Chapter 5 — Determining Whether a Legal Entity Is a VIE

5.1 Introduction

ASC 810-10

25-37 The initial determination of whether a legal entity is a VIE shall be made on the date at which a reporting entity becomes involved with the legal entity. For purposes of the Variable Interest Entities Subsections, involvement with a legal entity refers to ownership, contractual, or other pecuniary interests that may be determined to be variable interests. That determination shall be based on the circumstances on that date including future changes that are required in existing governing documents and existing contractual arrangements.

To determine which consolidation model a reporting entity should apply to evaluate its variable interest in a legal entity, the reporting entity must determine whether the legal entity is a VIE. This determination must be made upon a reporting entity’s initial involvement with a legal entity and reassessed upon the occurrence of a reconsideration event (see Chapter 9 for a discussion of VIE reconsideration events). If the legal entity is a VIE, a reporting entity with a variable interest (see Chapter 4) in that legal entity applies the VIE provisions of ASC 810-10 to determine whether it must consolidate the legal entity. If a legal entity is not a VIE, it is considered a voting interest entity, and a reporting entity applies the voting interest entity model to determine whether it must consolidate the legal entity (see Appendix D for a discussion of the voting interest entity model).

The consolidation conclusions under the VIE model can be different from those under the voting interest entity model. Because the differences between a VIE and a voting interest entity can be subtle, a reporting entity must have a complete understanding of all contractual arrangements (explicit and implicit) as well as the design and purpose of the legal entity.

Legal entities can differ in structure as well as legal form (e.g., corporations compared with limited partnerships and similar entities), which affects the method used to understand their design and purpose. In simple terms, the distinction is based on the nature and amount of the equity investment and the rights and obligations of the equity investors. If a legal entity has sufficient equity investment at risk to finance its operations, and those equity investors, through their equity investment at risk, make decisions that direct the significant activities of the legal entity, consolidation based on majority voting interest is generally appropriate. However, if equity is not sufficient, or the equity investors do not control the legal entity through their equity investment, the VIE model is used to identify the appropriate party, if any, to consolidate.

To qualify as a VIE, a legal entity needs to satisfy only one of the following characteristics (which are discussed in detail in the sections below):

The legal entity does not have sufficient equity investment at risk (Section 5.2).
The equity investors at risk, as a group, lack the characteristics of a controlling financial interest (Section 5.3).
The legal entity is structured with disproportionate voting rights, and substantially all of the activities are conducted on behalf of an investor with disproportionately few voting rights (Section 5.4).

5.1.1 Application of VIE Guidance to Multitiered Legal-Entity Structures

Section 3.2.2 describes the application of the VIE framework to multitiered legal-entity structures, noting that such an analysis begins at the bottom and proceeds to the top. Each entity within the structure should then be evaluated on a consolidated basis. The attributes and variable interests of the underlying consolidated entities generally should become those of the parent company upon consolidation. As a result of this framework, in certain structures, if a lower-tiered legal entity is a VIE and consolidated by another legal entity (its parent), the parent may be determined to be a VIE. For example, if the lower-tiered legal entity is a VIE because of insufficiency of equity investment at risk, when those attributes become those of the parent, the parent may also be determined to be a VIE depending on the design of the legal entity and whether the parent has other substantive activities or consolidated subsidiaries (see Examples 3-4 and 3-5 in Section 3.2.2).

5.1.2 Anticipating Changes in the Design of a Legal Entity

In general, the assumptions a reporting entity uses to determine whether a legal entity is a VIE are limited by the legal entity’s design as of the assessment date. In its evaluation, the reporting entity should not consider contractual changes to the legal entity’s design that are anticipated but not required. The governing documents and contractual arrangements establish a legal entity’s design and usually give insight into why the legal entity was formed and the primary activities it is expected to perform.

However, it would be appropriate to consider activities (and the potential funding sources of those activities) that are expected to be undertaken by the legal entity in its ordinary course of business as a result of its design. While a reporting entity must use judgment in determining whether an assumption is within the scope of the legal entity’s design, it would be appropriate to assume that the legal entity will enter into sales and purchase contracts as part of its ordinary course of business because its ability to enter into such contracts affects the variability in the designed operations.

5.2 Sufficiency of Equity

ASC 810-10

15-14 A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist. (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a VIE does not become one because of operating losses. The design of the legal entity is important in the application of these provisions.)

The total equity investment (equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements) at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. For this purpose, the total equity investment at risk has all of the following characteristics:
1. Includes only equity investments in the legal entity that participate significantly in profits and losses even if those investments do not carry voting rights
2. Does not include equity interests that the legal entity issued in exchange for subordinated interests in other VIEs
3. Does not include amounts provided to the equity investor directly or indirectly by the legal entity or by other parties involved with the legal entity (for example, by fees, charitable contributions, or other payments), unless the provider is a parent, subsidiary, or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor
4. Does not include amounts financed for the equity investor (for example, by loans or guarantees of loans) directly by the legal entity or by other parties involved with the legal entity, unless that party is a parent, subsidiary, or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor.

Paragraphs 810-10-25-45 through 25-47 discuss the amount of the total equity investment at risk that is necessary to permit a legal entity to finance its activities without additional subordinated financial support. . . .

A legal entity is not a VIE under this criterion if its total equity investment at risk is sufficient to finance its activities without additional subordinated financial support. In establishing this guidance, the FASB reasoned that an equity investment that is not sufficient to permit a legal entity to finance its own activities without additional subordinated financial support indicates that an analysis of voting rights is not an effective way to determine whether a reporting entity has a controlling financial interest in the legal entity. Therefore, the owner of a majority residual interest in a legal entity with insufficient equity may not be the appropriate party to consolidate. Nevertheless, in many instances, an equity investor with a majority of the voting interests may still be deemed to hold a controlling financial interest and would therefore consolidate the VIE if it is the party that has the power to direct the most significant activities of the VIE.

To determine whether there is sufficient equity investment at risk to permit the legal entity to finance its activities without additional subordinated financial support, a reporting entity must perform the following steps:

Step 1 — Identify whether an interest in a legal entity is considered GAAP equity (see Section 5.2.1).
Step 2 — Determine whether the equity investment is “at risk” on the basis of the equity investment population (see Section 5.2.2).
Step 3 — Determine whether the identified equity investment at risk is sufficient to finance the legal entity’s operations without additional subordinated financial support (see Section 5.2.3).

5.2.1 Identifying Whether an Interest in a Legal Entity Is Considered GAAP Equity (Step 1)

A reporting entity’s ultimate goal in performing the assessment in ASC 810-10-15-14(a) is to determine whether a legal entity is sufficiently capitalized with equity that has the characteristics typical of equity. Doing so requires identification of equity investment at risk, which first requires identification of whether an interest is considered GAAP equity. For more information, see Deloitte’s Roadmap Distinguishing Liabilities From Equity.

