C.5 Example of a Calculation of Expected Losses and Expected Residual Returns
Below is an example of a calculation of expected losses and expected residual returns. As noted in Section C.1, a reporting entity is generally not required to calculate expected losses and expected residual returns in performing a consolidation analysis under the VIE model. However, in this example, it is assumed that the reporting entity did not qualify for an exception to the VIE subsections of ASC 810-10 and that because a qualitative assessment under ASC 810-10-15-14(a) was inconclusive, the reporting entity calculated expected losses and expected residual returns in evaluating whether the legal entity is a VIE.
Assume that a legal entity (PowerCo) is created to hold a power plant with a fair value of $10 million at inception. PowerCo is funded by unrelated investors as follows:
- Contributions by two unrelated investors of $1 million each for an equity investment at risk.
- The issuance to a single investor of $5 million in senior fixed-rate bonds, due in 25 years in a lump-sum (“bullet maturity”) payment, with a 5 percent interest rate.
- The issuance to a single investor of $3 million in subordinated fixed-rate bonds, due in 25 years in a bullet maturity payment, with a 7.5 percent interest rate.
Further assume the following:
- 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, which will cover any shortfall of the subordinated debt principal payment 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 but retains a significant amount of the operating risk associated with the power plant.
- An unrelated party, ManageCo, runs the plant and makes all of the significant 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.
C.5.1 Performing Step 1
Under step 1 of the calculation, a reporting entity must identify variable
interests in the legal entity (see Section C.3.1). The interests in PowerCo
are analyzed below.
On the basis of the above analysis, the estimated cash flows from the operations of the power plant (including the sales to third parties) and the estimated changes in the fair value of the power plant not reflected in net income or loss (i.e., terminal value at the end of the plant’s useful life) represent the assets and contracts that create the variability in PowerCo. The equity, senior bond, subordinated bond, subordinated bond guarantee, and ManageCo contract represent the variable interests in PowerCo. Even if one of the variable interest holders qualified for an exception to the VIE model, each variable interest is still treated as an absorber of variability in the calculation of expected losses and expected residual returns.
C.5.2 Performing Step 2
Under step 2 of the calculation, a reporting entity must develop the scenarios
of estimated cash flows attributable to sources of variability under the VIE
model (see Section
C.3.2).
As noted in Section C.3.8, cash flow scenarios are developed on the basis of all of the possible variations in the operating results of PowerCo. PowerCo uses the “indirect method” to calculate the estimated cash flows for each scenario (i.e., it starts with GAAP net income and makes adjustments to arrive at the expected cash flows for each scenario such that the expected cash flows only include the cash flows created by PowerCo that are absorbed by the variable interest holders). In this case, PowerCo only considers cash flows related to the operations of the plant and the terminal value of the plant. PowerCo starts its calculation with amounts derived under GAAP and adjusts those amounts to exclude the impact on GAAP amounts of cash flows related to the variable interests (i.e., any cash inflow or outflow stemming from the equity, debt, the guarantee, or the management contract).
For simplicity, only three possible scenarios are contemplated in this example —
best case (Scenario 1), most likely case (Scenario 2), and worst case (Scenario
3). In practice, a reporting entity may need to consider more scenarios (see
Section C.3.8).
In addition, it is assumed for simplicity that the cash flows of PowerCo have
been estimated over a five-year period. 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 power plant is assumed
to be sold at fair value under each scenario, and the proceeds from the sale are
incorporated into the estimated cash flow scenarios. For each scenario, it is
assumed that the power plant is depreciated over 20 years. The table below shows
the results for all three scenarios:
C.5.3 Performing Step 3
Under step 3 of the calculation, a reporting entity must calculate the expected cash flows of the legal entity under the VIE model (see Section C.3.3).
To determine the expected cash flows of the entity under the VIE model, the
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). The table below shows the calculation
of the expected cash flows of PowerCo under the VIE model.
C.5.4 Performing Step 4
Under step 4 of the calculation, a reporting entity must calculate the expected variability (i.e., expected losses and expected residual returns) in expected cash flows for each scenario (see Section C.3.4).
Expected losses and expected residual returns 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 table below illustrates the calculation
of the discounted expected cash flows for the three scenarios:
In Table C-3, 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 measure 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. The approximate fair value of the variable interests is as follows:
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 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 table below illustrates the calculation of the variability for the three
scenarios:
The term “expected losses” does not refer to what a legal entity or variable interest holder expects to lose but to the variability in the cash flows to be absorbed by the variable interest holder. Negative variability results in an expected loss scenario, and positive variability results in an expected residual return scenario. In this example, the expected losses of PowerCo 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. However, just because there is sufficient equity investment at risk does not mean PowerCo is not a VIE. Rather, PowerCo would also have to consider the other two characteristics in ASC 810-10-15-14, including the impact on the ManageCo contract on the assessment of ASC 810-10-15-14.