a variable interest in specified assets of the entity. The expected losses of the entire entity are $40, and the expected losses relating to Investor A’s silo are $8. In this example, in the determination of the sufficiency of equity of the host entity, the amount of the host entity’s equity at risk is $25 ($30 – $5) and the expected losses of the host entity are $32 ($40 – $8). Therefore, the host entity is a VIE. Because the host entity is a VIE, Investor A must determine whether the silo is a VIE.

Example 2
Assume that an entity is formed and capitalized with $30 of equity from three unrelated investors (Investor A contributed $5, Investor B contributed $10, and Investor C contributed $15). The equity of Investor A is separate from the overall entity, specifically identifiable, and linked to a specific asset and loan of the entity. The entity obtains third-party financing in the form of three loans, totaling $270, from three unrelated lenders, and the entity uses the proceeds from Loan A to purchase Asset A, Loan B to purchase Asset B, and Loan C to purchase Asset C. The lenders have recourse only to the cash flows generated by the respective asset. The fair values of Assets A, B, and C are $100, $50, and $150, respectively. Further assume that one separate silo exists and that it consists of Asset A of $100, its related loan of $95, and the $5 equity from Investor A. The expected losses of Asset A are $8; Asset B, $12; and Asset C, $20. In this example, the fair value of the host entity (Assets B and C) is $200. Lender B does not have a variable interest in the host entity as a whole because the fair value of the asset (Asset B) in which it has a variable interest is less than half of the fair value of the total assets of the host entity (25 percent). Lender C has a variable interest in the host entity as a whole because the fair value of the asset (Asset C) in which it has a variable interest is greater than half of the fair value of the total assets of the host entity (75 percent). In the determination of the sufficiency of equity of the host entity, the amount of the host entity’s equity at risk is $25 ($30 – $5) because the silo’s equity must be excluded from the analysis. The expected losses of the host entity are $20 ($40 – $12 – $8) because the silo’s expected losses ($8 of expected losses from Asset A) and the expected losses associated with the variable interests in specified assets ($12 of expected losses from Asset B) must be excluded from the analysis. Therefore, the host entity is not a VIE.

5.08

Determining Whether the Silo Is a VIE If the Host Entity Is a VIE

Question
How should a reporting entity determine whether the silo is a VIE?

Answer
A silo cannot be a VIE unless the host entity is a VIE. Therefore, if the host entity is determined not to be a VIE, the silo is no longer viewed as a separate entity and the entire entity would be evaluated for consolidation under other consolidation guidance. If the host entity is a VIE, a reporting entity must separately evaluate the silo to determine whether it, too, is a VIE. This analysis includes determining whether the silo’s equity is sufficient to absorb expected losses under ASC 810-10-15-14(a). In performing this analysis, the reporting entity should only consider the expected losses (i.e., exclude the host entity’s expected losses) and at-risk equity (excluding the at-risk equity of the host entity) of the silo. That is, to determine whether the silo has sufficient equity, the reporting entity should compare the silo’s equity at risk with its expected losses.

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Example
Assume that an entity is formed and capitalized with $30 of equity from three unrelated investors (Investor A contributed $5, Investor B contributed $10, and Investor C contributed $15). The equity of Investor A is separate from the overall entity, specifically identifiable, and linked to a specific asset and loan of the entity. The entity obtains third-party financing in the form of two loans and the entity uses the proceeds to purchase two assets. Further assume that one separate silo exists; that this silo consists of an asset, its related loan, and the equity from Investor A; and that Investors B and C do not have a variable interest in specified assets of the entity. The expected losses of the entire entity are $40, and the expected losses associated with Investor A’s silo are $8. In this example, in the determination of the sufficiency of equity of the silo, the amount of the silo’s equity at risk is $5 and the expected losses of the silo are $8. Therefore, the silo is a VIE. The reporting entity must next determine which party, if any, is the primary beneficiary of the silo.

5.09

Determining the Primary Beneficiary of the Host Entity and Silo

Question
How should a reporting entity determine the primary beneficiary of the host entity and the silo?

Answer
Once it is determined that both the host entity and the silo are VIEs, the reporting entity must evaluate each of them separately to determine which party, if any, is the primary beneficiary of the host entity and which party, if any, is the primary beneficiary of the silo. In analyzing which party is the primary beneficiary of the host entity, the reporting entity should exclude the silo’s expected losses and residual returns (and thus the activities that give rise to these expected losses and residual returns) in identifying which party has both (1) the power to direct the activities that most significantly affect the economic performance of the host entity and (2) the obligation to absorb losses and the right to receive benefits that could potentially be significant to the host entity. (See Q&A 5.01 for a description of the process for identifying variable interests in specified assets and whether a silo exists.) That is, only the host entity’s activities, benefits, and losses should be used in the analysis. If a related-party relationship exists such that ASC 810-10-25-44 applies, the factors in that paragraph should be applied only to the host entity. Likewise, in analyzing which party is the primary beneficiary of the silo, the reporting entity should exclude the host entity’s expected losses and residual returns (and thus the activities that give rise to these expected losses and residual returns) in identifying which party has both (1) the power to direct the activities that most significantly affect the economic performance of the silo and (2) the obligation to absorb losses and the right to receive benefits that could potentially be significant to the silo. A reporting entity that has a variable interest in a host entity should also consider the guidance in ASC 810-1025-57, which states, “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.” This guidance precludes two parties from consolidating the same assets, liabilities, and equity of a silo. Therefore, the primary beneficiary of the host entity should only consolidate the host entity (excluding the silo).

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Section 6 — Determination of the Primary Beneficiary
ASC 810-10
25-38 A reporting entity shall consolidate a VIE when that reporting entity has a variable interest (or combination of variable interests) that provides the reporting entity with a controlling financial interest on the basis of the provisions in paragraphs 81010-25-38A through 25-38G. The reporting entity that consolidates a VIE is called the primary beneficiary of that VIE. [Paragraph 14] 25-38A A reporting entity with a variable interest in a VIE shall assess whether the reporting entity has a controlling financial interest in the VIE and, thus, is the VIE’s primary beneficiary. This shall include an assessment of the characteristics of the reporting entity’s variable interest(s) and other involvements (including involvement of related parties and de facto agents), if any, in the VIE, as well as the involvement of other variable interest holders. Paragraph 810-10-25-43 provides guidance on related parties and de facto agents. Additionally, the assessment shall consider the VIE’s purpose and design, including the risks that the VIE was designed to create and pass through to its variable interest holders. A reporting entity shall be deemed to have a controlling financial interest in a VIE if it has both of the following characteristics: a. b. The power to direct the activities of a VIE that most significantly impact the VIE’s 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. The quantitative approach described in the definitions of the terms expected losses, expected residual returns, and expected variability is not required and shall not be the sole determinant as to whether a reporting entity has these obligations or rights.

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 VIE’s economic performance. [Paragraph 14A] 25-38B A reporting entity must identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. A reporting entity’s 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. [Paragraph 14B] 25-38C A reporting entity’s determination of whether it has the power to direct the activities of a VIE that most significantly impact the VIE’s 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 entity’s 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 entity’s economic performance. [Paragraph 14C] 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 VIE’s 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 VIE’s 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 VIE’s 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). [Paragraph 14D] 25-38E If the activities that impact the VIE’s 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 VIE’s 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). [Paragraph 14E]
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ASC 810-10 (continued)
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. [Paragraph 14F] 25-38G Consideration shall be given to situations in which a reporting entity’s 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 VIE’s economic performance. Although this factor is not intended to be determinative in identifying a primary beneficiary, the level of a reporting entity’s economic interest may be indicative of the amount of power that reporting entity holds. [Paragraph 14G]

6.01 How a Reporting Entity Applies the VIE Model in ASC 810-10 When It Appears Not to Be the Primary Beneficiary
Question
Does a reporting entity need to apply the VIE model in ASC 810-10 when it appears not to be the primary beneficiary?

Answer
Yes. A reporting entity determines which variable interest holder, if any, is the primary beneficiary of a VIE only after it determines whether the entity is a VIE. Although a reporting entity may not be the primary beneficiary of a VIE, a reporting entity with a variable interest in that VIE must still disclose certain information about the VIE in accordance with ASC 810-10-50-4. Thus, when it appears that an investor would not be the primary beneficiary, the investor remains within the scope of the VIE model in ASC 810-10 unless: • • The VIE or reporting entity is determined to meet a scope exception in ASC 810-10-15-12 or ASC 810-1015-17. It is determined that the entity is not a VIE.

Even if a reporting entity is clearly not the primary beneficiary, the reporting entity must still perform sufficient analysis to meet the disclosure requirements of the VIE model in ASC 810-10.

6.02

Determining Whether More Than One Reporting Entity Can Consolidate a VIE
A reporting entity with a variable interest in a VIE shall assess whether the reporting entity has a controlling financial interest in the VIE and, thus, is the VIE’s primary beneficiary. . . . A reporting entity shall be deemed to have a controlling financial interest in a VIE if it has both of the following characteristics: a. b. The power to direct the activities of a VIE that most significantly impact the VIE’s 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. . . .

ASC 810-10-25-38A states, in part:

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 VIE’s economic performance.

Question
Can more than one reporting entity consolidate a VIE under the VIE model in ASC 810-10?

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Answer
As stated in ASC 810-10-25-38A, it is inappropriate for more than one reporting entity to consolidate the same VIE. However, because each reporting entity holding an interest in an entity independently determines (often on the basis of significant judgments) whether the entity is a VIE (including whether a scope exception in ASC 810-1015-12 or ASC 810-10-15-17 applies), when the reporting entities do not consistently conclude that the entity is a VIE under the VIE model in ASC 810-10, it is possible for more than one reporting entity to conclude that it should consolidate the same entity. The following are scenarios (not all-inclusive) in which more than one reporting entity could conclude that it should consolidate the same entity: • A reporting entity with voting control of another entity may determine that the other entity is a voting interest entity because there is sufficiency of equity and may consolidate the entity under the voting interest model in ASC 810-10. Because of the significant judgment and estimates involved in concluding whether an entity is a VIE, a second unrelated reporting entity involved with the entity may determine that the entity is a VIE and consolidate the entity under the VIE model in ASC 810-10. A reporting entity with voting control of another entity may qualify for the business scope exception in ASC 810-10-15-17(d) and may consolidate the entity under the voting interest model in ASC 810-10 (assume that the reporting entity purchased its equity interests after inception and therefore was deemed not to have significantly participated in the design or redesign of the entity). An unrelated reporting entity may not apply the business scope exception (e.g., because it participated in the entity’s design) and conclude that the entity is a VIE and that it is the VIE’s primary beneficiary.

Note that despite the guidance in ASC 810-10-25-38A, a reporting entity may not conclude that it should not consolidate a VIE solely because another reporting entity has concluded that the entity is a VIE and is consolidating the VIE. Each reporting entity must still independently analyze its involvement with an entity, whether the entity is a VIE, and whether it should consolidate the VIE.

6.03

Risks to Which an Entity Is Designed to Be Exposed

Question
How are the risks to which an entity is designed to be exposed relevant to the consolidation assessment?

Answer
When identifying the primary beneficiary of a VIE, a reporting entity should identify the purpose and design of the VIE, including the risks that the entity was designed to create and pass through to its variable interest holders. The reporting entity should understand how each risk affects the entity’s economic performance and identify the activities related to each risk. The identification of the primary beneficiary is based on an evaluation of which variable interest holder has the power to direct the identified activities that most significantly affect the entity’s economic performance. In each of the examples in ASC 810-10-55-93 through 55-205, the initial step in the identification of the primary beneficiary is an evaluation of the purpose and design of the entity, including the identification of the risks the entity was designed to create and pass through to the variable interest holders. For instance, in Case A (regarding a commercial mortgage-backed securitization), the reporting entity determines that the entity is exposed to the credit risk associated with the possible default by the borrowers. Ultimately, the entity’s economic performance is most significantly affected by the credit performance of the entity’s underlying assets; the variable interest holder with the power to direct the activities related to managing the entity’s assets that are delinquent or in default is the primary beneficiary.

6.04

Risks and Related Activities

Question
Does every risk that the entity was designed to create have related activities?

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Answer
As noted in Q&A 6.03, the identification of the risks that an entity was designed to create and pass through to its variable interest holders is an integral step in the identification of the entity’s primary beneficiary. However, in the identification of which reporting entity has the power to direct the activities of the VIE that most significantly affect the VIE’s economic performance, there may be risks that the entity is exposed to that do not have direct activities related to them. This is illustrated in Case E and Case F from ASC 810-10-55-147 through 55-171, in which one of the risks that the entity was designed to create and pass through is prepayment risk. In both of these examples, there are no variable interest holders that have the power to direct activities related to this risk and such risk does not receive any further consideration in the primary-beneficiary analysis.

6.05 Assessing Power to Direct When Decisions Are Made by a Board of Directors and a Manager
Under the VIE model in ASC 810-10, one characteristic that a reporting entity with a variable interest in a VIE must have to be considered the primary beneficiary of the VIE is the “power to direct the activities of a VIE that most significantly impact the VIE’s economic performance.” In many arrangements, a board of directors is established and one of the investors serves as the “managing member” or “managing partner” for the entity. Certain decisions will be made by the board of directors, and other decisions will be made by the managing member or managing partner.

Question
How should a reporting entity determine whether it has the power to direct the activities that most significantly affect the economic performance of a VIE when the decisions of the VIE are made both at the board of directors level and at the management level?

Answer
To determine whether it has the power to direct the most significant activities of an entity when decisions are made at different governance levels within an entity, a reporting entity must understand which activities are expected to most significantly affect the economic performance of an entity and the level in the entity at which those activities are directed. A reporting entity should begin its evaluation by understanding the design and purpose of the entity, including the risks that the VIE was designed to create and pass through to the variable interest holders. Once the risks of the entity that affect its economic performance are identified, the reporting entity would evaluate the activities that are expected to have the most significant impact on the economic performance of the entity and the types of decisions that can be made regarding those activities, including significant decisions made in directing and carrying out the entity’s current business activities. Items to consider include determining at what level in the entity the significant operating and capital decisions are made as well as at what level in the entity the operating and capital budgets are set. As part of this analysis, it is important for the reporting entity to distinguish between the ability to make significant decisions that are expected to be made in the ordinary course of carrying out the entity’s current business activities and the ability to make decisions in exceptional circumstances or to veto or prevent certain fundamental changes in the entity’s design or activities. The latter are generally considered protective rights, as discussed in ASC 810-10-25-38C, which do not give the reporting entity the power to direct the significant activities of the entity. If the significant operating and capital decisions are made by the board, a managing member or managing partner would not have the power to direct the activities that most significantly affect the economic performance of the entity because that power would be held by the board and the managing member or managing partner would effectively be serving as a service provider. Conversely, if a reporting entity concludes that the most significant activities of the entity are directed at the management level (and not at the board level), the board would not be considered to have the power to direct the activities that most significantly affect the economic performance of the VIE unless a single equity holder (or a related-party group of equity holders) controls representation on the board (i.e., has more than 50 percent representation on a board requiring a simple majority vote, thereby indirectly controlling the vote of the board) and the board has the ability to kick out the managing member or managing partner. In these situations, a kickout right held by the board, if substantive, may be considered a unilateral right of a single reporting entity to remove the party with power. (For more information, see Q&A 6.14.) In the following examples, assume that the entities being evaluated are VIEs because they have an insufficient amount of equity at risk:
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Example 1
Investors A and B, two unrelated parties, are investors in a manufacturing venture, Entity X, which has one facility. Investor A owns 60 percent of X, and B owns 40 percent of X. Investors A and B obtained their ownership in X by contributing cash in a ratio equal to their ownership percentages. The terms of the venture arrangement require B to purchase up to 10 percent of the product produced by X at cost-plus. The remainder of the product produced by X is sold to third parties at market rates. Investor B is the managing member of the entity. Entity X’s articles of incorporation state the following about the governance and management of X: • • Entity X’s board of directors comprises ten individuals, five individuals selected by A and five individuals selected by B. All significant operating and capital decisions regarding the operations of X, such as establishing operating and capital budgets, determining the pricing of the product produced by X, approving longterm customer contracts, and approving long-term supply contracts for raw materials, must be presented to the board and are determined by a simple majority vote. The managing member is responsible for ensuring that the day-to-day operations of X are executed in a manner consistent with the operating plan approved by the board and cannot deviate from the operating plan without approval from the board. The managing member reports to the board on a monthly basis. Investor B is paid a fixed annual fee for serving as managing member. The fee is at the same level of seniority as other operating liabilities of the entity.

• •

Profits and losses of X are split according to ownership percentage. The cost-plus purchase arrangement between B and X represents a variable interest because it is designed such that B reimburses X for all of the actual costs incurred to produce the product B purchases. Therefore, B also absorbs variability in X through the cost-plus pricing terms. Operating risk (including sales volume risk, product price risk, raw materials price risk, and other operating cost risk) is identified as the risk that will have the most significant impact on the entity’s economic performance. On the basis of the facts presented, which indicate that the key decisions and activities related to operating risk are directed at the board level, it would be appropriate to conclude that power over the entity is shared. That is, A and B together, through the board of directors, have the power to direct the activities of the entity and the voting structure of the entity essentially results in decisions requiring the consent of both A and B. Although B serves as the managing member of the entity, it does not have the power to direct the activities that most significantly affect the economic performance of the entity, since those decisions are made at the board level.

Example 2
Investors K and W, two unrelated parties, are investors in an energy venture, Entity X, an independent power producer with one power plant located in the southwestern United States. Investor K owns 60 percent of X, and W owns 40 percent of X. Investors K and W obtained their ownership in X by contributing cash in a ratio equal to their ownership percentages. The terms of the venture arrangement require W to purchase up to 20 percent of the power produced by X at cost-plus; however, the remainder of the power produced by X is sold to third parties at market rates. Entity X’s articles of incorporation state the following about the governance and management of X: • • Entity X’s board of directors comprises ten individuals, six individuals selected by K and four individuals selected by W. The following actions cannot be taken without a unanimous vote of the board: o o o o o Removal of the managing member. Appointment of a replacement managing member. Decisions to make calls for capital contributions. Admission of new members. Amendments to X’s articles of incorporation.

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o

Capital expenditures in excess of $100 million. Entity X’s average annual capital expenditures are $20 million. It is not expected that X will have capital expenditures in excess of $100 million.

The managing member makes all significant operating and capital decisions regarding the operations of X, such as establishing operating and capital budgets, determining the pricing of the power produced by X, determining when to operate the power plant, hiring and firing employees, deciding how to manage environmental risk, and negotiating long-term supply contracts for commodities. Investor W is the managing member and is paid a fixed annual fee plus 15 percent of the venture’s profits for serving as managing member. Investor W reports to the board on an annual basis.

• •

Profits and losses of X, after payment of W’s managing member fee, are split according to ownership percentage. Investor W’s equity interest represents a variable interest. In addition, the cost-plus purchase arrangement between W and X represents a variable interest, because the cost-plus arrangement is designed such that W reimburses X for all of the actual costs incurred to produce the power that W purchases. Therefore, W also absorbs variability in X through the cost-plus pricing terms. Operating risk (including commodity price risk and environmental risk) is identified as the risk that will have the most significant impact on the entity’s economic performance. On the basis of the facts presented, which indicate that the most significant decisions and activities related to operating risk are directed at the managing member level, the managing member (i.e., W) would be considered to have the power to direct the activities that most significantly affect the economic performance of the entity. On the basis of the facts and circumstances and the design of the entity, the rights of the board of directors represent protective rights under ASC 810-10-25-38C. The ability to remove the managing member does not affect the power analysis because no single reporting entity has the unilateral ability to remove the managing member. Note that had removal of the managing member been allowed by a simple majority vote of the board of directors, K may have been the party with the power to direct the activities that most significantly affect the economic performance of X.

6.06 Consideration of All Risks in the Determination of the Power to Direct Activities of the VIE
ASC 810-10-25-38A indicates that one characteristic a reporting entity must have to be considered the primary beneficiary of a VIE is the “power to direct the activities of a VIE that most significantly impact the VIE’s economic performance.”

Question
Does evaluating the power to direct activities of a VIE include an evaluation of power related to all activities that affect variable interest holders or just power related to activities that affect the returns to equity holders?

Answer
In assessing which activities of a VIE most significantly affect the VIE’s economic performance, the reporting entity must consider all of the risks and associated variability that the entity was designed to create and that are absorbed by any of the variable interests in the entity. Once the variable interests in a VIE have been identified,1 a reporting entity can determine the activities that most significantly affect the economic performance of the VIE by considering which activities have the most significant impact on the variability that will be absorbed by the variable interests in the entity. A reporting entity can then determine whether it has the power to direct those activities. The VIE model in ASC 810-10 does not define “economic performance,” but it does indicate that a reporting entity must assess the VIE’s purpose and design when evaluating the power to direct the activities of the VIE. This assessment includes a consideration of all risks and associated variability that are absorbed by any of the VIE’s variable interest holders. This is consistent with the fact that parties other than equity holders can be considered variable interest holders and, ultimately, the primary beneficiary of a VIE.

1

ASC 810-10-25-21 through 25-36 indicate that the determination of the variable interests in a VIE should be based on the purpose and design of the entity. For more information, see Q&A 2.01.
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6.07 Evaluating Power to Direct the Most Significant Activities of the VIE in Scenarios Involving a PPA
Before the effective date of ASU 2009-17, a reporting entity (the off-taker) that purchases output under a PPA, tolling agreement, or similar arrangement would, in determining whether the reporting entity is the primary beneficiary of the VIE, evaluate whether the agreement is a variable interest and, if so, whether that variable interest absorbs a majority of the entity’s expected losses, expected residual returns, or both. To determine whether it is the primary beneficiary under the VIE model in ASC 810-10, a reporting entity must evaluate whether the agreement gives it power over the activities that most significantly affect the economic performance of the VIE and whether the reporting entity has an obligation to absorb losses of, or the right to receive benefits from, the VIE that could potentially be significant to the VIE. Note that this Q&A assumes that the purchaser has concluded that the PPA or similar arrangement represents a variable interest (see Q&A 2.17 for additional guidance) and that the entity being evaluated holds a single power plant. Factors relevant to concluding that a PPA represents a variable interest might include the pricing of the PPA (fixed price per kWh vs. cost-plus) and whether the PPA contains puts, calls, or guarantees related to the value of the underlying plant.

Question
How should a reporting entity that purchases output under a PPA or similar agreement that is a variable interest evaluate whether it has the power to direct the activities that most significantly affect the economic performance of the VIE?

Answer2
A reporting entity should begin this evaluation by analyzing the design of the entity, including the risks that the VIE was designed to create and pass through to the variable interest holders (i.e., risks that may affect the economic performance of an entity). For an entity engaged in the generation of electricity, such risks may include commodity price risk (fuel, electricity), residual value risk, O&M risk (including efficiency and technology/obsolescence risk), regulatory risk, tax risk, credit risk, and catastrophic risk. A reporting entity should consider the above items related to the variable interest assessment (e.g., pricing, residual value features), as well as factors such as the length of the PPA, in assessing the entity’s design and identifying the risks that the VIE was designed to create and pass through to the variable interest holders. Next, the reporting entity would need to evaluate which of the risks are expected to have the most significant impact on the economic performance of the entity. This part of the evaluation should focus on which risks create variability for the entity and are absorbed by holders of variable interests in the entity (which is consistent with the evaluation to determine whether a reporting entity has a variable interest in an entity). Note that economic performance is a broad concept and extends beyond activities that contribute directly to the net income of a VIE. For example, consider a traditional PPA with fixed monthly capacity pricing and with an energy charge that includes variable pricing designed to pass through the variable cost of production to the off-taker. In this type of arrangement, the fixed-capacity payment is designed to (1) reimburse the seller’s capital investment in the plant, (2) cover fixed production costs, and (3) provide a return to the equity holders. The variable-price payments are often a pure pass-through mechanism that cause the price per kWh to change in order to pass fuel and variable O&M costs along to the off-taker. Therefore, in these arrangements, the decision to operate the facility (dispatch rights) does not necessarily have a direct impact on the profitability of the VIE; the capacity payment, which depends only on the availability of the plant, drives the net income of the VIE. A narrow focus on economic performance could lead one to conclude that the dispatch decision does not affect economic performance of the VIE because that decision does not significantly affect the net income of the VIE. However, in evaluating economic performance, a reporting entity must consider the fact that the dispatch decision drives the off-taker’s variable payment obligation and therefore directly affects the VIE’s level of exposure to commodity price risk (which may include electricity and fuel price risk) that the off-taker absorbs. Although a quantitative expected loss calculation is no longer required under the VIE model in ASC 810-10, a broad view of economic performance requires a qualitative consideration of the same sources of variability that were traditionally considered under an expected loss analysis. After the risks of the entity that are expected to have the most significant impact on the entity’s economic performance have been identified, a reporting entity would need to consider what are the most important decisions over activities that are used to manage those risks and that affect economic performance. These decisions and related activities may include, for example, decisions about when to operate the facility (dispatch rights), how to operate the facility, the purchasing of raw materials, the selling of excess output, the maintenance
2

For more information, see “Energy & Resources — Implementation of Statement 167,” which is available on Deloitte’s Technical Library.
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of the facility, the hiring and firing of employees, and the disposition of the plant at the end of the PPA term (e.g., the decision to refurbish or dismantle the plant). Since dispatch rights represent the decision to generate electricity (and thereby to be exposed to commodity price risk), these rights do constitute a power to direct activities of the VIE. The next step is to weigh the off-taker’s power with powers held by others, including the owner-operator, to determine which party has the power to direct the activities that most significantly affect the economic performance of the VIE. This assessment will require significant judgment because the types of decisions, and the significance of those decisions, may vary by the type of entity being evaluated. For example, the importance of certain decisions related to a traditional coal-fired power plant may be different from the importance of decisions related to a renewable energy plant (e.g., wind or solar). If, for instance, commodity price risk is the risk that most significantly affects the entity’s economic performance, the reporting entity that makes dispatch decisions (e.g., the off-taker) would most likely be deemed to have the power over the most significant activities of the VIE. On the other hand, if no party makes dispatch decisions, as may be the case with renewable energy technologies, the analysis of the power to direct should focus on the other ongoing activities (e.g., O&M) if those activities are expected to have a significant impact on the economic performance of the entity. If those activities are expected to have a significant impact on the economic performance of the entity, the reporting entity that makes decisions related to those activities would most likely be deemed to have the power over the most significant activities of the VIE. In limited situations, the ongoing activities performed throughout the life of a VIE, though they may be necessary for the VIE’s continued existence, may not be expected to significantly affect the VIE’s economic performance. In such situations, the determination of the primary beneficiary may need to focus on the activities performed and decisions made at the VIE’s inception as part of the VIE’s design, particularly when one reporting entity has an economic interest that is disproportionately greater than its stated power to direct the ongoing activities of the VIE. (For more information, see Q&A 6.18.)

6.08

Determination of a Primary Beneficiary for Every VIE

Question
Does the VIE model in ASC 810-10 require that every VIE have a primary beneficiary?

Answer
No. There may be situations in which a reporting entity determines that neither it nor any of the other interest holders are the VIE’s primary beneficiary. For example, this could occur if, under ASC 810-10-25-38D, power is “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 VIE’s economic performance.”

