Appendix C — Expected Losses and Expected Residual Returns

C.3 How to Calculate Expected Losses and Expected Residual Returns

As discussed in Section C.2, a reporting entity determines expected losses and expected residual returns by calculating the “expected cash flows of the entity” under the VIE model. To determine the expected cash flows of the legal 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 is useful for developing estimated cash flow scenarios under the VIE model. However, estimated cash flow scenarios under the VIE model exclude certain cash inflows and outflows that occur between the legal 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 legal 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 (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) of the legal entity.

The following steps outline an approach to determining the expected losses and expected residual returns of the legal entity under the VIE model:

Step 1 — Distinguish the sources of variability from the variable interests in the legal entity.
Step 2 — Develop the scenarios of estimated cash flows attributable to the sources of variability under the VIE model.
Step 3 — Calculate the expected cash flows of the legal 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.

C.3.1 Step 1 — Distinguish the Sources of Variability From the Variable Interests in the Legal Entity

Each of the legal entity’s assets, liabilities, contracts, and equity items represents either a source of variability or variable interests in the legal entity. The first step in calculating the expected cash flows of the legal entity (and, consequently, the expected losses and expected residual returns) is to distinguish the variable interests and the legal entity’s assets, liabilities, equity, and other contractual arrangements that represent sources (or creators) of variability. This step is important for a number of reasons.

First, unless otherwise exempt from the provisions of the VIE model, each holder of a variable interest in the legal 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 and is not subject to the disclosure requirements. Second, a reporting entity does not include cash flows to or from variable interests as cash outflows or inflows of the legal entity in developing cash flow scenarios. Consequently, it is important to distinguish sources of variability from variable interests to ensure that the calculation of the legal entity’s expected cash flows appropriately represents the amount of cash flows that would be expected to be allocated to variable interest holders.

Recall from Section C.1 that the determination of whether a legal 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 legal entity’s expected cash flows, and the calculation of expected residual returns, which represents positive variability from the amount identified as the legal entity’s expected cash flows. Under the VIE model, the basis for the distinction between the legal 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 Chapter 4.) In other words, if the returns of the legal 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 legal 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 legal entity.

Once the variable interests have been distinguished from the sources of variability, a reporting entity must further evaluate the variable interests. Under ASC 810-10-25-55 and 25-56, a reporting entity treats some interests in specified assets that otherwise would be considered variable interests as sources of variability in deriving the expected cash flows of the legal entity under the VIE model (see Section 4.3.11).

C.3.2 Step 2 — Develop the Scenarios of Estimated Cash Flows Attributable to Sources of Variability Under the VIE Model

In step 2, the reporting entity must develop various (non-probability-weighted) scenarios, each of which estimates the legal entity’s cash flows from sources of variability 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 legal 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 a market price if one existed.” Thus, the assumptions that management uses to develop the legal 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.

As a result of considering the legal entity’s “cash drivers” (i.e., key factors that affect the cash flows associated with the legal 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 legal entity. 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 legal 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 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 legal entity’s expected losses and expected residual returns, a reporting entity must calculate an amount for the expected cash flows of the legal 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 legal entity’s expected cash flows do not incorporate cash inflows or outflows that stem from a variable interest (identified in step 1). 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.

C.3.3 Step 3 — Calculate the Expected Cash Flows of the Legal 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 legal 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). The sum of the estimated (probability-weighted) cash flows for all scenarios is equal to the expected cash flows of the legal entity under the VIE model.

C.3.4 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. 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.”

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 legal entity from the discounted 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 legal entity. The sum of the positive variability scenarios is the expected residual returns of the entity.

C.3.5 Decision-Maker and Service-Provider Fees (Step 1)

The treatment of decision-maker and service-provider fees depends on whether the fees have to be treated as a variable interest (see Section 4.4). 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. If it is determined that decision-maker and service-provider fees are not variable interests, the fees would be included in the expected losses/expected residual returns calculation (i.e., included in the VIE’s cash flows).

C.3.6 Options or Guarantees on Specific Assets (Step 1)

A legal entity may write an option to purchase an asset of the entity (a call option written by the entity) or purchase a residual value guarantee on an asset of the entity (a put option purchased by the entity). In these or similar situations, questions may arise regarding whether the cash flows associated with the option should be included in the calculation of expected losses and expected residual returns.

The determination of whether the option (or guarantee) is included in the cash flows used to calculate expected losses and expected residual returns depends on whether the option (or guarantee) is determined to be a variable interest in the legal 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 legal entity’s assets and the option (or guarantee) is not considered an interest in a “silo” pursuant to ASC 810-10-25-57, the option (or guarantee) on the asset would not be considered a variable interest in the legal entity; therefore, the cash flows associated with the option (or guarantee) should be included in the calculation of expected losses and expected residual returns of the legal entity. However, if the option (or guarantee) is a variable interest in the legal entity (or in a “silo”), in all scenarios, the cash flows associated with the option (or guarantee) should not be included in the calculation of expected losses and expected residual returns of the legal entity.

