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3.3 Examples of variable interests
Publication date: 31 Jul 2022
us Consolidation guide
Variable interests are not limited solely to equity investments.
Excerpt of definition 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.
The following are examples of common arrangements that may be variable interests:
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ASC 810-10-55-16 through ASC 810-10-55-41 provide guidance that may be helpful when determining whether common contractual and ownership arrangements are variable interests. Certain of the items listed above are discussed in further detail below. It is worth noting that the following guidance focuses on how to apply the concept of a variable interest to various instruments and contracts.
3.3.1 Variable interests—equity investments
The most obvious variable interests are equity investments. Equity investors provide capital to an entity in exchange for an ownership interest that exposes the investors to the entity’s potential losses and potential returns. Therefore, they absorb the entity’s economic risks and rewards.
ASC 810-10-55-22 clarifies an important point; just because an equity investment is not at risk does not necessarily mean that the investment is not a variable interest. An equity investment that is not at risk may nevertheless absorb an entity’s expected losses and receive its expected residual returns (see CG 4.3).
Example CG 3-7 evaluates whether an interest in a trust preferred security is a variable interest.
EXAMPLE CG 3-7
Evaluating whether an interest in trust preferred securities is a variable interest
Evaluating whether an interest in trust preferred securities is a variable interest
Under a typical trust preferred securities structure, a sponsor creates a special purpose vehicle (a trust). The sponsor purchases 100% of the residual interest in the trust, which represents 3% of the overall equity of the trust.
The trust issues long-term, date-certain, redeemable preferred securities to investors. The trust then lends the proceeds of the preferred securities issuance to the sponsor. The sponsor issues debentures as evidence of its indebtedness to the trust (the trust’s only asset), and the sponsor issues a full and unconditional guarantee to the investors in the trust preferred securities.
The trust preferred securities have a fixed interest rate with the entire principal due at maturity. The securities are also callable after a specified period of time. In addition, the sponsor has the right to remove the trustee.
Trust preferred securities may be advantageous since the securities often receive partial equity credit by rating agencies and favorable regulatory capital treatment.
Does the sponsor have a variable interest in the trust?
Analysis
No. The sponsor would not have a variable interest in the trust. From the sponsor’s perspective, neither the residual interest held, nor the loan payable to the trust, would be considered variable interests.
The loan receivable from the sponsor is the only asset of the trust, and it is the obligation of the sponsor to pay the contractual interest and principle payments to the trust. The loan receivable is not a variable interest since the loan receivable is an asset of the trust and it creates variability (the credit risk of the sponsor) that is passed on to the variable interest holders. While the sponsor’s residual equity interest in the trust is exposed to variability in the form of credit risk, that variability is created by the sponsor entity itself. We believe that an interest held by a reporting entity would not be a variable interest if that interest only absorbs variability created by the same reporting entity.
In addition, the fact that a sponsor has unconditionally guaranteed the trust preferred securities is irrelevant, since the sponsor is guaranteeing its own obligations.
3.3.2 Variable interests—debt instruments and beneficial interests
A reporting entity may provide debt financing to an entity in exchange for fixed or variable returns. Because an entity’s activities and the resulting fluctuations in the fair value (or cash flows) of the entity may affect the ultimate collectability of these returns, debt instruments absorb variability. As a result, virtually all debt instruments are variable interests.
Investments in subordinated beneficial interests or subordinated debt instruments issued by a VIE are likely to be variable interests. The most subordinated interest in a VIE will absorb all or part of the expected losses of the VIE. For a voting interest entity the most subordinated interest is the entity’s equity; for a VIE it could be debt, beneficial interests, equity, or some other interest. The return to the most subordinated interest usually is a high rate of return (in relation to the interest rate of an instrument with similar terms that would be considered to be investment grade) or some form of participation in residual returns.
As the level of priority with respect to returns of investments increases, the variability associated with those returns diminishes. Senior debt (e.g., investment grade debt) and senior beneficial interests (usually with fixed interest rates or other fixed returns) nevertheless are variable interests–even though the degree of variability absorbed by senior interests may be reduced by subordinated interests and the relative credit quality of the entity. ASC 810-10-55-24 elaborates on these points.
Any of a VIE’s liabilities may be variable interests because a decrease in the fair value of a VIE’s assets could be so great that all of the liabilities would absorb that decrease. However, senior beneficial interests and senior debt instruments with fixed interest rates or other fixed returns normally would absorb little of the VIE’s expected variability. By definition, if a senior interest exists, interests subordinated to the senior interests will absorb losses first. The variability of a senior interest with a variable interest rate is usually not caused by changes in the value of the VIE’s assets and thus would usually be evaluated in the same way as a fixed-rate senior interest. Senior interests normally are not entitled to any of the residual return.
3.3.3 Variable interests—guarantees, put options, similar obligations
Options purchased/exercisable by the entity/options written by the reporting entity
Entities sometimes seek to offset (hedge) the potential risks associated with changes in the fair value of one or more of their assets or liabilities by entering into arrangements that transfer some or all of that risk to other parties. In addition, guarantees of the value of assets or liabilities, written put options on the assets of an entity, and other similar arrangements are examples of interests that may absorb the potential variability related to the entity’s operations and assets. In many cases, the writer of the contract will absorb at least some portion of the expected losses of the entity.