6.09

Evaluating the Characteristic in ASC 810-10-25-38A(b)

ASC 810-10-25-38A(b) states that for a reporting entity to be considered the primary beneficiary of a VIE, the reporting entity must possess the following characteristic:
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. The quantitative approach described in the definitions of the terms expected losses, expected residual returns, and expected variability is not required and shall not be the sole determinant as to whether a reporting entity has these obligations or rights. [Emphasis added]

Question 1
Can a reporting entity contemplate probability when determining whether a variable interest provides the reporting entity with 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?

Answer
Generally, no. A reporting entity should not consider probability when determining whether it meets the condition in ASC 810-10-25-38A(b). Therefore, even a remote possibility that a reporting entity could absorb losses or receive benefits that could be significant to the VIE would generally cause the reporting entity to meet the ASC 810-10-2538A(b) condition. However, in general, the more remote this possibility is, presumably the less likely it will be that
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the reporting entity would have the power to direct the activities that most significantly affect the VIE’s economic performance under ASC 810-10-25-38A(a). Note that the ASC 810-10-25-38A(b) analysis is different from the analysis of whether a fee is a variable interest under ASC 810-10-55-37 through 37A, in which a reporting entity does consider probability in its analysis. For guidance on determining whether a decision-maker fee that represents a variable interest could ever not potentially be significant to a VIE, see Q&A 3.29. Given the requirement to consider all possible scenarios regardless of the likelihood of their occurrence, a reporting entity will generally not need to perform a detailed quantitative calculation to determine whether a variable interest represents a potentially significant interest. That is, the determination can generally be made on the basis of the design of the VIE and the contractual terms of the reporting entity’s variable interest(s). In addition, the FASB noted in paragraph A43 in the Basis for Conclusions of Statement 167 that the results of the mathematical models that often are used to evaluate risks and rewards are less effective than a qualitative analysis of a reporting entity’s obligation to absorb losses or its rights to receive benefits of an entity. Therefore, in cases in which a reporting entity performs a more thorough quantitative analysis to support a conclusion that a variable interest is not potentially significant, the reporting entity should also consider whether the interest is qualitatively significant (see Question 3).

Question 2
Must the absolute amount of the benefits or losses generated by a VIE in a scenario be quantitatively significant to the VIE for a reporting entity to determine that the characteristic in ASC 810-10-25-38A(b) has been met?

Answer
No. If a reporting entity determines that it has the obligation to absorb losses of, or right to receive benefits from, the VIE that would be significant to the VIE in a given scenario, the absolute amount of the benefits or losses of the VIE in that scenario need not be quantitatively significant to the VIE for the reporting entity to determine that the characteristic in ASC 810-10-25-38A(b) has been met. In assessing whether the characteristic in ASC 810-1025-38A(b) is met, a reporting entity should perform the following steps: Step 1: A reporting entity should consider the risks that the VIE was designed to create and pass through to its variable interest holders and identify any loss or benefit scenario that could arise for the VIE from those risks. In performing this step, the reporting entity should not consider probability; rather, the reporting entity should focus on identifying all scenarios that are consistent with the VIE’s design. Step 2: For each scenario identified in step 1, the reporting entity should evaluate the extent to which its interest would absorb losses of the VIE or receive benefits from the VIE. A reporting entity would generally meet the condition in ASC 810-10-25-38A(b) if it concluded that the amount of losses its interest would absorb, or the amount of benefits its interest would receive, in that scenario would be significant in relation to the VIE’s performance in that scenario, even if the level of losses incurred or benefits generated by the VIE in that scenario is not quantitatively significant to the VIE.

Example
Entity A is designed to hold a diverse portfolio of high-credit-quality, short-term bonds. To mitigate credit risk, A obtains a financial guarantee designed to absorb any credit losses on the bond portfolio. The financial guarantee is a variable interest in A and is provided by a single reporting entity. Entity A is financed with debt securities that receive a pass-through of the interest earned on the underlying bond portfolio less any fees paid to the financial guarantor. The debt securities issued by A are widely dispersed. To evaluate whether it meets the characteristic in ASC 810-10-25-38A(b), each reporting entity involved with A would first consider the risks that A was designed to create and pass through to its variable interest holders (credit risk in this example) and identify any scenarios that would generate losses or benefits for A on the basis of those risks. Even if the absolute amount of losses or benefits that arise in A is expected to be insignificant to A, a reporting entity whose variable interest would absorb a significant amount of the losses or benefits of A in any of those scenarios would generally meet the characteristic in ASC 810-10-25-38A(b).

Question 3
Are there circumstances in which a reporting entity can conclude, on the basis of a consideration of qualitative factors, that a quantitatively significant variable interest is insignificant and therefore does not meet the condition in ASC 810-10-25-38A(b)? Conversely, could a reporting entity conclude, on the basis of a consideration of
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qualitative factors, that a quantitatively insignificant variable interest is significant and therefore does meet the condition in ASC 810-10-25-38A(b)?

Answer
Yes. In some cases, a reporting entity can conclude that a quantitatively significant interest does not meet the characteristic in ASC 810-10-25-38A(b) on the basis of qualitative factors and an overall consideration of its quantitative and qualitative assessments. While such a conclusion may be appropriate in some circumstances, a reporting entity should carefully consider such a conclusion, since paragraph A39 in the Basis for Conclusions of Statement 167 states that “obligations or rights that could potentially be significant often identify the enterprise that explicitly or implicitly has the power to direct the activities that most significantly impact the economic performance of a [VIE].” A reporting entity may also conclude that a quantitatively insignificant interest meets the characteristic in ASC 810-10-25-38A(b) on the basis of qualitative factors and an overall consideration of its quantitative and qualitative assessments. There are some interests that will usually meet the characteristic in ASC 810-10-25-38A(b). For example, if a decision maker’s or service provider’s fee and other interests would have individually or in the aggregate not met the conditions in ASC 810-10-55-37(c), (e), or (f), a reporting entity would generally not be able to conclude that its variable interest or interests are insignificant on the basis of qualitative factors. A consideration of qualitative factors in conjunction with quantitative factors is consistent with remarks made by the SEC staff at the 2009 AICPA National Conference on Current SEC and PCAOB Developments. In a speech by Arie S. Wilgenburg, the SEC staff noted that assessing significance requires reasonable judgment and should be based on the total mix of information, including both quantitative and qualitative factors. The SEC staff provided the following examples of qualitative factors that could be considered:
1. 2. The purpose and design of the entity. What risks was the entity designed to create and pass on to its variable interest holders? A second factor may be the terms and characteristics of your financial interest. While the probability of certain events occurring would generally not factor into an analysis of whether a financial interest could potentially be significant, the terms and characteristics of the financial interest (including the level of seniority of the interest), would be a factor to consider. A third factor might be the enterprise’s business purpose for holding the financial interest. For example, a trading-desk employee might purchase a financial interest in a structure solely for short-term trading purposes well after the date on which the enterprise first became involved with the structure. In this instance, the decision making associated with managing the structure is independent of the short-term investment decision. This seems different from an example in which a sponsor transfers financial assets into a structure, sells off various tranches, but retains a residual interest in the structure.

3.

A consideration of qualitative factors is also consistent with the following example from paragraph A42 in the Basis for Conclusions of Statement 167, which states, in part:
The Board also reasoned that a service provider’s right to receive a fixed fee, in and of itself, would not always represent an obligation or a benefit that could potentially be significant to the [VIE]. For example, the Board observed that a servicer of an entity’s loans may be paid a fee that is a fixed percentage of the balance of the loans. In that case, the servicer may be able to conclude, on the basis of the magnitude of the fixed percentage, that the fee could not ever potentially be significant to the entity because the fee would remain a constant percentage of the entity’s assets.

See Q&A 6.29 for an example illustrating the application of this guidance.

6.10

Reconsideration of the Primary Beneficiary of a VIE

Question
How frequently should a variable interest holder assess whether it is the primary beneficiary of a VIE?

Answer
On the date a reporting entity becomes involved with a VIE, it should determine whether it is the primary beneficiary of the VIE under ASC 810-10-25-38A. The reporting entity must then perform subsequent ongoing assessments of whether it is the primary beneficiary of the VIE throughout the entire period during which the

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reporting entity is involved with the VIE.3 A reporting entity may become involved with a VIE as of the date of its design or another date (e.g., situations in which the reporting entity initially became involved with a non-VIE that later became a VIE because of a reconsideration event under ASC 810-10-35-4). Those subsequent reassessments are not limited to the end of each reporting period. The reassessment requirements for VIEs are consistent with the reassessment requirements for voting interest entities (see ASC 810-10-45-4). Although a continual assessment of the primary-beneficiary guidance in ASC 810-10-25-38A is required, because consolidation of a VIE is based on the power to direct activities of the VIE, it is unlikely that the primary-beneficiary conclusion will change periodically in the absence of specific transactions or events that have an impact on the controlling financial interest in a VIE. However, for single-lessee leasing arrangements (and similar arrangements such as certain power purchase and supply arrangements), the primary beneficiary could change over time as one party ceases to direct the activities that are expected to most significantly affect the economic performance of the entity over its remaining life (e.g., as the lease contract approaches maturity). Paragraph A19 in the Basis for Conclusions of Statement 167 states:
On the basis of the amendments to the guidance in [ASC 810-10-25-38] for determining the primary beneficiary of a variable interest entity, the Board expected that the ongoing assessment of which [reporting entity], if any, is the primary beneficiary would require less effort and be less costly than the quantitative assessment of expected losses and residual returns previously required by [the VIE model in ASC 810-10]. Furthermore, the Board expected that the amendments to [ASC 810-10-25-38] would reduce the frequency in which the [reporting entity] with the controlling financial interest changes.

ASC 810-10-25-38A indicates that if a reporting entity has both of the following characteristics, it should be considered to have a controlling financial interest in a VIE (i.e., the reporting entity is the primary beneficiary of a VIE):
a. b. The power to direct the activities of a VIE that most significantly impact the VIE’s 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.

A change in the determination of whether a reporting entity meets both of the characteristics in ASC 810-10-2538A could occur as a result of any of the following events or circumstances: • There is a change in the design of a VIE (e.g., a change in the governance structure or management of the VIE, a change in the activities or purpose of a VIE, or a change in the primary risks that the VIE was designed to create and pass through to variable interest holders). A VIE issues additional variable interests, retires existing variable interests, or modifies the terms of existing variable interests (e.g., a VIE modifies the terms of existing variable interests and the modification affects the power of the variable interest holder to influence the activities of the VIE). There is a change in the counterparties to the variable interests of a VIE (e.g., a reporting entity acquires or disposes of variable interests in a VIE, and the acquired (disposed-of) interest, in conjunction with the reporting entity’s other involvement with the VIE, causes the reporting entity to gain (lose) the power to direct the activities that most significantly affect the VIE’s economic performance). A significant change in the anticipated economic performance of a VIE (e.g., as a result of losses significantly in excess of those originally expected for the VIE) or other events (including the commencement of new activities by a VIE) result in a change in the reporting entity that has the power to direct the activities that most significantly affect the VIE’s economic performance.4 Two or more variable interest holders become related parties or are no longer considered related parties, and such a related-party group has (had) both the power to direct the activities of the VIE and the obligation (right) to absorb losses (benefits) that could potentially be significant to the VIE, but neither related party individually possesses (possessed) both characteristics. A contingent event occurs that transfers the power to direct the activities of the entity that most significantly affect a VIE’s economic performance from one reporting entity to another reporting entity. (See Q&A 6.11 for a discussion of contingent power.) A troubled debt restructuring.


3 4

The reconsideration of whether an entity is a VIE is still based on the specific triggering events listed in ASC 810-10-35-4. See Q&A 3.31 for a discussion of when a decision maker or service provider is required to reassess whether its fee arrangement represents a variable interest in a VIE.
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Note that a reporting entity’s analysis of whether the primary beneficiary of a VIE has changed should not be limited to the list of factors above. A reporting entity should consider all facts and circumstances when determining whether the primary beneficiary has changed. Paragraph A14 in the Basis for Conclusions of Statement 167 notes that the FASB believed that indicators (such as the ones listed above) could be important to the analysis of whether there has been a change in the primary beneficiary, but the Board did not want any such factors to limit a reporting entity’s analysis of whether the primary beneficiary has changed.

6.11

The Effect of Contingencies on Determining the Primary Beneficiary
A reporting entity must identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. A reporting entity’s 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.

ASC 810-10-25-38B states:

In some situations, a variable interest holder will direct the most significant activities of a VIE only upon the occurrence of a contingent event. Questions have arisen about whether such a variable interest holder can be the primary beneficiary of the VIE before the occurrence of that contingent event.

Question
When determining the primary beneficiary, how should a reporting entity assess whether it has power to direct the most significant activities of a VIE when its ability to direct the most significant activities is contingent on the occurrence of a future event?

Answer
When a party can direct activities only upon the occurrence of a contingent event, the determination of which party has power will require an assessment of whether the contingent event results in a change in power (i.e., power shifts from one party to another upon the occurrence of a contingent event) over the most significant activities of the entity (in addition, the contingent event may change what the most significant activities of the entity are) or whether the contingent event initiates the most significant activities of the entity (i.e., the entity’s most significant activities only occur when the contingent event happens). The former situation is illustrated in Example 1 below, the latter in Example 2. Determining whether the contingent event results in a change in power over or initiates the most significant activities of the entity will be based on a number of factors, including: • • The nature of the activities of the VIE and its design. The significance of the activities and decisions that must be made before the occurrence of the contingent event compared with the significance of the activities and decisions that must be made once the contingent event occurs. If both sets of activities and decisions are significant to the economic performance of the VIE, the contingent event results in a change in power over the most significant activities of the VIE. However, if the activities and decisions before the contingent event are not significant to the economic performance of the VIE, the contingent event initiates the most significant activities of the VIE.

If a reporting entity concludes that the contingent event initiates the most significant activities of the VIE, all of the activities of the VIE (including the activities that occur after the contingent event) would be included in the evaluation of whether the reporting entity has the power to direct the activities that most significantly affect the VIE’s economic performance. In such instances, the party that directs the activities initiated by the contingent event would be the reporting entity with the power to direct the activities that most significantly affect the economic performance of the VIE. If a reporting entity concludes that the contingent event results in a change in power over the most significant activities of the VIE, the reporting entity must evaluate whether the contingency is substantive. This assessment should focus on the entire life of the VIE. Some factors that a reporting entity may consider in assessing whether the contingent event is substantive include: • • The nature of the activities of the VIE and its design. The terms of the contracts the VIE has entered into with the variable interest holders.
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• • •

The variable interest holders’ expectations regarding power at inception of the arrangement and throughout the life of the VIE. Whether the contingent event is outside the control of the variable interest holders of the VIE. The likelihood that the contingent event will occur (or not occur) in the future. This should include, but not be limited to, consideration of past history of whether a similar contingent event in similar arrangements has occurred.

Further, assumptions about which activities will most significantly affect the economic performance of a VIE may change as the primary-beneficiary determination is continually reassessed. Any new assumptions should be considered upon such primary-beneficiary reconsiderations.

Example 1
An entity5 (Entity C) is formed by two investors to develop and manufacture a new drug. Assume that C is a VIE and that each investor holds a variable interest in C. Investor A has power over the R&D activities to develop and obtain FDA approval for the drug (stage 1), and those activities most significantly affect C’s economic performance during that stage. Investor B has the power over the manufacturing process, distribution, and marketing of the drug if and when FDA approval is obtained (stage 2), and those activities would most significantly affect C’s economic performance during that stage. In determining which investor has the power to direct the activities that most significantly affect the economic performance of C, each investor should assess whether the contingent event (FDA approval) results in a change in power over the most significant activities of C (in addition, the contingent event may change what the most significant activities of C are) or whether the contingent event initiates the most significant activities of C. Entity C was designed such that there are two distinct stages during the life of C, and the variable interest holders expect that the second stage will only begin upon FDA approval. Also, the activities and decisions before and after FDA approval are significant to the economic performance of C (in this example, they are different activities directed by different parties).6 In addition, the variable interest holders conclude that there is substantial uncertainty about whether FDA approval will be obtained and that the approval is outside their control. For these reasons, in the absence of evidence to the contrary, FDA approval would be considered a contingent event that results in a change in power from Investor A to Investor B, and that contingent event is substantive. Therefore, the primary-beneficiary determination should focus on stage 1 activities until the contingent event occurs and the investor that has power over the R&D activities would initially have the power to direct the most significant activities of C. If FDA approval is obtained, the primary-beneficiary determination would focus on stage 2 activities and the variable interest holder that has the power over the manufacturing process, distribution, and marketing of the drug would have the power to direct the most significant activities of C.

Example 2
A VIE is created and financed with investment-grade, fixed-rate bonds and equity. All of the bonds are held by third-party investors. The VIE uses the proceeds to purchase commercial mortgage loans. The equity is held by a third party, which is also the special servicer. The transferor of the loans retains the primary servicing responsibilities. The primary servicing activities performed are administrative and include collection of payments on the loans and remittance to the interest holders, administration of escrow accounts, and collections of insurance claims. Upon delinquency or default by a borrower of a commercial mortgage loan, the responsibility for administration of the loan is transferred from the transferor (in this case, the primary servicer) to the special servicer. Furthermore, the special servicer, as the equity holder, has the approval rights for budgets, leases, and property managers of foreclosed properties. The special servicer concludes that the design of the VIE and the VIE’s governing documents allow the special servicer to adequately monitor and direct the performance of the underlying loans when necessary. In this situation, the contingent event (delinquency or default by a borrower) initiates the activities that most significantly affect the economic performance of the VIE (i.e., the management of the VIE’s assets that are delinquent or in default). The activities and decisions made before delinquency or default by a borrower (the primary servicing responsibilities) are not significant to the economic performance of the VIE. Although the special
5 6

For this example, assume that the guidance on development-stage enterprises does not apply to this entity. This example differs from the situation discussed in ASC 810-10-25-38E. The guidance in ASC 810-10-25-38E and ASC 810-10-55-193 relates to situations in which multiple unrelated parties are directing different activities and the nature of the activities is not the same. Under that guidance, a reporting entity must identify which of the activities most significantly affect the entity’s economic performance to determine which party has the characteristic in ASC 810-10-25-38A(a). However, that guidance discusses a situation in which the unrelated parties are directing activities at the same time, but does not address an entity with distinct stages involving different parties that have power during these stages.
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servicing activities are performed only upon delinquency or default of the underlying assets, the special servicing activities are expected to most significantly affect the economic performance of the VIE. A reporting entity does not have to exercise its power to have the power to direct the most significant activities of a VIE.

6.12

Consideration of Forward Starting Rights in the Primary Beneficiary Analysis

Question
In the assessment of which party has the power to direct the activities that most significantly affect the economic performance of the VIE, should a reporting entity consider call options, put options, and other forward starting rights?

Answer
Yes. Forward starting rights (such as call options and put options conveyed pursuant to contracts in existence as of the balance sheet date) are often central to the design of an entity and should not be disregarded in the primarybeneficiary analysis. While the existence of such rights, in isolation, may not be determinative in the identification of the party with power over the activities that are most significant to an entity’s economic performance, such rights are often useful to the determination of which party has that power and should be incorporated into the primary-beneficiary analysis. Economic performance is a concept that involves the anticipated performance of the VIE over its remaining life. Assessing power over the remaining life of the entity requires a consideration of all contractual rights and obligations, including those that are currently exercisable (such as a currently exercisable call option) and those that will arise in the future (e.g., a call option or a residual value guarantee on a leased asset at the end of the lease term) pursuant to contracts in existence as of the balance sheet date. Relevant considerations in both situations (i.e., currently exercisable rights and forward starting rights) may include the pricing of the feature (e.g., fixed exercise price or fair value exercise price and whether the option is in the money) and other business factors (e.g., whether a reporting entity holds a call option on an asset that is critical to its business operations). Consideration of the entity’s economic performance over its remaining life applies to both (1) entities with a limited range of activities that are intended to operate over a finite life (e.g., single-lessee leasing entities) and (2) traditional operating entities that do not have a finite life. A finite life for an entity could be stipulated in the formation documents that establish the entity or could be implied through the expected useful life of the asset or assets residing in the entity. Although forward starting rights should be considered in the primary-beneficiary analysis of both types of entities, such rights (depending on their terms and the design of the entity) may be more likely to have a meaningful impact on the analysis of entities with a limited life or limited range of activities. This is because significant decisions often must be made about the strategic direction of operating entities over time (as opposed to decisions about many limited-life entities, including, but not limited to, SPEs). An operating entity is not always tied to a particular asset or business strategy and may routinely require decisions regarding capital and resource deployment/redeployment. Consequently, significant power over current and future economic performance may be vested in the hands of the party with the substantive ability to make unilateral decisions about strategic or operating activities before the exercise of forward starting rights (e.g., call options exercisable on a future date or other forward starting contracts). Note that a reporting entity will need to use judgment to distinguish between forward starting rights that are not subject to a contingency (i.e., rights that are exercisable simply on the basis of the passage of time) and other situations in which a party’s ability to direct the most significant activities of a VIE is contingent on the occurrence of a future event. The former situation is addressed in this Q&A; the latter situation is discussed in Q&A 6.11.

Example 1
Entity A and Entity B participate in Entity C, an operating entity. Entity A holds a future call right on B’s interest in C. However, B has the substantive ability to make strategically significant unilateral decisions until its interest is bought out. In this example, A’s future call right may not change the power analysis under ASC 810-10-25-38A. However, all facts and circumstances would need to be considered, including the pricing of the call option and other business factors.

Example 2
Entity A is created and financed to purchase a single property to be leased for five years under an operating lease to Entity B. Entity B must provide a first-loss residual value guarantee for the expected future value of the leased
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property at the end of the lease term and has a fixed-price purchase option to acquire the leased property at the end of the lease term. In accordance with its design, A will not buy or sell any other assets (i.e., A is a single-asset leasing entity). In this example, A was designed to provide B with the risks and rewards of ownership of the leased asset. Even though the purchase option is not exercisable until the end of the lease term, it is central to the design of A and would be considered in the primary-beneficiary analysis.

6.13

Determination of Whether Kickout Rights are Substantive

Question
ASC 810-10-15-13A and 15-13B require that any terms, transactions, and other arrangements, whether contractual or noncontractual, that are deemed nonsubstantive should be ignored in the consolidation analysis. Accordingly, for kickout rights to be considered in the accounting analysis, in addition to being held by a single reporting entity (including its related parties and de facto agents), such rights need to be deemed substantive. How should the reporting entity determine whether kickout rights are substantive?

Answer
ASU 2009-17 removes the guidance in the VIE model in ASC 810-10 on determining whether kickout rights are substantive. Although there is no such guidance in the VIE model in ASC 810-10, the rights would generally be considered substantive if there are no significant barriers to the exercise of the rights. ASC 810-10-55-35, before the amendments by ASU 2009-17, states, in part, that barriers to exercise include, but are not limited to:
(1) 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 (2) Financial penalties or operational barriers associated with replacing the decision maker that would act as a significant disincentive for removal (3) The absence of an adequate number of qualified replacement decision makers or inadequate compensation to attract a qualified replacement (4) The absence of an explicit, reasonable mechanism in the contractual arrangement, or in the applicable laws or regulations, by which the parties holding the rights can call for and conduct a vote to exercise those rights (5) The inability of parties holding the rights to obtain the information necessary to exercise them.

The assessment of whether kickout rights are substantive should be based on a consideration of all relevant facts and circumstances.

6.14 Consideration of a Board of Directors as a Single Party in the Assessment of Kickout Rights
Under the VIE model in ASC 810-10, for kickout rights to be considered in the determination of whether an entity is a VIE or a reporting entity is a VIE’s primary beneficiary, they must be held by a single party (including related parties and de facto agents) and be deemed substantive.

Question
Can a board of directors be considered a single party when it has the unilateral ability to exercise kickout rights?

Answer
Generally, no. Typically, the board of directors is merely an extension of the entity’s equity holders. A board is usually established to act solely in a fiduciary capacity for the equity holders and generally consists of more than one individual. The kickout rights held by the board are essentially the kickout rights shared by the equity holders who elected the board. Therefore, the board should not be considered a single party and the kickout rights held by the board should not be considered in the determination of whether an entity is a VIE or a reporting entity is a VIE’s primary beneficiary. Similarly, a shell entity that serves as the feeder for the investments of multiple LPs generally cannot be considered a single entity. However, in certain situations, a single equity holder (or a related-party group of equity holders) may control representation on the board of directors (i.e., has more than 50 percent representation on a board requiring a simple majority vote, thereby indirectly controlling the board’s vote). In these situations, a kickout right held by the board of directors, if substantive, may be considered a unilateral right of a single party.
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The conclusion that a board of directors may not be viewed as a single party in the determination of whether a single party holds a kickout right should not affect the analysis of entities for which the board has the power to direct the activities of the entity that most significantly affect the entity’s economic performance (as opposed to the board having the right to kick out the party with that power). For more information, see Q&A 6.05 for a discussion of factors a reporting entity should consider when evaluating whether a board of directors has the power to direct the activities of an entity that most significantly affect the entity’s economic performance.

6.15

Withdrawal and Liquidation 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 entity’s economic performance.

ASC 810-10-25-38C states, in part:

ASC 810-10-20 defines kickout rights as:
The ability to remove the reporting entity with the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance.

In addition, kickout rights held by a single reporting entity can affect the determination of whether an entity is a VIE under ASC 810-10-15-14(b)(1).

Question
Should a withdrawal right or liquidation right held by a single investor be evaluated in the same manner as a kickout right?

Answer
It depends. If the withdrawal right or liquidation right is the in-substance equivalent of a kickout right, it should be evaluated in the same manner as a kickout right. To be considered an in-substance equivalent, the right, when exercised, must place the single investor that holds that right in the same position as if that investor exercises a kickout right. In addition, the right should only affect the determination of the primary beneficiary and whether an entity is a VIE if it is substantive and a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise it. For example, a withdrawal right would be considered the in-substance equivalent of a kickout right if a single investor could withdraw its investment, receive the entity’s underlying assets (resulting in the liquidation or dissolution of the entity), and hire a different party to manage those assets. Similarly, a liquidation right should be considered the in-substance equivalent of a kickout right if the right allows a single investor to liquidate an entity, establish a new entity with the same assets, and hire a new party to direct the activities of the entity. In making this determination, a reporting entity should consider all facts and circumstances. For example, if the assets of the entity are not readily marketable or there is no mechanism in place for the investor to obtain the same assets, if the assets require specialized management or expertise that parties other than the current decision maker do not have, or if there is a noncompete agreement that would prohibit parties other than the decision maker from managing the assets, the rights would not be considered substantive.

6.16 Evaluation of Shared Power Versus Multiple Unrelated Parties Performing Different Significant Activities
Question
How should a reporting entity’s evaluation of power differ when a VIE has one significant activity performed by multiple unrelated parties, as opposed to a VIE with multiple unrelated parties each performing different significant activities?

