4.1 Introduction
One of the first steps in assessing whether a reporting entity is required to consolidate
another legal entity is
to determine whether the reporting entity holds an explicit or implicit variable interest in the
legal entity being evaluated for consolidation. This determination is important for
several reasons, including the following:
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If a reporting entity determines that it does not have a variable interest in the legal entity, no further analysis is required. That is, that reporting entity is not required to consolidate the legal entity or provide any of the VIE disclosures related to the legal entity.
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The identification of the variable interests may affect whether the legal entity is a VIE (see Chapter 5).
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The evaluation of whether the reporting entity has a variable interest in a legal entity may affect its assessment of whether it has an obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE in the primary-beneficiary analysis (see Chapter 7).
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A reporting entity that has a variable interest in a VIE may be required to provide certain disclosures (see Section 11.2).
While there are many forms of variable interests, all variable interests will absorb portions of a VIE’s variability (changes in the fair
value of the VIE’s net assets exclusive of variable interests) that the legal entity
was designed to create. An interest that creates variability
would not be considered a variable interest. The VIE subsections of ASC 810-10 use
the terms “expected losses” and “expected residual returns” to describe the expected
variability in the fair value of a legal entity’s net assets exclusive of variable
interests.
It is often simple to identify whether a contract or arrangement is a variable
interest. A good rule of thumb is that most arrangements on the credit side of the
balance sheet (e.g., equity and debt) are variable interests because they absorb
variability as a result of the performance of the legal entity. However, identifying
whether other arrangements (e.g., derivatives, leases, and decision-maker and other service-provider contracts)
are variable interests can be more complex. See Section 4.4 for a discussion of decision-maker
and service-provider fees and the criteria for assessing whether such fees represent
variable interests and should therefore be evaluated further in the consolidation
flowchart.
As discussed in more detail in Section 4.2, the FASB established a two-step “by-design” approach for the identification of variable interests. Under this approach the reporting entity would (1) “[a]nalyze the nature of the risks in the legal entity” and (2) “[d]etermine the purpose(s) for which the legal entity was created and determine the variability (created by the risks identified in Step 1) the legal entity is designed to create and pass along to its interest holders.” The by-design principle is relevant because while a contract or arrangement may absorb certain variability from a legal entity, the contract or arrangement would generally not be a variable interest if the variability absorbed is related to a risk the legal entity was not “designed” to pass on to the interest holder.