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A reporting entity must first determine whether it holds a “variable interest” in an entity to be evaluated for potential consolidation under ASC 810. If a reporting entity concludes that it holds a variable interest in an entity, it must evaluate whether that entity is a VIE. That assessment, in turn, will dictate which of the two consolidation models–the VIE model or the voting interest model–applies to the entity in question.
Variable interests can take many forms, including equity and debt investments, guarantees, derivatives, management contracts, service contracts, and leases. In many instances, concluding whether an instrument or contract is a variable interest may require only a cursory analysis. In other cases, however, the evaluation may not be as straightforward. Moreover, variable interests can exist in implicit relationships, especially if related party relationships are involved. For example, an implicit variable interest may exist if a reporting entity can be compelled to protect a related party entity from making losses or to make funds available to that entity.

3.1.1 What is a “variable interest”?

ASC 810-10-20 defines the term variable interest as follows.

Excerpt from ASC 810-10-20

Variable Interests: The investments or other interests that will absorb portions of a variable interest entity’s (VIE’s) expected losses or receive portions of the entity’s expected residual returns are called variable interests. Variable interests in a VIE 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.

Expressed more simply, a variable interest is an economic arrangement that exposes or entitles a reporting entity to the economic risks and/or rewards of the entity—that is, the instrument or contract exposes its holder to an entity’s “variability.” ASC 810 frequently characterizes a variable interest as an interest that “absorbs” some or all of the variability that the entity was designed to create.
Not all instruments or contracts to which a reporting entity is a party are its variable interests—certain of those instruments and contracts create or generate the variability that the entity intends to pass on to its variable interest holders. ASC 810-10-55-19 articulates this concept.

ASC 810-10-55-19

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 entity’s variability—that distinguishes a variable interest. That role, in turn, often depends on the design of the legal entity.

Most assets of an entity create variability in an entity. They generate the cash flows that drive the success or failure of the entity, and therefore drive the economic performance (variability) of the entity. Most forms of financing or capital (including guarantees of debt and/or assets, and some derivative instruments) absorb variability in an entity (or in an asset). The return to the lender or capital provider is contingent upon the relative performance of the assets (or, in some cases, liabilities). Only those arrangements that absorb the variability of the entity are considered variable interests under the VIE model.
The “by design” approach serves as the framework for differentiating between an entity’s assets—that is, those items intended to “create” an entity’s variability–and its variable interests.
Example CG 3-1 and Example CG 3-2 demonstrate the identification of a variable interest.
EXAMPLE CG 3-1
Identifying variable interests
An entity’s primary activities involve the manufacture and sale of furniture. The entity purchases supplies and/or services from vendors, employees, and other parties to conduct its activities and create value in the business. The entity’s equity investors capitalize the entity at a level sufficient to achieve its business purpose.
Which party would absorb the variability of the entity?
Analysis
In this simple example, only the equity investors absorb the variability of the fair value of the entity’s net assets. The entity’s assets and other contractual arrangements create variability to the results of the entity’s activities (i.e., the value of the business). The equity investors share in the value of the business positively (i.e., when the activities generate returns greater than expected) or negatively (i.e., when the activities generate returns less than expected).
EXAMPLE CG 3-2
Identifying variable interests
An entity’s primary activities involve the manufacture and sale of furniture. The entity purchases supplies and/or services from vendors, employees, and other parties to conduct its activities and create value in the business. The entity’s equity investors capitalize the entity at a level sufficient to achieve its business purpose.
The entity has decided to finance the acquisition of a new manufacturing facility through a subordinated loan from a third-party bank.
Which parties hold a variable interest?
Analysis
The loan does not create variability in the value of the business–rather, the new manufacturing facility does, as the incremental cash inflows to the entity attributable to the facility will vary based on business conditions. As a creditor, the bank is exposed to the risks and uncertainties of the entity’s activities. The bank and the equity investors stand to lose or gain from changes in the value of the business, and thus they each have a variable interest in the entity.
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