While only an equity interest can be considered equity investment at risk, not all equity interests will be considered equity investment at risk. An interest classified outside the equity section (permanent or temporary, as described in Section 5.2.1.1) of a legal entity’s balance sheet is not an equity investment. Accordingly, an equity investment might include the following types of interest:

Common stock.
Preferred stock.
Ownership interests in partnerships and similar entities.
Certain beneficial interests in trusts and securitizations in the infrequent circumstances in which they are considered legal-form equity and classified as GAAP equity.

The above list is not comprehensive and does not suggest that those interests are equity investments; rather, it illustrates only that the types of interests qualifying as equity may be diverse. However, the interests must be classified as GAAP equity for accounting purposes under U.S. GAAP. This distinction applies even when the interest does not convey the right to vote on decisions of the legal entity. By extension, the following types of interests can never be considered equity for this purpose:

Debt.
A legal-form equity interest, including common stock, preferred stock, or ownership interests in partnerships and similar legal entities, that is classified as a liability under ASC 480-10.
Commitments to fund equity or to absorb losses.
Personal guarantees by an equity holder.

Interests that are not classified at the time of evaluation as equity for accounting purposes cannot meet the definition of an equity investment at risk. This applies even if an interest classified outside of equity has characteristics that are very similar to equity (e.g., a shareholder loan recognized outside of equity).

5.2.1.1 Mezzanine or Temporary Equity

Instruments accounted for as mezzanine or temporary equity would qualify for inclusion in a legal entity’s total equity investment at risk if those instruments meet the conditions in ASC 810-10-15-14(a). This guidance is consistent with ASC 815-10-15-76, which indicates that “[t]emporary equity is considered stockholders’ equity for purposes of the scope exception in paragraph 815-10-15-74(a) even if it is required to be displayed outside of the permanent equity section.”

However, interests classified as temporary equity may not significantly participate in the profits and losses of the legal entity and thus fail to meet the requirement in ASC 810-10-15-14(a)(1) for inclusion in equity investment at risk (see Section 5.2.2).

5.2.1.2 Personal Guarantee or Commitment to Fund

If an amount has only been guaranteed or committed (and not funded) by the equity holder as of the date of the VIE analysis, neither the amount guaranteed nor the fair value of the guarantee is considered equity investment at risk.

5.2.1.3 Instruments With a Similar Risks-and-Rewards Profile of Equity

A legal entity may be capitalized with equity as well as with other instruments that cannot be reported as equity under U.S. GAAP in the legal entity’s financial statements (e.g., participating subordinated debt). Sometimes the risks-and-rewards profile of such an instrument is similar to that of an equity investment. Whether interests in a legal entity qualify as equity investment at risk depends, in part, on their form. Instruments that cannot be reported as equity in a legal entity’s financial statements cannot qualify as equity investment at risk.

ASC 810-10-25-47 describes the following situation in which subordinated debt does not qualify as equity investment at risk:

[I]f a legal entity has a very small equity investment relative to other entities with similar activities and has outstanding subordinated debt that obviously is effectively a replacement for an additional equity investment, the equity would not be expected to be sufficient.

5.2.1.4 Equity of a Foreign Entity

An interest that is classified as equity under foreign GAAP does not automatically result in a conclusion that it represents equity investment at risk under ASC 810.

Example 5-1

A reporting entity holds a variable interest in a foreign entity that prepares its financial statements in accordance with its home-country GAAP. The reporting entity has an investment in the foreign entity that is classified as equity under the investee’s foreign GAAP but that does not qualify as equity under U.S. GAAP. This interest is not an equity investment under the VIE model. Even though the foreign entity reports the instrument as equity under its home-country GAAP, the financial instrument in the foreign entity still must qualify for recognition as equity under U.S. GAAP.

5.2.2 Determining Whether the Equity Investment Is “At Risk” (Step 2)

An interest classified as equity may not have the substantive characteristics of equity. Since the VIE consolidation framework is intended to apply to entities whose equity voting interests may not be the most appropriate determining factor in the identification of which party should consolidate, the FASB reasoned that equity interests that are not “at risk” should not be included in the sufficiency-of-equity test. To be considered part of the equity investment at risk, equity interests must:

Participate significantly in profits and losses.
Not be issued in exchange for subordinated interests in other VIEs.
Not be received from the legal entity or by parties involved with the legal entity unless that party is a parent, a subsidiary, or an affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor.
Not be financed by the legal entity or other parties involved with the legal entity unless that party is a parent, a subsidiary, or an affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor.

5.2.2.1 Significant Participation in Profits and Losses

Equity investment at risk includes only equity investments in the legal entity that participate significantly in profits and losses even if those investments do not carry voting rights. This characteristic is based on the contractual rights of an equity investment, not an assessment of probability. The determination of whether a legal entity participates significantly in profits and losses should be based on the legal entity’s profits and losses under GAAP, not the legal entity’s variability in returns (i.e., expected losses and expected residual returns; see Section 2.3). An equity investment must participate significantly in both profits and losses. An interest that participates in one but not the other is not at risk.

A reporting entity must determine whether an equity instrument participates significantly in the profits and losses of the potential VIE as a whole on the basis of the design of the potential VIE as of the date of the evaluation under ASC 810-10-15-14(a). Generally, instruments that participate on a pro rata basis in the profits and losses, based on GAAP, of all the potential VIE’s assets and liabilities are considered to participate significantly in the profits and losses of the potential VIE as a whole. By contrast, instruments that participate in the profits and losses of specified assets may not be considered to participate significantly in the profits and losses of the potential VIE as a whole and therefore would not qualify as equity investment at risk.

Example 5-2

A limited partnership is formed in which the general partner holds a 2 percent interest and the limited partners hold the remaining equity interests. Profits and losses of all assets and liabilities of the partnership are distributed pro rata according to ownership interests. There are no other arrangements between the entity and the general and limited partners. In this scenario, even though the general partner only absorbs and receives 2 percent of the profits and losses of the limited partnership, its equity interest participates pro rata in the profits and losses of the limited partnership as a whole. Therefore, the general partner’s equity interest participates significantly in the profits and losses of the limited partnership.

Example 5-3

Two unrelated parties, Enterprise A and Enterprise B, each contribute $10 million for equity investments in a legal entity. The legal entity uses the proceeds from the equity issuance, along with another $80 million obtained from the issuance of debt, to invest in two buildings, each worth $50 million. The common stock is classified in equity. Enterprise A contractually absorbs only the profits and losses of Building 1, and B contractually absorbs only the profits and losses of Building 2. In this example, even though the common stock is classified in equity, neither the equity of A nor that of B qualifies as an equity investment at risk because neither significantly participates in the profits and losses of the entity as a whole. The parties should evaluate their interest under the “silo” provisions in ASC 810-10-25-57 to determine whether silos exist (see Chapter 6).