Answer
ASC 810-10-25-38E requires that if multiple unrelated parties are responsible for different significant activities and the decisions relating to those activities do not require the consent of each party, a reporting entity with a variable interest must determine whether it has the power to direct the activities that have the most significant impact on the economic performance of the entity. ASC 810-10-25-38E requires that one party be identified as having power in these situations. Paragraph A56 of the Basis for Conclusions of Statement 167 states the FASB’s belief that “as
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the number of activities of an entity increases, it will be more likely that one decision maker (or governing body) will exist or that decisions about those activities would require the consent of the [reporting entities] involved with the entity.” When multiple unrelated parties are responsible for the same significant activity or activities that most significantly affect the economic performance of the VIE and consent is not required, the party with power over the majority of the significant activity or activities has power over the VIE. The determination of which party has power over the majority of the significant activities will require judgment and an evaluation of all facts and circumstances. The analysis of which party has the power to direct the activities that most significantly affect the economic performance of the VIE should consider all powers. In some cases, a party with multiple powers, when those powers are aggregated, may determine that it has the power to direct the activities that most significantly affect the economic performance of the entity. This may occur in situations in which the parties involved with an entity have power over different significant activities and portions of the same significant activities. In these cases, a reporting entity must perform a detailed analysis (as illustrated in the examples in ASC 810-10-55-182 through 55-198) to determine whether its power over certain significant activities, along with its power over portions of other significant activities, identify it as having the power to direct the activities of the VIE that most significantly affect the VIE’s economic performance. For example, if Party A controls an activity that is deemed to significantly affect the economic performance of an entity and Party B controls four activities, none of which individually affect the economic performance of the entity as significantly as the activity directed by Party A, but that in the aggregate more significantly affect the economic performance of the entity, Party B would have the power to direct the activities that most significantly affect the economic performance of the entity. In all the situations described above, to be considered the primary beneficiary, the party that has power must also have the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. The following flowchart illustrates how the party with the power to direct the most significant activities of the VIE is determined when multiple unrelated parties have power over the significant activities:
Is power over the activity or activities that most significantly affect the economic performance of the VIE considered shared (ASC 810-10-25-38D)? No Are there multiple activities that are different in nature and that most significantly affect the economic performance of the VIE that are directed by multiple unrelated parties (ASC 810-10-25-38E)? No No Does one party have the power over the majority of the activity or activities? Yes There is no primary beneficiary. The party with power over a majority of the activity or activities has the power to direct the activities of the VIE that most significantly affect the VIE’s economic performance. The party with power over the activity or activities that most significantly affect the economic performance of the VIE has the power to direct the activities of the VIE that most significantly affect the entity’s economic performance. Yes

Yes

In this flowchart, the party that is determined to have power over the activity or activities that most significantly affect the economic performance of the VIE would be considered the primary beneficiary of the VIE if that party has a variable interest and the obligation to absorb losses of, or right to receive benefits from, the VIE that could potentially be significant to the VIE.

6.17

Shared Power Within a Related-Party Group
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 VIE’s economic performance and if decisions about those activities require the consent of each of the parties sharing power [Emphasis added].
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ASC 810-10-25-38D states, in part:

Question
Can the parties within a related-party group conclude that power is shared among the parties in the related-party group?

Answer
No. The analysis of whether power is shared, as discussed in ASC 810-10-25-38D, only applies to unrelated parties. Two or more related parties cannot conclude that power is shared. Paragraph A71 in the Basis for Conclusions of Statement 167 states, in part, that “in situations in which a related-party group is considered the primary beneficiary of a VIE, the parties within the related-party group cannot conclude that power is shared.”

6.18 VIEs With No Ongoing Activities That Significantly Affect Their Economic Performance
To determine which reporting entity (if any) has the power to direct the activities of a VIE that most significantly affect the VIE’s economic performance, a reporting entity must identify these activities. This analysis involves consideration of the design of the VIE, including the risks that the VIE was designed to create and pass through to the variable interest holders.

Question
Are there situations in which VIEs will not have ongoing activities that significantly affect their economic performance?

Answer
Yes. In limited situations, the ongoing activities performed throughout the life of a VIE, though they may be necessary for the VIE’s continued existence (e.g., administrative activities in certain re-securitization entities, such as RE-REMICS7), may not be expected to significantly affect the VIE’s economic performance. In such situations, determination of the primary beneficiary will need to focus on the activities performed and decisions made at the VIE’s inception as part of the VIE’s design, because in these situations the initial design had the most significant impact on the economic performance of the VIE. However, when the ongoing activities of a VIE are expected to significantly affect the entity’s economic performance, a reporting entity will need to focus the power analysis on those ongoing activities.8 That is, it would not be appropriate to determine the primary beneficiary solely on the basis of decisions made at the VIE’s inception as part of the VIE’s design when there are ongoing activities that will significantly affect the economic performance of the VIE. In addition, as discussed below, an evaluation of involvement in design will generally only be determinative when one reporting entity (or related-party group) has an economic interest that is disproportionately greater than its ongoing, stated power to direct the activities of the VIE. ASC 810-10-25-38F states that a reporting entity’s involvement in the design of a VIE “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 . . . the power to direct the activities that most significantly impact [the VIE’s] economic performance.” However, ASC 810-10-25-38F also notes that involvement in design does not, in itself, establish that reporting entity as the party with power. In many situations, several parties will be involved in the design of a VIE and an analysis of the decisions made as part of the design would not be determinative or would not result in the identification of a primary beneficiary. ASC 810-10-25-38G states, in part:
Consideration should be given to situations in which a reporting entity’s 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 VIE’s economic performance.

In situations in which one reporting entity (or related-party group) holds an economic interest that is so significant that the other interest holders, as a group, do not hold more than an insignificant amount of the fair value of the VIE’s interests or those interests do not absorb more than an insignificant amount of the VIE’s variability, but that
7 8

RE-REMIC stands for re-securitization of real estate mortgage investment conduit securities. In addition, in certain financial structures, a single reporting entity may have the unilateral ability to liquidate the entity. Such ability may indicate that the reporting entity has the power to direct the activity that most significantly affects the economic performance of the entity. For more information, see Q&A 6.15.
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reporting entity does not have power over ongoing activities, the ongoing activities of the VIE may not be expected to significantly affect its economic performance. In such situations, the power analysis would most likely focus on the decisions made at the VIE’s inception as part of the design of the VIE. Thus, in situations in which the ongoing activities of a VIE are not expected to significantly affect the VIE’s economic performance and one reporting entity (or related-party group) holds an economic interest that is so significant that the other interest holders, as a group, do not hold more than an insignificant amount of the fair value of the VIE’s interests or those interests do not absorb more than an insignificant amount of the VIE’s variability, it would generally be appropriate to conclude that the reporting entity (or a reporting entity within the related-party group) with that significant economic interest made the decisions at the inception of the VIE or that the decisions were essentially made on the reporting entity’s behalf. Therefore, in such situations, it would be appropriate to conclude, after all facts and circumstances associated with the VIE have been considered, that the reporting entity (or the reporting entity within the related-party group) has a controlling financial interest in the VIE. In addition, when analyzing the design of a VIE whose ongoing activities are not expected to significantly affect its economic performance, a reporting entity should use judgment (in considering the guidance in ASC 810-10-2538G) to determine whether the economic interest of a reporting entity (or related-party group) is so significant that it suggests the decisions made during the design of the VIE were made by that reporting entity (or related-party group) or were made on its behalf. Note that when the primary-beneficiary analysis is based solely on the design of the VIE, the determination of whether one reporting entity (or related-party group) absorbs all but an insignificant amount of the variability in the VIE depends, in part, on a consideration of the VIE’s expected losses and expected residual returns. By focusing on expected losses and expected residual returns, a party with a small overall ownership percentage in a VIE could be exposed to a significant amount of a VIE’s variability (e.g., the holder of a residual interest when there is a large amount of senior interests). Similarly, a party with a large overall ownership percentage in a VIE may not be exposed to a significant amount of a VIE’s variability (e.g., if the party holds senior interests in a VIE whose capitalization also includes substantive subordinated and residual interests).

Related-Party Considerations
ASC 810-10
25-42 For purposes of determining whether it is the primary beneficiary of a VIE, a reporting entity with a variable interest shall treat variable interests in that same VIE held by its related parties as its own interests. [Paragraph 16] 25-43 For purposes of the Variable Interest Entities Subsections, the term related parties includes those parties identified in Topic 850 and certain other parties that are acting as de facto agents or de facto principals of the variable interest holder. All of the following are considered to be de facto agents of a reporting entity: a. b. c. d. A party that cannot finance its operations without subordinated financial support from the reporting entity, for example, another VIE of which the reporting entity is the primary beneficiary A party that received its interests as a contribution or a loan from the reporting entity An officer, employee, or member of the governing board of the reporting entity A party that has an agreement that it cannot sell, transfer, or encumber its interests in the VIE without the prior approval of the reporting entity. The right of prior approval creates a de facto agency relationship only if that right could constrain the other party’s ability to manage the economic risks or realize the economic rewards from its interests in a VIE through the sale, transfer, or encumbrance of those interests. However, a de facto agency relationship does not exist if both the reporting entity and the party have right of prior approval and the rights are based on mutually agreed terms by willing, independent parties. 1. 2. e. Subparagraph superseded by Accounting Standards Update No. 2009-17 Subparagraph superseded by Accounting Standards Update No. 2009-17

A party that has a close business relationship like the relationship between a professional service provider and one of its significant clients. [Paragraph 16]

6.19 Factors to Consider in the Determination of Whether a Relationship Represents a De Facto Agency
ASC 810-10-25-42 states that a reporting entity with a variable interest in a VIE should treat variable interests in that same VIE that are held by its related parties and de facto agents as its own interests when determining the primary beneficiary.

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Question
What are some factors that a reporting entity should consider in applying this guidance?

Answer
The VIE model in ASC 810-10 defines related parties as those identified in ASC 850-10 and certain other parties that are acting in a “de facto agency” capacity with the variable interest holder. ASC 850-10-20 defines the term “related parties” as follows:
Related parties include: a. b. Affiliates of the entity Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management Principal owners of the entity and members of their immediate families Management of the entity 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

c. d. e. f.

g.

Additional related parties, as defined in ASC 810-10-25-43, include certain other parties acting in a “de facto agency relationship” with the variable interest holder. De facto agents include, but are not limited to, the following: • • • • “A party that cannot finance its operations without subordinated financial support from the reporting entity, for example, another VIE of which the reporting entity is the primary beneficiary.” “A party that received its interests as a contribution or loan from the reporting entity.” “An officer, employee, or member of the governing board of the reporting entity.” “A party that has an agreement that it cannot sell, transfer, or encumber its interests in the VIE without the prior approval of the reporting entity. The right of prior approval creates a de facto agency relationship only if that right could constrain the other party’s ability to manage the economic risks or realize the economic rewards from its interests in a VIE through the sale, transfer, or encumbrance of those interests. However, a de facto agency relationship does not exist if both the reporting entity and the party have right of prior approval and the rights are based on mutually agreed terms by willing, independent parties.” (For more information, see Q&A 6.23). “A party that has a close business relationship, like the relationship between a professional service provider and one of its significant clients.”

In addition to the guidance in ASC 810-10-25-42 and 25-43, the SEC staff has indicated in informal discussions that ASC 470-50 and ASC 605-45 provide factors for a reporting entity to consider in evaluating an agency relationship. In these informal discussions, the SEC staff concluded that the principal in an agency relationship should consolidate a VIE on the basis of specific facts and circumstances. However, certain agency-like relationships are not addressed expressly in the VIE model in ASC 810-10 (because the principal has no direct interest in the VIE). In such instances, the determination that a reporting entity is an agent — and hence does not apply the VIE model in ASC 810-10 — requires careful analysis and contemporaneous documentation of the reasons for the conclusion that the reporting entity is an agent.

Example
Two parties enter into a joint venture for 20 years. The entity does not meet the scope exception in ASC 810-1015-17(d) and is determined to be a VIE. The joint venture partners have entered into a five-year lock-up agreement whereby neither party is permitted to sell, transfer, or encumber its interest in the joint venture without the written
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consent of the other party. Since the two parties both have the right of prior approval, mutually agreed on the prior approval terms, and are willing, independent parties, the two parties are not considered related parties (i.e., de facto agents) for the term of the lock-up period, in accordance with ASC 810-10-25-43(d).

6.20 Aggregation of Variable Interests When the Reporting Entity Does Not Hold a Variable Interest Directly in the Entity
Question
Should a reporting entity that does not hold a variable interest directly in a VIE consider variable interests held by its related parties, as that term is used in ASC 810-10-25-42 and 25-43, as its own?

Answer
Generally, no. Aggregation of a reporting entity’s variable interests is only required when the reporting entity holds a variable interest. ASC 810-10-25-42 states, “For purposes of determining whether it is the primary beneficiary of a VIE, a reporting entity with a variable interest shall treat variable interests in that same VIE held by its related parties as its own interests” (emphasis added). There is no additional requirement for reporting entities without variable interests to treat related-party interests as their own when preparing separate financial statements of the reporting entity that neither holds a variable interest nor includes the assets and liabilities of the related party in its financial statements. However, it may not always be apparent whether a reporting entity holds a variable interest because a reporting entity may not have a direct contractual interest in the VIE but may be implicitly exposed to the VIE’s expected losses or expected residual returns. A reporting entity should evaluate all arrangements (whether explicit or implicit) between parties with a high degree of scrutiny to determine whether a variable interest exists when (1) the reporting entity’s related parties have entered into transactions on behalf of the reporting entity and (2) the reporting entity otherwise would have consolidated the VIE if it was determined to have a direct or explicit variable interest in the VIE. See Q&A 2.13 for further discussion of an operating lease with a related party with an implicit guarantee and Q&A 2.11 for more information about a principal-agent relationship.

Example
VIE 1 was formed by issuance of an equity instrument to Enterprise 1 and a debt instrument to Enterprise 2. Enterprise 3, a related party of Enterprise 1, provided a loan to Enterprise 1 to purchase the interest, but Enterprise 3 does not have an interest directly in VIE 1 and does not limit Enterprise 1’s exposure to expected losses or expected residual returns. Enterprise 3 generally does not have to consider (when preparing financial statements as described above) whether it would need to consolidate VIE 1 because it does not hold a direct variable interest in that entity. However, Enterprise 3 holds a variable interest in Enterprise 1 via its related-party loan, and it may need to consider whether Enterprise 1 is a VIE. Further, regardless of whether Enterprise 1 is considered a VIE, if the terms of the loan are such that Enterprise 1 is acting as an agent for Enterprise 3 (e.g., a nonrecourse participating loan for which Enterprise 3 essentially is receiving all the risks and rewards of Enterprise 1’s interest in VIE 1), Enterprise 3 may be deemed to have an implicit variable interest in VIE 1. (For more information about implicit variable interests, see Q&As 2.11 and 2.13. Also see Q&A 6.19, ASC 470-50, and ASC 605-45 for additional guidance on determining whether a principal-agency relationship exists.)

6.21 De Facto Agency Relationship When Only Part of an Interest Is Received as a Loan or Contribution From Another Reporting Entity
ASC 810-10-25-43(b) states, “A party that received its interests as a contribution or a loan from the reporting entity” is considered a de facto agent of the reporting entity.

Question
If a party received only a portion of its interest as a loan or contribution from a reporting entity, is the party considered a de facto agent of the reporting entity under ASC 810-10-25-43(b)?

Answer
Yes. A de facto relationship is created by a loan or contribution of a portion of an interest. When aggregating variable interests within a related-party group under ASC 810-10-25-42, the reporting entity would combine the entire interest, not just the portion that was loaned or contributed, to determine whether the aggregate variable interests of the related-party group, if held by a single party, would identify that party as the primary beneficiary.
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Example
Enterprises A, B, and C have formed an entity that will manufacture products to be sold to the general public. Each enterprise will contribute $20 million for one-third of the equity of the entity. Enterprise A loaned B $11 million to acquire its interest in the entity. Even though B obtained only part of its interest in the entity by using the proceeds of a loan from A, B is considered a de facto agent of A. If the entity is determined to be a VIE, a reporting entity would need to perform a primary-beneficiary analysis in accordance with ASC 810-10-25-38A. Enterprises A, B, and C each meet the criteria in ASC 810-10-25-38A(b) because each of them has the obligation to absorb losses of, and right to receive benefits from, the entity that could be potentially significant to the entity. The next step in the primary-beneficiary analysis is to determine whether, individually, A, B, or C has the power to direct the activities of the entity that most significantly affect the entity’s economic performance. If A, B, or C does not individually have the power to direct the activities of the entity that most significantly affect the entity’s economic performance, but the related-party group of A and B has the characteristics in ASC 810-10-25-38A(a) and 25-38A(b), the primary beneficiary will be whichever party in the related-party group (A or B) is most closely associated with the entity (see ASC 810-10-25-44).

6.22

Related-Party Determination — Interests Received as a Loan

ASC 810-10-25-42 requires a reporting entity to aggregate its own variable interests with those of its related parties when determining the primary beneficiary of a VIE. ASC 810-10-25-43 defines related parties as “those parties identified in Topic 850 and certain other parties that are acting as de facto agents or de facto principals of the variable interest holder” (emphasis added). ASC 810-10-25-43(b) states, “A party that received its interests as a contribution or a loan from the reporting entity” is considered a de facto agent of a reporting entity.

Question
Do circumstances ever arise in which two reporting entities need not consider themselves related parties when one of the reporting entities has received its interest as a loan from the other reporting entity?

Answer
Yes, occasionally. A reporting entity must carefully examine the facts and circumstances associated with a loan between two variable interest holders when determining whether the parties meet the definition of related parties in ASC 810-10-25-43. The guidance in ASC 810-10-25-42 prevents a reporting entity from avoiding consolidation of a VIE under ASC 810-10-25-38A by structuring transactions to have its related parties hold variable interests in the VIE. If loans between variable interest holders are not made for the purpose that the guidance in ASC 810-10-2542 is intended to prevent, the parties may not be considered de facto agents (by virtue of the lent interest). The following factors (not all-inclusive) generally would indicate that the existence of a loan between two variable interest holders does not create a related-party relationship under ASC 810-10-25-42 and 25-43: • • The creditor does not control and is not able to significantly influence the debtor. The debtor receives the full benefits and obligations associated with its financed interest. The debtor’s rights associated with its interest are not affected by the fact that the financing was provided by another variable interest holder. The debtor was not required to obtain its financing from the creditor. That is, the debtor has the right to obtain its interest in whatever way it chooses (i.e., paying cash or financing the interest with any party it chooses). The loan is originated in the normal course of business as an arms-length commercial transaction. A reporting entity must consider whether the loan was provided at market rates, similarly to rates for similar types of transactions. The lender has full recourse to the debtor’s assets, the debtor’s ability to repay the loan does not depend on the performance of the interest lent, and the creditor is able to pursue any remedy available by law. The creditor has the right to sell, pledge, or hold the loan. The debtor has the right to sell or hold the financed interest. Restrictions placed on the financed interest should be considered in a manner similar to the analysis required by ASC 810-10-25-43(d).
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• • •

Example
Enterprise A develops and acquires a time-share membership association. Enterprise A transfers time-share properties to Entity B, a VIE established by A. In return for the transferred properties, A receives vacation credits from B. Entity B was established for the benefit of the vacation credit owners to care for, own, lease, maintain, operate, and manage the properties transferred by A. Enterprise A is granted the exclusive right to sell the vacation credits and retain the proceeds and will, in turn, sell the vacation credits to individual customers. The vacation credits represent a variable interest in B. Individual customers, which are otherwise unrelated to A, can purchase vacation credits from A by (1) paying cash outright, (2) paying cash financed from independent third parties, or, alternatively, (3) obtaining financing from A for a portion of the price of vacation credits. The terms of any financing from A are as follows: • • • • Time-share owners have the same rights and obligations, with respect to their interest in B, as owners that do not obtain financing from A, including the right to hold or sell their interest. Loans are originated at market rates. Enterprise A has full recourse provisions in the event of default. Enterprise A has the right to sell or hold the loans.

On the basis of these facts and circumstances, it appears that the intent of ASC 810-10-25-42 has not been met. That is, A did not create B to avoid consolidation; the purpose of the loan is not to protect an interest or indirectly expand holdings. Rather, B provides a legal entity under which the joint owners can care for, own, lease, maintain, operate, and manage the properties. Therefore, the individual time-share owners would not be considered a related party of A in the determination of which party, if any, is the primary beneficiary of B.

6.23 Considering Whether Restrictions on a Reporting Entity’s Ability to Sell, Transfer, or Encumber Its Interests in a VIE Constitute Constraint
The VIE model in ASC 810-10 defines a new term, “de facto agent.” A reporting entity should consider a de facto agent a related party in analyzing whether the reporting entity is the primary beneficiary of a VIE. If a reporting entity is deemed to have a de facto agency relationship with another variable interest holder and neither of the parties in the related-party group has the characteristics of a controlling financial interest in ASC 810-10-25-38A, the reporting entity must aggregate the variable interests to determine whether, as a group, the reporting entity and its related parties have those characteristics. ASC 810-10-25-43(d) states that a de facto agency is present when a party has entered into an agreement under which it “cannot sell, transfer, or encumber its interests in the VIE without the prior approval of the reporting entity.” However, a de facto agency relationship only exists if such approval constrains the other party’s ability to manage its economic interest in the VIE. As indicated in ASC 810-10-25-43(d), “a de facto agency relationship does not exist if both the reporting entity and the party have right of prior approval and the rights are based on mutually agreed terms by willing, independent parties.”

Question
What are some factors that a reporting entity should consider in determining whether its ability to restrict, through approval rights, the sale, transfer, or encumbrance of another party’s interests in a VIE constrains that party’s ability to manage the economic risks or realize the economic rewards from its interests in the VIE?

Answer
Whether such a restriction on sales or transfers constrains another party depends on the facts and circumstances. A restriction does not always constitute constraint and create a de facto agency relationship. Factors to consider may include, but are not limited to, the following: • Generally, a phrase such as “without prior approval which cannot be unreasonably withheld” within a contractual agreement indicates that a variable interest holder is not constrained from managing the economic risks or realizing the economic rewards of its interest. Conversely, a de facto agency relationship is presumed if such language is absent from contractual agreements or if the agreements only cite narrow specific circumstances that would not typically be encountered under which approval cannot be unreasonably withheld.

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If a party has the ability to realize the economic benefits of its interest by selling that interest without the reporting entity’s prior approval, the party would not be constrained even if the reporting entity’s approval is required for all other transfers or encumbrances of that interest. If the right of prior approval is designed solely to prevent transfer of the interest to a competitor or to a less creditworthy, or otherwise less qualified, holder, and such parties are not the only potential purchasers of that interest, the party would not be constrained. A party that cannot sell, transfer, or encumber its interest, but can manage the risk of owning the interest by hedging that risk is constrained.

Example 1
Enterprise X holds a $1 million interest in VIE 1. Enterprise Y, another holder of an interest in VIE 1, must approve all sales and transfers of X’s interest. Enterprise X does not have a similar right of prior approval for sales and transfers of Y’s interest in VIE 1. Enterprise X otherwise may encumber its interest in VIE 1 without the approval of Y; however, financial institutions will only loan $300,000 to X by using X’s $1 million interest as collateral. Thus, X is able to manage only a portion of its risk by encumbering its interest. Because X cannot realize, by encumbrance, all or most of the cash inflows that are the primary economic benefits of its interest, X is constrained and is deemed to have a de facto agency relationship with Y.

Example 2
Assume the same facts as in Example 1. Enterprise X enters into a total return swap with an unrelated third party, Banker 1, to economically hedge its variable interest. Under the total return swap, X will receive cash equal to substantially all of the benefits encompassed in its variable interest during the term of the swap. The terms of the swap are such that X is not acting as an agent for Banker 1. Although X has managed its risk of ownership in VIE 1, X is constrained (because a total return swap is not a sale, transfer, or encumbrance) and is deemed to have a de facto agency relationship with Y.

Example 3
Assume the same facts as in Example 1 except that VIE 1 is a franchise (that does not meet the scope exception in ASC 810-10-15-17(d)) and the franchise agreement stipulates that the franchisor must approve any prospective purchasers of the franchisee’s interest to prevent sales to competitors, less creditworthy purchasers, or purchasers who do not intend to maintain the franchise at the existing level of quality. There are several other potential purchasers who would qualify. The franchisee is not considered constrained under ASC 810-10-25-43(d) because it can still manage its economic interest in VIE 1 through sale and transfer (i.e., the restriction is only on the sale to a nonqualified investor and there are other qualified investors who could purchase the interest).

6.24

The Effect of a Put Option on a De Facto Agency Relationship

Enterprise B and Enterprise C each hold equity interests in a VIE. Enterprise B is restricted from selling, transferring, or encumbering its interests in the VIE without the prior approval of C. In addition, B does not hold prior approval rights to similarly restrict C’s ability to sell, transfer, or encumber its interests in the VIE. Furthermore, B holds an option that allows it to put its equity interest to C.

Question
Does the existence of the put option affect whether B has a de facto agency relationship with C under ASC 81010-25-43(d)?

Answer
It depends. In certain situations, the existence of a put option could affect whether there is a de facto agency relationship under the VIE model in ASC 810-10. The FASB believes that a reporting entity that can restrict, through approval rights, the sale, transfer, or encumbrance of another party’s interests in a VIE may, in effect, control the economic risks and rewards of those interests. Those rights suggest that the restricted party is acting as an agent. The right of prior approval creates a de facto agency relationship under ASC 810-10-25-43(d) if the right could constrain the party’s ability to manage the economic risks or realize the economic rewards from its interests in a VIE. However, as indicated in ASC 81010-25-43(d), “a de facto agency relationship does not exist if both the reporting entity and the party have right of prior approval and the rights are based on mutually agreed terms by willing, independent parties.”
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The existence of a fair value put option that is currently exercisable for 100 percent of the interest held and with no restrictions may be sufficient to allow the reporting entity holding the put option to manage the economic risks or realize the economic rewards from its interests in a VIE. However, the reporting entity should evaluate all facts and circumstances to determine whether a put option would affect whether a de facto agency relationship exists. For example, fair value should be based on an independent valuation as of the exercise date rather than on a predetermined formula that is not updated to reflect current market conditions. Conversely, if the exercise price of the put option is fixed9 or at other than fair value, the de facto agency relationship cannot be overcome.

6.25 Consideration of De Facto Agent Requirements in the Determination of the Primary Beneficiary in a Joint Venture Arrangement
Question
How do the modifications in ASU 2009-17 to the de facto agent requirements affect the analysis of the primary beneficiary in a joint venture arrangement?

