4.2 The By-Design Approach to Determining Variability

ASC 810-10

25-22 The variability to be considered in applying the Variable Interest Entities Subsections shall be based on an analysis of the design of the legal entity as outlined in the following steps:

Step 1: Analyze the nature of the risks in the legal entity (see paragraphs 810-10-25-24 through 25-25).
Step 2: Determine 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 (see paragraphs 810-10-25-26 through 25-36).

25-23 For purposes of paragraphs 810-10-25-21 through 25-36, interest holders include all potential variable interest holders (including contractual, ownership, or other pecuniary interests in the legal entity). After determining the variability to consider, the reporting entity can determine which interests are designed to absorb that variability. The cash flow and fair value are methods that can be used to measure the amount of variability (that is, expected losses and expected residual returns) of a legal entity. However, a method that is used to measure the amount of variability does not provide an appropriate basis for determining which variability should be considered in applying the Variable Interest Entities Subsections.

25-24 The risks to be considered in Step 1 that cause variability include, but are not limited to, the following:

Credit risk
Interest rate risk (including prepayment risk)
Foreign currency exchange risk
Commodity price risk
Equity price risk
Operations risk.

25-25 In determining the purpose for which the legal entity was created and the variability the legal entity was designed to create and pass along to its interest holders in Step 2, all relevant facts and circumstances shall be considered, including, but not limited to, the following factors:

The activities of the legal entity
The terms of the contracts the legal entity has entered into
The nature of the legal entity’s interests issued
How the legal entity’s interests were negotiated with or marketed to potential investors
Which parties participated significantly in the design or redesign of the legal entity.

25-26 Typically, assets and operations of the legal entity create the legal entity’s variability (and thus, are not variable interests), and liabilities and equity interests absorb that variability (and thus, are variable interests). Other contracts or arrangements may appear to both create and absorb variability because at times they may represent assets of the legal entity and at other times liabilities (either recorded or unrecorded). The role of a contract or arrangement in the design of the legal entity, regardless of its legal form or accounting classification, shall dictate whether that interest should be treated as creating variability for the entity or absorbing variability.

25-27 A review of the terms of the contracts that the legal entity has entered into shall include an analysis of the original formation documents, governing documents, marketing materials, and other contractual arrangements entered into by the legal entity and provided to potential investors or other parties associated with the legal entity.

25-28 Example 3 (see paragraph 810-10-55-55) is intended to demonstrate how to apply the provisions of this guidance on determining the variability to be considered, including whether arrangements (such as derivative instruments or guarantees of value) create variability (and are therefore not variable interests) or absorb variability (and are therefore variable interests).

25-29 A qualitative analysis of the design of the legal entity, as performed in accordance with the guidance in the Variable Interest Entities Subsections, will often be conclusive in determining the variability to consider in applying the guidance in the Variable Interest Entities Subsections, determining which interests are variable interests, and ultimately determining which variable interest holder, if any, is the primary beneficiary.

25-30 The following addresses various considerations related to determination of variability, specifically:

Terms of interests issued
Subordination
Certain interest rate risk
Certain derivative instruments.

Terms of Interests Issued

25-31 An analysis of the nature of the legal entity’s interests issued shall include consideration as to whether the terms of those interests, regardless of their legal form or accounting designation, transfer all or a portion of the risk or return (or both) of certain assets or operations of the legal entity to holders of those interests. The variability that is transferred to those interest holders strongly indicates a variability that the legal entity is designed to create and pass along to its interest holders.

Subordination

25-32 For legal entities that issue both senior interests and subordinated interests, the determination of which variability shall be considered often will be affected by whether the subordination (that is, the priority on claims to the legal entity’s cash flows) is substantive. The subordinated interest(s) (as discussed in paragraph 810-10-55-23) generally will absorb expected losses prior to the senior interest(s). As a consequence, the senior interest generally has a higher credit rating and lower interest rate compared with the subordinated interest. The amount of a subordinated interest in relation to the overall expected losses and residual returns of the legal entity often is the primary factor in determining whether such subordination is substantive. The variability that is absorbed by an interest that is substantively subordinated strongly indicates a particular variability that the legal entity was designed to create and pass along to its interest holders. If the subordinated interest is considered equity-at-risk, as that term is used in paragraph 810-10-15-14, that equity can be considered substantive for the purpose of determining the variability to be considered, even if it is not deemed sufficient under paragraphs 810-10-15-14(a) and 810-10-25-45.

Certain Interest Rate Risk

25-33 Periodic interest receipts or payments shall be excluded from the variability to consider if the legal entity was not designed to create and pass along the interest rate risk associated with such interest receipts or payments to its interest holders. However, interest rate fluctuations also can result in variations in cash proceeds received upon anticipated sales of fixed-rate investments in an actively managed portfolio or those held in a static pool that, by design, will be required to be sold prior to maturity to satisfy obligations of the legal entity. That variability is strongly indicated as a variability that the legal entity was designed to create and pass along to its interest holders.