5.2.2.1.1 Fixed-Rate, Nonparticipating Preferred Stock

Fixed-rate, nonparticipating preferred-stock or other fixed-return instruments classified in equity typically would not participate in fluctuations in a legal entity’s profits and losses. Accordingly, such interests typically would not participate significantly in the legal entity’s profits and losses. A reporting entity may determine, upon evaluating all the facts and circumstances, that a fixed-rate instrument participates significantly in the profits and losses of the legal entity. For example, the legal entity may have very little expected variability in profits and losses (e.g., the legal entity holds fixed-rate assets that have little risk).

5.2.2.1.2 Contracts and Instruments That Protect an Equity Investor

Contracts and instruments that are separate from the equity interest and entered into with a party other than the investee generally do not cause the equity investment to fail to be at risk.

Whether an equity interest participates significantly in the profits and losses of a legal entity generally is only based on the terms of the contracts or instruments with the legal entity. Therefore, a contract or instrument entered into with a party other than the investee that is separate from the equity interest itself does not disqualify the equity investment from being at risk. Contracts and instruments may affect the holder’s total return but do not directly affect returns from the legal entity on the equity investment. Therefore, the equity investment would be at risk as long as it meets the other conditions in ASC 810-10-15-14(a).

Put rights, total return swaps, guarantees, and similar arrangements with parties related to the legal entity may result in a conclusion that the equity interest is not at risk under ASC 810-10-15-14(a)(4) (see Section 5.2.2.4.1).

Note that if the direct holder of the equity interest is acting solely as an agent for the counterparty to the other instrument or contract, a reporting entity should attribute the direct holding to the counterparty in evaluating the accounting requirements under the VIE model.

5.2.2.2 Equity Investments Issued in Exchange for Subordinated Interests in Other VIEs

Equity investment at risk does not include equity interests that the legal entity issued in exchange for subordinated interests in other VIEs. An equity interest can be considered at risk for only one legal entity.

Example 5-4

Entity A (the reporting entity) contributes cash to Entity B (a legal entity that is a VIE) in exchange for common stock. Entity A contributes its investment in B to Entity C (a newly formed legal entity) in exchange for C’s common stock. Each common stock investment is classified as equity in the balance sheet of the respective issuer. By using its investment in B to fund its investment in C, A has received an equity investment in exchange for a subordinated interest in another legal entity. The equity investment in both B and C is funded with only one cash contribution. Hence, the common stock in B, but not the common stock in C, will be considered at risk.

5.2.2.3 Equity Investments Provided to the Equity Investor by the Legal Entity or by Parties Involved With the Legal Entity

Equity investment at risk does not include amounts (e.g., fees, charitable contributions, or other payments) provided to the equity investor directly or indirectly by the legal entity or by other parties involved with the legal entity unless the provider is a parent, subsidiary, or affiliate of the investor that must be included in the same set of consolidated financial statements as the investor.

ASC 810-10-15-14(a) requires the reporting entity to identify whether equity investment is at risk (i.e., to determine whether the equity investor’s “skin in the game” is sufficient to warrant a consolidation analysis under the voting interest entity model). If an equity investment is accompanied by a contemporaneous return of investment — or a guaranteed return of investment — the substance of the investment is not at risk. That is, if the equity investor is assured a return of investment at the time of making its investment, the transaction contains a round-trip component. If the equity investment is removed immediately from the legal entity, or otherwise returned to the investor by a party involved with the legal entity, the risk of loss does not substantively exist for that equity investment.

Example 5-5

Entities Z and X (both reporting entities) form Entity Y (a legal entity). Entities Z and X each contribute cash to Y in exchange for common stock in Y. Concurrently with this transaction, X agrees to pay Z an up-front fee equal in amount to Z’s cash investment in Y. In this circumstance, though Z has not withdrawn its cash investment in Y, because it has received a cash payment equal in amount to the cash investment, the equity investment contributed by Z is not considered to be at risk.

Considerable judgment is required in the assessment of an arrangement’s facts and circumstances to determine whether the arrangement represents a return of investment sufficient to disqualify an equity interest from treatment as equity investment at risk. Matters requiring assessment include the type, timing, source, and amount of a payment as well as whether the payment is contingent on any circumstances. For example, a fee arrangement after the formation of a venture, in which a venturer is paid an at-market fee for providing services to the venture, does not reduce the equity investment at risk.

ASC 810-10-15-14(a) specifically excludes arrangements between a parent, a subsidiary, or an affiliate of the equity investor when that party is required to be included in the same consolidated financial statements as the investor. Such a circumstance does not involve a return of investment but instead merely reshuffles it through intercompany accounts without affecting the consolidated financial statements.

5.2.2.3.1 Equity Received for Promises to Perform Services (“Sweat Equity”)

Equity investments acquired by an equity investor in exchange for promising to perform services, commonly referred to as “sweat equity,” cannot be included in equity investment at risk, because the equity is received in lieu of a fee for services performed. Similarly, equity investments acquired as a result of past services performed are not considered equity investment at risk.

Example 5-6

Three investors form Entity X to conduct research and development activities. Entity X issues equity with a par amount of $15 million ($5 million to each investor). Investor A contributes $5 million in cash. Investor B issues a guarantee that the fair value of the completion of the research and development activities will be at least $90 million. Investor C enters into an agreement with X to provide research scientists who will each work for 500 hours to complete the activities.

Only A’s $5 million in equity is considered equity at risk because B and C received their equity as payment from X for the guarantee (promise to stand ready) and the performance of services, respectively.

5.2.2.3.2 Fees Received for Services Performed at Inception or in the Future

Fees paid or the incurrence of an obligation to pay fees to the equity investor at the inception of the potential VIE (e.g., a developer or structuring fee) typically reduces the potential VIE’s equity investment at risk. The amount of the fee represents a return of the investor’s equity at risk. Since the equity investment is returned (or will be returned over time in the form of a payable), the portion of the investor’s equity investment returned in fees is not at risk (see Example 5-5).

By contrast, if the fees expected to be paid to, or incurred by, the investor in the future are commensurate with the service to be provided (at market rates, see Section 4.4.1), the equity investment at risk should not be reduced for these future fees. If future fees are in excess of market rates, and the equity investor is unconditionally entitled to the fees, the present value of the excess should reduce the potential VIE’s equity investment at risk because the above-market fees received are, in substance, a guaranteed return of equity.

5.2.2.3.3 Legal Entity’s Equity Obtained in Exchange for Intangible Assets

A reporting entity may acquire a legal entity’s equity in exchange for intangible assets that are contributed to the legal entity. We believe that equity acquired in such a manner may be considered equity investment at risk if the contributed intangible assets meet the requirements to be recognized as an asset separately from goodwill in accordance with ASC 805. For a discussion of the requirements for recognizing intangible assets, see Deloitte’s Roadmap Business Combinations.

Example 5-7

Investor A and Investor B form Entity X to manufacture an FDA approved drug. Investor A contributes $10 million in cash and B contributes technology with an approximate fair value of $10 million in exchange for each investor’s equity in X. The technology meets the requirements to be recognized as an asset separately from goodwill in accordance with ASC 805.