Answer
When identifying a VIE’s primary beneficiary, a reporting entity must consider all of its variable interests and other involvements (including those of related parties and de facto agents) with the VIE. Accordingly, a reporting entity may determine that together with its de facto agents, it has a controlling financial interest in a VIE and that one of the entities in the related-party group is the primary beneficiary. Before the adoption of ASU 2009-17, ASC 810-10-25-43(d)(1) stated that a de facto agency relationship is present when a party has agreed that “it cannot sell, transfer, or encumber its interests in the VIE without the prior approval of the reporting entity.” However, a de facto agency relationship only exists if such approval constrains the other party’s ability to manage its economic interest in the VIE. Accordingly, in a typical joint venture arrangement, in which a transfer restriction is imposed on all of the venturers to maintain the structure of the joint venture, a reporting entity generally assesses the joint venturers as a related-party group to determine the primary beneficiary. However, the VIE model in ASC 810-10, as amended by ASU 2009-17, provides an exemption to the de facto agent requirements in which the transfer restrictions “are based on mutually agreed terms by willing, independent parties” and the rights are substantive. Although the reporting entity will still need to determine whether it is the primary beneficiary of the VIE under the VIE model in ASC 810-10, the reporting entity may not be required to consider the other reporting entities as de facto agents in its analysis. ASC 810-10
25-44 In situations in which a reporting entity concludes that neither it nor one of its related parties has the characteristics in paragraph 810-10-25-38A but, as a group, the reporting entity and its related parties (including the de facto agents described in the preceding paragraph) have those characteristics, then the party within the related party group that is most closely associated with the VIE is the primary beneficiary. The determination of which party within the related party group is most closely associated with the VIE requires judgment and shall be based on an analysis of all relevant facts and circumstances, including all of the following: a. b. c. d. The existence of a principal-agency relationship between parties within the related party group The relationship and significance of the activities of the VIE to the various parties within the related party group A party’s exposure to the variability associated with the anticipated economic performance of the VIE The design of the VIE. [Paragraphs 16–17]

6.26 Determining Which Party in a Related-Party Group Is Most Closely Associated With a VIE
ASC 810-10-25-44 states, in part:
In situations in which a reporting entity concludes that neither it nor one of its related parties has the characteristics in paragraphs 810-10-25-38A but, as a group, the reporting entity and its related parties (including de facto agents described in the preceding paragraph) have those characteristics, then the party within the related party group that is most closely associated with the VIE is the primary beneficiary.
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A fixed-price put option purchased from a party related to the VIE is economically equivalent to a loan received from another party involved with the VIE, as described in ASC 810-10-15-14(a)(4). In this instance, equity equal to the amount of the fixed-price put option would not be considered “equity at risk.” For more information, see Q&A 3.10.
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Question
How does a reporting entity determine which party in a related-party group is most closely associated with a VIE?

Answer
A reporting entity must consider all facts and circumstances associated with a VIE in making this determination. No single factor is determinative, and a reporting entity must use judgment when evaluating such factors as “the relationships and significance of the activities of the VIE to the various parties within the related-party group.” In the absence of a related-party relationship, determination of the primary beneficiary relies on having the power to direct the activities of the VIE that most significantly affect the VIE’s economic performance and the obligation to absorb losses of, or right to receive benefits from, the VIE that could potentially be significant to the VIE. In addition, when a related-party relationship exists, each party within the related party group must first determine whether it meets the characteristics of a controlling financial interest in ASC 810-10-25-38A. (See Q&A 6.27 for a discussion of situations in which the members of the related party group are under common control.) However, when a related-party relationship exists and none of the parties in the related-party group have the characteristics of a controlling financial interest in ASC 810-10-25-38A, a reporting entity must consider additional qualitative factors when determining the primary beneficiary under ASC 810-10-25-44. As noted in Q&A 6.17, 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. ASC 810-10-25-44 cites four factors to evaluate. A reporting entity should evaluate each factor individually to identify the extent to which one or more factors point toward a particular party and the factors as a whole to determine which party is most closely associated with the VIE. For any given set of facts and circumstances, the relative weighting of each factor will most likely differ. However, it is important to recognize that the overall determination is which related party “is most closely associated with the VIE” as a whole; therefore, a comprehensive assessment of the relationship and significance of the activities of the VIE (ASC 810-10-25-44(b)) and the overall design of the VIE (ASC 810-10-25-44(d)) to each of the related parties (not just with respect to the reporting entity making the assessment) is paramount to the exercise of judgments made under ASC 810-1025-44. The following table discusses the four factors:
Factor a. The existence of a principal-agency relationship between parties within the related-party group. Comments The existence of a principal-agency relationship between parties typically indicates that the principal in the relationship is most closely associated with a VIE when this factor is considered under ASC 810-10-25-44. Assessing the relationship between related parties includes consideration of (1) whether a de facto agency relationship, as described in ASC 810-10-25-43, results in a principal-agency relationship and (2) the guidance in ASC 470-50 and ASC 605-45 to determine whether, by analogy, a principal-agency relationship exists. This analysis should consider all of the significant activities conducted by the VIE, the extent to which one or both parties have an active role in conducting those activities, and the relative importance of the activities of the VIE to each party. In assessing the importance of the VIE’s activities to each party, a reporting entity should consider factors such as supply arrangements, purchase arrangements, and other material contracts. It is generally possible to determine qualitatively whether one of the parties in a related-party group has greater exposure to the variability associated with the VIE’s anticipated economic performance. One important consideration to assessing this factor is contemplation of the design of the VIE, including the nature and reasoning behind the formation of the VIE at inception or as of the latest reconsideration date. A reporting entity should consider factors such as the business or economic purpose of the VIE, the role played by each of the parties in the design or redesign of the VIE, the level of ongoing involvement in the VIE’s financial and operating activities and decision making, and the VIE’s capital structure and levels of financial support.

b. The relationship and significance of the activities of the VIE to the various parties within the related-party group.

c. A party’s exposure to the variability associated with the anticipated economic performance of the VIE. d. The design of the VIE.

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At the 2004 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff stated:
It is important to read the words in paragraph 17 [codified as ASC 810-10-25-44] plainly. Paragraph 17 requires an overall assessment of which party is the most closely associated with the entity. When considering questions under paragraph 17, the staff considers all the factors in paragraph 17 and any other factors that may be relevant in making this overall assessment. We do not view paragraph 17 to be a matter of checking the boxes for the four factors listed and adding up who has the most boxes checked. Instead we look at all relevant factors in their entirety considering the facts and circumstances involved. We have also been asked whether any of the factors in paragraph 17 carry more weight than any others or whether any of the factors in paragraph 17 are determinative. There is no general answer to this question. Instead, the facts and circumstances of the situation should be considered to determine whether one factor or another is more important.

The relative weighting of each indicator is an important element of determining which party in a related-party group should consolidate a VIE. Factors should be weighted on the basis of individual facts and circumstances. Although no factor in ASC 810-10-25-44 is determinative, more relative weighting of one factor may be required depending on the nature of the transaction and the related-party relationship. For example, consider a scenario in which no one party within the related-party group controls another party within that group. In the analysis of the four factors in ASC 810-10-25-44, there is no principal-agency relationship within the related-party group, and neither the design of the VIE nor the relationships between the VIE and the related-party group conclusively demonstrate which party is most closely associated with the VIE (i.e., the facts and circumstances associated with the factors in ASC 810-10-25-44(a), (b), and (d) are not conclusive individually or in the aggregate). In this scenario, a party’s exposure to variability associated with the VIE’s anticipated economic performance (ASC 810-10-25-44(c)) may be the most significant factor for a reporting entity to consider in identifying the primary beneficiary (note that more weighting would not be given to ASC 810-10-25-44(c) when one party controls some or all parties within the related-party group, since that controlling party has the ability to dictate exposure to the variability associated with the VIE’s anticipated economic performance to the controlled parties). The reporting entity should always consider arrangements (explicit or implicit) between parties within the related-party group or any single party within the related-party group and the VIE.

Example 1
Enterprises A and B are related parties not under common control, and each made an equity investment in VIE X. There are no other variable interest holders or arrangements between A or B and X. A is exposed to the majority of the variability associated with X’s anticipated economic performance. Neither A nor B individually has the characteristics of a controlling financial interest in ASC 810-10-25-38A. However, through their aggregated variable interests, A and B, as a group, have those characteristics. Assume that in an ASC 810-10-25-44 analysis, conditions (a), (b), and (d) do not indicate which reporting entity is most closely associated with X because there is no apparent principal-agency relationship, the activities of X have roughly equal significance to both A and B, and both parties were equally involved in the design of X. Given the nature of the transaction, it would be appropriate to give more relative weighting to condition (c), a party’s exposure to variability associated with X’s anticipated economic performance, because no other factor in ASC 810-10-25-44 points toward a particular party. Because A absorbs a majority of the variability associated with X’s anticipated economic performance, it may be reasonable to conclude that A is the primary beneficiary of X.

Example 2
Enterprises A and B are related parties not under common control. They each made equity investments of $40 and $60, respectively, in VIE X. There are no other variable interest holders. At inception, A entered into a supply agreement with X to purchase 100 percent of the output of X at prices initially identified as, and continually adjusted to, fair value. There are no other arrangements between A and B and X. Enterprise A is exposed to slightly more of the variability associated with X’s anticipated economic performance than is B. Neither A nor B individually has the characteristics of a controlling financial interest in ASC 810-10-25-38A. However, the aggregate variable interests of A and B, as a group, have those characteristics. In this example, A entered into a contractual arrangement with X to purchase 100 percent of the output of X at prices initially identified as, and continually adjusted to, fair value. The contractual arrangement would be an important consideration in A’s evaluation of the factors associated with the activities (ASC 810-10-25-44(b)) and design of the

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entity (ASC 810-10-25-44(d)) and, individually, those factors may point toward A as the primary beneficiary. A also has slightly greater exposure to the variability associated with X’s anticipated economic performance. Although A must also assess the factors in ASC 810-10-25-44 with respect to B, in this example, consideration of all the factors seems to indicate that A is most closely associated with X, and it may be reasonable to conclude that A would be considered the primary beneficiary.

6.27 Determining the Primary Beneficiary in a Related-Party Group When Members of the Related-Party Group Are Under Common Control
ASC 810-10-25-44 states, in part:
In situations in which a reporting entity concludes that neither it nor one of its related parties has the characteristics in paragraphs 810-10-25-38A but, as a group, the reporting entity and its related parties (including de facto agents described in the preceding paragraph) have those characteristics, then the party within the related party group that is most closely associated with the VIE is the primary beneficiary.

Question
How does a reporting entity determine which party in a related-party group is most closely associated with a VIE when the related parties are under common control?

Answer
When related parties are under common control, each party within the related-party group must first determine whether it meets the characteristics of a controlling financial interest in ASC 810-10-25-38A. If each of the reporting entities within the related-party group concludes, individually, that the reporting entity’s variable interests do not provide it with both of the characteristics in ASC 810-10-25-38A, the related-party group would need to apply the guidance in ASC 810-10-25-44 to determine which party is most closely associated with the VIE. Although the analysis described in ASC 810-10-25-38A may indicate that one party within the related-party group appears to exhibit the characteristics of a controlling financial interest, a closer evaluation of the substance of the stated power and economic exposure is necessary when one party controls some or all parties within the related-party group, since that controlling party may have the ability to assign power or exposure to economics to a particular party to achieve a preferred consolidation result. A reporting entity should carefully consider the substance of the terms, transactions, and arrangements between the related parties and the parent company when determining whether one party in the related party group has both of the characteristics in ASC 810-10-25-38A. Thus, notwithstanding the stated power and economic exposure, all relevant facts and circumstances, including the guidance in ASC 810-10-25-44(a) through (d), may need to be considered even if one party within the relatedparty group appears to exhibit the characteristics of a controlling financial interest in ASC 810-10-25-38A. If one party within the related-party group appears to be most closely associated with the VIE on the basis of the guidance in ASC 810-10-24-44(a) through (d), but the stated power arrangements indicate that another party within the related-party group meets both of the characteristics in ASC 810-10-25-38A, the stated power of the parties may not be substantive. See Q&A 6.26 for guidance on determining which party in a related-party group is most closely associated with a VIE.

6.28 Consideration of the Factors in ASC 810-20 in the Determination of Which Related Party Is Most Closely Associated
A partnership agreement may restrict an LP’s ability to sell, transfer, or encumber its interests in a partnership without the approval of the GP. According to ASC 810-10-25-43(d), this results in a de facto agency relationship between the GP and LP, thereby creating a related-party group. However, as indicated in ASC 810-10-25-43(d), “a de facto agency relationship does not exist if both the reporting entity and the party have right of prior approval and the rights are based on mutually agreed terms by willing, independent parties.” ASC 810-10-25-44 discusses how to determine the primary beneficiary in a VIE when related parties hold interests in the same VIE. If two or more related parties hold variable interests in the same VIE and none of the related parties individually has the characteristics of a controlling financial interest in ASC 810-10-25-38A, but the aggregate variable interest held by those parties, as a group, has those characteristics, then the party, within the related-party group, that is most closely associated with the VIE is the primary beneficiary.

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ASC 810-20 provides guidance on determining whether a GP controls a limited partnership or similar entity when certain rights are held by the LPs. This guidance applies to limited partnerships or similar entities that are determined not to be VIEs and that are therefore not within the scope of the VIE model in ASC 810-10.

Question
Should a reporting entity consider the accounting conclusion that otherwise would have been reached under ASC 810-20 (if the partnership were not a VIE) when evaluating which party in a related-party group is “most closely associated” with a partnership under ASC 810-10-25-44?

Answer
No. A reporting entity should not consider the accounting conclusion under ASC 810-20 in determining which partner is most closely associated under ASC 810-10-25-44 because ASC 810-20 is a different accounting model than the VIE model in ASC 810-10. The reporting entity should therefore use the guidance in ASC 810-10-25-44 when making this determination. However, a reporting entity may find the factors considered in the ASC 810-20 analysis helpful in determining which party is most closely associated with the limited partnership.

Example
A GP determines that a limited partnership is a VIE and that there is a de facto agency relationship between the GP and the LPs. The GP performs an analysis under ASC 810-10-25-44 and concludes that the following factors, when compared with all other facts and circumstances, identify the GP as most closely associated with the partnership: • • The activities performed under a management agreement between the GP and the LPs are significant to the partnership (ASC 810-10-25-44(b)). The partnership was designed on behalf of the GP (ASC 810-10-25-44(d)).

If the limited partnership was not a VIE, the GP would consider similar factors when determining whether to consolidate the partnership under ASC 810-20; however, the accounting conclusion reached under ASC 810-20 should not be considered in this example.

6.29 Application of ASC 810-10-25-38A and ASC 810-10-25-44 When a Fee Paid to an Asset Manager Represents a Variable Interest and the Asset Manager Is Part of a Related-Party Group
In certain investment structures, an asset manager is paid a fee for managing the assets of a VIE and another entity that is a related party of the asset manager holds a significant investment in the VIE.

Question
If an asset manager determines that its fee represents a variable interest after evaluating the conditions in ASC 81010-55-37 through 37A (including consideration of the variable interests held by a related party), how should the asset manager evaluate whether it is the primary beneficiary of the VIE under ASC 810-10-25-38A and ASC 81010-25-44?

Answer
On the basis of our discussions with the FASB staff, we understand that ASC 810-10-25-44 requires an asset manager to first evaluate whether its variable interest(s) would provide it with both of the characteristics in ASC 810-10-25-38A. The FASB staff also confirmed that if the asset manager concludes that its fee interest (and any other variable interest held by the asset manager) does not provide it with both of the characteristics in ASC 81010-25-38A, the asset manager (and its related party) would need to apply the guidance in ASC 810-10-25-44 to determine which party is most closely associated with the VIE.

Evaluation of ASC 810-10-25-38A(a)
Note that when determining whether the asset manager’s fee interest is a variable interest under ASC 810-10-5537 through 37A, the asset manager is precluded from considering its interests separately from the variable interests held by its related party. Therefore, when the fee interest meets the definition of a variable interest under ASC 81010-55-37 through 37A (after consideration of the variable interests held by a related party), the asset manager will typically meet the characteristic in ASC 810-10-25-38A(a). This point is illustrated in the implementation guidance in ASC 810-10-55-93 through 55-205.
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Evaluation of ASC 810-10-25-38A(b)
To determine whether the asset manager’s fee arrangement meets the characteristic in ASC 810-10-25-38A(b), the reporting entity should determine whether the fee arrangement and any other variable interest held by the asset manager (but excluding variable interests held by a related party) are insignificant, as discussed in Q&A 6.09. In some cases, a reporting entity may conclude that a quantitatively significant interest does not meet the characteristic in ASC 810-10-25-38A(b) on the basis of qualitative factors and an overall consideration of its quantitative and qualitative assessments. In making this determination, the asset manager should consider the conclusions reached in the ASC 810-10-55-37 analysis (which are based on the design of the entity). If, considering only the asset manager’s fee and other interests (i.e., excluding the related party’s variable interest), the asset manager would not have failed to meet any condition in ASC 810-10-55-37, the asset manager may be able to conclude that the fee and other interests are insignificant on the basis of qualitative factors and an overall consideration of its quantitative and qualitative assessment. However, if the asset manager’s fee and other interests would have individually or in the aggregate not met the conditions in ASC 810-10-55-37(c), (e), or (f), the reporting entity would generally not be able to conclude that its variable interest or interests are insignificant on the basis of qualitative factors. If the asset manager cannot conclude that the fee does not meet the characteristic in ASC 810-10-25-38A(b) based on qualitative factors, the asset manager’s fee would generally meet the characteristic in ASC 810-10-2538A(b) if any portion of the fee is the most senior payment in the waterfall (because of the possibility that the return is sufficient only to pay that fee) or if the fee contains a significant performance-based element. Given the requirement to consider all possible scenarios regardless of the likelihood of their occurrence, a reporting entity will generally not need to perform a detailed quantitative calculation to assess whether the fee represents a significant interest. That is, the characteristic can generally be assessed on the basis of the design of the VIE and the contractual terms of the entity’s fee arrangement and other interest(s). Note that the ASC 810-10-25-38A(b) analysis is different from the analysis of whether a fee is a variable interest under ASC 810-10-55-37, in which a reporting entity does consider probability in its analysis. A reporting entity should carefully consider a conclusion that a quantitatively significant interest does not meet the characteristic in ASC 810-10-25-38A(b). Given the decision-making ability typically vested in an asset manager, such a conclusion would generally only be appropriate when an overall consideration of all quantitative and qualitative factors clearly indicates that the asset manager’s interest does not represent a significant interest.

Example 1
A VIE is designed to hold a diverse portfolio of asset-backed securities. The VIE is financed with a mix of debt and equity securities. The assets of the VIE are managed within the parameters established by the VIE’s governing documents. The parameters provide the asset manager with latitude to manage the VIE’s assets while maintaining an average portfolio rating of single B-plus or higher. The debt securities are widely dispersed among third-party investors. The equity securities are held by an investment fund. The investment fund is a related party of the asset manager. For its services, the asset manager earns a fixed fee calculated as 0.75 percent of the portfolio’s fair value. A portion of the fee is subordinate to other operating liabilities of the VIE, whereas a portion of the fee is the most senior payment in the waterfall. Although a portion of the fee is subordinated, the total fee is commensurate with the level of effort required to provide the asset management services. The asset manager concludes that the fee, excluding the interest held by the related-party investment fund, would meet the conditions in ASC 810-1055-37(e) and (f). In this example, the asset manager may be able to conclude that its fee does not represent a significant interest on the basis of qualitative factors and an overall consideration of its quantitative and qualitative assessments. Although a portion of the fee is subordinate and a portion is the most senior in the waterfall, the total fee is a fixed return on the fair value of the VIE’s assets. In addition, in considering qualitative and quantitative factors, the asset manager concludes (on the basis of the percentage of the fee and the design of the VIE) that the fee could never potentially be significant to the VIE. The asset manager holds no other interests in the VIE. If the asset manager concludes that it does not meet both of the characteristics in ASC 810-10-25-38A the asset manager would need to apply the guidance in ASC 810-10-25-44 to determine which party in the related-party group is most closely associated with the VIE.

Example 2
Assume the same facts as in Example 1 except that in addition to the fixed percentage fee, the asset manager receives a performance-based fee entitling it to 20 percent of the VIE’s returns above a 10 percent hurdle rate. The performance-based fee is subordinate to the other operating liabilities of the VIE.
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In this example, the asset manager concludes that its fee represents an interest that could potentially be significant to the VIE without regard to the likelihood that the performance-based fee would be earned. The fee is a subordinated, variable, performance-based fee that potentially entitles the asset manager to a significant amount of the VIE’s returns in certain scenarios. The asset manager would be the primary beneficiary of the VIE since it would possess both characteristics in ASC 810-10-25-38A.

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Section 7 — Initial Measurement and Subsequent Accounting
Initial Measurement
ASC 810-10
30-1 If the primary beneficiary of a variable interest entity (VIE) and the VIE are under common control, the primary beneficiary shall initially measure the assets, liabilities, and noncontrolling interests of the VIE at amounts at which they are carried in the accounts of the reporting entity that controls the VIE (or would be carried if the reporting entity issued financial statements prepared in conformity with generally accepted accounting principles [GAAP]). [Paragraph 18] 30-2 The initial consolidation of a VIE that is a business is a business combination and shall be accounted for in accordance with the provisions in Topic 805. [Paragraph 20]

7.01 Balance Sheet Classification of Parent’s Interest — Primary Beneficiary and VIE Under Common Control
Enterprise E and a VIE (VIE X) are under common control of Parent P. While P holds all of the outstanding common stock in VIE X, E has been determined to be the primary beneficiary of VIE X under ASC 810-10-25-44 because E is most closely associated with VIE X.

Question
How should E report P’s share of VIE X’s net assets in its stand-alone consolidated financial statements?

Answer
As discussed below, P’s equity interest should be classified in accordance with ASC 810-10-45-16.1 In addition, because E and VIE X are under common control, E should, in accordance with ASC 810-10-30-1, initially measure the assets, liabilities, and noncontrolling interest of VIE X at the amounts at which they are carried in the financial statements of the common parent (P). ASC 810-10-30-1 states:
If the primary beneficiary of a [VIE] and the VIE are under common control, the primary beneficiary shall initially measure the assets, liabilities, and noncontrolling interests of the VIE at amounts at which they are carried in the accounts of the reporting entity that controls the VIE (or would be carried if the reporting entity issued financial statements prepared in conformity with [GAAP]). [Emphasis added]

There are two approaches (described below) to reporting a parent’s or affiliate’s interest in the reporting entity’s consolidated subsidiary (i.e., the reporting of P’s interest in VIE X by E). The “traditional noncontrolling interest” approach (Approach A) is always acceptable. However, the SEC staff may question the use of Approach B in some circumstances. SEC registrants that wish to apply Approach B are encouraged to preclear the use of that approach with the SEC staff before issuing their financial statements.

Approach A — Traditional Noncontrolling Interest
Under Approach A, the reporting entity presents the parent’s or affiliate’s interest in a manner similar to a traditional noncontrolling interest. The equity owned by the parent or affiliate is presented as a separate component of the reporting entity’s shareholders’ equity. The parent’s or affiliate’s share of the reporting entity’s net income is shown in “net income attributable to the noncontrolling interest,” which is a single line item presented below the reporting entity’s net income.
1

For more information, see 810-10-45 (Q&A 43) in Deloitte’s FASB Accounting Standards Codification Manual.
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Approach B — Parent’s or Affiliate’s Interest Attributed to the Reporting Entity
Under Approach B, the parent’s or affiliate’s interest in the subsidiary is attributed to the reporting entity. Therefore, the balance of the parent’s or affiliate’s investment is included in the equity attributable to the reporting entity. It cannot be described as “noncontrolling interest” or presented separately from the equity attributable to the reporting entity. The amount should be described, for example, as “affiliate’s interest in subsidiary” or “parent’s interest in subsidiary.” The presentation of the parent’s or affiliate’s interest in the reporting entity’s consolidated income statement should be consistent with the balance sheet presentation. That is, the income attributable to that interest should be included in the “net income attributable to the reporting entity,” with no net income being attributed to the noncontrolling interest. It is not appropriate to use the balance sheet presentation from one approach and the income statement presentation from the other approach. ASC 810-10
30-3 When a reporting entity becomes the primary beneficiary of a VIE that is not a business, no goodwill shall be recognized. The primary beneficiary initially shall measure and recognize the assets (except for goodwill) and liabilities of the VIE in accordance with Sections 805-20-25 and 805-20-30. However, the primary beneficiary initially shall measure assets and liabilities that it has transferred to that VIE at, after, or shortly before the date that the reporting entity became the primary beneficiary at the same amounts at which the assets and liabilities would have been measured if they had not been transferred. No gain or loss shall be recognized because of such transfers. [Paragraph 21] 30-4 (b): a. The primary beneficiary of a VIE that is not a business shall recognize a gain or loss for the difference between (a) and The sum of: 1. 2. 3. b. The fair value of any consideration paid The fair value of any noncontrolling interests The reported amount of any previously held interests

The net amount of the VIE’s identifiable assets and liabilities recognized and measured in accordance with Topic 805. [Paragraph 21]

7.02 Qualification of an Entity as a Business for Recording Goodwill Upon Consolidation of a VIE
In December 2007, the FASB issued Statement 141(R) (codified in ASC 805), which amends the guidance on the initial consolidation of a VIE. Under ASC 810-10-30-2, if a VIE is a business (as defined in ASC 805-10-20), the primary beneficiary must initially consolidate the VIE as if it were a business combination accounted for under ASC 805, which includes recognition of goodwill, if any. The primary beneficiary should not recognize goodwill if the VIE is not a business. A reporting entity must also consider ASC 805 in determining whether an entity qualifies for the business scope exception in ASC 810-10-15-17(d).

Question
If an entity is disqualified under the scope exception because of conditions 1–4 of ASC 810-10-15-17(d), is it also disqualified as a business when a reporting entity applies ASC 810-10-30-2 and records goodwill?

Answer
No. The determination of whether an entity is a business under ASC 810-10-30-2 is strictly related to whether the entity meets the definition of a business in ASC 805-10-20. That is, even if the scope exception for a business in ASC 810-10-15-17(d) is not applicable because one or more of the four additional conditions in that paragraph are met, as long as the definition of a business in ASC 805-10-20 is met, goodwill, if any, should be recorded.

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Accounting After Initial Measurement
ASC 810-10
35-3 The principles of consolidated financial statements in this Topic apply to primary beneficiaries’ accounting for consolidated variable interest entities (VIEs). After the initial measurement, the assets, liabilities, and noncontrolling interests of a consolidated VIE shall be accounted for in consolidated financial statements as if the VIE were consolidated based on voting interests. Any specialized accounting requirements applicable to the type of business in which the VIE operates shall be applied as they would be applied to a consolidated subsidiary. The consolidated entity shall follow the requirements for elimination of intra-entity balances and transactions and other matters described in Section 810-10-45 and paragraphs 810-1050-1 through 50-1B and existing practices for consolidated subsidiaries. Fees or other sources of income or expense between a primary beneficiary and a consolidated VIE shall be eliminated against the related expense or income of the VIE. The resulting effect of that elimination on the net income or expense of the VIE shall be attributed to the primary beneficiary (and not to noncontrolling interests) in the consolidated financial statements. [Paragraph 22]

7.03

Accounting After Initial Measurement — Intercompany Eliminations

The amendments linked to ASC 810-10-65-1 (Statement 160) change the guidance on accounting for and presenting noncontrolling interests (commonly referred to as minority interests). ASC 810-10-35-3 requires that after initial measurement, the assets, liabilities, and noncontrolling interest of a consolidated VIE should be accounted for in the primary beneficiary’s consolidated financial statements “as if the VIE were consolidated based on voting interests”, as described in ASC 810-10-45.

Question
How does the guidance in ASC 810-10-35-3 on the elimination of intercompany transactions between a primary beneficiary and a VIE differ from the guidance in ASC 810-10-45 on consolidation based on voting interests?