4.2.1 Steps of the By-Design Approach

The by-design approach in ASC 810-10-25-22 requires a reporting entity to determine which variability to consider in evaluating whether an interest is a variable interest on the basis of the design and purpose of the legal entity. The reporting entity analyzes the legal entity to determine (1) its design, including the nature of the risks in the legal entity, and (2) why the legal entity was created and the variability that the legal entity is designed to create and pass along to its interest holders. In performing this analysis, the reporting entity should review in detail the terms of the contracts that the legal entity has entered into and provided to potential investors or other parties associated with the entity, including the original formation documents, governing documents, marketing materials, and other contractual arrangements. ASC 810-10-55-55 through 55-86 provide additional guidance, including indicators and examples, to help reporting entities apply this approach.

Under the by-design approach, the following two-step analysis is used in the evaluation of which variability to consider in the determination of whether an interest is a variable interest:

Step 1 — “Analyze the nature of the risks in the legal entity.”
Step 2 — “Determine 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.”

4.2.1.1 Performing Step 1

4.2.1.1.1 Types of Risks

Examples of risks that may cause variability include, but are not limited to, credit risk, interest rate risk (including prepayment risk), foreign currency exchange risk, commodity price risk, equity price risk, and operations risk. Although all risks should be considered in step 1, they should not all be included in the identification of variable interests. For example, a legal entity that has foreign currency risk or interest rate risk may not have been designed to pass on those risks. This might be the case if the legal entity invests excess cash in variable-rate debt securities; however, by design, its primary activities do not include investing in debt securities.

4.2.1.1.2 Interest Rate Variability

Interest rate variability, as discussed in ASC 810-10-25-33, is analyzed on the basis of the facts and circumstances. The interest rate variability associated with a legal entity’s assets is generally not a risk a legal entity is designed to create and pass along to its interest holders if a derivative instrument (e.g., an interest rate swap) is used to hedge such a risk. Therefore, interest rate variability that is hedged, or that arises from assets that will be held by the legal entity until maturity, should generally not be considered in the determination of whether an interest is a variable interest. However, this may not be the case if a derivative instrument used to hedge the risk is itself a variable interest (see Section 4.3.3).

Further, certain circumstances strongly indicate that a legal entity was designed to create and pass along interest rate risk to its interest holders, including the following:

Variations in cash proceeds to be received upon anticipated sales of fixed-rate investments in an actively managed investment portfolio.
Variations in the cash proceeds a legal entity will receive when it holds investments in a static pool that, by design, the potential VIE will be required to sell before maturity to satisfy its obligations.
Variations in fair value resulting from an “interest rate mismatch.” ASC 810-10-55-68 through 55-70 give an example in which a legal entity holds fixed-rate assets and floating-rate debt. The interest rate mismatch is not hedged; thus, the legal entity was designed to expose the debt and equity investors to changes in fair value of the investments. Therefore, interest rate risk associated with changes in the fair value of fixed-rate periodic interest rate payments received must be considered.

Interests that absorb interest rate variability associated with any of these three circumstances generally would be considered variable interests. We believe that prepayment risk and interest rate risk should be considered collectively in the evaluation of the risks that a legal entity is designed to create and pass along to its interest holders. Said differently, we generally believe that in situations in which a legal entity is designed to create and pass along prepayment risk, the legal entity has also been designed to similarly create and pass along interest rate risk.

4.2.1.2 Performing Step 2

4.2.1.2.1 Factors to Consider

ASC 810-10-25-25 states that in performing step 2 of the by-design approach, the reporting entity should consider the following factors:

The activities of the legal entity
The terms of the contracts the legal entity has entered into
The nature of the legal entity’s interests issued
How the legal entity’s interests were negotiated with or marketed to potential investors
Which parties participated significantly in the design or redesign of the legal entity.

In addition, ASC 810-10-25-31 through 25-34 provide the following strong indicators of variability that the legal entity was designed to create and pass along to its interest holders:

When the terms of the interests transfer all or a portion of the risk or return (or both) of certain assets or operations to the interest holder (see ASC 810-10-25-31).
When the terms indicate that an interest is substantively subordinated. The amount of a subordinated interest relative to the overall expected losses by the entity is an indicator of whether subordination is substantive (see ASC 810-10-25-32).
When fixed-rate investments are anticipated to be sold before maturity. This may result in variability to interest holders as a result of exposure to interest rate risk (see ASC 810-10-25-33).
When the legal entity enters into arrangements such as derivatives to either reduce or eliminate certain variability (see ASC 810-10-25-34 and Section 4.3.3).

