4.3 Identifying a Variable Interest

ASC 810-10

55-17 The identification of variable interests requires an economic analysis of the rights and obligations of a legal entity’s assets, liabilities, equity, and other contracts. Variable interests are contractual, ownership, or other pecuniary interests in a legal entity that change with changes in the fair value of the legal entity’s net assets exclusive of variable interests. The Variable Interest Entities Subsections 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.

55-18 For a legal entity that is not a VIE (sometimes called a voting interest entity), all of the legal entity’s assets, liabilities, and other contracts are deemed to create variability, and the equity investment is deemed to be sufficient to absorb the expected amount of that variability. In contrast, VIEs are designed so that some of the entity’s assets, liabilities, and other contracts create variability and some of the entity’s assets, liabilities, and other contracts (as well as its equity at risk) absorb or receive that variability.

55-19 The identification of variable interests involves determining which assets, liabilities, or contracts create the legal entity’s variability and which assets, liabilities, equity, and other contracts absorb or receive that variability. The latter are the legal entity’s variable interests. The labeling of an item as an asset, liability, equity, or as a contractual arrangement does not determine whether that item is a variable interest. It is the role of the item — to absorb or receive the legal entity’s variability — that distinguishes a variable interest. That role, in turn, often depends on the design of the legal entity.

ASC 810-10-20 defines variable interests in a legal entity as “contractual, ownership, or other pecuniary interests in a VIE that change with changes in the fair value of the VIE’s net assets exclusive of variable interests.” (For more information about the meaning of the term “net assets” under the VIE model, see Section C.2.1.) In addition, ASC 810-10-55-19 implies that variable interests absorb or receive the expected variability created by assets, liabilities, or contracts of a legal entity that are not, themselves, variable interests.

Generally, assets and operations of a legal entity create its variability while its liabilities and equity interests absorb that variability. Other contracts or arrangements entered into by the legal entity may appear both to create and to absorb variability (e.g., interest rate and foreign currency swaps) because they can be assets or liabilities depending on prevailing market conditions. In addition, for a hybrid instrument (see ASC 815-15-25-1), the host instrument and the embedded feature should be evaluated separately if the embedded feature is not clearly and closely related (see ASC 815-15-25-26 through 25-29) to the host (see Section 4.3.8 for further discussion).

Tables 4-1 and 4-2 summarize common interests and indicate whether such interests would or would not generally be considered a variable interest. Determining whether a reporting entity’s interest in another legal entity is a variable interest is only one step in applying the consolidation analysis. In the following situations, for example, holders of certain types of variable interests may be exempt from the VIE model’s consolidation requirements or may require special treatment:

A reporting entity, or the legal entity in which it has an interest, may qualify for one of the scope exceptions in ASC 810-10-15-12 or ASC 810-10-15-17 (see Sections 3.3 and 3.4, respectively).
A reporting entity’s variable interest in specified assets of a VIE may not be considered a variable interest in that legal entity unless, as described in ASC 810-10-25-55 and 25-56, the fair value of the specified assets is more than half of the total fair value of the VIE’s assets or the holder has other variable interests in the VIE as a whole (except interests that are insignificant or have little or no variability). However, the reporting entity’s variable interest may represent an interest in a “silo,” as described in ASC 810-10-25-57 (see Chapter 6).

Table 4-1 lists examples (not all-inclusive) of financial instruments and other contracts with a legal entity that generally would be considered variable interests in that legal entity. The table also contains links to detailed discussions of each instrument. Note that (1) the determination of whether a particular interest is a variable interest depends on the design of the legal entity and the role of that interest and (2) “legal entity” means the potential VIE in which the reporting entity holds an interest.

Table 4-1 Examples of Variable Interests

Financial Instruments or Other Contracts	Comments
Trade accounts payable	Generally, liabilities of a legal entity represent variable interests in the legal entity. However, trade accounts payable that are short-term, fixed in amount, not junior to any other liability, and not concentrated with a small number of vendors generally should not be treated as a variable interest in the legal entity because such types of trade accounts payable are routine and have little variability. Trade accounts payable that do not fit this description may be a variable interest in the legal entity.
Long-term liabilities of a legal entity (e.g., fixed-rate debt, floating-rate debt, mandatorily redeemable preferred stock)	A debt holder’s interest absorbs the variability in the value of the legal entity’s assets because the debt holder is exposed to that legal entity’s ability to pay (i.e., credit risk) and may be exposed to interest rate risk, depending on the design of the legal entity. See Section 4.3.2 for more information.
License and royalty arrangements	Generally, licenses, royalties, and similar arrangements represent variable interests in the legal entity since contractual terms typically require payments from the legal entity on the basis of the legal entity’s revenues or other performance indicators. Therefore, such arrangements absorb, in part, the variability associated with changes in the legal entity’s performance (i.e., changes in the fair value of the legal entity’s net assets).
Equity of a legal entity (e.g., mezzanine equity, preferred stock, common stock, partnership capital)	If the equity interest is equity investment at risk pursuant to ASC 810-10-15-14(a) (see Section 5.2.2), it is a variable interest that absorbs the variability associated with changes in the legal entity’s net assets. If the equity interest is not at risk pursuant to ASC 810-10-15-14(a), it is typically still a variable interest if it exposes the equity owner to the legal entity’s variability. See Section 4.3.1 for more information.
Guarantees written by a reporting entity*	The guarantee agreement transfers all or a portion of the risk of specified assets (or liabilities) of the legal entity to the guarantor, resulting in the guarantor’s absorbing the variability in values of those specified assets (or liabilities). See Section 4.3.4 for more information on analyzing guarantees. For a discussion of implicit variable interests, see Section 4.3.10.
Put options written by a reporting entity for a price other than fair value (e.g., fixed-price), and similar arrangements on specified assets owned by the legal entity*	Same as guarantees held by a legal entity; the put option writer is exposed to the variability in the values of the assets held by the legal entity if the strike price of the option is at a price other than fair value. However, whether a derivative or a contract with the characteristics of a derivative is a variable interest in a legal entity depends on the design of the legal entity and the characteristics of that instrument. See Section 4.3.4 for more information.
Stand-alone call options written by the legal entity on specified assets owned by that legal entity*	The holder of such a stand-alone call option absorbs positive variability in the value of the specified assets under that call option agreement in scenarios in which the call option would be exercised. However, whether a derivative or a contract with the characteristics of a derivative is a variable interest in the legal entity depends on the design of the legal entity and the characteristics of that instrument. See Section 4.3.7 for more information.
Fixed-price forward contracts to sell specified assets owned by a legal entity*	The counterparty to the forward contract absorbs variability in the fair value of the entity’s specified assets underlying the forward contract. However, whether a derivative or a contract with the characteristics of a derivative is a variable interest in the legal entity depends on the design of the legal entity and the characteristics of that instrument. See Section 4.3.5 for more information.
Total return swaps on specified assets owned by an entity*	The total return swap transfers all or a portion of the risk of specified assets (or liabilities) of the legal entity to the swap counterparty, resulting in the counterparty’s absorbing the variability created by those specified assets (or liabilities). See Section 4.3.7 for more information.
Other derivatives	Whether a derivative is a variable interest in a legal entity depends on the design of the legal entity and the characteristics of that instrument. See Section 4.3.6 for additional guidance on determining whether other derivatives are variable interests.
Fees paid to a decision maker or service provider (see Section 4.4 for detailed discussion of analyzing decision-maker and service-provider fees)	These fees would be considered variable interests if they fail to meet one or more of the three conditions in ASC 810-10-55-37, which are as follows: The fees are compensation for services provided and are commensurate with the level of effort required to provide those services. The decision maker or service provider does not hold other interests in the VIE that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE’s expected losses or receive more than an insignificant amount of the VIE’s expected residual returns. The service arrangement includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arm’s length. In addition, fees received related to assuming risk exposure are automatically a variable interest (see Section 4.4.1.1).
Stand-alone residual value guarantees of the legal entity’s leased assets, written put options covering such leased assets (legal entity is the lessor), or both*	Stand-alone residual value guarantees transfer all or a portion of the risk of specified assets of the legal entity to the guarantor, resulting in the guarantor’s absorbing the variability of those specified assets. Likewise, a written put option from the reporting entity to the legal entity is similar to a guarantee as the exposure to variability of the assets is the same.
Operating leases in which the legal entity is the lessor and there is an embedded residual value guarantee, a purchase option not based on fair value (i.e., a lessee call option), or both*	Because the embedded guarantee and purchase option are not clearly and closely related to the cash flows of the operating lease, the operating lease (i.e., the host contract) and the embedded items should be evaluated separately. The embedded items result in a variable interest,* as explained above. However, the host contract, an economic equivalent of an account receivable, creates variability for the legal entity and therefore is not a variable interest. See Section 4.3.9 for additional information, and see Section 4.3.10.1 for a discussion of an implicit variable interest.
Supply agreements with a variable cost component (when the legal entity is the supplier/seller)	For supply agreements designed to reimburse all or a portion of actual costs incurred, the counterparty to the supply agreement absorbs variability in the legal entity. Investors in the legal entity are partially protected from absorbing losses because the counterparty is reimbursing the legal entity for actual costs incurred. See Section 4.3.5.1 for more information.
* ASC 810-10-25-55 and 25-56 indicate that variable interests in a specified asset whose value is less than half of the total fair value of a VIE’s assets are not considered variable interests in that legal entity unless the reporting entity also holds another interest in the legal entity (see Section 4.3.11 for a discussion of interests in specified assets). In addition, the variable interest could result in consolidation of a “silo” within a VIE (see Chapter 6).

The table below lists examples (not all-inclusive) of financial instruments and other contracts with a legal entity that generally would not be considered variable interests in that legal entity (i.e., sources of variability). As in Table 4-1, note that determining whether a particular interest is a variable interest depends on the design of the legal entity and the role of that interest. Also note that “legal entity” means the potential VIE in which the reporting entity holds an interest.

Table 4-2 Examples of Sources of Variability

Financial Instruments or Other Contracts	Comments
Assets of the legal entity	Assets typically are the major source of a legal entity’s variability and are therefore not considered variable interests. However, see Table 4-1 for purchased guarantees, put options, and similar items that may be assets but are considered variable interests in the legal entity or in specified assets pursuant to ASC 810-10-25-55 and 25-56.
Options, guarantees, and similar financial instruments or contracts written by a legal entity	When the legal entity writes (sells) a put option, a guarantee, or a similar contract, those contracts normally create variability (e.g., the legal entity writes a put option on an asset owned by another party). Therefore, they are normally not variable interests to the counterparty. However, as described in Table 4-1, stand-alone call options written by the legal entity on specified assets owned by that legal entity would be variable interests.
Other derivatives	Whether a derivative is a variable interest in a legal entity depends on the design of the legal entity and the characteristics of that instrument. ASC 810-10-25-21 through 25-36 provide additional guidance on determining whether other derivatives are variable interests. See Section 4.3.6 for additional guidance on determining whether other derivatives are variable interests.
Fixed-price forward contracts to purchase assets not owned by the legal entity, fixed-price contracts to sell assets not owned by the legal entity	Typically, forward contracts related to assets the legal entity does not own create variability because they expose the legal entity to changes in the fair value of the assets underlying the forward purchase or sale contracts. See Section 4.3.5 for additional information.
Operating leases in which the legal entity is the lessor and there is no residual value guarantee, purchase option not based on fair value (i.e., a lessee call option), or other similar provision	The operating lease is the economic equivalent of an account receivable; therefore, it exposes the legal entity to variability (e.g., lessee performance). See Section 4.3.9 for additional information.