Entity X’s equity investment at risk is $20 million. The equity received by both A and B is considered at risk.

5.2.2.4 Equity Financed for the Equity Investor by the Legal Entity or Other Parties Involved With the Legal Entity

Equity investment at risk does not include amounts financed for the equity investor (e.g., by loans or guarantees of loans) directly by the legal entity or by another party involved with the legal entity1 unless that party is a parent, subsidiary, or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor.

This does not mean that a reporting entity must use its own capital (i.e., not have borrowing relationships) to acquire an interest in a legal entity. Rather, the reporting entity should use judgment and analyze the individual facts and circumstances carefully. For example, a reporting entity may borrow cash from a third-party bank and use a portion of the proceeds on borrowing to fund an equity investment in a legal entity. This situation is clearly different from one in which, instead of a third-party bank, the reporting entity borrows directly from the legal entity.

Transactions and relationships existing “around the legal entity” (see Section 4.3.10.1) are relevant in this assessment. This concept was discussed at the 2004 AICPA Conference on Current SEC and PCAOB Developments by an SEC staff member, Associate Chief Accountant Jane Poulin, who stated, in part:

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. 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 of a controlling financial interest as defined in paragraph 5(b) of FIN 46R [ASC 810-10-15-14(b)]. 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. [Footnotes omitted]

If financing of the equity investment is provided to the equity investor by an unrelated third party that is not involved with either the legal entity or other parties involved with the legal entity, the investment can be treated as equity investment at risk as long as the other criteria in ASC 810-10-15-14(a) are also met. Conversely, if one equity investor provides financing to another equity investor, the investment made by the equity investor who received the financing generally would be excluded from equity investment at risk.

In unusual circumstances, the equity investment may be at risk when (1) one equity investor provides financing to another equity investor and (2) the borrowing equity investor is acting solely in the capacity of agent for the other equity investor (see Example 5-10).

Example 5-8

Enterprises A, B, and C each contribute $100 to form Entity D. Enterprise A’s $100 contribution was funded by a loan from Bank Z (an unrelated enterprise). Therefore, A’s equity does not fail to meet the criterion in ASC 810-10-15-14(a)(4) because its loan was from an unrelated party that is not involved with either the legal entity or other parties involved with the legal entity.

Example 5-9

Enterprises A, B, and C each contribute $100 to form Entity D. Enterprise A’s $100 contribution was funded by a loan from Enterprise B (a bank), another party involved with D. Assume that A is not acting as an agent for B. In addition, B does not have to be included in A’s consolidated financial statements.

Enterprise A has financed its equity investment by obtaining a loan directly from another party that is involved with D. Subsequently, A’s equity fails to meet the criterion in ASC 810-10-15-14(a)(4) because its loan was from another party involved with D that does not need to be included in A’s consolidated financial statements. Therefore, A’s $100 contribution would not qualify as equity investment at risk.

Example 5-10

Enterprises B and C each contribute $50 to form a legal entity. Enterprise B funds its equity investment by obtaining a $50 loan from C. Under a separate agreement, B is required to vote its interest in the legal entity (in all matters) in accordance with C’s instructions; therefore, a principal-agent relationship exists. Assume that B and C are not included in the same set of consolidated financial statements.

In this example, all of B’s equity is considered equity investment at risk. Even though B obtained its equity through a loan from C (a party involved with the entity), B’s equity is still considered equity investment at risk because B is merely acting as C’s agent.

5.2.2.4.1 Put Options, Call Options, and Total Return Swaps

An equity interest subject to a put option, call option, or total return swap in which the counterparty is a party unrelated to the legal entity would not disqualify the equity investment from being at risk. Depending on the terms, a purchased put, a written call, or a total return swap entered into by an equity investor with the potential VIE or a party involved with the potential VIE may result in the disqualification of the investor’s equity from being considered equity investment at risk under ASC 810-10-15-14(a)(1) or ASC 810-10-15-14(a)(4).

The following table provides an analysis of whether an equity interest subject to a purchased put, a written call, or a total return swap qualifies as equity investment at risk under ASC 810-10-15-14(a)(1) or ASC 810-10-15-14(a)(4), respectively:

