Appendix C — Expected Losses and Expected Residual Returns
Appendix C — Expected Losses and Expected Residual Returns
Under FIN 46(R), the primary beneficiary of a
VIE was determined on the basis of the reporting
entity that absorbed the majority of the
legal
entity’s
expected
losses, received the majority of the entity’s
expected
residual returns, or both. As a result, reporting
entities were often required to perform a quantitative calculation
of expected losses and expected residual returns. However, with each
subsequent revision in ASU 2009-17 and ASU 2015-02 to the VIE
consolidation guidance, the FASB reduced the emphasis on this
quantitative analysis of expected losses and expected residual
returns. Consequently, the evaluation of the characteristics of the
primary beneficiary of a VIE has changed from focusing on a
quantitative analysis of expected losses and expected residual
returns to performing a qualitative analysis of whether the
reporting entity has both control over the activities that most
significantly affect the VIE’s economic performance and a variable
interest that could potentially be significant to the returns or
losses of the VIE (see further discussion in Section
7.3).
C.1 The Need to Calculate Expected Losses and Expected Residual Returns
The VIE model generally does not require entities to use the
quantitative approach described in the definitions of the terms “expected losses,”
“expected residual returns,” and “expected
variability”; rather, for all aspects of a VIE consolidation
analysis, a qualitative assessment of the relevant facts and circumstances is
generally sufficient. Nevertheless, to perform a VIE consolidation analysis, the
reporting entity should understand the relevant concepts underlying the quantitative
approach described in the definitions of those terms, including those related to the
following:
-
The definition of a variable interest (see Section 2.14).
-
The definition of subordinated financial support (see Section 2.13).
-
The assessment of whether a decision-maker fee is a variable interest. To determine whether a fee paid to a decision maker or service provider is a variable interest, a reporting entity may need to perform, as part of its evaluation under ASC 810-10-55-37(c), a quantitative calculation of expected losses and expected residual returns of a legal entity. See Section 4.4.
-
The identification of silos and variable interests in specified assets (see Chapter 6 and Section 4.3.11).
-
The determination of whether a legal entity is a VIE. In making such a determination, a reporting entity may need to calculate the legal entity’s expected losses to evaluate whether the legal entity’s equity at risk is sufficient to absorb expected losses (if a qualitative assessment under ASC 810-10-15-14(a) was not conclusive). See Section 5.2.
-
The reconsideration of whether a legal entity is a VIE (see Chapter 9).
-
The determination of which party, within a related-party group under common control or a group of related parties that share power, is the primary beneficiary of a VIE. In making this determination, a reporting entity may need to calculate the expected losses and residual returns of a legal entity to evaluate each party’s exposure to the variability associated with the anticipated economic performance of the VIE under ASC 810-10-25-44(c). See Section 7.4.2.4.
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.
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.
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.
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.