4.3.1 Equity Interests

ASC 810-10

55-22 Equity investments in a VIE are variable interests to the extent they are at risk. (Equity investments at risk are described in paragraph 810-10-15-14.) Some equity investments in a VIE that are determined to be not at risk by the application of that paragraph also may be variable interests if they absorb or receive some of the VIE’s variability. If a VIE has a contract with one of its equity investors (including a financial instrument such as a loan receivable), a reporting entity applying this guidance to that VIE shall consider whether that contract causes the equity investor’s investment not to be at risk. If the contract with the equity investor represents the only asset of the VIE, that equity investment is not at risk.

Equity is almost always a variable interest, because it typically represents the most subordinated interest in the legal entity’s capital structure. Therefore, equity will absorb the variability in the returns of the legal entity. In addition, equity investments may be variable interests even if it is determined that they are not at risk (equity investments at risk are described in Section 5.2.2) as long as they absorb or receive some of the legal entity’s variability. However, if a legal entity has a contract with one of its equity investors (e.g., the legal entity has a financial instrument such as a loan receivable from the equity investor), the reporting entity would consider whether that contract causes the equity investor’s investment not to be at risk. For example, if the contract with the equity investor (loan receivable) represents the only asset of the legal entity, that equity investment is not at risk and would not be considered a variable interest. The next section discusses such a scenario. A reporting entity should carefully consider any conclusion that its equity interest does not represent a variable interest because of an offsetting contract.

4.3.1.1 Trust Preferred Security Arrangements and Similar Structures

Some companies (“sponsors”) use trusts or other legal entities (“vehicles”) as issuers of trust preferred securities. The structures are marketed under a variety of names, including trust originated preferred securities, monthly income preferred securities, and quarterly income preferred securities.

A conventional trust preferred arrangement is structured as follows:

The sponsor invests a nominal amount of cash in exchange for common stock in a new legal entity (the “trust”).
The trust issues preferred securities to outside investors in exchange for cash (for an amount much larger than the cash invested by the sponsor).
The proceeds received from the issuance of the common and preferred securities are loaned to the sponsor in exchange for a note (the note’s terms are identical to those of the trust preferred securities).
The sponsor’s parent provides a guarantee to the trust for the repayment of the note payable.
The interest paid on the note by the sponsor to the trust is used by the trust to pay dividends on the preferred securities to outside investors.

In a conventional trust preferred arrangement, the trust has a contract (note receivable) with the sponsor, which is the trust’s only asset. The common stock’s absorption of expected losses depends solely on the sponsor’s ability to repay the note. That is, the trust was designed to create and pass along only the credit risk of sponsor to the sponsor. As a result, the common stock is not equity at risk and not a variable interest. Therefore, the sponsor would not consolidate the trust under the provisions of the VIE model.

The following diagram illustrates a typical conventional trust preferred arrangement:

Specific facts and circumstances must be considered in the assessment of whether a reporting entity is able to analogize to a conventional trust preferred security arrangement outcome in the determination of whether the reporting entity holds a variable interest in a similar type of arrangement. Trust preferred arrangements can be structured in many ways and can result in different conclusions under the VIE model. The FASB staff has informally indicated that a reporting entity (sponsor) should consider whether the arrangement is designed such that the sponsor’s interest in the trust constitutes an obligation to the trust or an investment in the trust.

The risks the trust was designed to create and pass along to the sponsor should be considered in the evaluation of the design of the legal entity. For example, in a conventional trust preferred security arrangement, the trust was designed to create and pass along the credit risk of the sponsor to the sponsor. The only asset of the trust is an obligation of the sponsor, and the sponsor controls the payment on its obligation. In a situation in which the trust holds the common stock of the sponsor, the trust is designed to create and pass along equity price risk to the sponsor. The sponsor does not necessarily control its own equity price because it is subject to a myriad of economic factors. As discussed in the two examples below, the FASB staff has expressed views on two scenarios similar to conventional trust preferred arrangements.

Example 4-2

Reverse Trust Preferred Structure

A trust receives preferred stock instead of holding a note receivable. The preferred stock is treated as debt in the financial statements of the sponsor under ASC 480-10. The investors have no recourse to the assets of the sponsor. The FASB staff’s view is that, in a manner similar to a conventional trust preferred arrangement, the common stock is not equity at risk and is not a variable interest because the contract (preferred stock) with the sponsor represents the only asset of the trust and the preferred stock represents an obligation of the sponsor to the trust; therefore, the only asset of the trust is an obligation of the sponsor.

Example 4-3

Treasury Stock Financing Arrangement

A sponsor seeks to reduce the amount of its common stock held by third-party investors by establishing an SPE. The proceeds received by the SPE from the sponsor and the investment bank (from the issuance of the SPE’s common stock and debt, respectively) are used to purchase the common stock of the sponsor on the open market. The SPE makes interest payments on the debt with the dividend proceeds from the sponsor’s common stock. The investment bank is entitled to additional returns from the SPE if the share price of the sponsor’s common stock exceeds specified thresholds.

The FASB staff’s view is that the sponsor has a variable interest in the SPE because the SPE was designed to create and pass along equity price risk to the sponsor. Unlike the sponsor in the example above, the sponsor in this example does not have an obligation to the SPE. Conversely, the sponsor has an investment in the SPE that absorbs variability because the common stock of the sponsor, purchased on the open market, is subject to economic factors not limited to the credit risk of the sponsor.

4.3.2 Beneficial Interests and Debt

ASC 810-10

55-23 Investments in subordinated beneficial interests or subordinated debt instruments issued by a VIE are likely to be variable interests. The most subordinated interest in a VIE will absorb all or part of the expected losses of the VIE. For a voting interest entity the most subordinated interest is the entity’s equity; for a VIE it could be debt, beneficial interests, equity, or some other interest. The return to the most subordinated interest usually is a high rate of return (in relation to the interest rate of an instrument with similar terms that would be considered to be investment grade) or some form of participation in residual returns.

55-24 Any of a VIE’s liabilities may be variable interests because a decrease in the fair value of a VIE’s assets could be so great that all of the liabilities would absorb that decrease. However, senior beneficial interests and senior debt instruments with fixed interest rates or other fixed returns normally would absorb little of the VIE’s expected variability. By definition, if a senior interest exists, interests subordinated to the senior interests will absorb losses first. The variability of a senior interest with a variable interest rate is usually not caused by changes in the value of the VIE’s assets and thus would usually be evaluated in the same way as a fixed-rate senior interest. Senior interests normally are not entitled to any of the residual return.

Beneficial interests or debt instruments that represent financing instruments of a legal entity are almost always variable interests, even if the instruments are the most senior in the capital structure of the legal entity. As liabilities, these instruments are designed to absorb variability in the performance of the legal entity’s assets because the debt holder is exposed to that legal entity’s ability to pay (i.e., credit risk) and may be exposed to interest rate risk, depending on the design of the legal entity.

4.3.2.1 Netting of Instruments Other Than Equity

As discussed in Sections 4.3.1 and 4.3.1.1, certain equity instruments would not be variable interests because of an offsetting contract with the legal entity. At times, a subordinated beneficial interest or debt holder of a legal entity also will be the counterparty to an asset of that legal entity (e.g., it also borrowed money from the legal entity).

In the determination of a reporting entity’s exposure to variability, the netting concept described in ASC 810-10-55-22 may apply to subordinated beneficial interests or subordinated debt instruments if the contract with the investor is the only asset of the legal entity. If the legal entity has multiple assets, the investor must consider whether the combination of its rights and interests economically exposes it to risks of the legal entity. For example, while an investor’s investment in the legal entity may not be greater than the asset of the legal entity to which it is the counterparty, the subordination of its investment may economically be equivalent to a guarantee of the legal entity’s other assets.

Example 4-4

Entity X is funded as follows:

Enterprise A: subordinated preferred stock — $100.
Enterprise B: senior debt — $100.

Entity X uses the $200 to invest in a $100 note from A and to invest $100 in “other debt securities” issued by parties unrelated to A, B, or X.

The above facts indicate that A has two relationships with X: (1) the subordinated preferred stock, an absorber of variability (i.e., a variable interest), and (2) a note payable due to X, a creator of variability.

In this example, A has indirectly guaranteed the “other debt securities” by subordinating its interest. That is, if the “other debt securities” are not paid when due (or otherwise decrease in value if X does not plan to hold them until maturity), A will absorb that loss by paying on its $100 note payable to X and receiving the residual amount in X through its preferred stock investment. Therefore, A’s subordinated preferred stock represents a variable interest in X.

Note that in certain circumstances, netting a variable interest with an asset in which the reporting entity is the counterparty will result in minimal (i.e., could not be potentially significant from a benefit or loss perspective) or no risk to the variable interest holder. If the reporting entity has other variable interests in the legal entity, the variable interest holder would still need to assess whether its interest, in combination with those other interests, represents an obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant in the primary-beneficiary assessment. (For more information, see Section 7.3.)

4.3.3 Certain Derivative Instruments

ASC 810-10

Certain Derivative Instruments

25-34 A legal entity may enter into an arrangement, such as a derivative instrument, to either reduce or eliminate the variability created by certain assets or operations of the legal entity or mismatches between the overall asset and liability profiles of the legal entity, thereby protecting certain liability and equity holders from exposure to such variability. During the life of the legal entity those arrangements can be in either an asset position or a liability position (recorded or unrecorded) from the perspective of the legal entity.

25-35 The following characteristics, if both are present, are strong indications that a derivative instrument is a creator of variability:

Its underlying is an observable market rate, price, index of prices or rates, or other market observable variable (including the occurrence or nonoccurrence of a specified market observable event).
The derivative counterparty is senior in priority relative to other interest holders in the legal entity.

25-36 If the changes in the fair value or cash flows of the derivative instrument are expected to offset all, or essentially all, of the risk or return (or both) related to a majority of the assets (excluding the derivative instrument) or operations of the legal entity, the design of the legal entity will need to be analyzed further to determine whether that instrument should be considered a creator of variability or a variable interest. For example, if a written call or put option or a total return swap that has the characteristics in (a) and (b) in the preceding paragraph relates to the majority of the assets owned by a legal entity, the design of the legal entity will need to be analyzed further (see paragraphs 810-10-25-21 through 25-29) to determine whether that instrument should be considered a creator of variability or a variable interest.