Table 5-1 Analysis of Equity Interests

Original Reporting Entity Holds Equity in a Potential VIE and:	Counterparty Is:	Participates Significantly in Profits and Losses (Compliant With ASC 810-10-15-14(a)(1)?)	Not Financed by the Legal Entity or Certain Other Parties (Compliant With ASC 810-10-15-14(a)(4)?)
Purchases a physically settled, fixed-price put on its equity investment.	Unrelated to the potential VIE.	Yes. Although the original reporting entity is protected from losses via its fixed-price put option, the equity interest itself will remain outstanding even if the put is exercised; thus, the equity interest participates in both the profits and losses of the potential VIE.	Yes. The counterparty is not the potential VIE or another party involved with the potential VIE.
Writes a physically settled, fixed-price call on its equity investment.	Unrelated to the potential VIE.	Yes. Although the counterparty can obtain some of the original reporting entity’s upside, the equity interest itself will remain outstanding even if the counterparty exercises its call; thus, the equity interest participates in both the profits and losses of the potential VIE.	Yes. The counterparty is not the potential VIE or another party involved with the potential VIE.
Enters into a net-cash-settled total return swap indexed to the all-in return on its equity investment.*	Unrelated to the potential VIE.	Yes. The equity interest itself participates in both the profits and losses of the potential VIE.	Yes. The counterparty is not the potential VIE or another party involved with the potential VIE.
Purchases a physically settled, fixed-price put on its equity investment.	The potential VIE.	No. The fixed-price put option purchased from the potential VIE allows the original reporting entity to simply put its equity instrument to the potential VIE to protect it from incurring losses. Thus, the equity interest does not participate significantly in the potential VIE’s losses.	No. The fixed-price put option purchased from the potential VIE is economically equivalent to the original reporting entity’s receipt of a loan guarantee from the potential VIE pertaining to the original reporting entity’s investment in the potential VIE.***
Writes a physically settled, fixed-price call on its equity investment.	The potential VIE.	No. The fixed-price call option written to the potential VIE results in the significant participation of the original reporting entity only in the potential VIE’s losses but not its profits (provided that the potential VIE acts rationally by exercising the call option when the fair value of the original reporting entity’s equity interest exceeds the fixed strike price).	Yes. The equity interest was not “financed” by the potential VIE.
Purchases a physically settled, fixed-price put on its equity investment.	A party related to the potential VIE.	Yes. Although the original reporting entity is protected from losses via its fixed-price put option, the equity interest itself will remain outstanding even if the put is exercised; thus, the equity interest participates in both the profits and losses of the potential VIE.†	No. The fixed-price put option purchased from the party related to the potential VIE is economically equivalent to the original reporting entity’s receipt of a loan guarantee from the counterparty pertaining to the original reporting entity’s investment in the potential VIE., *
Writes a physically settled, fixed-price call on its equity investment.	A party related to the potential VIE.	Yes. Although the counterparty can obtain some of the original reporting entity’s upside, the equity interest itself will remain outstanding even if the counterparty exercises its call; thus, the equity interest participates in both the profits and losses of the potential VIE.	Yes. The equity interest was not “financed” by the party related to the potential VIE, except for deep in-the-money call options.
Enters into a net-cash-settled total return swap indexed to the all-in return on its equity investment.*	A party related to the potential VIE.	Yes. The equity interest itself participates in both the profits and losses of the potential VIE.	Generally, no. The total return swap entered into with a party related to the potential VIE is economically equivalent to the original reporting entity’s receipt of a loan from the counterparty to finance the original reporting entity’s investment in the potential VIE. However, the equity investment may be at risk if the original reporting entity that holds the equity is acting solely as an agent for the other party related to the potential VIE. For guidance on determining whether the arrangement between the two equity investors is essentially a principal-agent relationship, see Section 5.2.2.4.**
* A total return swap on the equity interest is an arrangement in which (1) the original reporting entity will receive a fixed return (or variable interest rate return) and an amount equal to the decline in value of the equity interest and (2) the counterparty will receive all of the cash returns on the equity interest and the appreciation in value of the equity interest. In effect, a total return swap transfers substantially all of the risk and return related to the equity interest in the potential VIE without necessarily transferring the equity interest. See Section 4.3.7 for considerations related to whether a counterparty to a total return swap has a variable interest in the potential VIE. It is assumed in this example that the related party counterparty is not the reporting entity’s parent, subsidiary, or affiliate that is required to be included in the same set of consolidated financial statements as the entity. * We have historically viewed fixed-price put options to be the economic equivalent of a loan. That view was premised on the fact that a nonrecourse loan and a purchased put option give an investor similar down-side protections. While we appreciate that some may continue to hold that view, our perspective on the issue has evolved. Although purchased put options and nonrecourse loans provide similar down-side protections, substantive differences between them exist related to form and substance. Notably, a loan provides capital to the investor to make an investment, whereas the purchased put option does not provide any capital to the option’s holder up front. That is, a lender provides capital to the borrower when the lender extends a loan; an option’s writer does not extend financing to the buyer of the put option up front. On the basis of that distinction, we have updated our interpretation related to this matter and believe that a purchased put option should be considered analogous to a loan guarantee. The down-side protection provided by the put option is economically equivalent to a guarantee of the financing deployed to invest in the entity. We do not believe that it matters whether the put option guarantees a lender’s capital or that of the investor — we consider the two scenarios to be economically equivalent. † We understand that some may believe that as a result of such provisions, the put option’s holder does not participate significantly in profits and losses because the investor with the put option is protected from the potential VIE’s losses. In reaching this conclusion, some look to the remarks by SEC Associate Chief Accountant Jane Poulin at the 2004 AICPA Conference on Current SEC and PCAOB Developments (see Section 5.2.2.4).

5.2.3 Determining Whether the Identified Equity Investment at Risk Is Sufficient to Finance the Legal Entity’s Operations Without Additional Subordinated Financial Support (Step 3)

Once the amount of equity investment at risk is quantified in step 1 (see Section 5.2.1) and step 2 (see Section 5.2.2), a reporting entity must determine whether the equity investment at risk is sufficient to finance the legal entity’s operations without additional subordinated financial support. If not, the legal entity is a VIE. The purpose of this assessment is to identify whether a legal entity is sufficiently capitalized. Merely having at-risk equity is not enough; the legal entity must be able to finance its operations with that equity investment at risk. The reporting entity must use judgment to determine sufficiency since the various risk tolerances, investment objectives, and liquidity requirements of investing can influence the level of capital in a legal entity. The FASB’s guidance below is intended to help the reporting entity determine whether equity investment at risk is sufficient.

ASC 810-10

25-45 An equity investment at risk of less than 10 percent of the legal entity’s total assets shall not be considered sufficient to permit the legal entity to finance its activities without subordinated financial support in addition to the equity investment unless the equity investment can be demonstrated to be sufficient. The demonstration that equity is sufficient may be based on either qualitative analysis or quantitative analysis or a combination of both. Qualitative assessments, including, but not limited to, the qualitative assessments described in (a) and (b), will in some cases be conclusive in determining that the legal entity’s equity at risk is sufficient. If, after diligent effort, a reasonable conclusion about the sufficiency of the legal entity’s equity at risk cannot be reached based solely on qualitative considerations, the quantitative analyses implied by (c) shall be made. In instances in which neither a qualitative assessment nor a quantitative assessment, taken alone, is conclusive, the determination of whether the equity at risk is sufficient shall be based on a combination of qualitative and quantitative analyses.

The legal entity has demonstrated that it can finance its activities without additional subordinated financial support.
The legal entity has at least as much equity invested as other entities that hold only similar assets of similar quality in similar amounts and operate with no additional subordinated financial support.
The amount of equity invested in the legal entity exceeds the estimate of the legal entity’s expected losses based on reasonable quantitative evidence.

25-46 Some legal entities may require an equity investment at risk greater than 10 percent of their assets to finance their activities, especially if they engage in high-risk activities, hold high-risk assets, or have exposure to risks that are not reflected in the reported amounts of the legal entities’ assets or liabilities. The presumption in the preceding paragraph does not relieve a reporting entity of its responsibility to determine whether a particular legal entity with which the reporting entity is involved needs an equity investment at risk greater than 10 percent of its assets in order to finance its activities without subordinated financial support in addition to the equity investment.

25-47 The design of the legal entity (for example, its capital structure) and the apparent intentions of the parties that created the legal entity are important qualitative considerations, as are ratings of its outstanding debt (if any), the interest rates, and other terms of its financing arrangements. Often, no single factor will be conclusive and the determination will be based on the preponderance of evidence. For example, if a legal entity does not have a limited life and tightly constrained activities, if there are no unusual arrangements that appear designed to provide subordinated financial support, if its equity interests do not appear designed to require other subordinated financial support, and if the entity has been able to obtain commercial financing arrangements on customary terms, the equity would be expected to be sufficient. In contrast, if a legal entity has a very small equity investment relative to other entities with similar activities and has outstanding subordinated debt that obviously is effectively a replacement for an additional equity investment, the equity would not be expected to be sufficient.

Sufficiency of equity can be demonstrated by qualitative analysis, quantitative analysis, or a combination of both. However, the FASB clearly emphasized that a diligent qualitative assessment should be performed first, including whether (1) the legal entity has demonstrated that it can finance its activities without additional subordinated financial support and (2) the legal entity has at least as much equity invested as other entities that hold only similar assets of similar quality in similar amounts and operate with no additional subordinated financial support. If the qualitative analysis is not conclusive, the reporting entity can perform a quantitative analysis of whether the legal entity’s equity investment at risk exceeds the legal entity’s expected losses (see Appendix C for details on calculating expected losses). Conversely, if a qualitative assessment is conclusive, a quantitative approach is unnecessary.