Interests that absorb the variability associated with these indicators are likely to be variable interests. However, if a reporting entity creates certain risks in a legal entity, it generally cannot have a variable interest that absorbs those same risks from the legal entity (see Section 4.3.1.1 for an example).

As part of the analysis, a reporting entity should consider the original formation documents, governing documents, any amendments to the original formation or governing documents, marketing materials, or other contractual arrangements entered into by the legal entity and provided to potential investors or other parties associated with the legal entity.

4.2.1.2.2 Terms of Interests Issued

Under the by-design approach, the reporting entity considers whether the terms of the interests issued transfer all or a portion of the risk of the legal entity to holders of those interests. The reporting entity should not make this determination solely on the basis of a legal or accounting designation. For example, if a reporting entity transfers financial assets to a legal entity that is accounted for as a financing, it would be inappropriate for that reporting entity to ignore any risks it has in the legal entity solely on the basis that the transferred financial assets were not derecognized for accounting purposes.

Further, in accordance with ASC 810-10-15-13A, the reporting entity only considers substantive terms, transactions, and arrangements, whether contractual or noncontractual, when applying the VIE model. Thus, the reporting entity disregards any term, transaction, or arrangement when applying the VIE model if the term, transaction, or arrangement does not have a substantive effect on any of the following:

A legal entity’s status as a VIE.
A reporting entity’s power over a VIE.
A reporting entity’s obligation to absorb losses or its right to receive the benefits of the legal entity.

4.2.1.2.3 Subordination

Understanding which interests issued by a legal entity constitute subordinated financial support is important in the evaluation of a legal entity for consolidation. The presence of substantive subordinated interests would be a strong indicator of the variability that the legal entity is designed to create and pass along to its interest holders.

4.2.1.2.3.1 Subordinated Financial Support

Subordinated financial support, as defined in ASC 810-10-20, is “[v]ariable interests that will absorb some or all of a [VIE’s] expected losses.” In general, all forms of financing are “subordinated financial support” unless the financing is the most senior class of liabilities and is considered “investment-grade.” Standard & Poor’s and Moody’s categorize investment-grade debt as that rated BBB or higher and Baa or higher, respectively. If the debt is not rated, it should be considered investment-grade only if it possesses characteristics that warrant such a rating. A reporting entity should carefully consider whether a nonrated instrument possesses the characteristics to be treated as investment-grade. Considerations may include how the yield of a nonrated instrument compares to that of comparable investment-grade debt or whether other subordinated classes of debt and equity are designed to absorb the expected losses of the legal entity in such a manner that the nonrated instrument is protected from losses.

The determination that non-investment-grade debt is subordinated financial support is based on the view that the debt holder is exposed to a more than remote chance of experiencing a credit loss. Therefore, unless the financing is investment-grade or is unrated and possesses the same characteristics as investment-grade debt, the financing should be considered subordinated.

Example 4-1

An investor holds a common-stock investment of $20 and a debt instrument of $80 in an entity. The only other variable interest is $40 of preferred stock held by an unrelated third party. The common and preferred stock are considered equity at risk in accordance with ASC 810-10-15-14(a); however, the debt instrument is rated B by Standard & Poor’s. In this example, the debt instrument is not investment-grade and would be considered subordinated financial support.

4.2.1.2.3.2 Evaluation of Substantiveness of Subordination

As noted above, the existence of substantive subordinated interests would be a strong indicator of the variability the entity is designed to create and pass along to its interest holders.

A reporting entity determines whether financing represents subordinated financial support on the basis of how such financing absorbs expected losses compared with other variable interests in the legal entity (e.g., whether there are other substantive subordinated classes of support that are designed to absorb expected losses). In general, the more disparity there is between the interests, the more likely it is that the subordinated class is substantive. In making this assessment, the reporting entity would consider all facts and circumstances, including:

The amount and size of a subordinated interest compared with all other interests issued by the legal entity. That is, the size of a subordinated interest may be an indicator of whether the interest is designed to absorb the expected losses of the legal entity, which may in turn be an indicator that subordination is substantive.
The interest’s placement in the contractual priority of payments (“waterfall”) that governs the distribution of the legal entity’s cash flows. Distributions made to that interest in the later tiers of the waterfall may indicate that subordination is substantive.
Credit ratings and relative yields (interest rates) of the interests issued. A larger differential between rates may be an indicator that subordination is substantive.

In addition, it is important for reporting entities to understand which variable interests constitute subordinated financial support when performing other aspects of the evaluation of a legal entity for consolidation. For example, ASC 810-10-15-17(d)(3) requires the reporting entity to assess whether it has provided more than half of a potential VIE’s subordinated financial support when determining whether a potential VIE qualifies for the business scope exception (see Section 3.4.4.9). Further, ASC 810-10-15-14 requires the reporting entity to assess the design of the potential VIE’s subordinated financial support when determining whether a potential VIE is a VIE (see Section 5.2.3).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.