Answer
Under ASC 810-10-35-3, a reporting entity generally must follow the principles of the voting interest consolidation model. ASC 810-10-45-18 states, in part, “The elimination of the intra-entity income or loss may be allocated between the parent and noncontrolling interests.” However, ASC 810-10-35-3 contains additional guidance on the effect of certain intercompany eliminations when an entity consolidates a VIE. ASC 810-10-35-3 states, in part:
Fees or other sources of income or expense between a primary beneficiary and a consolidated VIE shall be eliminated against the related expense or income of the VIE. The resulting effect of that elimination on the net income or expense of the VIE shall be attributed to the primary beneficiary (and not to noncontrolling interests) in the consolidated financial statements.

On a consolidated basis, the primary beneficiary will continue to eliminate intercompany amounts received from a consolidated VIE. After elimination, these amounts will not be included in revenue or other income. However, the effect (i.e., the benefit) of these amounts received from the VIE still should be recognized in net income attributable to the primary beneficiary, as illustrated in the following example.

Example
Company X is a VIE capitalized by an equity investment of $10 from Enterprise Y and a loan of $990 from Enterprise Z. Enterprise Z has determined that it is the primary beneficiary of X. Each year, Z recognizes $75 of interest income as a result of its 7.5 percent interest rate on the debt. The following two tables illustrate the impact on Z’s financial statements of consolidating X under the voting interests approach and ASC 810-10-35-3, respectively. The differences between the two tables illustrate the effects of allocating eliminations and attributing the effect of the elimination to the primary beneficiary.

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Table 1 — Approach to Intercompany Eliminations Under the Voting Interest Model in ASC 810-10 Z Sales Cost of sales Operating margin Other income (expense) Interest income Interest expense Noncontrolling interest Net income $ 75 – – 2,075 $ – (75) – 125 $ (75) 75 (200) (200) $ – – (200) 2,000 $ 15,000 13,000 2,000 $ X (VIE) 1,500 1,300 200 Consolidating Entities $ – – – Consolidated Z $ 16,500 14,300 2,200

Under the voting interests approach, the effect of eliminating intercompany interest income or expense is allocated in proportion to equity ownership. Since Z does not have an equity interest in X, all income after eliminations is allocated to the noncontrolling interest. Net income attributable to Z has been reduced by $75.
Table 2 — Approach to Intercompany Eliminations Under the VIE Model in ASC 810-10 Z Sales Cost of sales Operating margin Other income (expense) Interest income Interest expense Noncontrolling interest Net income $ 75 – – 2,075 $ – (75) – 125 $ (75) 75 (125) (125) $ – – (125) 2,075 $ 15,000 13,000 2,000 $ X (VIE) 1,500 1,300 200 Consolidating Entities $ – – – Consolidated Z $ 16,500 14,300 2,200

Under the ASC 810-10-35-3 approach, the effect of eliminating intercompany interest income or expense has been attributed to Z (the primary beneficiary). Enterprise Z’s interest income has been eliminated. However, net income attributable to Z remains unchanged at $2,075. This reflects the fact that Y’s (the noncontrolling interest) legal right to net income is limited to $125.

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Section 8 — Presentation and Disclosures
ASC 810-10
45-25 a. b. A reporting entity shall present each of the following separately on the face of the statement of financial position: 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. [Paragraph 22A]

Presentation 8.01 Application of the Presentation Requirements of ASC 810-10-45-25 to a Consolidated VIE
Question
How should a reporting entity apply the presentation requirements of the assets and liabilities of a VIE under ASC 810-10-45-25?

Answer
A reporting entity should first apply the guidance in ASC 810-10-45-1, which states, in part:
In the preparation of consolidated financial statements, intra-entity balances and transactions shall be eliminated. This includes intra-entity open account balances, security holdings, sales and purchases, interest, dividends and so forth.

After the appropriate eliminations and consolidation of account balances, the reporting entity should apply the presentation requirements of ASC 810-10-45-25 to the consolidated balance sheets of the reporting entity. When identifying the assets and liabilities to be presented in accordance with that guidance, the reporting entity should consider only those assets and liabilities that continue to be presented and included in the consolidated balance sheets of a reporting entity after the principles of consolidated financial statements have been applied. A reporting entity should not gross up the assets and liabilities of a consolidated VIE to apply the guidance in ASC 810-1045-25.

Example
Entity A contributes $40 in cash in the form of a $10 investment and $30 loan to Entity B, a VIE. Entity B contributes $40 in cash for an investment in Entity C, also a VIE. Once capitalized, C borrows $160 from a thirdparty bank and uses the $40 contributed by B and the $160 borrowed from the bank to purchase $200 of investment-grade debt securities from third parties. The $160 borrowed from the bank is recourse only to these securities (i.e., the bank does not have recourse to the assets of A or B (B is the parent of C, and A is the parent of B)). The $200 of investment-grade debt securities may only be used to service the borrowing from the bank and, upon liquidation of C, to distribute the net assets of C to B. In addition to B and C both being VIEs, B is the primary beneficiary of C and A is the primary beneficiary of B. At issue is how the assets of VIEs B and C should be reported in the consolidated financial statements of the reporting entity, A. Entity A must first apply the guidance in ASC 810-10-45-1 and eliminate its investment in and loan to consolidated VIE B, and the elimination of B’s investment asset in VIE C. As a result of these eliminations, no assets or liabilities of consolidated VIE B exist in the consolidated statement of financial position; therefore, no separate balance sheet
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presentation for these items is required under ASC 810-10-45-25. Entity A would separately identify the $200 of investment-grade debt securities and $160 of bank borrowings in its consolidated financial statements, since these items meet the conditions in ASC 810-10-45-25.
Entity A Balances and Eliminations Entity A Loan Receivable Investment in B Equity Equity Interest Entity B Investment in C Debt (Held by A) Equity (Held by A) Entity C Assets — Securities Debt (Held by Bank) Equity (Held by B) $200 $160 $40 $40 $30 $10 $30 $10 $40

$10 Equity Interest $30 Loan $40 Entity B $40 Entity C $160 Debt $200 Third Parties $200 Securities

Bank

8.02

Separate Presentation of Certain Assets and Liabilities of Consolidated VIEs

ASC 810-10-45-25 requires that a reporting entity separately present the following on the face of its statement of financial position: • • The “[a]ssets of a consolidated [VIE] that can be used only to settle [specific] obligations of the consolidated VIE.” The “[l]iabilities of a consolidated VIE for which creditors (or beneficial interest holders) do not have recourse to the general credit of the primary beneficiary.”

Question
How should the assets and liabilities of a consolidated VIE that meet the separate presentation requirements be presented in a reporting entity’s consolidated financial statements?

Answer
This information must be presented on a gross basis. That is, a VIE’s liabilities would not be offset against its assets, and a VIE’s assets should not be combined as a single asset line item and its liabilities should not be combined as a single liability line item, unless this is permitted by other GAAP. Paragraph A81 in the Basis for Conclusions of Statement 167 notes that the Board rejected a linked presentation approach that would have allowed liabilities of a VIE to be reflected as a deduction from the related assets of the VIE. Therefore, a presentation of the assets and liabilities separately but on one side of the statement of financial position would also not be appropriate. The Basis for Conclusions of Statement 167 also notes that the Board considered, but rejected, a single-line-item display of assets and liabilities that meet the separate presentation criteria. Accordingly, the assets of the VIE (which may include, for example, cash, receivables, investments, or fixed assets) should not be combined on the face of the statement of financial position as a single line item unless they are the same category of asset (the same principle applies to liabilities of the VIE). The VIE model in ASC 810-10 does not provide additional guidance on how assets and liabilities that meet the separate presentation criteria should be presented in the statement of financial position. A reporting entity has presentation alternatives as long as the assets and liabilities that meet the separate presentation criteria are separately presented on the face of the statement of financial position. For example, a reporting entity could present receivables as one line item and parenthetically disclose the amount of receivables that are in a VIE and that meet the separate presentation criteria. Alternatively, a reporting entity could present receivables in two separate line items (one line item for those that are in a VIE and meet the separate presentation criteria and another line item for all other receivables). There may be other acceptable alternatives.

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In addition, although all assets and liabilities of consolidated VIEs that meet the separate presentation criteria must be separately presented on the balance sheet, this presentation does not need to be done on a VIE-by-VIE basis. Further, a reporting entity is permitted, but not required, to separately present noncontrolling interests in the equity section. However, such an election is an accounting policy choice that must be applied to all consolidated VIEs. Also note that ASC 810-10-45-25 does not require that the changes in the assets and liabilities be separately reflected in the statement of cash flows or in the statement of operations, unless this is required by other GAAP. However, a reporting entity is permitted to do so; such an election is an accounting policy choice that must be applied to all consolidated VIEs. In addition, the separate presentation criteria for assets are not the same as those for liabilities. Therefore, it is possible that only the assets or only the liabilities would have to be separately presented for certain entities.

8.03 VIEs

Optional Separate Presentation of Certain Assets and Liabilities of Consolidated

Question
May a reporting entity elect to separately present assets and liabilities of VIEs even if they do not meet the requirements for separate presentation in ASC 810-10-45-25?

Answer
Yes. The VIE model in ASC 810-10 does not preclude a reporting entity from separately presenting the assets and liabilities of a VIE. Further, ASC 810-20-45-1 addresses a similar question related to the consolidation of limited partnerships, stating the following:
An entity [that consolidates a limited partnership] has financial statement and disclosure alternatives that may provide additional useful information. For example, an entity may highlight the effects of consolidating a limited partnership by providing consolidating financial statements or separately classifying the assets and liabilities of the limited partnership(s) on the face of the balance sheet.

However, if a reporting entity elects to separately present assets and liabilities of a consolidated VIE, it should be clear on the face of the financial statements which assets and liabilities meet the separate presentation criteria (as discussed in Q&A 8.02) and which do not. In addition, such an election is an accounting policy choice that must be applied to all consolidated VIEs.

Disclosures
ASC 810-10
All Entities Within the Scope of the VIE Model in ASC 810-10 50-2AA The principal objectives of this Subsection’s 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 VIE’s 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 entity’s involvement with the VIE. How a reporting entity’s involvement with the VIE affects the reporting entity’s financial position, financial performance, and cash flows. [Paragraph 22B]

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 entity’s interest in that VIE. [Paragraph 22B] 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. [Paragraph 25]

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ASC 810-10 (continued)
Primary Beneficiary of a VIE 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): [Paragraph 23] a. b. [Subparagraph superseded by Accounting Standards Update No. 2009-17] [Subparagraph superseded by Accounting Standards Update No. 2009-17]

bb. The carrying amounts and classification of the VIE’s assets and liabilities in the statement of financial position that are consolidated in accordance with the Variable Interest Entities Subsections, including qualitative information about the relationship(s) between those assets and liabilities. For example, if the VIE’s 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. [Paragraph 23A]

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 VIE’s assets can be used for purposes other than the settlement of the VIE’s obligations, the disclosures in this paragraph are not required. [Paragraph 22E] Nonprimary Beneficiary Holder of a Variable Interest in a VIE 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 VIE’s primary beneficiary, shall disclose: a. b. The carrying amounts and classification of the assets and liabilities in the reporting entity’s statement of financial position that relate to the reporting entity’s variable interest in the VIE. The reporting entity’s 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 entity’s exposure to the VIE. If the reporting entity’s 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 entity’s 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 entity’s 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 VIE’s economic performance is shared in accordance with the guidance in paragraph 810-10-25-38D. [Paragraph 24]

c.

d. e.

Primary Beneficiaries or Other Holders of Interests in VIEs 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 entity’s 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 entity’s financial statements.

b.

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ASC 810-10 (continued)
c. 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.

Qualitative and quantitative information about the reporting entity’s involvement (giving consideration to both explicit arrangements and implicit variable interests) with the VIE, including, but not limited to, the nature, purpose, size, and activities of the VIE, including how the VIE is financed. 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. [Paragraph 22E]

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 VIE’s assets can be used for purposes other than the settlement of the VIE’s obligations, the disclosures in the preceding paragraph are not required. [Paragraph 22E] Scope-Related Disclosures 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. b. c. d. 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 entity’s involvement with the legal entities The reporting entity’s 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. [Paragraph 26]

Aggregation of Certain Disclosures 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 entity’s involvement with VIEs. [Paragraph 22C] 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 entity’s 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. [Paragraph 22D]

8.04 Disclosures About Securitizations Under ASC 860 Versus Disclosures About Securitizations Under the VIE Model in ASC 810-10
Question
If a reporting entity (1) securitizes assets under ASC 860 (regardless of whether the securitization achieved sale accounting or is accounted for as a financing or a failed sale) and (2) has a variable interest in, or is the primary beneficiary of, the securitization vehicle, should the reporting entity follow the disclosure requirements of ASC 86010-50 or the VIE model’s disclosure requirements in ASC 810-10-50?

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Answer
The reporting entity should provide disclosures that meet the requirements of both ASC 860-10-50 and ASC 81010-50. These disclosures may be provided in more than one note to the financial statements as long as the overall disclosure objectives are met.

8.05

Definition of Maximum Exposure to Loss for Disclosure Purposes

ASC 810-10-50-4 requires a reporting entity that has a variable interest in a VIE, but that is not the primary beneficiary of the VIE, to disclose its “maximum exposure to loss as a result of its involvement with the VIE.”

Question
What should a reporting entity include in the maximum exposure to loss that it must disclose under ASC 810-1050-4?

Answer
The reporting entity’s maximum exposure to loss (both explicit arrangements and implicit variable interests1 should be considered) includes (1) the amount invested in, and advanced to, the VIE as of the reporting date, plus (2) any legal or contractual obligation to provide financing in the future. A reporting entity’s maximum exposure to loss should include unavoidable future advances of funds or other assets to the VIE, net of the fair value of any goods or services that are received in exchange (e.g., losses related to a firm commitment to purchase future goods from the VIE at above market rates).

1

ASC 810-10-25-48 through 25-54 provide guidance on how to determine whether a reporting entity has an implicit variable interest in a VIE.
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Section 9 — Transition
ASC 810-10
Initial Consolidation When Earlier Consolidation Was Prevented Due to Lack of Information 30-7 A reporting entity that has not applied the Variable Interest Entities Subsections to a legal entity because of the condition described in paragraph 810-10-15-17(c) and that subsequently obtains the information necessary to apply the Variable Interest Entities Subsections to that entity shall apply the provisions of the Variable Interest Entities Subsections as of the date the information is acquired in accordance with the following paragraph. [Statement 167, paragraph 10] 30-8 The initial measurement by a consolidating entity of the assets, liabilities, and noncontrolling interests of the VIE at the date the requirements of the Variable Interest Entities Subsections first apply 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 Variable Interest Entities Subsections had been effective when the reporting entity first met the conditions to be the primary beneficiary. [Statement 167, paragraph 5] 30-8A 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 Variable Interest Entities Subsections first apply. [Statement 167, paragraph 5] 30-8B 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 Variable Interest Entities Subsections first apply. 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 Variable Interest Entities Subsections first apply if both of the following conditions are met: a. b. The activities of the VIE are primarily related to securitizations or other forms of asset-backed financings. The assets of the VIE can be used only to settle obligations of the entity. [Statement 167, paragraph 5]

30-8C The measurement alternative in the preceding paragraph 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. [Statement 167, paragraph 5] 30-8D 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. [Statement 167, paragraph 5] 30-9 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. [Statement 167, paragraph 9] Transition Related to FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R) 65-2 The following represents the transition and effective date information related to FASB Statement No. 167, Amendments to FASB Interpretation 46(R): a. Except as noted in item aa, the pending content that links to this paragraph is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. [Statement 167, paragraph 4]

aa. Except for the pending content in Section 810-10-50, the pending content that links to this paragraph shall not be applied to either of the following: 1. A reporting entity’s interest in an entity if all of the following conditions are met: i. The entity either: 01. Has all of the attributes specified in paragraph 946-10-15-2(a) through (d)
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ASC 810-10 (continued)
02. Does not have all of the attributes specified in paragraph 946-10-15-2(a) through (d) but is an entity for which it is acceptable based on industry practice to apply measurement principles that are consistent with those in Topic 946 (including recognizing changes in fair value currently in the statement of operations) for financial reporting purposes. ii. The reporting entity does not have an explicit or implicit obligation to fund losses of the entity that could potentially be significant to the entity. This condition should be evaluated considering the legal structure of the reporting entity’s interest, the purpose and design of the entity, and any guarantees provided by the reporting entity’s related parties. The entity is not: 01. A securitization entity 02. An asset-backed financing entity 03. An entity that was formerly considered a qualifying special-purpose entity. Examples of entities that may meet the preceding conditions include a mutual fund, a hedge fund, a mortgage real estate investment fund, a private equity fund, and a venture capital fund. Examples of entities that do not meet the preceding conditions include structured investment vehicles, collateralized debt/loan obligations, commercial paper conduits, credit card securitization structures, residential or commercial mortgage-backed entities, and government sponsored mortgage entities. 2. A reporting entity’s 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.

iii.

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. [ASU 2010-10] 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. [ASU 2010-10] [Emphasis added] 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. [Statement 167, paragraph 5] 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. [Statement 167, paragraph 5] 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. ii. The activities of the VIE are primarily related to securitizations or other forms of asset-backed financings. The assets of the VIE can be used only to settle obligations of the entity.

2.

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ASC 810-10 (continued)
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. [Statement 167, paragraph 5] 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. [Statement 167, paragraph 5] 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 VIEby-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. Management’s 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. [Statement 167, paragraph 6]

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 entity’s 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. [Statement 167, paragraph 7] The determinations of whether a legal entity is a VIE and which reporting entity, if any, is a VIE’s 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 entity’s 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. [Statement 167, paragraph 8] 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. [Statement 167, paragraph 8] 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. [Statement 167, paragraph 8] 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. [Statement 167, paragraph 9] 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.
185

f.

g.

h.

i.

j.

9.01 Whether a Reporting Entity Can Elect the FVO for a VIE Upon Adopting ASU 2009-17
A reporting entity that must consolidate a VIE as a result of the adoption of ASU 2009-17 may elect the FVO only if the reporting entity elects the FVO for all financial assets and financial liabilities of that VIE that are eligible for the FVO under ASC 825-10. Certain VIEs are used by reporting entities to create securities from a pool of receivables that are revolving in nature (such as credit card receivables). Although the reporting entity transfers the entire balance of the receivables into the VIE, the receivables are typically apportioned between an investor’s interest and a seller’s interest. The seller’s interest (which is held by the reporting entity that transfers the receivables to the VIE) represents the seller’s retained interest in the cash flows of the underlying receivables. Typically, the seller’s interest in the receivables is not derecognized from the balance sheet of the reporting entity that transferred the receivables to the VIE (i.e., the seller continues to recognize those amounts as accounts receivable in its balance sheet, and the seller’s interest is not recharacterized in the balance sheet). Note that this guidance only addresses the election of the FVO on the date of adoption of ASU 2009-17.

Question
Upon adopting ASU 2009-17, can a reporting entity elect the FVO for receivables in a consolidated VIE even if the reporting entity recognized a seller’s interest in the underlying receivables before initial consolidation of the entity under the VIE model in ASC 810-10, as amended by ASU 2009-17, and did not previously elect the FVO for that seller’s interest?

Answer
Yes. ASU 2009-17’s transition guidance does not require that a reporting entity elect the FVO for the entity’s assets or liabilities before electing the FVO upon consolidation. Rather, under the VIE model in ASC 810-10, as amended by ASU 2009-17, consolidating an entity upon adoption of ASU 2009-17 creates a new FVO election date. Therefore, a reporting entity can apply the FVO to the entire balance of receivables in the consolidated VIE (including the seller’s interest) as long as the reporting entity also elects the FVO for all items within the VIE that are eligible for the FVO.

9.02

Determining VIE and Primary-Beneficiary Status Upon Transition to ASU 2009-17

Question
When adopting ASU 2009-17, as of which date should a reporting entity determine whether an entity is a VIE and whether the reporting entity is the primary beneficiary?

Answer
The VIE model in ASC 810-10, as amended by ASU 2009-17, requires that, upon adoption, a reporting entity should determine whether an entity is a VIE, and whether the reporting entity is the VIE’s primary beneficiary, as of the date that the reporting entity first became involved with the entity,1 unless an event requiring reconsideration of those initial conclusions occurred after that date. When making this determination, a reporting entity must assume that ASU 2009-17 had been effective from the date of its first involvement with the entity. The following is an outline of the steps in the reporting entity’s determination: Step 1: The reporting entity should identify the entities (both VIEs and non-VIEs) that it is involved with as of the adoption date of ASU 2009-17 and the date it first became involved with those entities. Step 2: The reporting entity should determine for each entity whether any reconsideration events pursuant to ASC 810-10-35-4 have occurred that would have changed the entity’s VIE status (e.g., an entity would have become a VIE or would no longer have been a VIE) after the date identified in step 1. If so, the date of that reconsideration event is the date the reporting entity uses to determine the entity’s VIE status. If not, the date identified in step 1 is used to identify the entity’s VIE status.

1

Under the VIE model in ASC 810-10, as amended by ASU 2009-17, “involvement with a legal entity refers to ownership, contractual, or other pecuniary interests that may be determined to be variable interests.”
186

Step 3: The reporting entity should determine for each entity whether any changes in facts and circumstances have occurred that would have changed the primary-beneficiary conclusion under the VIE model in ASC 810-10, as amended by ASU 2009-17, after the date identified in step 2. If so, the date of the change in facts and circumstances is the date the reporting entity uses to determine whether it is the primary beneficiary of the entity. If not, the reporting entity uses the date identified in step 2 to determine whether it is the primary beneficiary of the entity. If, after applying the guidance in steps 1–3 to an entity, a reporting entity reaches the same consolidation conclusion for an entity as what was reflected in the reporting entity’s financial statements before the adoption of ASU 2009-17 (i.e., if the initial adoption of ASU 2009-17 for an entity does not result in the consolidation of a previously unconsolidated entity or the deconsolidation of a previously consolidated entity), the reporting entity would not need to perform the remaining step (step 4) of this analysis for that entity. However, the reporting entity would need to assess the disclosure requirements in ASC 810-10-50 if that entity is a VIE as of the adoption date and the reporting entity holds a variable interest. If, after applying the guidance in steps 1–3 to an entity, a reporting entity reaches a consolidation conclusion different from its consolidation conclusion for that entity before the adoption of ASU 2009-17 (i.e., if the initial adoption of ASU 2009-17 results in consolidation of a previously unconsolidated entity or deconsolidation of a previously consolidated entity as of the adoption date), the reporting entity must, under ASC 810-10-65-2(b), (c), and (e), measure the components of that newly consolidated entity or any retained interest in that newly deconsolidated entity at their carrying amounts as of the adoption date. To determine carrying amounts for newly consolidated or deconsolidated entities, a reporting entity will need to proceed to step 4. Step 4: A reporting entity must determine the amounts of the assets, liabilities, and noncontrolling interests of the newly consolidated entity, or the amount of any retained interests in the newly deconsolidated entity, that would have been recorded in the reporting entity’s financial statements as of the adoption date, as if ASU 2009-17 had been effective as of the date of the reporting entity’s initial involvement with the entity or the most recent date on which the primary-beneficiary conclusion would have changed (i.e., the same primary-beneficiary date identified in step 3 above). These amounts are the carrying amounts referred to in ASU 2009-17. Any difference between the net amount added (for consolidating reporting entities) or removed (for deconsolidating reporting entities) from the reporting entity’s balance sheet and the amount of any previously recognized interest or retained interest is recognized as a cumulative-effect adjustment to retained earnings. Note: ASU 2009-17 indicates that if, at transition, it is not practicable for a reporting entity to obtain the information to make the determinations in steps 2 and 3 above, the reporting entity should make those determinations on the date that ASU 2009-17 is first applied. In such cases, the primary beneficiary would be required to measure the elements of the VIE at fair value as of the adoption date. In addition, if it is not practicable for a reporting entity to determine carrying amounts, as discussed in step 4 above, the reporting entity would be required to measure the elements of the VIE at fair value as of the adoption date. For certain securitization entities in the aforementioned impracticable situations, the reporting entity would also have the alternative to measure certain amounts of the entity at their unpaid principal balances as of the adoption date, as discussed in ASC 81010-65-2(b) and (c) and ASC 810-10-65-2(f) through (h). In addition, ASC 810-10-65-2(d) provides guidance on a reporting entity’s ability to elect the FVO when it is required to consolidate an entity as a result of the initial adoption of ASU 2009-17. The following example illustrates the application of steps 1–4 above:

Example 1
Enterprise A is a calendar-year-end enterprise that initially became involved with Entity X by acquiring a variable interest in X (a VIE) on March 1, 2003. Assume that before adopting ASU 2009-17, A was not the primary beneficiary and therefore did not consolidate X under the VIE model in ASC 810-10 (i.e., A did not consolidate X as of December 31, 2009). Since the date of its initial involvement with X, various changes in facts and circumstances have occurred that would have required reconsideration of A’s consolidation analysis under ASU 2009-17. Upon adopting ASU 2009-17, A determines that X was a VIE as of September 15, 2007 (i.e., the most recent date on which a VIE reconsideration event under ASC 810-10-35-4 occurred and the entity’s VIE status changed). Enterprise A also made the following determinations regarding its primary-beneficiary status:

187

Description Date of first involvement with entity Change in facts and circumstances and VIE reconsideration event under ASC 810-10-35-4 Change in facts and circumstances and VIE reconsideration event under ASC 810-10-35-4 Adoption date of ASU 2009-17

Date March 1, 2003 July 15, 2006 September 15, 2007 January 1, 2010

VIE and Primary Beneficiary Status under ASU 2009-17 VIE/primary beneficiary Not VIE/not primary beneficiary VIE/primary beneficiary VIE/primary beneficiary

The initial measurement of the carrying amounts of the VIE would occur as of September 15, 2007, because that was the most recent date on which a change in facts and circumstances would have changed A’s primarybeneficiary conclusions under the VIE model in ASC 810-10, as amended by ASU 2009-17. Enterprise A would then need to adjust those amounts as if X had been a consolidated entity from September 15, 2007, through the adoption date of ASU 2009-17 (which, in this example, is January 1, 2010). Those adjusted amounts (the carrying amounts) would be recorded in A’s financial statements as of January 1, 2010. Any difference between those amounts added to the balance sheet and the amount of any previously recognized interest related to X would be recognized as a cumulative-effect adjustment to retained earnings.

