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3.2 “By design” approach–determining an entity’s variable interests
Publication date: 31 Jul 2022
us Consolidation guide 3.2
Subsequent to the release of the VIE guidance in 2003, diversity in practice developed in determining whether certain contracts should be considered creators of variability or, conversely, absorbers of variability (i.e., variable interests). Much of this diversity stemmed from different views regarding the role played by certain derivatives, particularly interest rate swaps and foreign currency derivatives. In determining whether these contracts (as well as certain cash instruments) were variable interests, some believed that only those items that absorbed variability resulting from changes in the entity’s cash flows (cash flow variability) should be considered variable interests, while others believed that those instruments that absorbed changes in the entity’s fair value (fair value variability) should also be considered variable interests. These different viewpoints fostered diversity in practice with respect to identifying the risks associated with an entity (i.e., the entity’s variability) and evaluating which party absorbed those risks.
The FASB staff responded to this diversity in practice by issuing guidance that indicates that, as the first step in its consolidation analysis, a reporting entity should carefully analyze an entity’s design. The goal of this analysis is to determine the variability that the entity was designed to create and distribute to its interest holders. This evaluation affects not only the determination of which interests are variable interests in the entity, but also whether the entity is considered a VIE, and which party, if any, is the primary beneficiary of the VIE.
In many instances, it will be evident what variability an entity was designed to create and distribute to its interest holders. The analysis may not be so clear-cut in other cases. In any event, the “by design” model is intended to provide a framework that facilitates more consistent identification of an entity’s “variability” and thus, by extension, more consistent application of the VIE model. ASC 810-10-55-55 through ASC 810-10-55-86 provides eight examples that illustrate how to apply this guidance.
The “by design” model in ASC 810-10-25-22 through ASC 810-10-25-36 describes a two-step process for determining which variability should be considered in the assessment of an entity’s variability. The two-step process is as follows:
The variability to be considered in applying the Variable Interest Entities Subsections shall be based on an analysis of the design of the legal entity as outlined in the following steps:
- Step 1: Analyze the nature of the risks in the legal entity (see paragraphs 810-10-25-24 through 25-25)
- Step 2: Determine the purpose(s) for which the legal entity was created and determine the variability (created by the risks identified in Step 1) the legal entity is designed to create and pass along to its interest holders (see paragraphs 810-10-25-26 through 36).
ASC 810-10-25-23 clarifies that, during this initial analysis, all instruments and contractual arrangements to which an entity is a party should be considered, and variability may be measured using methods that consider potential changes in cash flows and fair value of the entity.
For the purposes of paragraphs 810-10-25-21 through 25-36, interest holders include all potential variable interest holders (including contractual, ownership, or other pecuniary interests in the legal entity). After determining the variability to consider, the reporting entity can determine which interests are designed to absorb that variability. The cash flow and fair value are methods that can be used to measure the amount of variability (that is, expected losses and expected residual returns) of a legal entity. However, a method that is used to measure the amount of variability does not provide an appropriate basis for determining which variability should be considered in applying the Variable Interest Entities Subsections.
3.2.1 “By design” approach–step 1: identify the risks of the entity
Step 1 of the “by design” model is generally a straightforward exercise–its objective is to identify all of the risks of the entity. ASC 810-10-25-24 cites the following examples of possible risks to which an entity may be subject.
The risks to be considered in Step 1 that cause variability include, but are not limited to, the following:
- Credit risk
- Interest rate risk (including prepayment risk)
- Foreign currency exchange risk
- Commodity price risk
- Equity price risk
- Operations risk.
3.2.2 “By design” approach–Step 2: variability created to pass along
The purpose of Step 2 is to identify which of the risks identified in Step 1 create variability and thus are relevant to the assessment of an entity’s variability. Under the “by design” model, the relevant risks are those that the entity was designed to pass along to variable interest holders, as outlined in ASC 810-10-25-25.