During the development of the by-design approach (see Section 4.2.1), the FASB debated whether certain derivative instruments, such as interest rate swaps and foreign currency swaps, should be considered a variable interest in a legal entity by the counterparty to the derivative. From an economic standpoint, these types of derivatives could be viewed as both creating and absorbing variability in a legal entity. For example, in an interest rate swap in which the legal entity pays a fixed rate and receives a variable rate, the counterparty is absorbing fair value variability and creating cash flow variability for the legal entity. Although it would be atypical for such an instrument to give the counterparty power over the legal entity, the principles in ASC 810-10-25-35 and 25-36 provide a framework for the counterparties to conclude that many of these instruments are not variable interests in the legal entity, which permits the counterparties to avoid further analysis of whether the legal entity is a VIE as well as the disclosures required by variable interest holders in a VIE.

Under the guidance in ASC 810-10-25-35 and 25-36, even if an instrument absorbs variability, it may be considered a creator of variability (i.e., not a variable interest) as long as it possesses the characteristics in ASC 810-10-25-35 and does not absorb all, or essentially all, of the variability related to a majority of the assets in the legal entity. The guidance is intended to be narrow in scope, applying only to derivative contracts that possess the characteristics in ASC 810-10-25-35.

The flowchart below illustrates how a reporting entity should apply the guidance in ASC 810-10-25-35 and 25-36.

The examples below illustrate the application of this guidance in certain situations. However, each transaction must be evaluated on the basis of its own facts and circumstances.

Example 4-5

An entity is created and financed with equity and variable-rate debt. The entity uses the proceeds to purchase BB-rated, fixed-rate securities. In addition, the entity enters into a “plain vanilla” interest rate swap with an unrelated third party (swap counterparty) that economically converts the fixed-rate securities to a variable rate. The notional amount of the swap is related to a majority of the assets in the entity. The swap counterparty has no other involvement with the entity. Assume that the interest rate swap possesses the following characteristics necessary to apply ASC 810-10-25-35 and 25-36:

The interest rate swap meets the definition of a derivative, as described in ASC 815-10-15-83.
The interest rate swap’s underlying is an observable market rate.
The swap counterparty is senior in priority to the entity’s other interest holders.

The interest rate swap would probably be considered a creator of variability even though that swap absorbs interest rate variability. Although the notional amount of the swap is related to a majority of the assets of the entity, changes in the cash flows or fair value of the swap are not expected to offset all, or essentially all, of the risk or return (or both) related to the investments because the fair value and cash flows of the entity’s investments are expected to be affected by risk factors other than changes in interest rate risk (e.g., credit risk of the BB-rated fixed-rate securities). The swap is designed to offset only interest rate risk, which does not constitute essentially all of the overall risk in the entity. Upon further analysis of the entity’s design, it is determined that the interest rate swap would most likely not be considered a variable interest.

Example 4-6

An entity is created solely to hold common stock in a public company. The entity enters into a total return swap agreement with an unrelated third party in which (1) the entity pays the third party the return on common stock held by the entity as of certain predetermined dates, and (2) the third party pays to the entity a fixed periodic amount. The enterprise has no other involvement in the entity. Assume that the swap possesses the following characteristics necessary to apply ASC 810-10-25-35 and 25-36:

The swap meets the definition of a derivative in ASC 815-10-15-83.
The swap’s underlying (common stock of the entity) is publicly traded and therefore has an observable market price.
The swap counterparty is senior in priority to the other interest holders.

While the total return swap possesses the characteristics described above, it offsets all, or essentially all, of the risk or return (or both) related to the majority of the assets (common stock) held by the entity because the fair value and cash flows of the entity’s investment will vary solely with changes in the price of the common stock and are not expected to be affected by other risk factors. Under the swap agreement, the third party is absorbing all of that price risk, and the entity’s residual interest holders are receiving a fixed return. Further analysis of the entity’s design indicates that the total return swap would most likely be considered a variable interest (see also Example 4-15).

4.3.3.1 Meaning of the Term “Derivative Instrument”

The term derivative instrument, as used in ASC 810-10-25-35 and 25-36, refers only to instruments that meet the definition of a derivative in ASC 815-10-15-83 (see Section 1.4 of Deloitte’s Roadmap Derivatives). This was confirmed through discussions with the FASB staff. The term includes derivative instruments that might not be subject to the requirements of ASC 815 because they qualify for a scope exception in ASC 815-10-15-13. If a reporting entity holds an instrument that does not meet the ASC 815-10-15-83 definition of a derivative instrument, the reporting entity may not apply ASC 810-10-25-35 and 25-36 to determine whether that instrument is a variable interest.

If a reporting entity cannot apply the guidance in ASC 810-10-25-35 and 25-36, the reporting entity should further analyze the design of the legal entity under the VIE model to determine whether the instrument is a creator of variability or a variable interest.

Instruments that have derivative-like features, including guarantees, written put options, liquidity agreements, and forward contracts may be variable interests (see Sections 4.3.4 through 4.3.8 for additional information). While these instruments are subject to the provisions of the VIE model (regardless of whether they meet the definition of a derivative under ASC 815), only those instruments that meet the definition of a derivative under ASC 815 can apply ASC 810-10-25-35 and 25-36.

4.3.3.2 Meaning of the Term “Market-Observable Variable”

To apply ASC 810-10-25-35 and 25-36 to a derivative instrument, a reporting entity must determine whether the instrument possesses the following characteristics:

The derivative instrument’s underlying is an observable market rate, price, index of prices or rates, or other market-observable variable (including the occurrence or nonoccurrence of a specified market-observable event).
The derivative counterparty is senior in priority to other interest holders in the legal entity.

To be a market-observable underlying, the market price, index, rate, or other variable underlying the derivative must be verifiable through an active, liquid market. A derivative with an underlying that is entity-specific (such as an entity’s sales or service revenues) or that is not based on market events (such as the occurrence of a hurricane or an earthquake) would not meet the conditions in ASC 810-10-25-35 even if the contract met the definition of a derivative in ASC 815-10-15-83. This was confirmed through discussions with the FASB staff.

For example, commodities that trade on an active market, such as a commodities exchange, would be deemed to have an observable market price. However, a manufactured product that is sold by a reporting entity and its competitors in the marketplace, but not through an active, liquid market, would not be deemed to have an observable market price.

Another example is an interest rate index such as SOFR, which would be considered an observable market interest rate index. Conversely, a bank’s prime rate would not be considered an observable market interest rate index because it is determined by the bank and not in an active, liquid market.

The concept of “market observable variable” used in ASC 810-10-25-35 is not analogous to the notion of “observable inputs” used in ASC 820. Under ASC 820, “observable inputs” are not limited to variables that are verifiable in active, liquid markets.

4.3.3.3 Meaning of the Term “Essentially All”

A reporting entity must analyze an instrument that possesses characteristics specified in ASC 810-10-25-35, but that is expected to offset all or “essentially all” of the risk or return (or both) related to the majority of the assets or operations of the legal entity, to determine whether the instrument is a creator of variability or a variable interest.

In determining whether an instrument offsets “essentially all” of the risk or return of a majority of the assets of a legal entity, a reporting entity must consider whether the instrument offsets “essentially all” of the overall risk or return of a majority of the assets in the legal entity. The magnitude of the total risk or return should be considered, not whether a reporting entity’s interest offsets some of each type of risk or return in the legal entity. The determination of whether an instrument offsets “essentially all” of the risk or return (or both) is a matter of judgment — there are no strict quantitative guidelines. All facts and circumstances should be considered. This was confirmed through discussions with the FASB staff.

For example, assume that two types of risk are created in a legal entity: operating risk and credit risk. Operating risk accounts for 98 percent of the total risk in the legal entity. The reporting entity holds a derivative instrument in the legal entity that offsets all of the operating risk but none of the credit risk. There are no other arrangements between the legal entity and the reporting entity.

In this example, although the derivative instrument does not absorb each type of risk in the legal entity, it does offset essentially all of the overall risk in the legal entity because operating risk represents essentially all of the risk or return of a majority of the assets in the legal entity. Therefore, the reporting entity must further analyze the design of the legal entity to determine whether the derivative instrument is considered a creator of variability or a variable interest.

4.3.4 Guarantees, Puts, and Other Similar Arrangements

ASC 810-10

55-25 Guarantees of the value of the assets or liabilities of a VIE, written put options on the assets of the VIE, or similar obligations such as some liquidity commitments or agreements (explicit or implicit) to replace impaired assets held by the VIE are variable interests if they protect holders of other interests from suffering losses. To the extent the counterparties of guarantees, written put options, or similar arrangements will be called on to perform in the event expected losses occur, those arrangements are variable interests, including fees or premiums to be paid to those counterparties. The size of the premium or fee required by the counterparty to such an arrangement is one indication of the amount of risk expected to be absorbed by that counterparty.

55-26 If the VIE is the writer of a guarantee, written put option, or similar arrangement, the items usually would create variability. Thus, those items usually will not be a variable interest of the VIE (but may be a variable interest in the counterparty).

Since guarantees of assets or liabilities of a legal entity, written put options on the assets of the legal entity, and similar arrangements expose the counterparty to expected losses of the potential VIE, those arrangements are typically variable interests. However, whether such an arrangement is a variable interest in a legal entity depends on the design of the legal entity and the characteristics of that instrument. In addition, when analyzing guarantees, written put options, or similar arrangements related to assets of a potential VIE, reporting entities must determine whether the specified asset subject to the arrangement has a fair value that is less than half of the total fair value of a potential VIE’s assets (see Section 4.3.11). In addition, if the specified asset is less than half of the total fair value of the potential VIE’s assets, the arrangement is not considered a variable interest in the entire legal entity but could result in consolidation of a “silo” within a VIE (see Chapter 6).

Guarantees and similar arrangements in a potential VIE may not be explicitly identified by a reporting entity that has an implicit obligation to protect the assets or liabilities of a legal entity. For a discussion of implicit variable interests, see Section 4.3.10.

In situations in which an instrument such as a guarantee is written by the potential VIE, the instrument would generally create variability because it would expose the potential VIE to losses, and it would generally not represent a variable interest in the potential VIE.

Example 4-7

Catastrophe Bond Structure

A property and casualty insurer has insurance risk related to the occurrence of catastrophic natural disasters. The insurer forms an off-shore exempted reinsurance company (i.e., an SPE) that is managed by a third party. The purpose of the SPE, which is capitalized by bonds, is to write a reinsurance policy to the insurer. The proceeds from the bond issuance are invested, and those investments collateralize the SPE’s obligations under the reinsurance policy. The bonds are serviced by returns on the investment portfolio and premiums paid by the insurer under the reinsurance policy. Upon the occurrence of a catastrophic event covered by the reinsurance policy, the SPE’s investments are liquidated to pay the claim to the insurer. The reinsurance policy and the bonds are generally coterminous, and to the extent that funds are available, the bonds will be repaid when the reinsurance policy expires.

In essence, the SPE is designed to absorb risk from the insurer. Therefore, in a manner consistent with any insurance arrangement, although the insurer is exposed to the nonperformance risk of the SPE, the reinsurance agreement is a creator of the SPE’s variability as opposed to a variable interest (i.e., which absorbs the variability of the SPE).

4.3.5 Forward Contracts

ASC 810-10

55-27 Forward contracts to buy assets or to sell assets that are not owned by the VIE at a fixed price will usually expose the VIE to risks that will increase the VIE’s expected variability. Thus, most forward contracts to buy assets or to sell assets that are not owned by the VIE are not variable interests in the VIE.