Example 2
Enterprise A initially became involved in X by acquiring a variable interest in X (a VIE) on March 1, 2003. Assume that before adopting ASU 2009-17, A was the primary beneficiary and therefore consolidated X under the VIE model in ASC 810-10 (i.e., A consolidated X as of December 31, 2009). Since the date of its initial involvement with X, various changes in facts and circumstances have occurred that would have required reconsideration of A’s consolidation analysis under the VIE model in ASC 810-10, as amended by ASU 2009-17. Upon adopting ASU 2009-17, A determines that X was a VIE as of March 1, 2003 (i.e., the date A first became involved with the entity). Although reconsideration events under ASC 810-10-35-4 have occurred since the date of A’s initial involvement with X, none of those reconsideration events would have changed X’s VIE status; thus, the date of initial involvement is used to determine X’s VIE status. Enterprise A also made the following determinations regarding its primary-beneficiary status:
Description Date of first involvement with entity Change in facts and circumstances and VIE reconsideration event under ASC 810-10-35-4 Adoption date of ASU 2009-17 Date March 1, 2003 September 15, 2007 January 1, 2010 VIE and Primary Beneficiary Status under ASU 2009-17 VIE/primary beneficiary VIE/not primary beneficiary VIE/not primary beneficiary

The initial measurement of A’s retained interest in the VIE would occur as of September 15, 2007, because that was the most recent date on which a change in facts and circumstances would have changed A’s primarybeneficiary conclusion (the VIE conclusion did not change and therefore has no effect on the analysis). Enterprise A would then need to adjust that amount on the basis of how it would have accounted for its retained interest in X if X had not been consolidated from September 15, 2007, through the adoption date of ASU 2009-17 (which, in this example, is January 1, 2010). That adjusted amount (the carrying amount) would be recorded in A’s financial statements as of January 1, 2010. Any difference between that amount and the amounts derecognized from the balance sheet would be recognized as a cumulative-effect adjustment to retained earnings.

188

Appendix A — Implementation Guidance
ASC 810-10
Identifying Variable Interests 55-16 The Variable Interest Entities Subsections provide guidance for identifying entities for which analysis of voting interests, and the holdings of those voting interests, is not effective in determining whether a controlling financial interest exists because the holders of the equity investment at risk do not have sufficient equity at risk for the legal entity to finance its activities without additional subordinated financial support or because they lack any of the following: a. b. c. The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s 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.

Those entities are called variable interest entities (VIEs). The Variable Interest Entities Subsections also provide guidance for determining whether a reporting entity shall consolidate a VIE. A reporting entity that consolidates a VIE is called the primary beneficiary of that VIE. This Subsection provides guidance for identifying variable interests in a VIE. [Paragraph B1] 55-17 The identification of variable interests requires an economic analysis of the rights and obligations of a legal entity’s assets, liabilities, equity, and other contracts. Variable interests are contractual, ownership, or other pecuniary interests in a legal entity that change with changes in the fair value of the legal entity’s net assets exclusive of variable interests. The Variable Interest Entities Subsections use the terms expected losses and expected residual returns to describe the expected variability in the fair value of a legal entity’s net assets exclusive of variable interests. [Paragraph B2] 55-18 For a legal entity that is not a VIE (sometimes called a voting interest entity), all of the legal entity’s assets, liabilities, and other contracts are deemed to create variability, and the equity investment is deemed to be sufficient to absorb the expected amount of that variability. In contrast, VIEs are designed so that some of the entity’s assets, liabilities, and other contracts create variability and some of the entity’s assets, liabilities, and other contracts (as well as its equity at risk) absorb or receive that variability. [Paragraph B3] 55-19 The identification of variable interests involves determining which assets, liabilities, or contracts create the legal entity’s variability and which assets, liabilities, equity, and other contracts absorb or receive that variability. The latter are the legal entity’s variable interests. The labeling of an item as an asset, liability, equity, or as a contractual arrangement does not determine whether that item is a variable interest. It is the role of the item—to absorb or receive the legal entity’s variability—that distinguishes a variable interest. That role, in turn, often depends on the design of the legal entity. [Paragraph B4] 55-20 Paragraphs 810-10-55-16 through 55-41 describe examples of variable interests in VIEs subject to the Variable Interest Entities Subsections. These paragraphs are not intended to provide a complete list of all possible variable interests. In addition, the descriptions are not intended to be exhaustive of the possible roles, and the possible variability, of the assets, liabilities, equity, and other contracts. Actual instruments may play different roles and be more or less variable than the examples discussed. 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. [Paragraph B5] 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 810-10-2555 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. [Paragraph B6]

189

ASC 810-10 (continued)
Equity Investments, Beneficial Interests, and Debt Instruments 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 VIE’s 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 investor’s 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. [Paragraph B7] 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 entity’s 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. [Paragraph B8] 55-24 Any of a VIE’s liabilities may be variable interests because a decrease in the fair value of a VIE’s 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 VIE’s 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 VIE’s 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. [Paragraph B9] Guarantees, Written Put Options, and Similar Obligations 55-25 Guarantees of the value of the assets or liabilities of a VIE, written put options on the assets of the VIE, or similar obligations such as some liquidity commitments or agreements (explicit or implicit) to replace impaired assets held by the VIE are variable interests if they protect holders of other interests from suffering losses. To the extent the counterparties of guarantees, written put options, or similar arrangements will be called on to perform in the event expected losses occur, those arrangements are variable interests, including fees or premiums to be paid to those counterparties. The size of the premium or fee required by the counterparty to such an arrangement is one indication of the amount of risk expected to be absorbed by that counterparty. [Paragraph B10] 55-26 If the VIE is the writer of a guarantee, written put option, or similar arrangement, the items usually would create variability. Thus, those items usually will not be a variable interest of the VIE (but may be a variable interest in the counterparty). [Paragraph B11] Forward Contracts 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 VIE’s 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. [Paragraph B12] 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. [Paragraph B13] Other Derivative Instruments 55-29 Derivative instruments held or written by a VIE shall be analyzed in terms of their option-like, forward-like, 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. [Paragraph B14] 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. [Paragraph B15] 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. [Paragraph B16] Assets of the Entity 55-32 Assets held by a VIE almost always create variability and, thus, are not variable interests. However, as discussed separately in this Subsection, assets of the VIE that take the form of derivatives, guarantees, or other similar contracts may be variable interests. [Paragraph B17]

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ASC 810-10 (continued)
Fees Paid to Decision Makers or Service Providers 55-37 Fees paid to a legal entity’s decision maker(s) or service provider(s) are not variable interests if all of the following conditions are met: a. b. c. The fees are compensation for services provided and are commensurate with the level of effort required to provide those services. Substantially all of the fees are at or above the same level of seniority as other operating liabilities of the VIE that arise in the normal course of the VIE’s activities, such as trade payables. The decision maker or service provider does not hold other interests in the VIE that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE’s expected losses or receive more than an insignificant amount of the VIE’s expected residual returns. The service arrangement includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arm’s length. The total amount of anticipated fees are insignificant relative to the total amount of the VIE’s anticipated economic performance. The anticipated fees are expected to absorb an insignificant amount of the variability associated with the VIE’s anticipated economic performance. [Paragraph B22]

d. e. f.

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 entity’s decision maker(s) or service provider(s) should be treated as though it is the decision maker’s or service provider’s own interest. For that purpose, a related party includes any party identified in paragraph 810-10-25-43 other than: a. b. 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. [ASU 2010-10]

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. [Paragraph B23] Operating Leases 55-39 Receivables under an operating lease are assets of the lessor entity and provide returns to the lessor entity with respect to the leased property during that portion of the asset’s life that is covered by the lease. Most operating leases do not absorb variability in the fair value of a VIE’s net assets because they are a component of that variability. Guarantees of the residual values of leased assets (or similar arrangements related to leased assets) and options to acquire leased assets at the end of the lease terms at specified prices may be variable interests in the lessor entity if they meet the conditions described in paragraphs 810-10-25-55 through 25-56. Alternatively, such arrangements may be variable interests in portions of a VIE as described in paragraph 810-10-25-57. The guidance in paragraphs 810-10-55-23 through 55-24 related to debt instruments applies to creditors of lessor entities. [Paragraph B24] Variable Interest of One VIE in Another VIE 55-40 One VIE is the primary beneficiary of another VIE if it meets the conditions in paragraph 810-10-25-38A. A VIE that is the primary beneficiary of a second VIE will consolidate that second VIE. If another reporting entity consolidates the first VIE, that reporting entity’s consolidated financial statements include the second VIE because the second VIE had already been consolidated by the first. For example, if Entity A (a VIE) is the primary beneficiary of Entity B (a VIE), Entity A consolidates Entity B. If Entity C is the primary beneficiary of Entity A, Entity C consolidates Entity A, and Entity C’s consolidated financial statements include Entity B because Entity A has consolidated Entity B. [Paragraph B25] 55-41 A transferor’s interests in financial assets in a VIE is a variable interest in the transferee entity but it is not a variable interest in a second VIE to which the transferee issues a beneficial interest. The following illustrates this point: a. b. c. Entity A transfers financial assets to VIE B (a VIE that holds no other assets), retains a subordinated beneficial interest, and reports the transfer as a sale under the provisions of Topic 860. VIE B issues all of its senior beneficial interests in the transferred assets to VIE C. VIE C issues various types of interests in return for cash and uses the cash to pay VIE B. VIE B uses the cash received from VIE C to pay Entity A. Entity A’s subordinated beneficial interest is a variable interest in VIE B, but neither VIE B nor Entity A has a variable interest in VIE C. [Paragraph B26]

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Example 5: Identifying a Primary Beneficiary 55-93 The following cases are provided solely to illustrate the application of the guidance in paragraphs 810-10-25-38A through 25-38G related to the identification of a primary beneficiary: a. b. c. d. e. f. g. h. i. Commercial mortgage-backed securitization (Case A) Asset-backed collateralized debt obligation (Case B) Structured investment vehicle (Case C) Commercial paper conduit (Case D) Guaranteed mortgage-backed securitization (Case E) Residential mortgage-backed securitization (Case F) Property lease entity (Case G) Collaboration—Joint venture arrangement (Case H) Furniture manufacturing entity (Case I).

55-94 The identification of a primary beneficiary, if any, in Cases A-I is based solely on the specific facts and circumstances presented. These Cases are hypothetical and are not meant to represent actual transactions in the marketplace. Although certain aspects of the Cases may be present in actual fact patterns, all relevant facts and circumstances of a specific fact pattern or structure would need to be evaluated to reach an accounting conclusion. All of the Cases share the following assumptions: a. b. All the entities are presumed to be VIEs. All variable interests are presumed to be variable interests in the VIE as a whole, rather than variable interests in specified assets of the VIE, on the basis of the guidance in paragraphs 810-10-25-55 through 25-59.

55-95 In some Cases, certain fees are described as representing, or not representing, a variable interest on the basis of paragraphs 810-10-55-37 through 55-38. However, the Cases were not meant to illustrate the application of the guidance in those paragraphs, and additional facts would be necessary to determine which condition(s) resulted in the fee representing a variable interest. Finally, determining the primary beneficiary in accordance with the guidance in the Variable Interest Entities Subsections requires judgment and is on the basis of individual facts and circumstances of the VIE and the reporting entity with the variable interest or interests. Case A: Commercial Mortgage-Backed Securitization [Appendix C — Example 1] 55-96 A VIE is created and financed with $94 of investment grade 7-year fixed-rate bonds (issued in 3 tranches) and $6 of equity. All of the bonds are held by third-party investors. The equity is held by a third party, who is also the special servicer. The equity tranche was designed to absorb the first dollar risk of loss and to receive any residual return from the VIE. The VIE uses the proceeds to purchase $100 of BB-rated fixed-rate commercial mortgage loans with contractual maturities of 7 years from a transferor. The commercial mortgage loans contain provisions that require each borrower to pay the full scheduled interest and principal if the loan is extinguished prior to maturity. The transaction was marketed to potential bondholders as an investment in a portfolio of commercial mortgage loans with exposure to the credit risk associated with the possible default by the borrowers. 55-97 Each month, interest received from all of the pooled loans is paid to the investors in the fixed-rate bonds, in order of seniority, until all accrued interest on those bonds is paid. The same distribution occurs when principal payments are received. 55-98 If there is a shortfall in contractual payments from the borrowers or if the loan collateral is liquidated and does not generate sufficient proceeds to meet payments on all bond classes, the equity tranche and then the most subordinate bond class will incur losses, with further losses impacting more senior bond classes in reverse order of priority. 55-99 The transferor retains the primary servicing responsibilities. The primary servicing activities performed 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 as the primary servicer to the special servicer. Furthermore, the special servicer, as the equity holder, has the approval rights for budgets, leases, and property managers of foreclosed properties. 55-100 The special servicer is involved in the creation of the VIE and required at the creation date that certain loans, which it deemed to be of high risk, be removed from the initial pool of loans that were going to be purchased by the VIE from the transferor. The special servicer also reviewed the VIE’s governing documents to ensure that the special servicer would be allowed to act quickly and effectively in situations in which a loan becomes delinquent. The special servicer concluded the VIE’s governing documents allowed the special servicer to adequately monitor and direct the performance of the underlying loans. 55-101 For its services as primary servicer, the transferor earns a fixed fee, calculated as a percentage of the unpaid principal balance on the underlying loans. The special servicer also earns a fixed fee, calculated as a percentage of the unpaid principal balance on the underlying loans. No party has the ability to remove the primary servicer or the special servicer.

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55-102 To evaluate the facts and circumstances and determine which reporting entity, if any, is the primary beneficiary of a VIE, paragraph 810-10-25-38A requires that a reporting entity determine the purpose and design of the VIE, including the risks that the VIE was designed to create and pass through to its variable interest holders. In making this assessment, the variable interest holders of the VIE determined the following: a. b. The primary purposes for which the VIE was created were to provide liquidity to the transferor to originate additional loans and to provide investors with the ability to invest in a pool of commercial mortgage loans. The VIE was marketed to debt investors as a VIE 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. Additionally, the marketing of the transaction indicated that such risks would be mitigated by subordination of the equity tranche. The VIE is not exposed to prepayment risk because the commercial mortgage loans contain provisions that require the borrower to pay the full scheduled interest and principal if the loan is extinguished prior to maturity.

c.

55-103 The special servicer and the bondholders are the variable interest holders in the VIE. The fees paid to the transferor do not represent a variable interest on the basis of a consideration of the conditions in paragraphs 810-10-55-37 through 55-38. The fees paid to the special servicer represent a variable interest on the basis of a consideration of the conditions in those paragraphs. 55-104 Paragraph 810-10-25-38B requires that a reporting entity identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The economic performance of the VIE is most significantly impacted by the performance of its underlying assets. Thus, the activities that most significantly impact the VIE’s economic performance are the activities that most significantly impact the performance of the underlying assets. The special servicer has the ability to manage the VIE’s assets that are delinquent or in default to improve the economic performance of the VIE. Additionally, the special servicer, as the equity holder, can approve budgets, leases, and property managers on foreclosed property. The special servicing activities are performed only upon delinquency or default of the underlying assets. However, a reporting entity’s ability to direct the activities of a VIE 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. The special servicer’s involvement in the design of the VIE does not, in isolation, result in the special servicer being the primary beneficiary of the VIE. However, in this situation, that involvement indicated that the special servicer had the opportunity and the incentive to establish arrangements that result in the special servicer being the variable interest holder with the power to direct the activities that most significantly impact the VIE’s economic performance. 55-105 The bondholders of the VIE have no voting rights and no other rights that provide them with the power to direct the activities that most significantly impact the VIE’s economic performance. 55-106 The activities that the primary servicer has the power to direct are administrative in nature and do not most significantly impact the VIE’s economic performance. In addition, the primary servicer, and its related parties, do not hold a variable interest in the VIE. Thus, the primary servicer cannot be the primary beneficiary of the VIE. 55-107 If a reporting entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, then under the requirements of paragraph 810-10-25-38A, that reporting entity also is required to determine whether it has 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. 55-108 The special servicer, for its servicing activities, receives a fixed fee that provides it with the right to receive benefits of the VIE. The special servicer concluded that the benefits could not potentially be significant to the VIE. The special servicer, as the equity tranche holder, has the obligation to absorb losses and the right to receive benefits, either of which could potentially be significant to the VIE. As equity tranche holder, the special servicer is the most subordinate tranche and therefore absorbs the first dollar risk of loss and has the right to receive benefits, including the VIE’s actual residual returns, if any. 55-109 On the basis of the specific facts and circumstances presented in this Case and the analysis performed, the special servicer would be deemed to be the primary beneficiary of the VIE because: a. b. It is the variable interest holder with the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. As the equity tranche holder, it has the obligation to absorb losses of the VIE and the right to receive benefits from the VIE, either of which could potentially be significant to the VIE.

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Case B: Asset-Backed Collateralized Debt Obligation [Appendix C — Example 2] 55-110 A VIE is created and financed with $90 of AAA-rated fixed-rate debt securities, $6 of BB-rated fixed-rate debt securities, and $4 of equity. All debt securities issued by the VIE are held by third-party investors. The equity tranche is held 35 percent by the manager of the VIE and 65 percent by a third-party investor. The VIE uses the proceeds to purchase a portfolio of asset-backed securities with varying tenors and interest rates. 55-111 The transaction 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 management of the portfolio. The equity tranche was designed to absorb the first dollar risk of loss related to credit risk and interest rate risk and to receive any residual returns from a favorable change in interest rates or credit risk that affects the proceeds received on the sale of investments in the portfolio. 55-112 The assets of the VIE are managed within the parameters established by the underlying trust documents. The parameters provide the manager with the latitude to manage the VIE’s assets while maintaining an average portfolio rating of single B-plus or higher. If the average rating of the portfolio declines, the VIE’s governing documents require that the manager’s discretion in managing the portfolio be curtailed. 55-113 For its services, the manager earns a base, fixed fee and a performance fee in which it receives a portion of the VIE’s profit above a targeted return. The manager can be removed, without cause, by a simple majority decision of the AAA-rated debt holders. As the debt of the entity is widely disbursed, no one party has the ability to unilaterally remove the manager. If removal of the manager occurs, the manager will continue to hold a 35 percent equity interest in the VIE. 55-114 The third-party equity investor has rights that are limited to administrative matters. 55-115 To evaluate the facts and circumstances and determine which reporting entity, if any, is the primary beneficiary of a VIE, paragraph 810-10-25-38A requires that a reporting entity determine the purpose and design of the VIE, including the risks that the VIE was designed to create and pass through to its variable interest holders. In making this assessment, the variable interest holders of the VIE determined the following: a. The primary purposes for which the VIE was created were to provide investors with the ability to invest in a pool of asset-backed securities, to earn a positive spread between the interest that the VIE earns on its portfolio and the interest paid to the debt investors, and to generate management fees for the manager. The transaction 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 management of the portfolio. Additionally, the marketing of the transaction indicated that such risks would be mitigated by the support from the equity tranche. The equity tranche was designed to absorb the first dollar risk of loss related to credit risk and interest rate risk and to receive any residual returns from a favorable change in interest rates or credit risk that affects the proceeds received on the sale of asset-backed securities in the portfolio.

b.

c.

55-116 The third-party debt investors, the third-party equity investor, and the manager are the variable interest holders in the VIE. The fees paid to the manager represent a variable interest on the basis of a consideration of the conditions in paragraphs 810-10-55-37 through 55-38. 55-117 Paragraph 810-10-25-38B requires that a reporting entity identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The economic performance of the VIE is most significantly impacted by the performance of the VIE’s portfolio of assets. Thus, the activities that most significantly impact the VIE’s economic performance are the activities that most significantly impact the performance of the portfolio of assets. The manager has the ability to manage the VIE’s assets within the parameters of the trust documents. If the average rating of the portfolio declines, the VIE’s governing documents require that the manager’s discretion in managing the portfolio be curtailed. Although the AAA-rated debt holders can remove the manager without cause, no one party has the unilateral ability to exercise the kick-out rights over the manager. Therefore, such kick-out rights would not be considered in this primary beneficiary analysis. 55-118 The debt holders of the VIE do not have voting rights or other rights that provide them with the power to direct activities that most significantly impact the VIE’s economic performance. Although the AAA-rated debt holders can remove the manager without cause, no one party has the unilateral ability to exercise the kick out rights over the manager. 55-119 The third-party equity investor has the power to direct certain activities. However, the activities that the third-party equity investor has the power to direct are administrative and do not most significantly impact the VIE’s economic performance.

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55-120 If a reporting entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, then under the requirements of paragraph 810-10-25-38A, that reporting entity also is required to determine whether it has 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. The manager, as the 35 percent equity tranche holder, has the obligation to absorb losses and the right to receive benefits. As equity tranche holder, the manager has the most subordinate tranche and therefore absorbs 35 percent of the first dollar risk of loss and has the right to receive 35 percent of any residual benefits. Furthermore, the manager receives a performance-based fee that provides it with the right to receive benefits of the VIE. Through the equity interest and performance-based fee, the manager has the obligation to absorb losses of the VIE that could potentially be significant to the VIE and the right to receive benefits from the VIE that could potentially be significant to the VIE. 55-121 On the basis of the specific facts and circumstances presented in this Case and the analysis performed, the manager would be deemed to be the primary beneficiary of the VIE because: a. b. It is the variable interest holder with the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance (and no single entity has the unilateral ability to exercise kick-out rights). Through its equity interest and performance-based fee, it has the obligation to absorb losses of the VIE that could potentially be significant to the VIE and the right to receive benefits from the VIE that could potentially be significant to the VIE.

Case C: Structured Investment Vehicle [Appendix C — Example 3] 55-122 A VIE is created and financed with $94 of AAA-rated fixed-rate short-term debt with a 6-month maturity and $6 of equity. The VIE uses the proceeds to purchase a portfolio of floating-rate debt with an average life of four years and varying interest rates and short-term deposits with highly rated banks. The short-term debt securities and equity are held by multiple third-party investors. Upon maturity of the short-term debt, the VIE will either refinance the debt with existing investors or reissue the debt to new investors at existing market rates. 55-123 The primary purpose of the VIE is to generate profits by maximizing the spread it earns on its asset portfolio and its weighted-average cost of funding. The transaction was marketed to potential debt investors as an investment in a portfolio of high-quality debt with exposure to the credit risk associated with the possible default by the issuers of the debt in the portfolio. The equity tranche is designed to absorb the first dollar risk of loss related to credit, liquidity, market value, and interest rate risk and to receive any benefit from a favorable change in credit, market value, and interest rates. 55-124 The VIE is exposed to liquidity risk because the average tenor of the assets is greater than its liabilities. To mitigate liquidity risk, the VIE maintains a certain portion of its assets in short-term deposits with highly rated banks. The VIE has not entered into a liquidity facility to further mitigate liquidity risk. 55-125 The sponsor of the VIE was significantly involved with the creation of the VIE. The sponsor performs various functions to manage the operations of the VIE, which include: a. Investment management—This management must adhere to the investment guidelines established at inception of the VIE. These guidelines include descriptions of eligible investments and requirements regarding the composition of the credit portfolio (including limits on country risk exposures, diversification limits, and ratings requirements). Funding management—This function provides funding management and operational support in relation to the debt issued and the equity with the objective of minimizing the cost of borrowing, managing interest rate and liquidity risks, and managing the capital adequacy of the VIE. Defeasance management—An event of defeasance occurs upon the failure of the rating agencies to maintain the ratings of the debt securities issued by the VIE at or above certain specified levels. In the event of defeasance, the sponsor is responsible for overseeing the orderly liquidation of the investment portfolio and the orderly discharge of the VIE’s obligations. This includes managing the market and credit risks of the portfolio. [FIN 46(R), paragraph Cn31]

b.

c.

55-126 For its services, the sponsor receives a fixed fee, calculated as an annual percentage of the aggregate equity outstanding, and a performance-based fee, calculated as a percentage of the VIE’s profit above a targeted return. 55-127 The debt security holders of the VIE have no voting rights. The equity holders have limited voting rights that are typically limited to voting on amendments to the constitutional documents of the VIE.

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55-128 To evaluate the facts and circumstances and determine which reporting entity, if any, is the primary beneficiary of a VIE, paragraph 810-10-25-38A requires that a reporting entity determine the purpose and design of the VIE, including the risks that the VIE was designed to create and pass through to its variable interest holders. In making this assessment, the variable interest holders of the VIE determined the following: a. The primary purposes for which the VIE was created were to provide investors with the ability to invest in a pool of high-quality debt, to maximize the spread it earns on its asset portfolio over its weighted-average cost of funding, and to generate management fees for the sponsor. The transaction was marketed to potential debt investors as an investment in a portfolio of high-quality debt with exposure to the credit risk associated with the possible default by the issuers of the debt in the portfolio. The equity tranche is negotiated to absorb the first dollar risk of loss related to credit, liquidity, market value, and interest rate risk and to receive a portion of the benefit from a favorable change in credit, market value, and interest rates. The principal risks to which the VIE is exposed include credit, interest rate, and liquidity risk.

b. c.

d.

55-129 The third-party debt investors, the third-party equity investors, and the sponsor are the variable interest holders in the VIE. The fees paid to the sponsor represent a variable interest on the basis of a consideration of the conditions in paragraphs 810-10-55-37 through 55-38. 55-130 Paragraph 810-10-25-38B requires that a reporting entity identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The economic performance of the VIE is significantly impacted by the performance of the VIE’s portfolio of assets and by the terms of the short-term debt. Thus, the activities that significantly impact the VIE’s economic performance are the activities that significantly impact the performance of the portfolio of assets and the terms of the short-term debt (when the debt is refinanced or reissued). The sponsor manages the VIE’s investment, funding, and defeasance activities. The fact that the sponsor was significantly involved with the creation of the VIE does not, in isolation, result in the sponsor being the primary beneficiary of the VIE. However, the fact that the sponsor was involved with the creation of the VIE indicated that the sponsor had the opportunity and the incentive to establish arrangements that result in the sponsor being the variable interest holder with the power to direct the activities that most significantly impact the VIE’s economic performance. 55-131 The debt security holders of the VIE have no voting rights and no other rights that provide them with the power to direct the activities that most significantly impact the VIE’s economic performance. Although the equity holders have voting rights, they are limited to voting on amendments to the constitutional documents of the VIE, and those rights do not provide the equity holders with the power to direct the activities that most significantly impact the VIE’s economic performance. 55-132 If a reporting entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, then under the requirements of paragraph 810-10-25-38A, that reporting entity also is required to determine whether it has 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. The sponsor, through its performance-based fee arrangement, receives benefits that could potentially be significant to the VIE. As the entity is designed to earn a spread between the returns on the assets and the liabilities, the sponsor receives a significant portion of the primary benefit the VIE was designed to create. The sponsor also considered whether it had an implicit financial responsibility to ensure that the VIE operates as designed. The sponsor determined that it has an implicit financial responsibility and that such obligation could potentially be significant. This determination was influenced by the sponsor’s concern regarding the risk to its reputation in the marketplace if the VIE did not operate as designed. 55-133 On the basis of the specific facts and circumstances presented in this Case and the analysis performed, the sponsor would be deemed to be the primary beneficiary of the VIE because: a. b. It is the variable interest holder with the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Through its performance-based fee arrangement and implicit financial responsibility to ensure that the VIE operates as designed, it has the obligation to absorb losses of the VIE that could potentially be significant to the VIE and the right to receive benefits from the VIE that could potentially be significant to the VIE.

Case D: Commercial Paper Conduit [Appendix C — Example 4] 55-134 A VIE is created by a reporting entity (the sponsor) and financed with $98 of AAA-rated fixed-rate short-term debt with a 3-month maturity and $2 of subordinated notes. The VIE uses the proceeds to purchase a portfolio of mediumterm assets with average tenors of three years. The asset portfolio is obtained from multiple sellers. The short-term debt and subordinated notes are held by multiple third-party investors. Upon maturity of the short-term debt, the VIE will either refinance the debt with existing investors or reissue the debt to new investors.