In determining the purpose for which the legal entity was created and the variability the legal entity was designed to create and pass along to its interest holders in Step 2, all relevant facts and circumstances shall be considered, including, but not limited to, the following factors:
- The activities of the legal entity
- The terms of the contracts the legal entity has entered into
- The nature of the legal entity’s interests issued
- How the legal entity’s interests were negotiated with or marketed to potential investors
- Which parties participated significantly in the design or redesign of the legal entity.
Typically, assets and operations of the legal entity create the legal entity’s variability (and thus, are not variable interests), and liabilities and equity interests absorb that variability (and thus, are variable interests). Other contracts or arrangements may appear to both create and absorb variability because at times they may represent assets of the legal entity and at other times liabilities (either recorded or unrecorded). The role of a contract or arrangement in the design of the legal entity, regardless of its legal form or accounting classification, shall dictate whether that interest should be treated as creating variability for the entity or absorbing variability.
In performing Step 2 of the “by design” model, an entity’s governing documents, marketing materials, and terms of all other contractual arrangements should be examined to determine the variability that the entity was designed to create, taking into account the risks identified in Step 1.
When evaluating the risks the entity was designed to create and pass along to its interest holders, we believe that if a reporting entity creates certain risks in an entity, it generally cannot have a variable interest that absorbs those same risks.
To assist financial statement preparers, ASC 810-10-25-30 highlights factors that should be considered when identifying the variability that the legal entity is designed to create and pass along to its interest holders. The considerations relate to the following:
- Terms of the interests issued
- Subordination of the interest
- Certain interest rate risk
- Certain derivative instruments
Each of these considerations is discussed below.
3.2.3 “By design” approach—terms of the interests issued
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.
If the interest transfers risk and/or return of the entity’s assets or operations to the holder of the interest, this is a strong indicator that the interest is a variable interest.
ASC 810-10-55-172 through ASC 810-10-55-181 provides an example (Case G) of the application of this concept involving a property lease entity. In that example, an entity is established with funding in the form of a five-year fixed-rate note and equity so that it can acquire property. The property is leased under a five-year lease to a lessee that has provided a residual value guarantee for the expected future value of the property at the end of five years. Because the residual value guarantee effectively transfers substantially all of the risks of the underlying property, there is a strong indication that the residual value guarantee is a variable interest. In other words, the residual value guarantee would be a variable interest because it absorbs the variability that the entity is designed to create.
The determination of whether an interest is a variable interest should not be based solely on the legal or accounting designation. Rather, the assessment should be based on whether the interest was designed to transfer risk to the interest holder, regardless of its accounting or legal treatment. This concept is illustrated in Example CG 3-3 and Example CG 3-4.
EXAMPLE CG 3-3
Interest obtained from a transaction that fails sale accounting
Interest obtained from a transaction that fails sale accounting
Assume that a reporting entity legally sells (transfers) a group of whole loans to a single-purpose securitization trust in return for cash, a beneficial interest in the trust entity (certain pass-through certificates issued by the trust), and a noncontingent fixed-price call option on the loans transferred.
Notwithstanding the sale of the loans’ legal title to the trust, the existence of the fixed-price call results in the transfer failing sale accounting under ASC 860, Transfers and Servicing (ASC 860). As a result, the transfer must be accounted for as a secured borrowing by both parties (i.e., the transferor borrowed the proceeds from the transferee). The transferor continues to report the legally transferred loans on its balance sheet, along with a liability corresponding to the cash received. The transferor entity does not recognize the beneficial interest in its financial statements.
Does the transferor entity hold a variable interest in the securitization trust?
Analysis
The transferor entity’s analysis should focus on the design of the securitization trust, the terms of all relevant agreements, and the risks intended to be passed on to its variable interest holders. The accounting characterization of the loan portfolio’s transfer, and the corresponding financial reporting of the exchange by both parties, should not affect this evaluation.
In this instance, the securitization trust legally owns the portfolio of loans, and it can be inferred that the design of the trust entity is to pass along the risks of those loans to its beneficial interest holders. For purposes of applying the VIE model, the trust’s assets consist of the acquired loans–not a receivable from the transferor. Thus, the holders of the trust’s pass-through certificates, including the transferor, should be considered to hold a variable interest in the trust–even though, in the transferor’s case, the certificates are not recognized on its balance sheet (because of applying the “failed-sale” reporting model to the exchange).