55-28 A forward contract to sell assets that are owned by the VIE at a fixed price will usually absorb the variability in the fair value of the asset that is the subject of the contract. Thus, most forward contracts to sell assets that are owned by the VIE are variable interests with respect to the related assets. Because forward contracts to sell assets that are owned by the VIE relate to specific assets of the VIE, it will be necessary to apply the guidance in paragraphs 810-10-25-55 through 25-56 to determine whether a forward contract to sell an asset owned by a VIE is a variable interest in the VIE as opposed to a variable interest in that specific asset.

Determining whether a forward contract is a variable interest depends on many factors, including the design of the legal entity, whether the asset is owned by the legal entity, the pricing of the forward contract, other significant risks in the legal entity (besides volatility in the pricing of the assets in the forward contract), and the relationship of the fair value of the assets subject to the forward contract compared to the overall value of the legal entity’s assets. Typically, a fixed-price forward contract to sell assets owned by a legal entity would be a variable interest, because the counterparty to the forward contract absorbs variability in the fair value of the entity’s specified assets underlying the forward contract. Conversely, a fixed-price forward contract to purchase assets not currently owned by the legal entity, or a fixed-price contract to sell assets to the legal entity, would typically not be a variable interest, because these contracts tend to create variability for the legal entity. See Section E.5.2 for a detailed discussion of the identification of variable interests for forward contracts in the power and utilities (P&U) industry.

In addition, a forward contract to purchase an asset by a reporting entity at the fair market value on future delivery dates is typically not a variable interest in the legal entity.

Finally, for forward contracts on assets owned by the legal entity, it is important to understand whether the specified asset subject to the arrangement has a fair value that is less than half of the total fair value of a potential VIE’s assets (see Section 4.3.11). In addition, the arrangement could result in consolidation of a “silo” within a VIE (see Chapter 6).

4.3.5.1 Purchase and Supply Arrangements

For purchase and supply arrangements in which a reporting entity enters into a contract either to purchase products from, or to sell products or services to, another entity, the reporting entity must first determine whether that contract contains a lease within the scope of ASC 842. See Section 4.3.9 for a discussion of the evaluation of leases as variable interests.

If the contract does not contain a lease, the reporting entity must then determine whether it constitutes a derivative under ASC 810-10-25-35 and 25-36 (see Section 4.3.3). If the contract does not possess the necessary characteristics to be evaluated under that guidance, the reporting entity should determine whether the purchase and supply arrangement is a variable interest.

The determination of whether a purchase or supply contract is a variable interest will be based on what risks the legal entity is designed to be subject to and whether the role of the contract is to transfer to the counterparty of the purchase or supply agreement a portion of any of those risks from the equity, debt investors, or both. This is consistent with ASC 810-10-25-31, which states:

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.

To determine whether the role of the contract is to transfer all or a portion of the risk or return (or both) of the assets or operations of the legal entity to the contract counterparty, the reporting entity must understand (1) the contract’s pricing, including whether it is fixed, variable, at-market value, or off-market; (2) the predominant risks in the legal entity; and (3) any other involvement the counterparty may have with the legal entity. For example, a purchase or supply agreement that is off-market, when entered into, will always be a variable interest because the pricing terms of the contract result in a reallocation of expected losses between the interest holders. See Section 4.3.5.2 for further discussion of off-market contracts.

The table below illustrates the application of this guidance to certain types of purchase and supply contracts. Determining whether a contract is a variable interest will ultimately depend on individual facts and circumstances. Assume that a legal entity is created to hold a manufacturing facility and is funded by two unrelated equity holders (Investor 1 and Investor 2). An unrelated reporting entity enters into either a purchase contract or a supply contract with the legal entity, as described in the table. The contract is priced at market terms as of its inception date. The reporting entity has no other involvement with the legal entity. Assume that ASC 810-10-25-35 and 25-36 do not apply because the contract is not associated with an observable market. The reporting entity has identified three potential risks in the legal entity: operating risk, credit risk, and product price risk.

Table 4-3 Purchase and Supply Contracts

Type of Contract	Variable Interest?
Fixed-price purchase contract in which the reporting entity purchases 100 percent of the manufactured product from the legal entity	No. The legal entity is designed to be subject to operating risk, credit risk, and raw material price risk. The role of the fixed-price purchase contract is not to transfer a portion of those risks from the equity investors to the reporting entity since the price paid under the contract does not change as a result of changes in operating costs, raw material costs, or default by the purchaser. The variability associated with those risks is designed to be absorbed by the equity investors.
Variable-price purchase contract in which the reporting entity purchases 100 percent of the manufactured product from the legal entity. The contract reimburses the legal entity for actual costs incurred in manufacturing the product	Yes. The legal entity is designed to be subject to operating risk, credit risk of the counterparty, and raw material price risk. The role of the variable-price purchase contract is to transfer raw material price risk and some portion of operating risk from the equity investors to the reporting entity. Risk of changes in raw material prices and a portion of operating costs will be borne by the purchaser.
Fixed-price supply contract in which the reporting entity supplies the raw materials to the legal entity	No. The legal entity is designed to be subject to operating risk and product price risk. The role of the fixed-price supply contract is not to transfer the product price risk from the equity investors to the reporting entity. Rather, the fixed-price supply contract creates variability since the legal entity has fixed its raw material price. Risk of changes in product prices and operating risk will be borne by the equity investors. (See Section 4.3.5.2 for a discussion of off-market supply agreements.)
Variable-price supply contract in which the reporting entity supplies the raw materials to the legal entity	No. The legal entity is designed to be subject to raw material price risk, operating risk, and product price risk. The role of the variable-price supply contract is not to transfer raw material price risk from the equity investors to the reporting entity. Risk of changes in raw material costs will be borne by the equity investors. (See Section 4.3.5.2 for a discussion of off-market supply agreements.)

4.3.5.2 Off-Market Supply Agreements

An off-market supply agreement will generally be a variable interest because it absorbs expected losses or receives expected residual returns that otherwise would be allocated to the investors. See also Example 5-44, which discusses the role of an off-market supply contract in an analysis of whether a legal entity is a VIE under ASC 810-10-15-14(b)(2).

Example 4-8

Investor A and Investor B (unrelated parties) each hold a 50 percent equity interest in a legal entity. The legal entity owns a manufacturing facility that makes a product that is sold in the marketplace. Investor A enters into an agreement to supply the legal entity with the raw materials it needs to manufacture its product. The pricing of the supply agreement is off-market as of the inception date of the contract. Assume that A and B have no other interests in the legal entity.

In this example, the supply agreement between A and the legal entity is a variable interest. The off-market supply agreement reallocates expected losses between A and B; therefore the contract absorbs expected losses and receives residual returns. For example, if the selling price of the raw materials were below market, A would absorb expected losses beyond its 50 percent equity interest because it is not receiving the normal profit on the sale. If the selling price of the raw materials were above market, A would receive, in the form of a premium, expected residual returns beyond its 50 percent equity interest.

This conclusion would not change if a nonequity investor were to enter into the off-market supply agreement with the legal entity. The off-market contract would reallocate expected losses or expected residual returns from the equity investors to the counterparty to the supply agreement.

4.3.5.3 PPAs, Tolling Agreements, or Similar Arrangements

Performing the variable interest assessment for PPAs and tolling arrangements can be particularly challenging. Before evaluating whether the arrangement is a variable interest, a reporting entity is required to determine whether the arrangement is:

An operating lease that qualifies for the scope exception in ASC 810-10-55-39 for an operating lease.
A derivative under ASC 815 that creates (rather than absorbs) variability in accordance with ASC 810-10-25-35 and 25-36.

The example below illustrates a common example for a power plant entity.

Example 4-9

A legal entity (PowerCo) is created to hold a generating facility and is funded by two unrelated equity holders and one unrelated debt holder. Assume the following:

PowerCo uses the proceeds from the equity contributions and debt to purchase the generating facility.
As a condition of lending, the debt holder requires PowerCo to enter into a 20-year forward contract to sell 100 percent of its output to a third party.
PowerCo holds the title to the facility, which has a useful life of 40 years.

See Section E.5.2.1 for comprehensive guidance on how to evaluate these types of contracts.

4.3.5.4 Purchase and Sale Arrangements for Real Estate

The determination of whether a purchase and sale arrangement (PSA) for real estate is a variable interest will be based on identification of the risks the legal entity is designed to create and pass along to its interest holders and whether the role of the PSA is to transfer all or a portion of any of those risks from the investors to the PSA counterparty. To determine whether the role of the PSA is to transfer all or a portion of the risks to the counterparty, a reporting entity must understand (1) the pricing of the PSA (e.g., fixed, variable, at-market, or off-market), (2) the predominant risks of the legal entity, and (3) any other involvement the counterparty may have with the legal entity.

If the PSA is for an asset to be developed (i.e., requires the potential VIE to further develop the asset before the asset is delivered under the PSA), that asset would not be considered “owned by the VIE” because the assets being developed do not yet exist. Therefore, in accordance with ASC 810-10-55-27, a fixed-price PSA would generally not be a variable interest because it does not expose the purchaser to risks associated with real estate development cost overruns. On the other hand, in accordance with ASC 810-10-55-28, if the PSA was for a developed asset or land, the purchaser would generally have a variable interest as a result of the PSA because the purchaser is exposed to fluctuations in the fair value of the assets “owned by the VIE” unless the variable interest is in specified assets — see Section 4.3.11. See also Section E.3.2 for a discussion of land option agreements.

Example 4-10

Company H entered into a PSA with Company P, a legal entity that develops retail real estate. Company H agreed to purchase a completed retail shopping center and related land for $11.5 million upon the completion of construction by P. Company H does not hold an equity interest in P, and P holds legal title to the land and to the construction under development, which comprise all of the assets held by P. The risks P was designed to create and pass along to its interest holders are related to real estate development, including changes in the price of materials or labor (or supply thereof), condemnation, and casualty. Since the price of the PSA with H is fixed, any cost overruns associated with the development are absorbed by the parties funding the construction, specifically the equity and debt investors of P.

Since H has no obligation to fund cost overruns associated with the development, H does not have a variable interest in P because the PSA is effectively a forward contract to buy assets that are not owned by P. Rather, the PSA is a creator of variability for P because it exposes P to the risk of generating a profit through development of the assets subject to the fixed-price forward contract.

Alternatively, if H had a forward contract to purchase land or other assets completed and owned by P, H would have a variable interest in P, subject to the determination of whether the interest is in specified assets under ASC 810-10-25-55 (see Section 4.3.11).

4.3.6 Other Derivatives

ASC 810-10

55-29 Derivative instruments held or written by a VIE shall be analyzed in terms of their option-like, forward-like, or other variable characteristics. If the instrument creates variability, in the sense that it exposes the VIE to risks that will increase expected variability, the instrument is not a variable interest. If the instrument absorbs or receives variability, in the sense that it reduces the exposure of the VIE to risks that cause variability, the instrument is a variable interest.