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55-135 The sponsor of the VIE provides credit enhancement in the form of a letter of credit equal to 5 percent of the VIE’s assets and it provides a liquidity facility to fund the cash flow shortfalls on 100 percent of the short-term debt. Cash flow shortfalls could arise due to a mismatch between collections on the underlying assets of the VIE and payments due to the shortterm debt holders or to the inability of the VIE to refinance or reissue the short-term debt upon maturity. 55-136 a. b. c. A credit default of the VIE’s assets resulting in deficient cash flows is absorbed as follows: First by the subordinated note holders Second by the sponsor’s letter of credit Third by the short-term debt holders.

The sponsor’s liquidity facility does not advance against defaulted assets. [FIN 46(R), paragraph Cn42] 55-137 The VIE is exposed to liquidity risk because the average life of the assets is greater than that of its liabilities. The VIE enters into a liquidity facility with the sponsor to mitigate liquidity risk. 55-138 The transaction was marketed to potential debt investors as an investment in a portfolio of highly rated mediumterm assets with minimal exposure to the credit risk associated with the possible default by the issuers of the assets in the portfolio. The subordinated notes were designed to absorb the first dollar risk of loss related to credit. The VIE is marketed to all investors as having a low probability of credit exposure due to the nature of the assets obtained. Furthermore, the VIE is marketed to the short-term debt holders as having protection from liquidity risk due to the liquidity facility provided by the sponsor. 55-139 a. b. c. d. e. The sponsor of the VIE performs various functions to manage the operations of the VIE. Specifically, the sponsor: Establishes the terms of the VIE Approves the sellers permitted to sell to the VIE Approves the assets to be purchased by the VIE Makes decisions regarding the funding of the VIE including determining the tenor and other features of the shortterm debt issued Administers the VIE by monitoring the assets, arranging for debt placement, compiling monthly reports, and ensuring compliance with the VIE’s credit and investment policies.

55-140 For providing credit and liquidity facilities and management services, the sponsor receives a fixed fee calculated as an annual percentage of the asset value. [FIN 46(R), paragraph Cn46] The short-term debt holders and subordinated note holders have no voting rights. 55-141 To evaluate the facts and circumstances and determine which reporting entity, if any, is the primary beneficiary of a VIE, paragraph 810-10-25-38A requires that a reporting entity determine the purpose and design of the VIE, including the risks that the VIE was designed to create and pass through to its variable interest holders. In making this assessment, the variable interest holders of the VIE determined the following: a. The primary purposes for which the VIE was created were to provide investors with the ability to invest in a pool of highly rated medium-term assets, to provide the multiple sellers to the VIE with access to lower-cost funding, to earn a positive spread between the interest that the VIE earns on its asset portfolio and its weighted-average cost of funding, and to generate fees for the sponsor. The transaction was marketed to potential debt investors as an investment in a portfolio of highly rated medium-term assets with minimal exposure to the credit risk associated with the possible default by the issuers of the assets in the portfolio. The subordinated debt is designed to absorb the first dollar risk of loss related to credit and interest rate risk. The VIE is marketed to all investors as having a low probability of credit loss due to the nature of the assets obtained. Furthermore, the VIE is marketed to the short-term debt holders as having protection from liquidity risk due to the liquidity facility provided by the sponsor. The principal risks to which the VIE is exposed include credit, interest rate, and liquidity.

b.

c.

55-142 The short-term debt holders, the third-party subordinated note holders, and the sponsor are the variable interest holders in the VIE. The fees paid to the sponsor represent a variable interest on the basis of a consideration of the conditions in paragraphs 810-10-55-37 through 55-38.

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55-143 Paragraph 810-10-25-38B requires that a reporting entity identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The economic performance of the VIE is significantly impacted by the performance of the VIE’s portfolio of assets and by the terms of the short-term debt. Thus, the activities that significantly impact the VIE’s economic performance are the activities that significantly impact the performance of the portfolio of assets and the terms of the short-term debt (when the debt is refinanced or reissued). The sponsor manages the operations of the VIE. Specifically, the sponsor establishes the terms of the VIE, approves the sellers permitted to sell to the VIE, approves the assets to be purchased by the VIE, makes decisions about the funding of the VIE including determining the tenor and other features of the short-term debt issued, and administers the VIE by monitoring the assets, arranging for debt placement, and ensuring compliance with the VIE’s credit and investment policies. The fact that the sponsor was significantly involved with the creation of the VIE does not, in isolation, result in the sponsor being the primary beneficiary of the VIE. However, the fact that the sponsor was involved with the creation of the VIE may indicate that the sponsor had the opportunity and the incentive to establish arrangements that result in the sponsor being the variable interest holder with the power to direct the activities that most significantly impact the VIE’s economic performance. 55-144 The short-term debt holders and subordinated note holders of the VIE have no voting rights and no other rights that provide them with power to direct the activities that most significantly impact the VIE’s economic performance. 55-145 If a reporting entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, then under the requirements of paragraph 810-10-25-38A, that reporting entity also is required to determine whether it has 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. The sponsor, through its fee arrangement, receives benefits from the VIE that could potentially be significant to the VIE. The sponsor, through its letter of credit and liquidity facility, also has the obligation to absorb losses of the VIE that could potentially be significant to the VIE. 55-146 On the basis of the specific facts and circumstances presented in this Case and the analysis performed, the sponsor would be deemed to be the primary beneficiary of the VIE because: a. b. It is the variable interest holder with the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Through its letter of credit and liquidity facility, the sponsor has the obligation to absorb losses that could potentially be significant to the VIE, and, through its fee arrangement, the sponsor has the right to receive benefits that could potentially be significant to the VIE.

Case E: Guaranteed Mortgage-Backed Securitization [Appendix C — Example 5] 55-147 A VIE is created and financed with $100 of a single class of investment-grade 30-year fixed-rate debt securities. The VIE uses the proceeds to purchase $100 of 30-year fixed-rate residential mortgage loans from the transferor. The VIE enters into a guarantee facility that absorbs 100 percent of the credit losses incurred on the VIE’s assets. The assets acquired by the VIE are underwritten by the transferor in accordance with the parameters established by the guarantor. Additionally, all activities of the VIE are prespecified by the trust agreement and servicing guide, which are both established by the guarantor. No critical decisions are generally required for the VIE unless default of an underlying asset is reasonably foreseeable or occurs. 55-148 The transaction was marketed to potential debt security holders as an investment in a portfolio of residential mortgage loans with exposure to the credit risk of the guarantor and to the prepayment risk associated with the underlying loans of the VIE. Each month, the security holders receive interest and principal payments in proportion to their percentage ownership of the underlying loans. 55-149 If there is a shortfall in contractually required loan payments from the borrowers or if the loan is foreclosed on and the liquidation of the underlying property does not generate sufficient proceeds to meet the required payments on all securities, the guarantor will make payments to the debt securities holders to ensure timely payment of principal and accrued interest on the debt securities. 55-150 The guarantor also serves as the master servicer for the VIE. As master servicer, the guarantor services the securities issued by the VIE. Generally, if a mortgage loan is 120 days (or 4 consecutive months) delinquent, and if other circumstances are met, the guarantor has the right to buy the loan from the VIE. The master servicer can only be removed for a material breach in its obligations. As compensation for the guarantee and services provided, the guarantor receives a fee that is calculated monthly as a percentage of the unpaid principal balance on the underlying loans. 55-151 As master servicer, the guarantor also is responsible for supervising and monitoring the servicing of the residential mortgage loans (primary servicing). The VIE’s governing documents provide that the guarantor is responsible for the primary servicing of the loans; however, the guarantor is allowed to, and does, hire the transferor to perform primary servicing activities that are conducted under the supervision of the guarantor. The guarantor monitors the primary servicer’s performance and has the right to remove the primary servicer at any time it considers such a removal to be in the best interest of the security holders.

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55-152 The primary servicing activities are performed under the servicing guide established by the guarantor. Examples of the primary servicing activities include collecting and remitting principal and interest payments, administering escrow accounts, and managing default. When a loan becomes delinquent or it is reasonably foreseeable of becoming delinquent, the primary servicer can propose a default mitigation strategy in which the guarantor can approve, reject, or require another course of action if it considers such action is in the best interest of the security holders. As compensation for servicing the underlying loans, the transferor receives a fee that is calculated monthly as a percentage of the unpaid principal balance on the underlying loans. 55-153 To evaluate the facts and circumstances and determine which reporting entity, if any, is the primary beneficiary of a VIE, paragraph 810-10-25-38A requires that a reporting entity determine the purpose and design of the VIE, including the risks that the VIE was designed to create and pass through to its variable interest holders. In making this assessment, the variable interest holders of the VIE determined the following: a. The primary purposes for which the VIE was created were to provide investors with the ability to invest in a pool of residential mortgage loans with a third-party guarantee for 100 percent of the principal and interest payments due on the mortgage loans in the VIE, to provide the transferor to the VIE with access to liquidity for its originated loans and an ongoing servicing fee, and to generate fees for the guarantor. The transaction was marketed to potential debt security holders as an investment in a portfolio of residential mortgage loans with exposure to the credit risk of the guarantor and prepayment risk associated with the underlying assets of the VIE. The principal risks to which the VIE is exposed include credit risk of the underlying assets, prepayment risk, and the risk of fluctuations in the value of the underlying real estate. The credit risk of the underlying assets and the risk of fluctuations in the value of the underlying real estate are fully absorbed by the guarantor.

b.

c.

55-154 The debt securities holders and the guarantor are the variable interest holders in the VIE. The fees paid to the transferor do not represent a variable interest on the basis of a consideration of the conditions in paragraphs 810-10-55-37 through 55-38. 55-155 Paragraph 810-10-25-38B requires that a reporting entity identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The economic performance of the VIE is most significantly impacted by the performance of its underlying assets. Thus, the activities that most significantly impact the VIE’s economic performance are the activities that most significantly impact the performance of the underlying assets. The guarantor, who is also the master servicer, has the ability (through establishment of the servicing terms, to appoint and remove the primary servicer, to direct default mitigation, and to purchase defaulted assets) to manage the VIE’s assets that become delinquent (or may become delinquent in the reasonably foreseeable future) to improve the economic performance of the VIE. 55-156 Prepayment risk is also a risk that the VIE was designed to create and pass through. However, no variable interest holder has the power to direct activities related to such risk. 55-157 Because the guarantor is able to appoint and replace the primary servicer and direct default mitigation, the primary servicer does not have the power to direct the activities that most significantly impact the VIE’s economic performance. In addition, the primary servicer and its related parties do not hold a variable interest in the VIE. Thus, the primary servicer cannot be the primary beneficiary of the VIE. Furthermore, the security holders have no voting rights and, thus, no power to direct the activities that most significantly impact the VIE’s economic performance. 55-158 If a reporting entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, then under the requirements of paragraph 810-10-25-38A, that reporting entity also is required to determine whether it has 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. The guarantor, through its fee arrangement, receives benefits, which may or may not potentially be significant under this analysis; however, the guarantor has the obligation to absorb losses of the VIE that could potentially be significant through its guarantee obligation. 55-159 On the basis of the specific facts and circumstances presented in this Case and the analysis performed, the guarantor would be deemed to be the primary beneficiary of the VIE because: a. b. It is the variable interest holder with the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Through its guarantee, it has the obligation to absorb losses of the VIE that could potentially be significant to the VIE.

Case F: Residential Mortgage-Backed Securitization [Appendix C — Example 6] 55-160 A VIE is created and financed with $100 of 30-year fixed-rate debt securities. The securities are issued in 2 tranches (a $90 senior tranche and a $10 residual tranche). The senior tranche securities are investment grade and are widely dispersed among third-party investors. The residual tranche securities are held by the transferor. The VIE uses the proceeds to purchase $100 of 30-year fixed-rate residential mortgage loans from a transferor. A default on the underlying loans is absorbed first by the residual tranche held by the transferor. All activities of the VIE are prespecified by a pooling and servicing agreement for the transaction. No critical decisions are generally required for the VIE unless default of an underlying asset is reasonably foreseeable or occurs.

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55-161 The transaction was marketed to potential senior debt security holders as an investment in a portfolio of residential mortgage loans with exposure to the credit risk of the underlying loan borrowers and to the prepayment risk associated with the underlying loans of the VIE. Each month the security holders receive interest and principal payments in proportion to their percentage of ownership of the underlying loans. The residual tranche was designed to provide a credit enhancement to the transaction and to absorb the first dollar risk of loss related to credit. 55-162 The primary servicing responsibilities are retained by the transferor. No party has the ability to remove the transferor as servicer. 55-163 The servicing activities are performed in accordance with the pooling and servicing agreement. Examples of the servicing activities include collecting and remitting principal and interest payments, administering escrow accounts, monitoring overdue payments, and overall default management. Default management includes evaluating the borrower’s financial condition to determine which loss mitigation strategy (specified in the pooling and servicing agreement) will maximize recoveries on a particular loan. The acceptable default management strategies are limited to the actions specified in the pooling and servicing agreement and include all of the following: a. b. c. Modifying the terms of loans when default is reasonably foreseeable Temporary forbearance on collections of principal and interest (such amounts would be added to the unpaid balance on the loan) Short sales in which the servicer allows the underlying borrower to sell the mortgaged property even if the anticipated sale price will not permit full recovery of the contractual loan amounts.

55-164 As compensation for servicing the underlying loans, the transferor receives a fee, calculated monthly as a percentage of the unpaid principal balance on the underlying loans. Although the servicing activities, particularly managing default, are required to be performed in accordance with the pooling and servicing agreement, the transferor, as servicer, has discretion in determining which strategies within the pooling and servicing agreement to utilize to attempt to maximize the VIE’s economic performance. 55-165 To evaluate the facts and circumstances and determine which reporting entity, if any, is the primary beneficiary of a VIE, paragraph 810-10-25-38A requires that a reporting entity determine the purpose and design of the VIE, including the risks that the VIE was designed to create and pass through to its variable interest holders. In making this assessment, the variable interest holders of the VIE determined the following: a. The primary purposes for which the VIE was created were to provide investors with the ability to invest in a pool of residential mortgage loans and to provide the transferor to the VIE with access to liquidity for its originated loans and an ongoing servicing fee and potential residual returns. The transaction was marketed to potential senior debt security holders as an investment in a portfolio of residential mortgage loans with credit enhancement provided by the residual tranche and prepayment risk associated with the underlying assets of the VIE. The marketing of the transaction indicated that credit risk would be mitigated by the subordination of the residual tranche. The principal risks to which the VIE is exposed include credit of the underlying assets, prepayment risk, and the risk of fluctuations in the value of the underlying real estate.

b.

c.

55-166 The debt security holders and the transferor are the variable interest holders in the VIE. The fee paid to the transferor (in its role as servicer) represents a variable interest on the basis of a consideration of the conditions in paragraphs 810-10-55-37 through 55-38. 55-167 Paragraph 810-10-25-38B requires that a reporting entity identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The economic performance of the VIE is most significantly impacted by the performance of its underlying assets. Thus, the activities that most significantly impact the VIE’s economic performance are the activities that most significantly impact the performance of the underlying assets. The transferor, as servicer, has the ability to manage the VIE’s assets that become delinquent (or are reasonably foreseeable of becoming delinquent) to improve the economic performance of the VIE. Additionally, no party can remove the transferor in its role as servicer. The default management activities are performed only after default of the underlying assets or when default is reasonably foreseeable. However, a reporting entity’s ability to direct the activities of a VIE 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. 55-168 Prepayment risk is also a risk that the VIE was designed to create and pass through. However, no variable interest holder has the power to direct matters related to such risk. 55-169 The senior security holders have no voting rights and, thus, no power to direct the activities that most significantly impact the VIE’s economic performance.

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55-170 If a reporting entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, then under the requirements of paragraph 810-10-25-38A, that reporting entity also is required to determine whether it has 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. The transferor, through its residual tranche ownership, has the obligation to absorb losses and the right to receive benefits, either of which could potentially be significant to the VIE. The transferor, for its servicing activities, receives a fixed fee that provides it with the right to receive benefits of the VIE. The transferor concluded that those benefits could not potentially be significant to the VIE. 55-171 On the basis of the specific facts and circumstances presented in this Case and the analysis performed, the transferor would be deemed to be the primary beneficiary of the VIE because: a. b. It is the variable interest holder with the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Through its residual tranche ownership, it has the obligation to absorb losses and the right to receive benefits, either of which could potentially be significant to the VIE.

Case G: Property Lease Entity [Appendix C — Example 7] 55-172 A VIE is created and financed with $950 of 5-year fixed-rate debt and $50 of equity. The VIE uses the proceeds from the issuance to purchase property to be leased to a lessee with an AA credit rating. The equity is subordinate to the debt because the debt is paid before any cash flows are available to the equity investors. 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. The lessee, however, is considered the owner of the property for tax purposes and, thus, receives tax depreciation benefits. 55-173 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 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 VIE. If the property is sold for an amount less than the option price, the lessee is required to pay the VIE the difference between the option price and the sales proceeds, which is not to exceed a specified percentage of the option price. If the property is sold for an amount greater than the option price, the lessee is entitled to the excess of the sales proceeds over the option price. A third-party residual value guarantor provides a very small additional residual value guarantee to the lessor VIE, which allows the lessor to achieve direct financing lease treatment. 55-174 The governing documents for the VIE do not permit the VIE 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 VIE do not provide the equity holders with the power to direct any activities of the VIE. The VIE was formed so that the lessee would have rights to use the property under an operating lease and would retain substantially all of the risks and rewards from appreciation or depreciation in value of the leased property. 55-175 The transaction 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 equity investors is expected to be slightly greater than the return to the debt investors because the equity is subordinated to the debt. 55-176 To evaluate the facts and circumstances and determine which reporting entity, if any, is the primary beneficiary of a VIE, paragraph 810-10-25-38A requires that a reporting entity determine the purpose and design of the VIE, including the risks that the VIE was designed to create and pass through to its variable interest holders. In making this assessment, the variable interest holders of the VIE determined the following: a. b. The primary purpose for which the VIE was created was to provide the lessee with use of the property for five years with substantially all of the rights and obligations of ownership, including tax benefits. The VIE 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 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 effectively transfers substantially all of the risk associated with the underlying property (that is, decreases in value) to the lessee and the fixed-price purchase option effectively transfers substantially all of the rewards from the underlying property (that is, increases in value) to the lessee. The VIE 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 debt investors, the equity investors, and the lessee are the variable interest holders in the VIE.

c.

d.

55-177

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55-178 Paragraph 810-10-25-38B requires that a reporting entity identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The economic performance of the VIE is significantly impacted by the fair value of the underlying property and the credit of the lessee. The lessee’s 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. The lessee also has the ability to increase the benefits it can receive and limit the losses it can suffer by the manner in which it uses the property and how it remarkets the property. 55-179 The debt holders do not have the power to direct activities that most significantly impact the VIE’s economic performance. Although the equity holders establish the terms of the lease agreement, the terms of the lease agreement do not provide the equity holders with the power to direct activities that most significantly impact the VIE’s economic performance. 55-180 If a reporting entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, then under the requirements of paragraph 810-10-25-38A, that reporting entity also is required to determine whether it has 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. The lessee has both the obligation to absorb losses that could potentially be significant to the VIE and the right to receive benefits that could potentially be significant to the VIE through the residual value guarantee and the purchase option, respectively. 55-181 On the basis of the specific facts and circumstances presented in this Case and the analysis performed, the lessee would be deemed the primary beneficiary of the VIE because: a. b. It is the variable interest holder with the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Through its residual value guarantee and purchase option, it has the obligation to absorb losses of the VIE that could potentially be significant to the VIE and the right to receive benefits from the VIE that could potentially be significant to the VIE.

Case H: Collaboration—Joint Venture Arrangement [Appendix C — Example 8] 55-182 The following Cases illustrate the application of the guidance in paragraphs 810-10-25-38A through 25-38G related to the determination of the entity that has the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. a. b. c. d. 55-183 a. Joint decision making, different activities (Case H1) Separate decision making, different activities (Case H2) Separate decision making, same activities (Case H3) Separate decision making, similar and different activities (Case H4). Each of the Cases share the following assumptions: Reporting Entity A and Reporting Entity B form a VIE to manufacture, distribute, and sell a beverage. The VIE is funded with $95 million of 20-year fixed-rate debt and $5 million of equity. The debt is widely dispersed among third-party investors. The equity is held by Reporting Entity A and Reporting Entity B. Reporting Entity A and Reporting Entity B are not related parties. Reporting Entity A and Reporting Entity B each have 50 percent of the voting rights and each represents 50 percent of the board of directors. Reporting Entity A is a beverage manufacturer and distributor. Reporting Entity B is also a beverage manufacturer and distributor.

b. c.

Case H1: Joint Decision Making, Different Activities [Appendix C — Example 8] 55-184 Reporting Entity A is responsible for manufacturing the beverage. Reporting Entity B is responsible for distributing and selling the beverage. Decisions about the manufacturing, distributing, and selling of the beverage require the consent of both Reporting Entity A and Reporting Entity B. All other decisions about the VIE are jointly decided by Reporting Entity A and Reporting Entity B through their voting interests and equal board representation. Any matters that cannot be resolved or agreed upon must be resolved through a third-party arbitration process. 55-185 To evaluate the facts and circumstances and determine which reporting entity, if any, is the primary beneficiary of a VIE, paragraph 810-10-25-38A requires that a reporting entity determine the purpose and design of the VIE, including the risks that the VIE was designed to create and pass through to its variable interest holders. In making this assessment, the variable interest holders of the VIE determined that the primary purpose for which the VIE was created was to provide Reporting Entity A with access to Reporting Entity B’s distribution and sales network and for Reporting Entity B to gain access to Reporting Entity A’s manufacturing process and technology. 55-186 Reporting Entity A and Reporting Entity B (through their equity investment) and the debt investors are the variable interest holders in the VIE.

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55-187 Paragraph 810-10-25-38B requires that a reporting entity identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The economic performance of the VIE is significantly impacted by the manufacturing of the beverage and by the selling and distributing of the beverage. Thus, the activities that significantly impact the VIE’s economic performance are the activities that significantly impact the manufacturing of the beverage and the selling and distributing of the beverage. 55-188 Paragraph 810-10-25-38D provides that if a reporting entity determines that power is, in fact, shared among multiple parties such that no one party has the power to direct the activities of a VIE that most significantly impact the VIE’s 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 VIE’s economic performance, and if decisions about those activities require the consent of each of the parties sharing power. 55-189 Reporting Entity A and Reporting Entity B share the power to direct the activities that will most significantly impact the economic performance of the VIE through their ability to make decisions about the manufacturing, distributing, and selling of the beverage and because of the fact that those decisions require each party’s consent. 55-190 The debt holders of the VIE have no voting rights and no other rights that provide them with the power to direct the activities that most significantly impact the VIE’s economic performance. 55-191 If a reporting entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, then under the requirements of paragraph 810-10-25-38A, that reporting entity also is required to determine whether it has 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. Reporting Entity A and Reporting Entity B both have the obligation to absorb losses and the right to receive benefits that could potentially be significant to the VIE through their equity interests. 55-192 On the basis of the specific facts and circumstances presented in this Case and the analysis performed, the VIE does not have a primary beneficiary because the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance, is, in fact, shared among multiple parties (Reporting Entity A and Reporting Entity B) such that no one party has the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Case H2: Separate Decision Making, Different Activities [Appendix C — Example 8A] 55-193 Assume that decisions about the manufacturing, distributing, and selling of the beverage do not require the consent of both Reporting Entity A and Reporting Entity B. Each reporting entity would be required to identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The party with the power to direct those activities would be the primary beneficiary of the VIE. Because decisions about these activities do not require the consent of both Reporting Entity A and Reporting Entity B, power would not be considered shared, and either Reporting Entity A or Reporting Entity B would be the primary beneficiary of the VIE, on the basis of which party has the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Case H3: Separate Decision Making, Same Activities [Appendix C — Example 8B] 55-194 Assume that Reporting Entity A and Reporting Entity B each manufacture, distribute, and sell the beverage in different locations, but decisions about these activities do not require the consent of both Reporting Entity A and Reporting Entity B. That is, each reporting entity is responsible for the same activities. Because decisions about these activities do not require the consent of both Reporting Entity A and Reporting Entity B, power would not be considered shared. 55-195 If a reporting entity concludes that power is not shared but the activities that most significantly impact the VIE’s economic performance are directed by multiple unrelated parties and the nature of the activities that each party is directing is the same, the party, if any, with the power over the majority of those activities shall be considered to have the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance. If no party directs the majority of those activities, the VIE does not have a primary beneficiary. 55-196 If Reporting Entity A or Reporting Entity B has power over the majority of those activities, then that party would be the primary beneficiary of the VIE. Case H4: Separate Decision Making, Similar and Different Activities [Appendix C — Example 8C] 55-197 Assume that Reporting Entity A and Reporting Entity B are each responsible for manufacturing the beverage, but Reporting Entity B is also responsible for all of the distributing and selling of the beverage, and decisions about the manufacturing, distributing, and selling of the beverage do not require the consent of both Reporting Entity A and Reporting Entity B. Each reporting entity would be required to identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The party with the power to direct those activities would be the primary beneficiary of the VIE. That is, power would not be considered shared, and either Reporting Entity A or Reporting Entity B would be the primary beneficiary of the VIE. However, if a reporting entity concludes that power is not shared but the activities that most significantly impact the VIE’s economic performance are directed by multiple unrelated parties and the nature of the activities that each party is directing is the same, the party, if any, with the power over the majority of those activities shall be considered to have the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance. If no party directs the majority of those activities, the VIE does not have a primary beneficiary.
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ASC 810-10 (continued)
55-198 Reporting Entity B may conclude that its power over some of the manufacturing of the beverage, combined with its power over all of the distributing and selling of the beverage, results in its being the party with the power to direct the activities that most significantly impact the VIE’s economic performance. However, if Reporting Entity B were to conclude that the distributing and selling of the beverage did not significantly impact the economic performance of the VIE, then the primary beneficiary of the VIE would be the party, if any, with the power over the majority of the manufacturing of the beverage. Case I: Furniture Manufacturing Entity [Appendix C — Example 9] 55-199 A VIE is created by a furniture manufacturer and a financial investor to manufacture and sell wood furniture to retail customers in a particular geographic region. The VIE was created because the furniture manufacturer has no viable distribution channel in that particular geographic region. The VIE is established with $100 of equity, contributed by the furniture manufacturer, and $3 million of 10-year fixed-rate debt, provided by a financial investor. The furniture manufacturer establishes the sales and marketing strategy of the VIE, manages the day-to-day activities of the VIE, and is responsible for preparing and implementing the annual budget for the VIE. The VIE has a distribution contract with a third party that does not represent a variable interest in the VIE. Interest is paid to the fixed-rate debt holder (the financial investor) from operations before funds are available to the equity holder. The furniture manufacturer has guaranteed the fixed-rate debt to the financial investor. The debt agreement includes a clause such that if there is a materially adverse change that materially impairs the ability of the VIE and the furniture manufacturer to pay the debt, then the financial investor can take possession of all the assets of the VIE. An independent third party must objectively determine whether a materially adverse change has occurred on the basis of the terms of the debt agreement (an example of a materially adverse change under the debt agreement is the bankruptcy of the VIE). 55-200 To evaluate the facts and circumstances and determine which reporting entity, if any, is the primary beneficiary of a VIE, paragraph 810-10-25-38A requires that a reporting entity determine the purpose and design of the VIE, including the risks that the VIE was designed to create and pass through to its variable interest holders. In making this assessment, the variable interest holders of the VIE determined the following: a. b. c. 55-201 The primary purpose for which the VIE was created was to enable the furniture manufacturer to extend its existing business line into a particular geographic region that lacked a viable distribution channel. The VIE was marketed to the financial investor as a fixed-rate investment in a retail operating entity, supported by the furniture manufacturer’s expertise and guarantee. The furniture manufacturer’s guarantee of the debt effectively transfers all of the operating risk of the VIE to the furniture manufacturer. The furniture manufacturer and the financial investor (debt holder) are the variable interest holders in the VIE.