C.3.7 Low-Income Housing or Similar Tax Credits (Step 1)

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 income tax effect should not be confused with the estimated income taxes to be paid by the potential VIE. This amount should be considered, because the legal entity’s payment of income taxes affects the amount of cash flows available to the variable interest holders.

Occasionally, the economics of the legal entity and the fair value of a variable interest necessitate consideration of the effects of noncash tax credits that may be passed through the legal 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, by design, a reporting entity may invest in a legal entity that receives tax incentives in the form of tax credits (e.g., affordable housing projects, or projects that produce energy or fuel from alternative sources) to receive a pass-through of the tax benefits. Regardless of whether the tax benefits will be used by the legal entity or the investors in the legal entity, because the tax benefits affect the fair value of the legal entity and the amount that an investor would be willing to pay for an interest in the legal entity, a reporting entity should include these tax benefits in the expected cash flows at fair value when calculating expected losses and expected residual returns. At the 2004 AICPA Conference on Current SEC and PCAOB Developments, the SEC staff supported this position, stating:

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.

C.3.8 Developing Estimated Cash Flow Scenarios and Assigning Probabilities (Steps 2 and 3)

As indicated above, to calculate expected losses and expected residual returns, a reporting entity must develop estimated cash flow scenarios. 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 legal entity under the VIE model, discounted at the risk-free rate, to approximate the fair value of the legal entity’s net assets, exclusive of variable interests (also to approximate the fair value of the legal 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 Section C.3.11.)

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. Under this approach, a reporting entity considers thousands of scenarios on the basis of primary factors that affect the cash flows and variability of the legal entity. Such an approach may be especially useful if there are multiple drivers of expected losses in the legal 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 prices of assets, supply and demand for products, technological innovation and obsolescence) on the legal 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 a legal entity’s business that are not required by existing governing documents and contractual arrangements. For example, scenarios used for a legal 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 legal entity’s governing documents or contractual arrangements.
Scenarios should, however, include changes within the design of the legal entity’s business that are a source of the legal entity’s variability. For example, assume that a legal 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 legal 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 a legal entity.
In general, the more scenarios that are developed, the more precise the analysis of the variability that each holder absorbs in the legal entity will be.
The calculations of the legal entity’s expected losses and expected residual returns include those associated with variable interests in the legal entity. Some variable interest holders may hold interests in specified assets of the legal entity that are not considered variable interests in the entity. For more information, see ASC 810-10-25-55 and 25-56 and Section C.3.6.
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 legal entity’s net assets exclusive of variable interests, as well as the fair value of the legal 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 Section C.3.11.
Management of a reporting entity 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 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 loss and residual return 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. 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.

Note that, as discussed above, the calculation of expected cash flows under the VIE model in ASC 810-10 is not exactly the same as that under Concepts Statement 7.

C.3.9 Inclusion of Noncash Receipts or Distributions in the Estimated Cash Flow Scenarios (Step 2)

In one or more of the scenarios considered in the development of a legal entity’s estimated cash flows, a variable interest holder could contribute noncash assets (e.g., real estate, other tangible assets, or investments) to the legal entity or receive such noncash assets from it. When developing a legal entity’s estimated cash flow scenarios for the calculation of expected losses or expected residual returns, 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 legal entity or if the legal 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. As noted in Section C.2, cash outflows stemming from variable interests are not included as cash outflows of the legal entity in the determination of the legal entity’s expected losses or expected residual returns. Similarly, cash flows that represent receipts from holders of variable interests are not considered cash inflows to the legal entity.

For 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 a finance 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 source (or creator) of variability. Thus, each scenario would include an amount equal to the estimated 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.

C.3.10 Discount Rate to Use in Calculating Expected Losses and Expected Residual Returns (Step 4)

The risk-free rate should be applied to the individual, probability-weighted cash flows in each scenario developed for calculating expected losses and expected residual returns. 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 in Section C.4).

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 probability-weighted 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. See also the next section, which discusses the impact of ASC 820-10 on an expected loss/residual return calculation.

C.3.11 Impact of ASC 820-10 on the Calculation of Expected Losses and Expected Residual Returns (Step 4)

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, and that 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.

Although ASC 820-10 is not intended to amend the provisions of the VIE model, 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 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 as one method of checking the overall reasonableness of the cash flows used in the expected loss/residual return calculation by comparing 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. 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, 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.

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