C.4 Cash Flow and Fair Value Approaches to Calculating Expected Losses and Expected Residual Returns
Two approaches may be used to calculate expected losses and expected residual returns: the cash flow approach and the fair value approach. Under each, 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.
C.4.1 Cash Flow Approach
The underlying principle of the cash flow approach is that a legal entity’s variability arises from fluctuations in its cash flows. Under the cash flow method, changes in future interest rates are not anticipated. In an expected loss/residual return calculation, the only variations in the risk-free rates used are within each cash flow scenario and reflect the time value of money for varying periods.
Example C-1
Assume that Entity X (a U.S. legal entity) is created with cash contributions from various equity investors and that its governing documents state that its life is five years. Assume that there are three cash flow scenarios for X’s expected loss/residual return 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, and so forth. 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.
C.4.2 Fair Value Approach
The underlying principle of the fair value approach is that the source of a
legal entity’s variability is fluctuations in the fair value of the legal
entity’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 legal entity may encounter. The different yield curves used
under the fair value approach should be consistent with the assumptions used in
the related scenario. Consequently, in the calculation of expected losses under
the fair value approach, the discount rates applied in each of the three
scenarios would incorporate the changes in interest rates that Entity X in
Example C-1 above 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).
C.4.3 Appropriateness of the Cash Flow Approach or Fair Value Approach to Calculating Expected Losses and Expected Residual Returns
ASC 810-10-25-21 through 25-36 provide guidance on determining whether an interest in a legal entity is a variable interest. Those paragraphs discuss 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 interest in a VIE should consider the guidance in ASC 810-10-25-21 through 25-36 in determining the variability that a legal entity is designed to create and pass along to its interest holders and, in light of its determination, whether to use the cash flow method or fair value method to calculate expected losses and expected residual returns.
In many instances, the legal entity 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 legal entity 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 legal entity that is designed to create and pass along fair value variability attributable to changes in interest rates. In this example, the legal entity 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 given the reporting entity’s specific facts and circumstances.
C.4.4 Using the Cash Flow Approach or Fair Value Approach 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. To meet the condition in ASC 810-10-55-37(c), the decision maker or service provider cannot hold other variable interests in the legal entity that individually, or in the aggregate, absorb more than an insignificant amount of the legal entity’s expected losses or receive more than an insignificant amount of the legal entity’s expected residual returns. In determining whether this condition is met, in accordance with ASC 810-10-55-37, a decision maker or service provider should consider its direct economic interests in the legal entity (other than the fee arrangement) together with its indirect economic interests in the legal entity held through related parties.
ASC 810 does not specify any particular approach that a reporting entity should use to determine whether the condition in ASC 810-10-55-37(c) is met. A decision maker or service provider will generally be able to perform a qualitative analysis to determine whether the condition in ASC 810-10-55-37(c) is met. As indicated in ASC 810-10-55-37D, a quantitative analysis typically would not be needed. However, if a reporting entity determines that such analysis is necessary, the decision maker or service provider generally should apply a variation of the “top-down” allocation method (described below) to all legal entities evaluated.
Before ASU 2009-17’s amendments to the VIE model, 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 legal entity and the variable interest holders in allocating expected losses and expected residual returns to the variable interests. The top-down and bottoms-up methods and their variations are summarized below.
Method | Comments |
|---|---|
Top-down | 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. That is, the cash flows that are used to calculate the aggregate expected losses and aggregate expected residual returns of the legal entity 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 legal entity. |
Bottoms-up | Under the bottoms-up method, the aggregate expected losses (and aggregate expected residual returns, if necessary) of the legal entity 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 legal entity, 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 take into account the timing or causes of the expected losses and expected residual returns of the legal entity 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 legal entity or when the timing of the occurrence of the risks that the legal entity was designed to pass on to the variable interest holders has a significant impact on the overall variability of the legal entity that will be absorbed by the variable interest holders. |
Although the calculation of expected losses and expected residual returns is not prevalent under the VIE model, the top-down method may be appropriate in the assessment of the condition in ASC 810-10-55-37(c) if a reporting entity determines that a quantitative analysis is necessary for such evaluation. When a quantitative analysis is deemed necessary, a decision maker or service provider can select any reasonable top-down method of allocating a legal entity’s expected losses and expected residual returns to the variable interest holders. However, because the application of different variations of the top-down method could result in different conclusions under ASC 810-10-55-37(c), the reporting entity should apply a consistent variation of the method to all legal entities for which a quantitative analysis of ASC 810-10-55-37(c) is deemed necessary.
Because it is assumed under the bottoms-up method that only the aggregate expected losses and aggregate expected residual returns of the VIE will occur, this approach is appropriate only when (1) there is a single 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 legal entity’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.2 Because neither of the conditions necessary for application of the bottoms-up method typically exist for decision-making or servicing contracts (because (1) a decision maker or service contract generally will not absorb all the elements of the variability of a legal entity, (2) the timing of the variability will affect the absorption, or (3) both), the bottoms-up method is generally not appropriate when a quantitative analysis is deemed necessary to the evaluation of the condition in ASC 810-10-55-37(c).
Footnotes
2
The aggregate expected losses of a legal entity 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 legal entity that are being allocated are treated as a single “hypothetical” scenario that is assumed to occur.