The qualitative analysis requires, in part, a consideration of quantitative measures (e.g., percentage of equity investment at risk compared to total assets). To perform the assessment correctly, the reporting entity must first determine the appropriate ratio of equity investment at risk to total assets by comparing, on a fair value basis as of the assessment date, the equity investment at risk to total assets.

Under U.S. GAAP, a reporting entity must sometimes use carryover historical cost to record initial equity contributions made in the form of nonmonetary assets (e.g., formation of a joint venture or a contribution of nonmonetary assets pursuant to SAB Topic 5.G). Nonetheless, a reporting entity should use the fair value of the asset (e.g., fixed asset, intellectual property) as of the contribution date, not the carrying value of the asset in the contributor’s books before the transfer, as the amount of the equity investment at risk.

When performing the quantitative assessment, the reporting entity should not include amounts reported as components of other comprehensive income or loss in the equity investment at risk. Because the assessment is performed on a fair value basis, such amounts are already reflected in the fair value of the equity investment at risk and therefore should not be double-counted.

ASC 810-10 provides a rebuttable presumption that a ratio of under 10 percent of equity investment at risk to total assets is not sufficient. This test is often misconstrued to mean that an equity investment in excess of 10 percent is sufficient. However, it should not be interpreted that way because the test is one directional and nondeterminative. The 10 percent presumption is intended to supersede guidance that existed before the effective date of FIN 46(R), as explained in paragraph E23 in the Basis for Conclusions of FIN 46(R):

Because precisely estimating expected losses may be difficult and an entity may need an equity investment greater than its expected losses, the Board established a presumption that an equity investment is insufficient to allow an entity to finance its activities unless the investment is equal to at least 10 percent of the entity’s total assets. Another reason for that presumption is to emphasize that the requirement for 3 percent equity referred to in EITF Issue No. 90-15, “Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions,” is superseded and that an equity investment as small as 3 percent is insufficient for many variable interest entities. The Board intends that presumption to apply in one direction only. That is, an equity investment of less than 10 percent is presumed to be insufficient, but an equity investment of 10 percent is not presumed to be sufficient.

If the proportion of equity investment at risk to total assets (again, both on a fair value basis) is under 10 percent, additional facts and circumstances would be considered, and the hurdle for concluding that equity investment at risk is sufficient would be raised significantly.

There are two qualitative approaches to assessing the sufficiency of the legal entity’s equity investment at risk. The first is to evaluate whether the legal entity has demonstrated that it can finance its activities without additional subordinated financial support. Such an evaluation will require consideration of facts and circumstances, and it may be difficult for the legal entity to demonstrate that it can finance its activities without such additional support when the legal entity is capitalized with a variety of forms of equity investment. Certain factors, such as the following, may indicate that a legal entity does not have sufficient equity investment at risk to finance its operations:

The existence of non-investment-grade debt may indicate that a lender does not view the legal entity as having sufficient capitalization.
A venture that has external borrowings that require a parental guarantee may likewise indicate that a lender does not view the legal entity as sufficiently capitalized. However, this could be overcome if the guarantees are normal for similar legal entities or if investment-grade debt could have been obtained in the absence of the guarantee (or both).

Other factors, such as the following, may indicate the opposite (i.e., that a legal entity does have sufficient equity investment at risk to finance its operations):

The existence of investment-grade debt may indicate that third parties deem the legal entity to be sufficiently capitalized.
The absence of subordinated financial support within the legal entity’s capital structure may, depending on how long the legal entity has operated, indicate that the legal entity has the wherewithal to finance its own operations on the strength of its equity investment at risk alone.

The negative factors above may prove difficult to overcome. However, neither group of indicators is determinative nor should it be considered in isolation (i.e., without an assessment of the associated facts and circumstances). Reporting entities will need to exercise considerable judgment in qualitatively assessing sufficiency.

The second approach to assessing the sufficiency of the legal entity’s equity investment at risk is to evaluate evidence provided by other entities that have demonstrated their ability to finance operations without additional subordinated financial support. The comparable entities, however, must be extremely similar to the legal entity being analyzed. The following is a nonexhaustive list of the factors that should be considered in the assessment of similarity:

The location of the entities, both physically and in terms of where the entities do business.
The industry sector in which the entities operate.
The size of the entities’ assets, liabilities, equity, results of operations, and cash flows.
The risks to which the entities are exposed, both internally and externally.
The regulatory environment in which the entities operate.

If, after using these approaches, the results are still inconclusive, a reporting entity would perform a quantitative analysis. In doing so, the reporting entity would determine whether the legal entity’s expected losses can be absorbed in total by the equity investment at risk or whether other instruments absorb expected losses (see Appendix C for guidance on calculating expected losses). In its simplest form, the quantitative analysis can be characterized as follows:

Equity investment at risk > Expected losses = Sufficient equity investment at risk

However, in a manner similar to the qualitative assessment described above, reporting entities must use judgment when performing the quantitative assessment.

Example 5-11

A legal entity is formed with (1) a $50 million equity investment that meets the conditions in ASC 810-10-15-14(a) for being “at risk” and (2) $950 million in high-credit-quality senior debt (e.g., AAA-rated). The high credit rating of the debt suggests the independent rating agencies believe that variable interests other than the debt holders will absorb the legal entity’s expected losses. If the only variable interest besides the debt is the equity, the equity is considered to be sufficient to finance the legal entity’s activities without additional subordinated financial support.

Although the reporting entity has reached a conclusion about the sufficiency of the legal entity’s equity at risk, the reporting entity must still analyze the legal entity to determine whether it fails to meet any of the characteristics in ASC 810-10-15-14(b) and (c) before concluding that the legal entity is not a VIE. See Sections 5.3 and 5.4, respectively.

Example 5-12

A legal entity is formed with (1) a 1 percent equity investment that meets the conditions in ASC 810-10-15-14(a) for being “at risk” and (2) 99 percent debt, which contractually receives a high rate of return in relation to the interest rate of an investment-grade instrument with similar terms. Since the legal entity only has 1 percent equity and has issued subordinated debt in exchange for agreeing to pay a high rate of return, a qualitative analysis would demonstrate that the legal entity is a VIE because the equity investment at risk is not sufficient.

Regardless of whether a reporting entity is analyzing a potential VIE qualitatively or quantitatively, any future financings that are required by the governing or contractual arrangements that exist as of the evaluation date (or that are contemplated by the involved parties in a manner consistent with the design of the potential VIE) should be included in the determination of the sufficiency of equity investment at risk. The reporting entity may only consider financings and activities associated with the current design of the potential VIE. Commitments to fund equity or to absorb losses are not considered GAAP equity (see Section 5.1.2).