55-202 Paragraph 810-10-25-38B requires that a reporting entity identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. The economic performance of the VIE is most significantly impacted by the operations of the VIE because the operating cash flows of the VIE are used to repay the financial investor. Thus, the activities that most significantly impact the VIE’s economic performance are the operating activities of the VIE. The furniture manufacturer has the ability to establish the sales and marketing strategy of the VIE and manage the day-to-day activities of the VIE. 55-203 The debt holder has the power to take possession of all of the assets of the VIE if there is a materially adverse change under the debt agreement. However, the debt holder’s rights under the materially adverse change clause represent protective rights. Protective rights held by other parties do not preclude a reporting entity from having the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance. Protective rights are designed to protect the interests of the party holding those rights without giving that party a controlling financial interest in the VIE to which they relate. The debt holder’s rights protect the interests of the debt holder; however, the VIE’s economic performance is most significantly impacted by the activities over which the furniture manufacturer has power. The debt holder’s protective rights do not prevent the furniture manufacturer from having the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. 55-204 If a reporting entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, then under the requirements of paragraph 810-10-25-38A, that reporting entity also is required to determine whether it has the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits that could potentially be significant to the VIE. The furniture manufacturer has the obligation to absorb losses that could potentially be significant through its equity interest and debt guarantee and the right to receive benefits that could potentially be significant through its equity interest. 55-205 On the basis of the specific facts and circumstances presented in this Case and the analysis performed, the furniture manufacturer would be the primary beneficiary of the VIE because: a. b. It is the variable interest holder with the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Through its equity interest and debt guarantee, it has the obligation to absorb losses of the VIE that could potentially be significant to the VIE and the right to receive benefits from the VIE that could potentially be significant to the VIE.

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Appendix B — Glossary of Terms and Abbreviations Used in the VIE Model in ASC 810-10
Glossary of Terms
ASC 810-10-20
Expected Losses A legal entity that has no history of net losses and expects to continue to be profitable in the foreseeable future can be a variable interest entity (VIE). A legal entity that expects to be profitable will have expected losses. A VIE’s expected losses are the expected negative variability in the fair value of its net assets exclusive of variable interests and not the anticipated amount or variability of the net income or loss. [FSP FIN 46(R)-2, paragraphs 1, 2, and 8] 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). [Paragraph 2] Expected Residual Returns A variable interest entity’s (VIE’s) expected residual returns are the expected positive variability in the fair value of its net assets exclusive of variable interests. [Paragraph 8] Expected Variability Expected variability is the sum of the absolute values of the expected residual return and the expected loss. [Paragraph 2] Expected variability in the fair value of net assets includes expected variability resulting from the operating results of the legal entity. [Paragraph 8] 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 VIE’s economic performance. [Paragraph 14C] 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. [Paragraph 3] 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 VIE’s economic performance. [Paragraph 14C] Primary Beneficiary An entity that consolidates a variable interest entity (VIE). [Paragraph 2] See paragraphs 810-10-25-38 through 25-38G for guidance on determining the primary beneficiary.

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ASC 810-10-20 (continued)
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 entity’s 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. [Paragraph 14C]

Qualifying Special-Purpose Entity Glossary term superseded by Accounting Standards Update No. 2009-16 Subordinated Financial Support Variable interests that will absorb some or all of a variable interest entity’s (VIE’s) expected losses. [Paragraph 2] Variable Interest Entity A legal entity subject to consolidation according to the provisions of the Variable Interest Entities Subsections of Subtopic 810-10. [Paragraph 2] Variable Interests The investments or other interests that will absorb portions of a variable interest entity’s (VIE’s) expected losses or receive portions of the entity’s expected residual returns are called variable interests. [Paragraph 6] 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 VIE’s 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. [Paragraph 2]

Abbreviations
AcSEC AICPA CDO CIRA EITF FASB FVO GAAP GASB GP IAS IFRS Accounting Standards Executive Committee American Institute of Certified Public Accountants Collateralized Debt Obligation Common Interest Realty Association Emerging Issues Task Force Financial Accounting Standards Board Fair Value Option Generally Accepted Accounting Principles Governmental Accounting Standards Board General Partner International Accounting Standards International Financial Reporting Standards

FASAB Federal Accounting Standards Advisory Board

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LIBOR LP MMF NAV NFP O&M PPA QSPE R&D SEC SIV SPE TSA VIE

London Interbank Offered Rate Limited Partner Money Market Mutual Fund Net Asset Value Not-For-Profit Entity Operations and Maintenance Power Purchase Arrangements Qualifying Special Purpose Entity Research and Development Securities and Exchange Commission Structured Investment Vehicles Special Purpose Entity Technical Service Agreement Variable Interest Entity

PCAOB Public Company Accounting Oversight Board

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Appendix C — Key Differences Between U.S. GAAP and IFRSs — Consolidated Financial Statements
Under U.S. GAAP, ASC 810 is the primary source of guidance on determining when and how to prepare consolidated financial statements. Under IFRSs, IAS 27 and SIC-12 are the primary sources of guidance on determining when and how to prepare consolidated financial statements.

Question
What are the key differences between U.S. GAAP and IFRSs in the determination of when and how to prepare consolidated financial statements?

Answer
The table below summarizes these differences and is followed by a detailed explanation of each difference.1
Subject Determining when to consolidate an entity U.S. GAAP There are two different models for determining when consolidation is appropriate. If a reporting entity has an interest in a VIE, it must apply the VIE consolidation model under ASC 810-10, which is based on power and economics. If a reporting entity has an interest in an entity that is not a VIE, it must apply the controlbased consolidation model (the voting interest model) under ASC 810-10. Under the voting interest model in ASC 810-10, a controlling financial interest is defined as “ownership of a majority voting interest” in another entity. ASC 323-10 further indicates that the power to control another entity may exist in other contracts or agreements outside of a controlling financial interest. The VIE model in ASC 810-10 states that a reporting entity has a controlling financial interest if it has both of the following characteristics: (1) the power to direct the activities of the entity that most significantly affect the entity’s economic performance and (2) the obligation to absorb losses of the entity that could potentially be significant to the entity or the right to receive benefits from the entity that could potentially be significant to the entity. If a reporting entity determines that control is shared among multiple unrelated parties involved with a VIE, no party consolidates the VIE. Under the VIE model in ASC 810-10, power is considered shared if (1) two or more unrelated parties together have the power to direct the VIE’s most significant activities and (2) decisions about those activities require the consent of each of the parties sharing power. IFRSs There is one model for determining whether consolidation is appropriate that encompasses the guidance in both IAS 27 and SIC-12. In this case, a reporting entity considers both governance and economic indicators of control in IAS 27 and SIC-12 to determine whether consolidation is appropriate.

Definition of control

IAS 27 defines control as the power to govern the financial and operating policies of an entity to obtain benefits from its activities. In this case, the definition of control encompasses both the notion of governance and the economic consequences of that governance. IAS 27 and SIC-12 provide indicators of when the substance of a relationship indicates control is present.

Shared power

IAS 27 and SIC-12 do not address the concept of shared power. However, IAS 31 provides guidance when there is joint control, which is defined as “the contractually agreed sharing of control over an economic activity, and exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control.”

1

Differences are based on comparison of authoritative literature under U.S. GAAP and IFRSs and do not necessarily include interpretations of such literature.
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Subject Consideration of potential voting rights

U.S. GAAP Under the voting interest model in ASC 810-10, an entity is not required to consider potential voting rights when determining whether control is present; rather, such potential voting rights may indicate control. The VIE model in ASC 810-10 does not specifically address the impact of potential voting rights on the determination of which party has the power to direct the most significant activities of an entity. No exception is provided for preparing consolidating financial statements when either (1) a parent controls a subsidiary or (2) a reporting entity is determined to be the primary beneficiary of a VIE. Under the VIE model in ASC 810-10, the primary beneficiary of a VIE is required to separately present on the face of the balance sheet (1) assets of the consolidated VIE that can only be used to settle obligations of the VIE and (2) liabilities of the consolidated VIE for which creditors do not have recourse to the general credit of the primary beneficiary. Consolidation is not prohibited if a parent and subsidiary have different reporting periods. When a difference in reporting periods is less than three months, it is usually acceptable for a parent to consolidate a subsidiary on the basis of the subsidiary’s financial statements; however, the difference is not to exceed three months. In the consolidated financial statements, accounting policies of a subsidiary are not required to be conformed with the accounting policies of a parent.

IFRSs An entity must consider the existence and effect of potential voting rights that are currently exercisable when determining whether control is present.

Exception for preparing consolidated financial statements Presentation requirements for certain consolidated entities

A parent may elect not to consolidate a controlled subsidiary if specific conditions are met. If the election is made, the parent must account for its investment in a subsidiary not held for sale at cost or fair value in accordance with IAS 39. Presentation requirements for SPEs are not specifically addressed.

Different reporting dates

A parent is prohibited from consolidating a subsidiary with a different reporting period unless it is impractical to do so. If it is impractical for a subsidiary to have the same reporting period as its parent, the difference can be no greater than three months, and adjustments should be made for significant transactions. In the consolidated financial statements, the accounting policies of a subsidiary must be conformed with the accounting policies of a parent.

Consolidated accounting policies

Determining When to Consolidate an Entity
Under U.S. GAAP, there are two different models for determining whether consolidation is appropriate. If a reporting entity has an interest in another entity that meets the definition of a VIE in ASC 810-10-15-14, the VIE model under ASC 810-10 should be applied. Under this model, consolidation is based on power and economics; i.e., which interest holder has (1) the power to direct the activities of the VIE that most significantly affect the VIE’s economic performance and (2) the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. However, if a reporting entity has an interest in another entity that is not considered a VIE or that is not within the scope of the VIE model in ASC 810-10, the voting interest model in ASC 810-10 must be applied. Under this model, consolidation is based on whether the reporting entity has a controlling financial interest in the entity (see below for the definition of a controlling financial interest under ASC 810-10). Under IFRSs, a reporting entity must consider the indicators of control in both IAS 27 and SIC-12 to determine whether consolidation is appropriate. Under this model, a reporting entity should consider which party controls an entity on the basis of an evaluation of both governance indicators (IAS 27) and economic indicators (SIC-12). While IAS 27 indicates that control is presumed to exist when an entity owns a majority of the voting power of another entity, control may occur without a majority ownership of the voting power of an entity. Therefore, consolidation under IFRSs is not strictly a risk-and-rewards model or voting-control model but a combination of both.

Definition of Control
Under U.S. GAAP, ASC 810-10-15-8 defines control or a controlling financial interest as “ownership of a majority voting interest” in another entity. Specifically, the Codification defines a subsidiary in ASC 810-10-20 as an “entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as its parent, holds a controlling financial interest.” On the basis of this definition, under the voting interest model in ASC 810-10, a controlling financial interest is presumed to exist, and consolidation is required, when an investor owns a majority of the voting interests in an
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investee. However, if the investee is a VIE and is within the scope of the VIE model in ASC 810-10, consolidation is based on which party has (1) the power to direct the activities of the VIE that most significantly affect the VIE’s economic performance and (2) the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. Under IFRSs, paragraph 4 of IAS 27 defines control as “the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.” Furthermore, this definition of control encompasses the notion of governance as well as the economic consequences of that governance (i.e., benefits and risks). In this case, governance relates to the power to make decisions and implies having the capacity or ability to accomplish something (e.g., the ability to govern the decision-making process through the selection of financial and operating policies). In certain cases, control is not obtained through ownership of a majority of the voting power of another entity. Rather, the substance of a relationship between two entities must be considered.

Shared Power
Under U.S. GAAP, if a reporting entity determines that control is shared among multiple unrelated parties involved with an entity, no party consolidates the entity. Under the VIE model in ASC 810-10, power is considered shared if (1) two or more unrelated parties together have the power to direct the VIE’s most significant activities and (2) decisions about those activities require the consent of each of the parties’ sharing power. If multiple unrelated parties have power over significant activities that are different in nature, and consent regarding all of those activities is not required, then the party with the power over the activities that most significantly affect the VIE’s economic performance is considered to have power over the entity. If multiple unrelated parties have power over the same activity or activities that most significantly affect the economic performance of the VIE, and consent regarding the activity or activities is not required, the party with power over the majority of the significant activity or activities is considered to have power over the VIE. If no party has power over the majority of the same significant activity or activities, there is no primary beneficiary. Under IFRSs, shared power is not defined. However, IAS 31 provides guidance when there is joint control, which is defined as “the contractually agreed sharing of control over an economic activity, and exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control.”2

Consideration of Potential Voting Rights
Under U.S. GAAP, the voting interest model in ASC 810-10 does not require a reporting entity to consider the effect of potential voting rights (e.g., warrants, share call options, instruments convertible into voting shares) when determining whether a controlling financial interest exists. The VIE model in ASC 810-10 does not specifically address the impact of potential voting rights on the determination of which party has the power to direct the most significant activities of an entity. For example, under the voting interest model in ASC 810-10, a reporting entity is not required to consider the additional voting shares it would receive in an investee upon exercise of a stock purchase warrant when determining whether it holds a majority ownership interest in the investee. However, potential voting rights associated with unexercised options and unsettled forwards may be an indicator of control. Under IFRSs, paragraphs 14 and 15 of IAS 27 require that a reporting entity consider the “existence and effect of potential voting rights that are currently exercisable or convertible” when determining whether control is present (emphasis added). In the example above, the reporting enterprise must consider the additional voting shares it would receive upon exercise of the stock purchase warrant when determining whether it controls the voting power of the investee. When determining whether the effect of potential voting shares should be considered, the reporting entity should not consider the intention or financial capabilities of management to exercise or convert the potential voting rights. For example, a reporting entity must consider the potential voting shares of any instrument that is either currently exercisable or convertible and that is considered substantive, regardless of whether the instrument is out-ofthe-money or whether the reporting entity intends to exercise the option. (Note that an instrument would not be considered substantive if its strike or exercise price was so far out-of-the-money that it was unlikely that the instrument would be exercised.)

Exception for Preparing Consolidated Financial Statements
Under U.S. GAAP, there are no exceptions to the consolidation requirements of those standards when (1) a parent controls a subsidiary or (2) an entity is determined to be the primary beneficiary of a VIE.
2

For more information, see 323-10 (Q&A 02) in Deloitte’s FASB Accounting Standards Codification Manual.
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Under IFRSs, paragraph 10 of IAS 27 states that a parent may elect not to prepare consolidated financial statements if the following conditions are met:
a. the parent itself is a wholly owned subsidiary, or is a partially owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements; the parent’s debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); the parent did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and the ultimate or any intermediate parent of the parent produces consolidated financial statements available for public use that comply with International Financial Reporting Standards.

b. c.

d.

If a parent elects not to consolidate its subsidiary, the parent must account for its investment in that subsidiary not classified as held for sale under IFRS 5 at cost or at fair value in accordance with IAS 39.

Presentation Requirements for Certain Consolidated Entities
Under U.S. GAAP, the VIE model in ASC 810-10 requires a reporting entity to present separately on the face of its balance sheet the (1) assets of consolidated VIEs that can only be used to settle obligations of those VIEs and (2) liabilities of consolidated VIEs for which creditors do not have recourse to the general credit of the primary beneficiary. Under IFRSs, there is no specific requirement to present separately the assets or liabilities of a special-purpose entity. However, paragraph 58 of IAS 1 states that an entity should use judgment in determining whether to present items separately and should take into account (1) “the nature and liquidity of assets”, (2) “the function of assets within the entity”, and (3) “the amounts, nature and timing of liabilities.”

Different Reporting Date
Under U.S. GAAP, the voting interest model in ASC 810-10 provides that a difference between the fiscal reporting period of a parent and that of its subsidiary does not prohibit a parent from presenting consolidating financial statements. Rather, ASC 810-10-45-12 indicates that it is usually acceptable for a parent to consolidate the financial statements of a subsidiary that are prepared as of a reporting date that differs from the parent’s if that difference is not greater than three months. In this case, the voting interest model in ASC 810-10 requires that the parent either disclose or recognize any intervening events that materially affect the financial position or results of operations of the subsidiary. Under IFRSs, paragraph 26 of IAS 27 (now paragraph 22 of IAS 27 (revised 2008))3 requires that financial statements of a subsidiary used in preparing consolidated financial statements be prepared as of the parent’s reporting date. If the reporting periods of a subsidiary and parent are different, the subsidiary must prepare additional financial statements as of the consolidated reporting date for the consolidated financial statements. If a subsidiary’s financial statements are prepared as of a date different from the consolidated reporting date (not to exceed three months), adjustments to the financial statements of the subsidiary must be made for the effects of significant transactions or events that occur during the intervening period.

Consolidated Accounting Policies
Under U.S. GAAP, the accounting policies of a subsidiary do not need to conform to the accounting policies of the parent in the consolidating financial statements. Specifically, ASC 810-10-25-15 provides that the specialized industry accounting principles at a subsidiary level should be retained in consolidation. Under IFRSs, paragraph 28 of IAS 27 (now paragraph 24 of IAS 27 (revised 2008)) requires that “uniform accounting policies for like transactions and other events in similar circumstances” be used in the preparation of the consolidated financial statements of a parent and subsidiary. As a result, the financial statements of a subsidiary must be adjusted before consolidation on the basis of the consolidated accounting policies of the parent.

Classification of the Noncontrolling Interest
Under U.S. GAAP, a reporting entity is required to classify the noncontrolling interest within equity separately and apart from the parent’s shareholders’ equity in the same manner as is required under IAS 27.
IAS 27 (revised 2008) is effective for fiscal years beginning on or after July 1, 2009. Early adoption is permitted.
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3

Appendix D — Reference Guide
On July 1, 2009, the Codification became the single source of authoritative nongovernmental GAAP in the United States. The Codification is effective for interim and annual periods ending after September 15, 2009. The chart below includes cross-references for the paragraphs within ASC 810-10 to the paragraphs within Interpretation 46(R), as amended by Statement 167. The chart, which is organized by topic and by section within the Roadmap, may help users navigate through the codification of Statement 167.
Topic Codification Section Paragraph Reference — Interpretation 46(R), as amended by Statement 167 Paragraphs 1–1A; Paragraphs E5, E7, E18–E20 Paragraph 2A Paragraph 4 Paragraphs 2, 6; Paragraphs B2–B4 FSP FIN 46(R)-5 FSP FIN 46(R)-6 FSP FIN 46(R)-6 Paragraphs 5, 3 Paragraphs 9–10, D31 Paragraph B22 Section Within Roadmap

Overview and Background Substantive Terms and Arrangements Scope and Scope Exceptions Determination of Whether the Reporting Entity Holds a Variable Interest Implicit Variable Interests The By-Design Approach to Determining Variability Considerations Related to Determination of Variability Determination of Whether an Entity Is a VIE Sufficiency of Equity Investment at Risk Analysis of Fees Paid to a Decision Maker or Service Provider Initial Determination of Whether an Entity Is a VIE Reconsideration of Whether the Entity Is a VIE Development-Stage Entities Expected Losses and Expected Residual Returns Interests in Specified Assets of the VIE and Silo Provisions Determination of the Primary Beneficiary Related-Party Considerations

810-10-05-8 through 05-13 810-10-15-13A and 15-13B 810-10-15-12 and 15-17 Variable Interests; 810-10-5517 through 55-19 810-10-25-48 through 25-54 810-10-25-20 through 25-29 810-10-25-30 through 25-36 810-10-15-14 through 15-15 810-10-25-45 through 25-47 810-10-55-37 through 37A

Section 1 Section 1 Section 1 Section 2

Section 2 Section 2 Section 2 Section 3 Section 3 Section 3

810-10-25-37 810-10-35-4 810-10-15-16 Expected Losses, Expected Residual Returns, and Variability 810-10-25-55 through 25-59 810-10-25-38 through 25-38G 810-10-25-42 through 25-44

Paragraph 6 Paragraph 7 Paragraph 11 FSP FIN 46(R)-2; Paragraphs 2, 8 Paragraphs 12–13, FSP FIN 46(R)-1; Issue 08-04 Paragraphs 14–14G Paragraphs 16–17

Section 3 Section 3 Section 3 Section 4

Section 5 Section 6 Section 6

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Topic

Codification Section

Paragraph Reference — Interpretation 46(R), as amended by Statement 167 Paragraphs 18–21 Paragraph 22 Paragraph 22A

Section Within Roadmap

Initial Measurement Accounting After Initial Measurement Presentation Disclosures Initial Consolidation When Earlier Consolidation Was Prevented Because of Lack of Information Transition Implementation Guidance Implementation Guidance Implementation Guidance

810-10-30-1 through 30-6 810-10-35-3 810-10-45-25

Section 7 Section 7 Section 8 Section 8 Section 9

810-10-50-2AA through 50-6; Paragraphs 22B–26 810-10-5-9 through 50-10 810-10-30-7 through 30-9 Statement 167, paragraph 5; Statement 167, paragraphs 8–10 Statement 167, paragraphs 4–9; ASU 2010-10 Paragraphs B1–B17 Paragraphs B22–B26 Appendix C

810-10-65-2 810-10-55-16 through 55-32 810-10-55-37 through 55-41 810-10-55-93 through 81010-55-205

Section 9 Appendix A Appendix A Appendix A

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Appendix E — Glossary of Standards
FASB Accounting Standards Update No. 2010-10, Amendments for Certain Investment Funds FASB Accounting Standards Update No. 2009-17, Improvements to Financial Reporting by Enterprises Involved With Variable Interest Entities FASB Accounting Standards Update No. 2009-16, Accounting for Transfers of Financial Assets FASB Accounting Standards Update No. 2009-4, Accounting for Redeemable Equity Instruments FASB Accounting Standards Codification Subtopic 310-10, Receivables: Overall (SOP 01-6, Opinion 21, Opinion 43, Statement 114) FASB Accounting Standards Codification Subtopic 323-10, Investments — Equity Method and Joint Ventures: Overall (APB 18) FASB Accounting Standards Codification Subtopic 360-10, Property, Plant, and Equipment: Overall (Statement 144) FASB Accounting Standards Codification Subtopic 460-10, Guarantees: Overall (Interpretation 45) FASB Accounting Standards Codification Subtopic 470-50, Debt: Modifications and Extinguishments (Issue 96-16) FASB Accounting Standards Codification Subtopic 480-10, Distinguishing Liabilities From Equity: Overall (Statement 150) FASB Accounting Standards Codification Subtopic 605-45, Revenue Recognition: Principal Agent Considerations (Issue 99-19) FASB Accounting Standards Codification Topic 712, Compensation — Nonretirement Postemployment Benefits (Statement 112) FASB Accounting Standards Codification Topic 715, Compensation — Retirement Benefits (Statement 87, Statement 88, Statement 158) FASB Accounting Standards Codification Subtopic 805-10, Business Combinations: Overall (Statement 141(R)) FASB Accounting Standards Codification Subtopic 805-20, Business Combinations: Identifiable Assets and Liabilities, and Any Noncontrolling Interest (Statement 141(R)) FASB Accounting Standards Codification Subtopic 810-10, Consolidation: Overall (ARB 51, Statement 160, Interpretation 46(R)) FASB Accounting Standards Codification Subtopic 810-20, Consolidation: Control of Partnerships and Similar Entities (Issue 04-5) FASB Accounting Standards Codification Subtopic 815-10, Derivatives and Hedging: Overall (Statement 133) FASB Accounting Standards Codification Subtopic 815-15, Derivatives and Hedging: Embedded Derivatives (Statement 133) FASB Accounting Standards Codification Subtopic 820-10, Fair Value Measurements and Disclosures: Overall (Statement 157) FASB Accounting Standards Codification Subtopic 825-10, Financial Instruments: Overall (Statement 159) FASB Accounting Standards Codification Topic 840, Leases (Statement 13)

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FASB Accounting Standards Codification Subtopic 850-10, Related Party Disclosures: Overall (Statement 57) FASB Accounting Standards Codification Subtopic 860-10, Transfers and Servicing: Overall (Statement 140, as amended by Statement 166) FASB Accounting Standards Codification Subtopic 915-10, Development Stage Entities: Overall (Statement 7) FASB Accounting Standards Codification Subtopic 944-10, Financial Services — Insurance: Overall (Statement 60) FASB Accounting Standards Codification Subtopic 944-80, Financial Services — Insurance: Separate Accounts (SOP 03-1) FASB Accounting Standards Codification Subtopic 946-10, Financial Services — Investment Companies: Overall FASB Accounting Standards Codification Topic 954, Health Care Entities FASB Accounting Standards Codification Topic 958, Not-for-Profit Entities FASB Accounting Standards Codification Subtopic 960-325, Plan Accounting — Defined Benefit Pension Plans: Investments—Other FASB Accounting Standards Codification Subtopic 962-325, Plan Accounting — Defined Contribution Pension Plans: Investments—Other FASB Accounting Standards Codification Topic 965, Plan Accounting — Health and Welfare Benefit Plans FASB Accounting Standards Codification Topic 972, Real Estate — Common Interest Realty Associations FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R) FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51 FASB Statement No. 141(R), Business Combinations FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities — an interpretation of ARB No. 51 FASB Staff Position (FSP) No. FIN 46(R)-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)” FASB Staff Position (FSP) No. FIN 46(R)-5, “Implicit Variable Interests Under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities” FASB Staff Position (FSP) No. FIN 46(R)-2, “Calculation of Expected Losses Under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities” FASB Staff Position (FSP) No. FIN 46(R)-1, “Reporting Variable Interests in Specified Assets of Variable Interest Entities as Separate Variable Interest Entities Under Paragraph 13 of FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities” FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements EITF Issue No. 08-04, “Transition Guidance for Conforming Changes to Issue No. 98-5” EITF Issue No.84-04, “Acquisition, Development, and Construction Loans” EITF Topic No. D-98, “Classification and Measurement of Redeemable Securities” SEC Staff Accounting Bulletin Topic 3.C, “Redeemable Preferred Stock” SEC Staff Accounting Bulletin Topic 5.G, “Transfers of Nonmonetary Assets by Promoters or Shareholders” SEC Regulation S-X, Rule 6-03, “Special Rules of General Application to Registered Investment Companies” SEC Accounting Series Release No. 268 (FRR Section 211), Redeemable Preferred Stocks IFRS 5, Non-Current Assets Held for Sale and Discontinued Operations IAS 1, Presentation of Financial Statements IAS 27, Consolidated and Separate Financial Statements IAS 27 (Revised 2008), Consolidated and Separate Financial Statements
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IAS 31, Interests in Joint Ventures IAS 39, Financial Instruments: Recognition and Measurement SIC-12, Consolidation — Special Purpose Entities Canadian Institute of Chartered Accountants Handbook

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