The noncontingent fixed-price call option also exposes the transferor to changes in the fair value of the transferred loans. The transferor should therefore determine whether the call option represents a variable interest in specified assets, or an additional variable interest in the trust entity. If the fair value of the transferred loans represents greater than 50% of the trust entity’s total assets, the call option represents an additional variable interest in the trust entity. Refer to CG 3.7 for further discussion on variable interests in specified assets when the transferred loans represent less than 50% of the trust entity’s total assets.
EXAMPLE CG 3-4
Variable interest in lease arrangements
Variable interest in lease arrangements
A reporting entity leases one asset from an entity that holds only two assets. The reporting entity has a fixed-price purchase option to acquire the asset. The fair value of the leased asset is more than 50% of the fair value of the entity’s total assets. The lease qualifies as a finance lease.
Does the reporting entity have variable interest in the lessor entity?
Analysis
The fixed-price purchase option should be viewed as a variable interest in the entity since the fair value of the leased asset represents more than 50% of the fair value of the entity’s total assets. If the fair value of the leased asset represented less than 50% of the fair value of the entity’s total assets, the contract would be a variable interest in specified assets (see CG 3.7).
If the entity were considered a VIE, the reporting entity could be required to assess consolidation of the VIE under the power and losses/benefits criteria. The results achieved by consolidating the entire entity (i.e., recording both assets and the liabilities of the VIE) could be substantially different from those that would result from applying finance lease accounting to only the leased asset under ASC 842.
In contrast, the reporting entity would not have a variable interest in the entity if it borrowed funds from the entity to acquire a leased asset from a third party. Similar to Example CG 3-2, a loan from the entity would create, not absorb, variability within the entity as the borrowing would expose the entity to the reporting entity’s credit risk and potentially interest rate risk.
3.2.4 “By design” approach—substantive subordination of interests
For entities that issue both senior and subordinated interests, the absorption of risks by substantive subordinated interests is a strong indicator of the variability that the entity is designed to create.
Excerpt from ASC 810-10-25-32
For legal entities that issue both senior interests and subordinated interests, the determination of which variability shall be considered often will be affected by whether the subordination (that is, the priority on claims to the legal entity’s cash flows) is substantive. The subordinated interest(s) (as discussed in paragraph 810-10-55-23) generally will absorb expected losses prior to the senior interest(s). As a consequence, the senior interest generally has a higher credit rating and lower interest rate compared with the subordinated interest. The amount of a subordinated interest in relation to the overall expected losses and residual returns of the legal entity often is the primary factor in determining whether such subordination is substantive. The variability that is absorbed by an interest that is substantively subordinated strongly indicates a particular variability that the legal entity was designed to create and pass along to its interest holders.
When considering whether a subordinated interest is substantive, we believe that all relevant facts and circumstances should be considered, including:
- The interest’s entitlement to cash flows and its relative placement in the contractual priority of payments (“waterfall”) that governs the distribution of cash flows to lenders and investors of the entity
- Yields (interest rates) of the various interests issued
- Amount and size of the subordinated interests to all other interests issued (i.e., its size in relation to the total capitalization of the entity)
- Credit ratings of the interests issued
- The nature of the investors (institutional or retail) and how the instrument was marketed which may provide insight into the risk of an investment relative to other interests in the entity
3.2.5 “By design” approach—certain interest rate risk
Whether a reporting entity should consider the variability of an entity that is attributable to interest rate risk is addressed in ASC 810.
Periodic interest receipts or payments shall be excluded from the variability to consider if the legal entity was not designed to create and pass along the interest rate risk associated with such interest receipts or payments to its interest holders. However, interest rate fluctuations also can result in variations in cash proceeds received upon anticipated sales of fixed-rate investments in an actively managed portfolio or those held in a static pool that, by design, will be required to be sold prior to maturity to satisfy obligations of the legal entity. That variability is strongly indicated as variability that the legal entity was designed to create and pass along to its interest holders.