If a derivative instrument does not meet the narrow scope requirements of ASC 810-10-25-35 (see Section 4.3.3), a reporting entity should carefully consider the derivative’s characteristics and the design of the legal entity to determine whether the derivative is a variable interest. Specifically, if the derivative exposes the legal entity to risk, the instrument is not a variable interest. Conversely, if the derivative reduces the legal entity’s risk (i.e., protects others from being exposed), the instrument is a variable interest. Understanding the legal entity’s design and the characteristics of the instrument are key in the reporting entity’s analysis of whether a derivative, or a contract with the characteristics of a derivative, is a variable interest in the legal entity.

Note that for a purchase and supply arrangement, the reporting entity must first determine whether the contract contains a lease (see Section 4.3.5 for further discussion).

4.3.7 Total Return Swaps and Similar Arrangements

ASC 810-10

55-30 Derivatives, including total return swaps and similar arrangements, can be used to transfer substantially all of the risk or return (or both) related to certain assets of [a] VIE without actually transferring the assets. Derivative instruments with this characteristic shall be evaluated carefully.

A total return swap is a swap agreement in which one party makes payments to another party on the basis of the return of an underlying asset of a legal entity. Accordingly, a total return swap transfers all or a portion of the risk of specified assets (or liabilities) of the legal entity to the swap counterparty, resulting in the counterparty’s absorption of the variability created by those specified assets (or liabilities). By its nature, a total return swap is typically a variable interest.

When determining whether a variable interest exists, reporting entities should note that interests with similar economics and legal characteristics sometimes go by different names in the marketplace, while products with different economics and characteristics may go by the same or similar names. A reporting entity cannot necessarily rely on the name given to a transaction or how it is described in summary term sheets.

For example, many finance lease arrangements are equivalent to total return swaps in that the lessee receives the benefits of the leased assets in exchange for making lease payments during the lease term. Any arrangement that embodies the same or similar contractual terms and economic risks and rewards as a total return swap would be considered equivalent to a total return swap (and therefore potentially a variable interest). Finance leases as variable interests are further discussed in Section 4.3.9.2 and Example 4-13.

In addition, although it only absorbs returns of a legal entity, a call option written by the legal entity on specified assets owned by that legal entity typically represents a variable interest. The holder of such a stand-alone call option absorbs positive variability in the value of the specified assets under that call option agreement in scenarios in which the call option would be exercised.

Finally, for total return swaps and similar arrangements on assets owned by the legal entity, a reporting entity must determine whether the specified asset subject to the arrangement has a fair value that is less than half of the total fair value of a potential VIE’s assets (see Section 4.3.11). If the specified asset is less than half, the arrangement is not considered a variable interest in the entire legal entity but could result in consolidation of a “silo” within a VIE (see Chapter 6).

4.3.8 Embedded Derivatives

ASC 810-10

55-31 Some assets and liabilities of a VIE have embedded derivatives. For the purpose of identifying variable interests, an embedded derivative that is clearly and closely related economically to its asset or liability host is not to be evaluated separately.

Embedded derivatives can result from both implicit and explicit terms that affect the cash flows or the value of the contract in a manner similar to a derivative. Although embedded derivatives are commonly identified in debt and equity instruments, they may also exist in other contracts (e.g., leases, service arrangements, insurance contracts). An instrument that contains embedded derivatives is referred to as a hybrid instrument because it consists of both the host contract and the embedded derivative(s).

For further discussion of the identification of embedded features, see Section 4.2 of Deloitte’s Roadmap Derivatives.

Under ASC 815-15-25-1, all of the following criteria must be met before an entity can separate an embedded derivative from the host contract and account for it under ASC 815:

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
The hybrid instrument is not remeasured at fair value under otherwise applicable [GAAP] with changes in fair value reported in earnings as they occur.
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

Further, ASC 810-10-55-31 states that “an embedded derivative that is clearly and closely related economically to its asset or liability host is not to be evaluated separately.” Accordingly, regardless of whether the other two criteria in ASC 815-15-25-1 are met, reporting entities should separately evaluate any embedded feature that is not clearly and closely related to its host to determine whether the feature is a variable interest. In the evaluation of whether an instrument is a variable interest, the determination of whether the embedded feature should be analyzed separately from its host contract should be consistent with the determination of whether such feature meets the “clearly and closely related” criterion described in ASC 815-15-25-1(a). If a reporting entity determines that an embedded feature should not be bifurcated from its host contract and accounted for under ASC 815 solely because it fails to meet another criterion in ASC 815-15-25-1, the “no bifurcation” conclusion would not affect whether the embedded derivative should be separately evaluated under the VIE model.

For example, if an embedded feature meets the criterion in ASC 815-15-25-1(a) but does not meet the criterion in ASC 815-15-25-1(b) or (c), it should not be separated from its host contract and accounted for separately under ASC 815. In the evaluation of variable interests under AS 810-10, however, a separate assessment of that same embedded feature would be required under ASC 810-10-55-31 because it is not clearly and closely related to its host contract. Alternately, if a reporting entity determines that an embedded feature should not be separated from its host contract and accounted for separately under ASC 815 because its economic characteristics and risks are clearly and closely related to those of the host contract, the embedded feature would similarly not represent a unit of account that is separate from its host contract in the identification of variable interests under ASC 810-10. In other words, the VIE model only requires a reporting entity to analyze whether the embedded derivative is clearly and closely related economically to its asset or liability host (i.e., ASC 815-15-25-1(a)).

For additional guidance on determining whether an embedded derivative is clearly and closely related economically to an asset or liability host, see ASC 815-15-25-16 through 25-29, and ASC 815-15-55-165 through 55-226. Further, see Section 4.3.2 of Deloitte’s Roadmap Derivatives for a discussion of the evaluation of the “clearly and closely related” criterion.

Example 4-11

Enterprise A leases equipment from Entity B (B’s only asset) for a monthly payment of $10,000 for 36 months. The lease agreement includes a residual value guarantee provision in which A guarantees that the fair value of the leased equipment will be no less than $25,000 at the end of the 36-month term. The lease is an operating lease.

The hybrid instrument embodies a host contract (the operating lease) and an embedded derivative (the residual value guarantee provision). The residual value guarantee provision is not clearly and closely related to the operating lease because the economic characteristics and risks of the guarantee are different from those related to the cash flows of the operating lease. Therefore, the hybrid instrument meets the criterion in ASC 815-15-25-1(a). As a result, the residual value guarantee must be evaluated separately from the host operating lease (a source of variability) in accordance with ASC 810-10-55-31.

The operating lease host, an equivalent of an account receivable, creates variability and therefore is not a variable interest in B. However, the residual value guarantee transfers the risk of the legal entity’s asset to the lessee and accordingly is deemed a variable interest in B. Although the embedded feature (residual value guarantee) should not be separated from the operating lease host pursuant to ASC 815 because it fails to meet the criterion in ASC 815-15-25-1(c), it would still need to be analyzed separately under the VIE model.

4.3.9 Leases

ASC 810-10

55-39 Receivables under an operating lease are assets of the lessor entity and provide returns to the lessor entity with respect to the leased property during that portion of the asset’s life that is covered by the lease. Most operating leases do not absorb variability in the fair value of a VIE’s net assets because they are a component of that variability. Guarantees of the residual values of leased assets (or similar arrangements related to leased assets) and options to acquire leased assets at the end of the lease terms at specified prices may be variable interests in the lessor entity if they meet the conditions described in paragraphs 810-10-25-55 through 25-56. Alternatively, such arrangements may be variable interests in portions of a VIE as described in paragraph 810-10-25-57. The guidance in paragraphs 810-10-55-23 through 55-24 related to debt instruments applies to creditors of lessor entities.

The flowchart below illustrates how a reporting entity (lessee) should evaluate whether a lease is a variable interest in the legal entity (lessor).

4.3.9.1 Determining When a Lease Represents a Variable Interest — Potential VIE Is the Lessor

A leasing arrangement accounted for as an operating lease that does not include a residual value guarantee (or similar arrangement) or a fixed-price purchase option, and that is consistent with prevailing market terms at the inception of the lease, generally does not represent a variable interest because the arrangement is akin to a receivable of the lessor entity (the potential VIE). However, residual value guarantees or fixed-price purchase options are not the only provisions in a lease that may represent a variable interest in the lessor entity. All relationships and contractual arrangements between the lessee, lessor, and variable interest holders of the lessor should be evaluated to determine whether those relationships or arrangements result in the lessee’s absorption of expected losses or receipt of expected residual returns of the legal entity, even if the lessee has not entered into an arrangement that would be an explicit variable interest in the legal entity.

If there are other features in an operating lease, such as a purchase option, residual value guarantee, renewal option, or lease prepayment, it is important to understand whether the specified asset subject to the lease has a fair value that is less than half of the total fair value of a potential VIE’s assets. If the specified asset is less than half, the arrangement is not considered a variable interest in the entire legal entity but could result in consolidation of a “silo” within a VIE (see Chapter 6).

See Section 4.3.10.2 for a discussion of when an implicit guarantee may exist in a related-party lease.

Example 4-12

Company A leases property from an unrelated party, Company B. The lease requires fixed monthly payments and contains no residual value guarantees or fixed-price purchase options. At the inception of the lease, the terms were consistent with fair market rentals. The lease meets the classification for an operating lease. The operating lease is the only contractual relationship between A, B, and variable interest holders of B. Company A’s operating lease would not be considered a variable interest in B.

As the example above illustrates, the classification of a leasing arrangement is important in the identification of a variable interest. Such classification is also important in the subsequent accounting and income statement characterization under ASC 842. Although ASC 842 requires a lessee to account for most leases on its balance sheet, including those that have historically been accounted for as operating leases before the adoption of ASC 842, the guidance also requires a lessee to classify a lease as an operating or finance lease for subsequent accounting and income statement characterization purposes.

4.3.9.2 Finance Lease — Potential VIE Is the Lessor

Many question whether a finance lease represents a variable interest since ASC 810-10-55-39 only addresses operating leases. Further, some have questioned whether it is appropriate to consider whether the lessor entity should be consolidated by the lessee since a finance lease results in the capitalization of the asset with a corresponding financing obligation under ASC 842. Unless the fair value of the assets subject to a lease represent less than half of the fair value of the lessor entity’s assets (see Chapter 6), a finance lease represents a variable interest in the legal entity. Specifically, the finance lease arrangement is equivalent to a total return swap in which the lessee receives the benefits of the leased assets in exchange for making lease payments during the lease term. Accordingly, the lessee reporting entity is required to consider whether the lessor entity is a VIE and whether the potential VIE should be consolidated by the lessee reporting entity. While the accounting treatment of a finance lease under ASC 842 may be similar to consolidation of the asset and related debt obligation under the VIE model, a holder of a variable interest must evaluate its interest in the potential VIE unless it qualifies for a scope exception in either ASC 810-10-15-12 or ASC 810-10-15-17.

Example 4-13

A lessor legal entity (a VIE) holds a single asset that it leases to a reporting entity. The lease contains a residual value guarantee and a purchase option. The lessee reporting entity accounts for the lease as a finance lease because the minimum lease payments and the residual value guarantee exceed substantially all of the fair value of the leased property. Therefore, the lessee has a variable interest in the VIE. Further, the lessee reporting entity controls all aspects of operating the leased asset, as well as the right and obligation to purchase the property or remarket the property to a third party at the end of the lease. On the basis of facts and circumstances, a determination is likely to be made that the lessee reporting entity has the power over the most significant activities of the VIE and should consolidate the VIE because of the terms of the finance lease (see Chapter 7 for further discussion of identifying the primary beneficiary).

