## C.2 Definitions of Expected Losses and Expected Residual Returns

ASC 810-10 — Glossary

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.

Expected Losses and Expected Residual Returns

Expected losses and expected residual returns refer to amounts derived from expected cash flows as described in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements. However, expected losses and expected residual returns refer to amounts discounted and otherwise adjusted for market factors and assumptions rather than to undiscounted cash flow estimates. The definitions of expected losses and expected residual returns specify which amounts are to be considered in determining expected losses and expected residual returns of a variable interest entity (VIE).

Expected 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.

Expected Variability

Expected variability is the sum of the absolute values of the expected residual return and the expected loss. Expected variability in the fair value of net assets includes expected variability resulting from the operating results of the legal entity.

The terms “expected losses” and “expected residual returns” refer to amounts derived from the calculation of “expected cash flows of a VIE.” 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 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.1 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.

To apply the cash flow scenario technique under the VIE model, a reporting entity must include the cash flows stemming from sources of variability in, and exclude cash flows stemming from variable interests from, the cash flows that it would otherwise use in the calculation of the expected value of the VIE under Concepts Statement 7. For example, cash flow amounts representing distributions that
stem from 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 stemming from 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 creators of variability. The
objective of the expected cash flows calculation under the VIE model is for the
reporting entity to arrive at a single estimate of the amount 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 of 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 of the expected residual return scenarios. Because there are many possible outcomes for each legal entity (i.e., many cash flow scenarios), each legal entity will have expected losses and expected residual returns.

The calculation of expected cash flows under Concepts Statement 7 or the VIE
guidance 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 from the VIE’s mean cash flows. For example, if the
expected cash flows of a VIE are calculated at $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 Section C.3 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.

### C.2.1 Meaning of “Net Assets” in the Definitions of Expected Losses and Expected Residual Returns

The definitions of “expected losses” and “expected residual returns” contain
references to the fair value of the “net assets exclusive of variable
interests.” The term “net assets exclusive of variable interests” does not refer to the net assets as identified on a legal
entity’s balance sheet under GAAP. Under the VIE model, the term “net assets
exclusive of variable interests” represents the sources of variability in the
entity. That is, the objective of the net asset calculation is to include only the estimated cash flows stemming from assets,
liabilities, contracts, or other relationships that do not represent variable
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 may include unrecognized firm commitments, contractual
arrangements with service providers or decision makers, or supply contracts that
are not recorded under GAAP. Conversely, a derivative under GAAP that is deemed
a variable interest would not be part of the net assets exclusive of variable
interests, as used in the calculations.

In addition, for expected losses and expected residual returns, net assets are exclusive of (1) variable interests and (2) interests in specific assets (as described in ASC 810-10-25-55 and 25-56). 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.

## Footnotes

1

A “scenario” is a single cash flow outcome that is developed on the basis of the potential variability in the economic performance of a legal entity, exclusive of cash flows received from or distributed to the variable interests in the legal entity. Multiple cash flow scenarios are determined and probability-weighted in the calculation of the aggregate expected losses and aggregate expected residual returns of a legal entity. See Section C.3 for further discussion of the number of cash flow scenarios used in calculating the expected losses and expected residual returns of a legal entity.