Interest rate risk should be excluded from variability if the entity was not designed to pass along interest rate risk to its interest holders. However, if an entity holds fixed-rate investments and expects to actively manage the portfolio by selling prior to maturity, the entity may be designed to pass along interest rate risk to its interest holders. The cash received upon redemption will vary based on fluctuations in the interest rate.
Example CG 3-5 may be helpful in applying this guidance.
EXAMPLE CG 3-5
Variability created by a bond investment expected to be held to maturity
Variability created by a bond investment expected to be held to maturity
Consider an entity established to invest in a fixed-rate bond that is expected to be held to its maturity, which is funded with matching maturity fixed-rate debt.
Should the entity’s variability include interest rate risk?
Analysis
No. The entity’s variability arises from its investment in the fixed-rate bond, which exposes the entity to the issuer’s credit risk. As the issuer of the fixed-rate bond’s credit risk changes, so too will the fair value of the entity’s net assets. The entity’s variability would not, however, include variability caused by changes in interest rates since there is no planned sale of the fixed-rate bond.
Case A through Case D provided in ASC 810-10-55-55 through ASC 810-10-55-70 illustrate how to consider interest rate risk variability in the context of VIEs that hold financial assets.
3.2.6 “By design” approach—certain derivative instruments
ASC 810-10-25-35 to ASC 810-10-25-36 provide guidance for assessing whether certain derivative contracts create or absorb variability.
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.
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 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 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.
This guidance does not constitute a “scope exception” for derivatives, but rather simplifies the analysis for many common derivatives (e.g., certain market-based interest rate swaps and foreign currency contracts).
First, the contract should be analyzed to determine whether it meets the characteristics of a derivative under ASC 815, Derivatives and Hedging (ASC 815). We believe that those contracts that meet the characteristics of a derivative are eligible for consideration under the “by design” guidance, regardless of whether the contract qualifies for one or more of the scope exceptions in ASC 815-10.
Next, an evaluation of the contract’s underlying must be made to determine whether it is based on an observable market rate, price, index of prices or rates, or other market observable variable(s) (including the occurrence or nonoccurrence of a specified market observable event). ASC 815-10-15-88 through ASC 815-10-15-91 provide additional guidance on what constitutes an underlying of a derivative. Generally, normal market contracts such as SOFR-based interest rate swaps, foreign currency contracts, and commodity futures have market observable variables.
Finally, whether the derivative contract is senior in priority (i.e., senior in the entity’s priority of payments “waterfall”) relative to other interest holders in the entity should be considered. We believe that if the derivative is at least pari passu with the most senior interest(s) issued by the entity, this condition would be met.
However, the “by design” guidance specifies that even if the two conditions discussed above are met, a derivative may still be a variable interest as opposed to a creator of variability, if the changes in the value of the instrument are expected to offset all, or essentially all, of the risk or return related to the majority of the assets or operations of the entity. In these cases, the design of the entity must be further evaluated. If the entity was designed to create and pass along specific risks to the derivative counterparty, the derivative would likely be considered a variable interest. Example CG 3-6 illustrates this assessment.
EXAMPLE CG 3-6
Evaluating whether a “receive-variable, pay-fixed” interest rate swap agreement is a variable interest
Evaluating whether a “receive-variable, pay-fixed” interest rate swap agreement is a variable interest
An entity’s only asset is a fixed-rate bond that is funded with variable-rate liabilities. The entity enters into a “receive-variable, pay-fixed” interest rate swap, which allows the entity to pay a fixed interest rate in return for receiving a variable interest rate.
Is the interest rate swap agreement a variable interest in the entity?
Analysis
Yes. This swap arrangement synthetically creates a variable-rate asset, which will absorb the interest rate exposure from the fixed-rate bond. As the bond is the only asset of the entity, it may be considered that the entity was designed to pass along the bond’s interest rate risk to the interest rate swap’s counterparty.
Refer to CG 3.3.5 for a further discussion of derivatives and embedded derivatives.
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