4.3.10 Implicit Variable Interests

ASC 810-10

Implicit Variable Interests

25-49 The following guidance addresses whether a reporting entity should consider whether it holds an implicit variable interest in a VIE or potential VIE if specific conditions exist.

25-50 The identification of variable interests (implicit and explicit) may affect the following:

The determination as to whether the potential VIE shall be considered a VIE
The calculation of expected losses and residual returns
The determination as to which party, if any, is the primary beneficiary of the VIE.

Thus, identifying whether a reporting entity holds a variable interest in a VIE or potential VIE is necessary to apply the provisions of the guidance in the Variable Interest Entities Subsections.

25-51 An implicit variable interest is an implied pecuniary interest in a VIE that changes with changes in the fair value of the VIE’s net assets exclusive of variable interests. Implicit variable interests may arise from transactions with related parties, as well as from transactions with unrelated parties.

25-52 The identification of explicit variable interests involves determining which contractual, ownership, or other pecuniary interests in a legal entity directly absorb or receive the variability of the legal entity. An implicit variable interest acts the same as an explicit variable interest except it involves the absorbing and (or) receiving of variability indirectly from the legal entity, rather than directly from the legal entity. Therefore, the identification of an implicit variable interest involves determining whether a reporting entity may be indirectly absorbing or receiving the variability of the legal entity. The determination of whether an implicit variable interest exists is a matter of judgment that depends on the relevant facts and circumstances. For example, an implicit variable interest may exist if the reporting entity can be required to protect a variable interest holder in a legal entity from absorbing losses incurred by the legal entity.

25-53 The significance of a reporting entity’s involvement or interest shall not be considered in determining whether the reporting entity holds an implicit variable interest in the legal entity. There are transactions in which a reporting entity has an interest in, or other involvement with, a VIE or potential VIE that is not considered a variable interest, and the reporting entity’s related party holds a variable interest in the same VIE or potential VIE. A reporting entity’s interest in, or other pecuniary involvement with, a VIE may take many different forms such as a lessee under a leasing arrangement or a party to a supply contract, service contract, or derivative contract.

25-54 The reporting entity shall consider whether it holds an implicit variable interest in the VIE or potential VIE. The determination of whether an implicit variable interest exists shall be based on all facts and circumstances in determining whether the reporting entity may absorb variability of the VIE or potential VIE. A reporting entity that holds an implicit variable interest in a VIE and is a related party to other variable interest holders shall apply the guidance in paragraphs 810-10-25-42 through 25-44B to determine whether it is the primary beneficiary of the VIE. The guidance in paragraphs 810-10-25-49 through 25-54 applies to related parties as defined in paragraph 810-10-25-43. For example, the guidance in paragraphs 810-10-25-49 through 25-54 applies to any of the following situations:

A reporting entity and a VIE are under common control.
A reporting entity has an interest in, or other involvement with, a VIE and an officer of that reporting entity has a variable interest in the same VIE.
A reporting entity enters into a contractual arrangement with an unrelated third party that has a variable interest in a VIE and that arrangement establishes a related party relationship.

4.3.10.1 Implicit Variable Interests and “Activities Around the Entity”

The identification of explicit variable interests involves determining which contractual, ownership, or other pecuniary interests in a legal entity directly absorb or receive the variability of the legal entity. An implicit variable interest acts the same as an explicit variable interest except that it involves the absorbing or receiving (or both) of variability indirectly, rather than directly, from the legal entity. Therefore, the identification of an implicit variable interest involves determining whether a reporting entity may be indirectly absorbing or receiving the variability of the legal entity, which may be contractual or implicit.

At the 2004 AICPA Conference on Current SEC and PCAOB Developments, an SEC staff member, Associate Chief Accountant Jane Poulin, used the phrase “activities around the entity.” This expression refers to certain transactions and relationships between a direct interest holder in a potential VIE and other entities that indirectly alter the holder’s exposure to the risks-and-rewards profile of the direct interest holder’s investment. Ms. Poulin stated:

We have seen a number of questions about whether certain aspects of a relationship that a variable interest holder has with a variable interest entity (VIE) need to be considered when analyzing the application of FIN 46R [codified in ASC 810-10]. These aspects of a relationship are sometimes referred to as “activities around the entity.” It might be helpful to consider a simple example. Say a company (Investor A) made an equity investment in a potential VIE and Investor A separately made a loan with full recourse to another variable interest holder (Investor B). We have been asked whether the loan in this situation can be ignored when analyzing the application of FIN 46R. The short answer is no. First, FIN 46R specifically requires you to consider loans between investors as well as those between the entity and the enterprise in determining whether equity investments are at risk, and whether the at risk holders possess the characteristics . . . defined in paragraph 5(b) of FIN 46R [codified as ASC 810-10-15-14]. It is often difficult to determine the substance of a lending relationship and its impact on a VIE analysis on its face. You need to evaluate the substance of the facts and circumstances. The presence of a loan between investors will bring into question, in this example, whether Investor B’s investment is at risk and depending on B’s ownership percentage and voting rights, will influence whether the at risk equity holders possess the characteristics of a controlling financial interest.

Other “activities around the entity” that should be considered when applying FIN 46R include equity investments between investors, puts and calls between the enterprise and other investors and non-investors, service arrangements with investors and non-investors, and derivatives such as total return swaps. There may be other activities around the entity that need to be considered which I have not specifically mentioned. These activities can impact the entire analysis under FIN 46R including the assessment of whether an entity is a VIE as well as who is the primary beneficiary.

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. [Footnotes omitted]

At the 2005 AICPA Conference on Current SEC and PCAOB Developments, an SEC staff member, Mark Northan, emphasized that although FSP FIN 46(R)-5 (codified in ASC 810-10-25-49 through 25-54) focuses on noncontractual interests between related parties, implicit interests can also result from contractual arrangements between a reporting entity and unrelated variable interest holders. The SEC staff provided the following questions for reporting entities to consider in determining whether an implicit variable interest exists:

Was the arrangement entered into in contemplation of the entity’s formation?
Was the arrangement entered into contemporaneously with the issuance of a variable interest?
Why was the arrangement entered into with a variable interest holder instead of with the entity?
Did the arrangement reference specified assets of the [VIE]?

In a manner consistent with explicit variable interests, implicit variable interests and activities around the entity may affect the determination of whether:

The legal entity is a VIE (see Chapter 5), including whether an investor’s equity is at risk, as described in ASC 810-10-15-14(a).
The reporting entity should consolidate a VIE, including whether the reporting entity’s obligation to absorb losses or its right to receive benefits of the VIE could potentially be significant to the VIE (see Chapter 7).
The reporting entity is required to provide the VIE disclosures (see Section 11.2).

In many cases, an implicit arrangement protects another variable interest holder from absorbing losses in a VIE, limits the holder’s ability to receive residual returns in a VIE, or both. Entities can also be designed to enable a reporting entity to circumvent the provisions of the VIE model by placing a party (often a related party) between the reporting entity and a VIE. In all cases, the role of a contract or arrangement in the design of a legal entity must be carefully evaluated, with a focus on its substance rather than on its legal form or accounting designation.

In the diagram below, anything within the circle represents arrangements that are potential explicit variable interests in Entity X. Arrangements between the investors and other entities outside the circle represent activities around the entity and are potential implicit or indirect variable interests in Entity X.

Investors A and B hold the only potential explicit variable interests in Entity X as a result of their equity investments of $1 million and Investor B’s asset guarantee. However, a reporting entity must consider whether any arrangements outside the circle represent an implicit variable interest in Entity X — that is, Reporting Entities C, D, E, and F should “look through” the counterparty to determine whether the role of their interest is to absorb variability of Entity X.

In addition to the questions discussed at the 2005 AICPA Conference on Current SEC and PCAOB Developments, questions for a reporting entity to consider in determining whether it holds an implicit variable interest include the following:

Does a related party, through an ownership interest or by virtue of holding a significant role in the operations, have the ability to require (or have substantial influence over a decision to require) the reporting entity to reimburse the related party for its losses?
Is there an economic motivation for the reporting entity to protect the related party or its variable interest holders from potential losses?
Does the related-party relationship lack the following: (1) conflict-of-interest policies, (2) significant regulatory requirements that create disincentives, (3) fiduciary responsibility clauses, or (4) other similar restrictions that would prevent or deter a reporting entity from forcing a related party to absorb losses?
Are there situations in which losses have been sustained in the past and, though not contractually required to be, were absorbed by the reporting entity?
Are the unrelated parties (e.g., creditors, legal advisers) unaware of the relationships between the parties?
Do other parties (e.g., a lender) involved with the reporting entity believe that there are implicit variable interests (e.g., guarantees)?
Have implicit variable interests existed in past relationships that are similar to the current arrangement?

The determination of whether an interest is an implicit variable interest will depend on the role of that interest in the design of the legal entity and should be based on facts and circumstances. The examples below may help a reporting entity determine whether an interest represents an implicit variable interest.

Example 4-14

Purchased Call and Written Put Option

Investor A has a variable interest in Entity X. Investor A writes a call option to Entity C, an unrelated enterprise, that allows C to call A’s variable interest in X. In addition, A purchases a put option from Entity D (an unrelated entity) that allows A to put its variable interest in X to D.

In this example, neither C nor D holds an explicit variable interest in X. However, given the arrangements (call and put options) C and D have with A (a holder of an explicit variable interest in X), C and D will need to consider whether, on the basis of the facts and circumstances, they hold an implicit variable interest in X. Thus, C and D should consider the following:

Whether the call and put options were entered into in contemplation of X’s formation.
Whether the call and put options were entered into contemporaneously with the issuance of the variable interest held by A.
The reason the call and put options were entered into with A and not X.
Whether the call and put options concern specified assets of X.
The specific terms and conditions of the call and put options (e.g., whether the strike price is fixed).

Example 4-15

Total Return Swap

Investor B holds an equity interest in Entity X that is a variable interest pursuant to the VIE model. Investor B enters into a total return swap agreement (the “swap”) with Entity E, an unrelated enterprise, with the following terms and conditions:

Investor B pays E any dividends it receives as a result of its equity interest in X.
Investor B pays E the appreciation in the value of its equity interest in X, if any, on certain predetermined dates, including the maturity date of the swap.
Enterprise E pays B the depreciation in the value of B’s equity interest in X, if any, on those same dates.
Enterprise E pays B a fixed periodic amount.
Investor B must vote its interest in accordance with E’s instructions.
The swap matures in five years, a date in advance of the expected liquidation of X.
Both B and E are constrained; that is, neither entity can transfer or assign its rights under the swap, and B cannot sell or transfer its variable interest in X. In the absence of such constraints, certain qualified parties would engage in those transactions.
The likelihood that either B or E will fail to perform on any of the swap terms is remote.
Investor B’s variable interest is collateral for its obligation to E.