The existence of a requirement to provide future financings does not automatically indicate that there is insufficient equity investment at risk to finance a legal entity’s operations without additional subordinated financial support. A reporting entity should consider whether the legal entity can finance its current operations and activities with equity that exists as of the evaluation date and without additional subordinated financial support. The fact that equity commitments are outstanding does not necessarily mean that there is insufficient equity. For example:

A commitment to fund future acquisitions or expansion activity would not necessarily indicate that a legal entity is insufficiently capitalized currently. The reporting entity should consider whether the acquisitions are currently necessary to operate the business.
A legal entity may choose to fund a substantial amount of its capital with equity despite its ability to obtain investment-grade debt. Such a scenario is not an indicator that the legal entity’s equity commitments outstanding are insufficient equity investment at risk if the legal entity has (1) received sufficient equity (i.e., without considering future equity to be received from equity commitments outstanding) to finance its operations without additional financial support and (2) elected to finance the remaining capital with additional equity.

Reporting entities should carefully consider all the facts and circumstances associated with future financing arrangements.

Example 5-13

Investors A and B each contributed $20 million in return for an equity investment in Entity C, a legal entity that used the proceeds from the equity issuance to purchase a warehouse. Entity C plans to convert the warehouse into a condominium building, which it intends to sell upon completion of the conversion. In addition, A and B have each agreed to provide an additional $80 million of financing for the conversion on an as-needed basis. Because C was designed to purchase and convert the warehouse, the commitments made by A and B would lead to the conclusion that C is insufficiently capitalized and is therefore a VIE.

Note that C’s status as a VIE would need to be reconsidered upon each additional equity funding in accordance with the guidance in ASC 810-10-35-4(d). See Section 9.1.4 for additional information.

Example 5-14

Company A forms Entity C to acquire and operate Company X. Company A contributes $100 million in return for an equity investment in C. In addition, Investor B, an unrelated third party, contributes $100 million in return for an equity investment in C. Company A and Investor B have each agreed to provide additional financing for any future acquisitions that C may make. Although A and B have agreed to fund C’s future acquisitions, this agreement alone would not lead to a conclusion that C is insufficiently capitalized. Because C was designed to purchase and operate X, the assessment of whether C is insufficiently capitalized should only include C’s current activities (i.e., acquiring and operating X).

5.2.3.1 Whether a Quantitative Analysis Overrides a Qualitative Analysis

A quantitative analysis will not override a conclusive qualitative analysis. In the VIE assessment, a qualitative assessment may be preferable to an expected loss calculation for the following reasons:

The qualitative approach may help a reporting entity avoid the detailed estimates and computations of the quantitative approach (which could require significant effort and costs).
While a quantitative approach may appear more precise and less subjective, the reporting entity may lack objective evidence on which to base the estimates and assumptions used to make the computation, resulting in imprecision and subjectivity.

Reasoned professional judgment that takes into account all facts and circumstances (including qualitative and quantitative considerations) is often as good as, or even better than, mathematical computations based on estimates and assumptions.

Example 5-15

Enterprise A contributes $1,000 in return for an equity investment in Entity B, a legal entity, which represents equity investment at risk. Enterprise A must assess whether B’s equity at risk is sufficient to finance its activities without additional subordinated financial support. Enterprise A initially determines that the available qualitative evidence regarding the sufficiency of B’s equity at risk is not conclusive. Therefore, A performs an expected loss calculation and determines that B’s expected losses are $995.

Although B’s $1,000 equity at risk exceeds the calculated expected losses of $995, the relatively insignificant difference between the two amounts provides little assurance that the quantitative approach alone is adequate in the assessment of the sufficiency of the equity at risk. In this case, A must consider this quantitative analysis as well as the qualitative evidence to determine whether B’s equity at risk is sufficient.

5.2.3.2 Existence of Subordinated Debt

In a qualitative assessment of the sufficiency of equity investment at risk, the existence of subordinated debt is a factor indicating that a legal entity’s total equity investment at risk may not be sufficient to absorb expected losses. That is, by virtue of its subordination, subordinated debt is expected to absorb expected losses beyond a legal entity’s equity investment at risk. However, the existence of subordinated debt should not be considered determinative in itself; an evaluation of the sufficiency of equity at risk should be based on all facts and circumstances.

Example 5-16

Entity D is formed with $50 of equity investment at risk and $50 of long-term debt. The long-term debt consists of two issuances: Debt A, $45, and Debt B, $5. Debt B is subordinate to Debt A. Because D was recently formed, it could not obtain senior debt (Debt A) in an investment-grade form.

In a qualitative assessment, the existence of subordinated debt is a factor indicating that D does not have sufficient equity at risk. That factor should be considered along with all other facts and circumstances (e.g., a 50 percent ratio of equity at risk frequently exceeds expected losses). If the qualitative assessment is inconclusive, a quantitative analysis (i.e., calculation of expected losses/residual returns) should be performed to determine whether D is a VIE.

Example 5-17

Assume that in the example above it was determined that Entity D was a VIE. Two years later, D engages in additional business activities beyond those that were considered at formation and is an established, profitable business. Given its desire to further expand its business, D issues a new tranche of debt (Debt C) whose rank is identical in seniority (e.g., priority in liquidation) to that of Debt B. Because of its stable financial condition, the tranche of debt is rated investment-grade. Given the identical priority in liquidation of Debt B and Debt C, one can infer that Debt A (which is senior to Debt B) and Debt B would be rated investment-grade as well. No other debt securities are outstanding, and no other evidence of subordinated financial support (e.g., guarantees) is noted. Assume that a reconsideration event under ASC 810-10-35-4(c) has occurred because the additional business activities increase D’s expected losses (see Chapter 9). Therefore, the variable interest holders must determine whether D is still a VIE.

In a qualitative assessment, D’s ability to issue investment-grade debt that has the same priority in liquidation as Debt B is one factor indicating that D, as of the reconsideration date, has sufficient equity at risk. In other words, in the absence of other forms of subordinated financial support, D would not have been able to obtain an investment-grade rating on the new debt if its existing equity at risk was not sufficient. However, all other facts and circumstances existing as of the reconsideration date should be considered. If the qualitative assessment is not conclusive, a quantitative analysis should be performed to determine whether D is a VIE as of the reconsideration date.

Example 5-18

Entity M is formed with equity and three issuances of debt. One of the debt instruments is investment-grade, while the other two are unrated debt. At formation, a qualitative assessment provides conclusive evidence that M has sufficient equity at risk. There are no other factors that would cause M to be a VIE.

Five years later, M has incurred losses in several periods and disposes of two significant lines of business. Entity M also obtains additional financing in the form of subordinated debt that is rated as below investment-grade. Entity M continues to maintain an investment-grade rating on its other tranches of debt. Assume that a reconsideration event under ASC 810-10-35-4(d) has occurred because M has curtailed its activities in a way that decreases its expected losses (see Chapter 9). Therefore, the variable interest holders must determine whether M is a VIE as of the reconsideration date.

While M continues to have investment-grade debt outstanding, the subsequent issuance of subordinated debt is, in a qualitative assessment, one factor indicating that M does not have sufficient equity at risk (in other words, if M had sufficient equity at risk to finance its activities, the issuance of subordinated debt that is below investment-grade would be unnecessary). However, all other facts and circumstances existing as of the reconsideration date should be considered. If the qualitative assessment is inconclusive, a quantitative analysis should be performed to determine whether M is a VIE as of the reconsideration date.

5.2.3.3 Determining Whether a Variable Interest Is Subordinated Financial Support

Not all variable interests should be considered subordinated financial support. Interests in a legal entity that are considered variable interests because they absorb expected losses of the legal entity are not necessarily subordinated financial support. Variable interests, as defined in ASC 810-10-20, are “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.” ASC 810-10-55-19 further indicates that variable interests absorb or receive the expected variability created by assets, liabilities, or contracts of a VIE that are not, themselves, variable interests.

The determination of whether a variable interest is subordinated financial support will be based on how that interest absorbs expected losses compared with other variable interests in the legal entity. The determination will be based on all facts and circumstances. If the terms of the arrangement cause the variable interest to absorb expected losses before or at the same level as the most subordinated interests (e.g., equity, subordinated debt), or the most subordinated interests are not large enough to absorb the legal entity’s expected losses, the variable interest would generally be considered subordinated financial support. For example, investment-grade debt is a variable interest that would generally not be considered subordinated financial support. See Section 4.2.1.2.3 for additional discussion.

Example 5-19

An investor holds a common-stock investment of $50 and a debt instrument of $60 in a legal entity. The only other variable interest is $40 of preferred stock held by an unrelated third party. The common and preferred stock are considered equity at risk in accordance with ASC 810-10-15-14(a), and the expected losses of the entity are $40. The entity is designed so that common and preferred stock absorb expected losses before the debt.

In this example, the common stock, preferred stock, and debt are all considered variable interests because they are expected to absorb some of the potential VIE’s variability. However, because the common and preferred stock ($90) are expected to absorb 100 percent of the expected losses ($40), the debt is not considered subordinated financial support.

5.2.3.4 Interaction Between Minimum Regulatory Capital and the Sufficiency of Equity Investment at Risk

Certain entities operate in regulatory environments in which an external party — sometimes a governmental agency — establishes requirements for the minimum level of capital a reporting entity must maintain. For example, the levels of capitalization that reporting entities in the banking industry are required to maintain may be influenced by their exposure (i.e., financial positions taken, including derivative exposure). The minimum level of capital required by regulation may be less than the 10 percent rebuttable presumption discussed in Section 5.2.3. Although meeting the minimum level of regulatory capital is not enough evidence alone to support a conclusion that equity investment at risk is sufficient, the consideration of regulatory capital requirements (and compliance with those requirements) may be appropriate in the assessment of whether a legal entity has sufficient capital to finance its operations.

5.2.4 Development-Stage Entities

Before the adoption of ASU 2014-10,2 certain entities could qualify for specialized accounting under ASC 915 as development-stage entities. Such entities were, by definition, in a stage of development as opposed to conducting operations in accordance with their principal plan. Accordingly, those qualifying entities differed in nature from other entities, often being capitalized only to the extent required to perform a specific task related to development.

Although ASU 2014-10 removed the concept of a development-stage entity, we believe that it is still necessary to consider the design of a legal entity in the determination of whether its equity investment at risk is sufficient. That is, considering only the legal entity’s current stage of development may be appropriate in the assessment of sufficiency of equity. Specifically, if a legal entity is in the development stage and there is substantial uncertainty about whether the legal entity will proceed to the next stage, it may be appropriate to consider only the current stage in the sufficiency assessment. This approach is consistent with the assessment of power of a multiple-stage entity as well as the evaluation of forward starting rights (including puts, calls, and forward contracts) in a primary-beneficiary assessment. See Section 7.2.9.1 for a discussion of forward starting rights in a primary-beneficiary assessment. For additional discussion of whether a substantive contingency exists regarding proceeding to the next stage of development, see Section 7.2.9.2.

A reporting entity should initially assess whether a development-stage entity is a VIE on the date on which it first becomes involved with the legal entity. This assessment must be reconsidered upon the occurrence of any of the events in ASC 810-10-35-4. For a development-stage entity, this would include, but not be limited to:

Funding of additional equity.
Commencement of additional activities (e.g., entering a subsequent “phase” of development).

Example 5-20

Entity D is a development-stage entity. Investor A and Investor B each contributed $1 million of equity financing to D. Entity D’s current activities consist of product development and marketing surveys (“phase I”). Upon successful completion of phase I, D plans to commence test marketing (i.e., selling these products in selected areas) (“phase II”). During the final phase of D’s development stage, it plans to engage in limited-scale production and selling efforts (“phase III”). Entity D’s by-laws allow A and B to fund additional equity upon the completion of phase I and phase II. However, it is not certain that D will proceed to phase II.

In the assessment of whether D has sufficient equity at risk under ASC 810-10-15-14(a), only the current phase of D’s development needs to be considered. Thus, if, at inception, the $2 million of equity capital is deemed sufficient to finance phase I, D would be considered to have sufficient equity investment at risk. This determination should be reassessed at the commencement of phase II and phase III, upon the funding of additional equity financing, or upon the occurrence of any of the events in ASC 810-10-35-4.

Example 5-21

Entity A is a biopharmaceutical entity whose purpose and design are to complete phase II clinical trials. Currently, A is developing a drug candidate that is in phase I clinical trials, and A has concluded that there is substantial uncertainty about its ability to complete such trials. At the inception of the phase I clinical trials, A received an additional equity investment. Upon receiving that investment, A determined that it should assess whether under ASC 810-10-15-14(a) there was sufficient equity for completing the phase I clinical trials. Although A expects to need additional subordinated financial support to conduct phase II clinical trials, those trials represent the next stage for A as a development-stage entity. Accordingly, any additional subordinated financial support needed for phase II clinical trials would not be considered in the assessment of the sufficiency of equity for phase I clinical trials.

It may be appropriate for A to consider only its current clinical trial phase (i.e., I, II, or III) when assessing whether it has sufficient equity at risk under ASC 810-10-15-14(a). However, an entity generally should take into account its overall purpose and design and the associated risks when performing such an assessment. On the basis of the nature of the underlying intellectual property, there may be circumstances in which an entity concludes that there is limited uncertainty that it will move from one phase of clinical trials to the next. In such instances, it would not be appropriate to limit the assessment of the sufficiency of equity to simply the completion of the current phase of clinical trials.

Footnotes

This relationship may be an indicator of a de facto agency relationship under ASC 810-10-25-43(b). See Section 8.2.3.2.

ASU 2014-10 eliminated the specialized approach for considering sufficiency of equity investment at risk for development-stage entities. That guidance became effective for public business entities for annual periods beginning after December 15, 2015, and interim periods therein. For entities other than public business entities, the guidance became effective for annual periods beginning after December 15, 2016, and for interim periods beginning after December 15, 2017. Reporting entities that have historically applied this exception should consider the impact of ASU 2014-10 on their historical conclusions.