In this example, E does not have an explicit variable interest in X by virtue of the total return swap agreement described above. However, the total return swap arrangement between E and B (a holder of an explicit variable interest in X) requires E to consider whether it holds an implicit variable interest in X.

Entity E must therefore consider whether the total return swap results in E’s absorption of the variability in X. Although E does not legally own the assets of X, the total return swap generally results in the transfer of risks and rewards of the assets in X from B to E. Therefore, E would probably conclude that it holds an implicit variable interest in X.

This conclusion is consistent with ASC 810-10-55-30 (see Section 4.3.7), which addresses interests that transfer all or a portion of the risk of specified assets (or liabilities) of a VIE (total return swaps are examples of such an arrangement). This risk transfer strongly indicates a variability that X was designed to create and pass along to its interest holders. Therefore, if E had entered into the total return swap agreement directly with X, E would most likely conclude that it holds a variable interest in X. Note also that a principal-agency relationship exists between E and B, respectively, because B is required to vote its interest in X, as directed by E. When applying the provisions of the VIE model, B should attribute its interest to E.

Example 4-16

Back-to-Back Asset Guarantee

Investor B holds an equity interest in Entity X and provides an asset guarantee (guarantee of value) to X. The equity interest and guarantee of value are both variable interests pursuant to the VIE model. Investor B enters into a guarantee contract with Entity F (an unrelated entity) that requires F to pay B for any decrease in value of the assets held by X.

Although F does not have an explicit variable interest in X, the guarantee arrangement between F and B (a holder of an explicit variable interest in X) requires F to consider, on the basis of the facts and circumstances, whether it holds an implicit variable interest in X.

Entity F must therefore consider whether the guarantee contract results in F’s absorption of the variability in X. Although F does not legally own the assets of X, the guarantee contract generally results in the transfer of risks and rewards of the assets in X from B to F. Therefore, F would most likely conclude that it holds an implicit variable interest in X.

This conclusion is consistent with the guidance in ASC 810-10-55-30 (see Section 4.3.7), which addresses interests that transfer all or a portion of the risk of specified assets (or liabilities) of a VIE (asset guarantees are examples of such arrangements). The transfer of this risk is a strong indicator of a variability that X was designed to create and pass along to its interest holders. Therefore, if F had entered into the asset guarantee agreement directly with X, F would most likely conclude that it holds a variable interest in X.

4.3.10.2 Determining Whether an Implicit Guarantee (Variable Interest) Exists

Although the paragraphs below focus on whether an implicit guarantee exists in a leasing arrangement between related parties, reporting entities should analyze all arrangements to determine whether an implicit guarantee exists. An implicit variable interest may arise from transactions with any party, whether related (see ASC 810-10-25-49 through 25-54) or unrelated (see ASC 810-10-25-51).

As discussed in Section 4.3.9.1, an arrangement accounted for as an operating lease that does not include a guarantee (or similar arrangement) or fixed-price purchase option, and that is consistent with prevailing market terms at the inception of the lease, generally does not represent a variable interest to the lessee because the arrangement is a receivable of the lessor entity (the potential VIE). As a “receivable,” the arrangement creates, rather than absorbs, variability for the lessor entity. However, ASC 810-10-55-25 states, in part:

Guarantees of the value of the assets or liabilities of a VIE . . . or similar obligations such as . . . agreements (explicit or implicit) to replace impaired assets held by the VIE are variable interests if they protect holders of other interests from suffering losses. [Emphasis added]

In the VIE analysis, it is important to determine whether an implicit guarantee exists because (1) any implicit guarantee may cause the lessor entity to be a VIE under ASC 810-10-15-14(b)(2) (see Section 5.3.2) since such a guarantee protects the holders of the equity investment at risk from the expected losses of the entity and (2) the lessee (or its related parties) may hold a variable interest in the lessor VIE and should determine whether it is the lessor VIE’s primary beneficiary.

In situations in which a lessee does not have an explicit contract with a potential VIE (lessor entity) that qualifies as a variable interest (e.g., a guarantee), the lessee still may have a variable interest in the lessor entity through an implicit guarantee. This may be more relevant in a related-party leasing arrangement in which the holder of a potential variable interest in the lessor entity has the ability to exert influence on the lessee because of the related-party relationship. Whether an implicit guarantee exists depends on the relationship between the related parties and the nature of their variable interests in the lessor entity. For example, such a guarantee may exist if the holder of a potential variable interest in the lessor entity has the ability to exert its influence on the lessee enterprise and thereby require the lessee to protect the lessor entity from losses on the leased property. Payments made to the lessor entity by the lessee, as well as payments made directly to an interest holder of the lessor, should be considered protection from such losses.

A reporting entity should consider all facts and circumstances in determining whether a related-party lessee (and its related parties) has provided an implicit guarantee of the lessor entity’s property. To do so, the reporting entity would perform a two-step analysis.

Step 1 involves the determination of whether a party that has an ownership interest in, or that holds a significant role in the operations of, the lessee can require — or have substantial influence over a decision to require — the lessee to reimburse the lessor entity for losses it incurs in holding the leased asset.

For example, a decision to renew the lease at above-market rents or provide compensation directly to the variable interest holder could be indicative of an implicit guarantee. The guarantee is not limited to an outright reimbursement of the lessor for incurred losses.

Some examples of possible substantial influence under step 1 include the following:

The lessee and the lessor are both controlled by a common parent.
The lessor is wholly or substantially owned by a stockholder or group of stockholders who also own a stake in, and can exercise substantial influence over, the lessee entity.
The lessor is wholly or substantially owned by a stockholder or group of stockholders who hold a significant role in the operations of the lessee entity (e.g., holding a senior officer or director position in the lessee or a controlling parent company).

If the step 1 conditions have been met, an implicit guarantee may exist. The reporting entity would then proceed to step 2.

In step 2, the reporting entity would consider whether:

There is an apparent economic motivation for the lessee to protect the lessor entity or holders of variable interests in the lessor entity (ASC 810-10-55-25 indicates that a guarantee cannot exist unless it protects holders of other interests from suffering losses). For example, if the lessee and the lessor are both wholly owned subsidiaries of a common parent, the parent (as the shareholder in the lessor) would probably not benefit (on a net basis) from an implicit guarantee. Additional factors (not all-inclusive) to consider are whether (1) a tax strategy exists that creates an economic motivation or (2) parent financing is secured by assets of the lessee.
The lessee (or its ultimate parent) has a fiduciary responsibility. For example, if the lessee has minority shareholders who would be disadvantaged by an implicit guarantee, the lessee may have a fiduciary responsibility that would prevent or significantly deter an implicit guarantee.
The lessee (or its ultimate parent) has clear conflict-of-interest policies that would preclude the existence of an implicit guarantee. The reporting entity would also consider whether the policies are effectively monitored and violations are reported to a level in the organization that has authority over the violator.
The lessee is subject to regulatory requirements that create significant disincentives or preclude transactions that result in an implicit guarantee, or would raise a question about the legality of an implicit guarantee.
Similar transactions have occurred in the past in which a loss has been sustained, and no performance has constituted an implicit guarantee.
Other unrelated parties (e.g., creditors, legal advisers) are aware of the existence of any implicit guarantee between the related parties to the transaction.

In addition, at the 2005 AICPA Conference on Current SEC and PCAOB Developments, the SEC staff indicated that preparers should consider the following questions (not all-inclusive) in identifying implicit variable interests:

Was the arrangement entered into in contemplation of the entity’s formation?
Was the arrangement entered into contemporaneously with the issuance of a variable interest?
Why was the arrangement entered into with a variable interest holder instead of with the entity?
Did the arrangement reference specified assets of the [VIE]?

Example 4-17

Implicit Guarantee Exists

Operating Company (Operating) is a nonpublic entity that leases real estate under a long-term operating lease from a related party, Real Estate, which is wholly owned by the majority shareholder (Shareholder) of Operating. Real Estate (a VIE) was capitalized with $30,000 of equity from Shareholder and $970,000 of bank debt, with recourse to the assets of Real Estate and to the personal assets of Shareholder. Real Estate owns no assets other than the real estate asset leased to Operating. The lease contains no explicit guarantees of the residual value of the real estate or fixed-price purchase options. At the inception of the lease, the terms were consistent with fair market rentals. The lease meets the criteria for classification as an operating lease. The operating lease is the only contractual relationship between Operating and Real Estate.

The following diagram depicts the relationship described above:

ASC 810-10-55-25 indicates that guarantees of the value of the assets or liabilities of a VIE may be explicit or implicit. Although the operating lease itself does not contain a contractual guarantee of the value of Real Estate’s leased asset, as a result of the related-party relationship between the two entities, the following two-step analysis must be performed to determine whether Operating has provided an implicit guarantee of Real Estate’s leased asset to protect Shareholder’s investment in Real Estate and Shareholder’s personal guarantee of Real Estate’s debt:

Step 1 — Shareholder can require Operating to reimburse it or Real Estate for losses incurred through its controlling interest. Therefore, step 2 must be performed.
Step 2 — Shareholder has an economic motivation to require Operating to reimburse it for losses incurred by Real Estate because the minority interest holder will incur a portion of the losses pushed to Operating. If Shareholder does not have a fiduciary responsibility or clear conflict of interest policy that would preclude the pushing of losses to Operating, and no factors indicate that Shareholder is unable to require performance, an implicit guarantee exists. As a result of the implicit guarantee, Operating would hold a variable interest in Real Estate (this implicit guarantee of Real Estate’s leased asset exists whether the guaranteed payment is made directly to Real Estate or directly to Shareholder). Although Operating and Shareholder are related, both Operating (i.e., through its implicit guarantee of the assets of Real Estate) and Shareholder (i.e., through its equity interest and personal guarantee of the debt) must first follow the guidance in ASC 810-10-25-38A to determine whether either entity individually meets both the power and economics criteria and should consolidate Real Estate. If neither Operating nor Shareholder individually meets both criteria, they must apply the guidance in ASC 810-10-25-42 through 25-44 to determine whether one of the parties should consolidate Real Estate.

Example 4-18

Implicit Guarantee Does Not Exist

Enterprise H is a public holding company with two wholly owned subsidiaries, Entity R and Enterprise O. Enterprise O is a regulated operating entity that must file stand-alone financial statements with its regulator. The regulator requires that all related-party transactions entered into by O be on market terms and imposes certain restrictions on dividends that O can pay. Entity R is a real estate company whose only asset is a building leased to O. The lease is a long-term, market-rate operating lease with no explicit residual value guarantee or purchase option. Entity R is funded by 20 percent equity issued to H and an 80 percent intercompany loan from H. Since an operating lease is generally not a variable interest under ASC 810-10-55-39 and since O and R are related parties, O must consider whether it has provided an implicit guarantee to R because of H’s potential ability to require O to fund any losses of R. The following two-step analysis must be performed:

Step 1 — Enterprise H, because of its 100 percent ownership in O, can control O. Therefore, step 2 must be performed.
Step 2 — The following assessment would be conducted:
- Enterprise O and Entity R are both wholly owned subsidiaries of Enterprise H. Therefore, the parent would not benefit (on a net basis) from an implicit guarantee.
- Enterprise O is subject to regulatory requirements that require transactions with related parties to be conducted at market terms. In addition, there are significant disincentives within the regulatory requirements for capital transactions.

If no other overriding factors indicate that H is able to require O to protect it from losses incurred on its investment in R, an implicit guarantee does not exist.

However, note that an accounting alternative is available to private companies under which a legal entity under common control may elect not to apply the VIE guidance as long as the reporting entity, the common-control parent, and the legal entity being evaluated for consolidation are not public business entities and meet the criteria in ASC 810-10-15-17AD. See Section 3.5 for more information about qualifying for this accounting alternative.

4.3.11 Variable Interests in Specified Assets

ASC 810-10

25-55 A variable interest in specified assets of a VIE (such as a guarantee or subordinated residual interest) shall be deemed to be a variable interest in the VIE only if the fair value of the specified assets is more than half of the total fair value of the VIE’s assets or if the holder has another variable interest in the VIE as a whole (except interests that are insignificant or have little or no variability). This exception is necessary to prevent a reporting entity that would otherwise be the primary beneficiary of a VIE from circumventing the requirement for consolidation simply by arranging for other parties with interests in certain assets to hold small or inconsequential interests in the VIE as a whole. The expected losses and expected residual returns applicable to variable interests in specified assets of a VIE shall be deemed to be expected losses and expected residual returns of the VIE only if that variable interest is deemed to be a variable interest in the VIE.

25-56 Expected losses related to variable interests in specified assets are not considered part of the expected losses of the legal entity for purposes of determining the adequacy of the equity at risk in the legal entity or for identifying the primary beneficiary unless the specified assets constitute a majority of the assets of the legal entity. For example, expected losses absorbed by a guarantor of the residual value of underlying asset are not considered expected losses of a VIE if the fair value of the underlying asset is not a majority of the fair value of the VIE’s total assets.

The flowchart below outlines the reporting entity’s consolidation analysis depending on whether it has a variable interest in specified assets of a legal entity. It is assumed in the flowchart that the specified assets are not in a silo. If a silo exists, a reporting entity may need to perform a separate consolidation analysis for the separate silo rather than consider whether a party has a variable interest in a specified asset in the overall legal entity. See Chapter 6 for additional information on silos.

4.3.11.1 Identifying Interests in Specified Assets

An interest in specified assets is a contractual, ownership, or other pecuniary interest whose value changes according to changes in the value of selected assets of the legal entity. In other words, the risks and returns that are associated with the interest are tied to a specific asset or group of assets and not to the risks and returns of the legal entity as a whole. The existence of such interests is the means by which a subset of assets or activities may be effectively segregated from the remaining assets or activities of the legal entity. Interests that typically are considered interests in specified assets include the following:

A fixed-price purchase option or residual value guarantee on a leased asset. Consider an example in which a reporting entity leases equipment from a legal entity, and the terms of the lease allow the reporting entity to purchase the equipment at the end of the lease term for a fixed price. In this case, the reporting entity has a variable interest in specified assets (i.e., the leased equipment) of the legal entity.
Nonrecourse debt. Consider an example in which a reporting entity provides a loan to a legal entity, and the loan is repaid solely from the cash flows that come from specified securities held by the legal entity. In this case, if the securities do not fully repay the loan or if the legal entity is bankrupt, the reporting entity has no recourse to other assets of the legal entity, and the loan is an interest in specified assets (the specified securities).
Credit guarantees and put options held by the legal entity. Consider an example in which a legal entity holds a portfolio of receivables and purchases a credit guarantee from a third party. In this case, the third party has an interest in specified assets (the portfolio of receivables).
Certain types of equity or other residual interests. Consider an example in which a reporting entity holds preferred stock, such as so-called tracking or targeted stock, that pays a return that is based on specified activities of the legal entity.
A forward contract to purchase or sell an asset at a price other than fair value.

To the extent that a reporting entity’s variable interest is not in specified assets, the reporting entity would apply the VIE model to the legal entity as a whole to determine whether the legal entity is a VIE. In performing this assessment, the reporting entity should consider the effect of variable interests in specified assets that may be held by other parties involved with the legal entity. See Section 4.3.11.3 for further discussion.

Example 4-19

Enterprise A owns 100 percent of the equity in Entity X, which is a VIE. Entity X is a lessor of three commercial real estate assets, each of which is approximately 33 percent of the fair value of X. Each lease contains a residual value guarantee of the asset at the end of the lease term. The residual value guarantees would be considered interests in specified assets under ASC 810-10-25-55.

Therefore, the expected losses absorbed by the residual value guarantees would be excluded from the expected losses of the VIE before the evaluation of the design of X and the risks that X was designed to create and pass along to its variable interest holders.

4.3.11.2 Variable Interests in Specified Assets of the Legal Entity That Are More Than 50 Percent of the Total Fair Value of the Legal Entity’s Assets

A reporting entity should carefully consider whether a variable interest is in a specified asset or in the legal entity as a whole. For example, a provider of a guarantee does not always hold a variable interest in the guaranteed legal entity. However, a guarantee of any portion of a legal entity’s liabilities is generally considered a variable interest in the legal entity. ASC 810-10-25-55 explains that a reporting entity has a variable interest in the legal entity if the fair value of the specified assets is more than 50 percent of the total fair value of the legal entity’s assets.

A literal read of the literature would suggest that guarantees of the legal entity’s assets (e.g., a residual value guarantee of a leased asset) that represent more than half of the total fair value of the legal entity’s assets are considered variable interests in the legal entity; the reporting entity would therefore apply the VIE model in ASC 810-10 to the legal entity as a whole to determine whether the legal entity is a VIE. However, we believe that there are scenarios in which a class of variable interest may exist that is exposed to the variability in a specified group of assets and that the holders of such interests have no recourse to the assets of the legal entity. Rather, their recourse is limited to the specified group of assets. Further, essentially none of the returns of the specified assets will accrue to the legal entity as a whole or to holders of other classes of variable interests in specified assets. In such circumstances, the holders of the guarantee would need to consider the silo provisions in ASC 810-10-25-57 to determine (1) whether a silo exists and (2) whether the reporting entity should consolidate the silo. A silo may exist in such cases even if the specified group of assets represents more than 50 percent of the fair value of the legal entity’s assets as a whole. See Chapter 6.

If the variable interest in specified assets is not more than 50 percent of the total fair value of the legal entity’s assets, the guarantee is considered a variable interest in specified assets rather than a variable interest in the legal entity (as long as the reporting entity, including its related parties, has no other variable interest in the legal entity, as further discussed in Sections 4.3.11.3 and 4.3.11.4). In such instances, the reporting entity holding such an interest generally would not be the primary beneficiary of the legal entity. However, the holder of an interest in specified assets must consider the silo provisions of ASC 810-10-25-57 to determine whether a silo exists and whether the reporting entity should consolidate the silo. If, after considering the provisions in ASC 810-10-25-57, the reporting entity determines that a silo does not exist, the reporting entity would stop its consolidation analysis.

In the calculation of whether a reporting entity’s variable interest in specified assets is more than 50 percent of the total fair value of the legal entity’s assets, it is appropriate to deduct the fair value of a silo’s assets, if any, from the total assets of the host entity before such a computation is performed. See Section 6.2.2 for further discussion.

4.3.11.3 Considering a Reporting Entity’s Other Interests

ASC 810-10-25-55 explains that if a reporting entity has (1) a variable interest in specified assets of a legal entity and (2) another variable interest in the legal entity as a whole, the reporting entity’s interest in specified assets is considered a variable interest in the legal entity as a whole. However, if the holder’s other interest in the legal entity as a whole is insignificant or deemed to have little or no variability, the holder’s interest in specified assets would not be considered a variable interest in the legal entity as a whole.

A reporting entity should consider all facts and circumstances associated with its interests in the legal entity in determining whether its interest in the legal entity as a whole is significant or will absorb more than little or no variability in the legal entity’s cash flows. When determining significance, the reporting entity should consider quantitative factors (e.g., the fair value of the “non-guarantee” interest in relation to the fair value of other assets in the legal entity) and qualitative factors (e.g., specific rights or obligations borne by the interest in the legal entity and the purpose served by this interest in the design of the legal entity). Little or no variability would be expected to be a lower threshold than “insignificant,” as used in ASC 810-10-55-37 (see Section 4.4.2.1). The objective is to determine whether the other interest held by the party with an interest in specified assets is a substantive interest in the legal entity as a whole or whether the interest was designed to circumvent a consolidation conclusion that would otherwise be reached under the VIE model in ASC 810-10. A reporting entity will make this determination by considering all the interests in the legal entity and the risks that the legal entity was designed to pass along to its interest holders.

In addition to potentially affecting the determination of the primary beneficiary of a VIE, identifying whether an interest in specified assets is an interest in the legal entity as a whole could influence the determination of whether the legal entity is a VIE. This is because the expected losses and expected residual returns that would be attributable to the interest holder in specified assets are excluded from the calculation of the expected losses and expected residual returns of the legal entity as a whole. Therefore, ASC 810-10-25-55 prevents a reporting entity from structuring the terms of the interests issued by a legal entity to achieve a desired accounting result regarding whether the legal entity is a VIE and whether the reporting entity is the primary beneficiary of the VIE.

Example 4-20

Assume the same facts as in Example 4-19, except that (1) Enterprise A owns 99.97 percent of the equity in Entity X and (2) X requires that, in conjunction with entering into the lease, each lessee invest in 0.01 percent of the equity of X.

Since the equity held by each lessee has little or no variability, the residual value guarantees would still be considered interests in specified assets under ASC 810-10-25-55. However, if the requirement was for each lessee to invest in 5 percent of the equity of X, such equity interest would be considered a more-than-insignificant other interest. This would result in the conclusion by each lessee that its combined interest (residual value guarantee and equity interest) is a variable interest in the entity as a whole as opposed to specified assets of the legal entity.

4.3.11.4 Considering a Related Party’s Interest

We believe that in assessing the guidance in ASC 810-10-25-55, a reporting entity should consider its interests (direct, indirect, and implicit) and interests held by its related parties to determine its variable interest in a legal entity. There is no specific guidance in ASC 810-10 on how to consider variable interests held by a related party in the assessment of whether a reporting entity has a variable interest in specified assets. Therefore, a reporting entity could analogize to the related-party guidance in ASC 810-10-55-37D when considering such interests. For example, a reporting entity would consider its related party’s interest on a proportionate basis.

Example 4-21

Enterprises A and B are related parties (see Chapter 8). Individually, (1) A has a variable interest in VIE X as a whole and (2) B has a variable interest in specified assets of X because B provides a credit guarantee on X’s receivables, which have a fair value that is less than 50 percent of the fair value of X’s total assets. Further, B has a 20 percent direct ownership interest in A. Because A and B are related parties, B has an additional indirect interest in X through its direct 20 percent ownership in A. Unless B’s proportionate interest in X (i.e., through B’s 20 percent interest in A and A’s variable interest in X) is insignificant or has little or no variability, B would conclude that it has a variable interest in X in accordance with ASC 810-10-25-55 because B has a variable interest in specified assets of X and another variable interest in the VIE as a whole.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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.