Guarantees of the value of the assets or liabilities of a VIE, written put options on the assets of the VIE, or similar obligations such as some liquidity commitments or agreements (explicit or implicit) to replace impaired assets held by the VIE are variable interests if they protect holders of other interests from suffering losses. To the extent the counterparties of guarantees, written put options, or similar arrangements will be called on to perform in the event expected losses occur, those arrangements are variable interests, including fees or premiums to be paid to those counterparties. The size of the premium or fee required by the counterparty to such an arrangement is one indication of the amount of risk expected to be absorbed by that counterparty.
As discussed below, the analysis of a guarantee can differ, depending on whether the underlying or reference obligation is an asset or liability of the entity. That distinction can have major implications on the consolidation evaluation.
A guarantee of the value of an entity’s assets must first be evaluated to determine whether the contract should be considered a variable interest in the entire entity or, alternatively, should be viewed as a variable interest in the underlying, specified assets. The latter concept, known as “variable interests in specified assets,” is described in further detail in CG 3.7. If a guarantor has guaranteed the value of a specific asset of the entity, that guarantee is a variable interest in the entire entity only if the fair value of the guaranteed assets constitutes a majority (greater than 50%) of the fair value of the entity’s total assets.
When analyzing a guarantee of an entity’s obligations, the foregoing distinction (interest in an entity versus an interest in the underlying guaranteed item) is not relevant. These contracts are analyzed exclusively as potential variable interests in the entity, as discussed in more detail below.
Similar to a guarantee, a fixed-price put option written by a reporting entity and purchased by an entity is usually a variable interest. The entity (that purchased the put) receives the right, but not the obligation, to put (sell) the referenced item to the reporting entity at a fixed-price (i.e., the strike price) during a specified period or on a specified date. When an entity purchases a put option, it receives the right to transfer the potential risk of loss on the underlying item to the writer of the put (i.e., the option writer absorbs the risk of loss on the asset’s value).
Typically, in these arrangements, the purchaser of a put option pays a premium to the writer for its rights under the contract (i.e., the price of protection on the underlying asset). That amount is influenced by factors such as the duration of the option, the difference between the exercise price and the fair value of the underlying assets, price volatility, and other characteristics of the underlying assets. In exchange, the writer of the put is exposed to the risk of loss if the fair value of the underlying assets declines, but profits only to the extent of the premium received–as, presumably, if the underlying assets increase in value over the put’s life, the holder of the option will not exercise it.
If a reporting entity has guaranteed a liability of an entity (effectively, a written put option), that guarantee is a variable interest in the entity. This is because the guarantee is protecting holders of other variable interests from suffering losses. For example, a financial guarantor of beneficial interests issued by a securitization entity has a variable interest in that entity. When assessing such financial guarantee of liabilities of the entity, it is important to note that they are always variable interests, regardless of the design of the entity.
If the entity has the option to buy an asset (i.e., a call option) from the option writer at a specified price, this contract usually is not a variable interest in the entity, as the option is creating variability for the entity.
Options written by the VIE
If a VIE is the writer of a guarantee, written put option, or similar arrangement, the items usually would create variability. Thus, those items usually will not be a variable interest of the VIE (but may be a variable interest in the counterparty).
If a VIE is a writer of a put option, the purchaser of this option has the right to sell an asset or its investment back to the VIE. The contract transfers risk of loss from the purchaser of the option to the VIE, and therefore creates variability for the VIE. As a result, such contracts are not generally viewed as variable interests. The variability resulting from these arrangements must be considered in determining the entity’s economic risks and rewards. This is also consistent with the example in the “by design” guidance (Case E; ASC 810-10-55-71 through ASC 810-10-55-74), which concludes that the credit default swap written by the VIE should be considered a “creator” of variability.
If the entity writes a call option on its assets, the purchaser of this option has the right to buy an asset of the entity at a specified price. This contract is a variable interest in the asset as it absorbs variability in the asset, and it may be a variable interest in the VIE if the underlying asset represents more than 50% of the fair value of the VIE’s total assets. If the underlying asset represents less than 50% of the fair value of the VIE’s total assets, the contract would be a variable interest in specified assets (see CG 3.7).
Options written/purchased among reporting entities
A reporting entity may write options to, or purchase options from, a counterparty with respect to an investee’s assets/liabilities/equity (e.g., the right to purchase a joint venture partner’s equity interest in the venture). These options are not direct variable interests in the investee entity since they are not related to a specific contract with the investee entity.
Even though the investee entity is not the counterparty to such options, they do alter the cash flows with respect to the variable interests held by the parties that entered into the option arrangement. Therefore, these arrangements may impact the consolidation analysis of the parties that entered into the option agreement. Example CG 3-8 illustrates this concept.
EXAMPLE CG 3-8
Evaluating whether a purchased call option is a variable interest when the investee entity is not the direct counterparty to the option
Evaluating whether a purchased call option is a variable interest when the investee entity is not the direct counterparty to the option
A venture is created whereby Company A and Company B each contributes $50 million in cash in exchange for a 50% equity ownership. Company A and Company B each has equal representation on the venture’s board of directors and decisions require a unanimous vote. Company A has an option to purchase Company B’s entire equity interest for $60 million exercisable two years from the venture’s inception date.
Is the option to purchase Company B’s equity interest a variable interest for Company A at inception under ASC 810?
Analysis
Yes. The option is a variable interest since it is exercisable at a fixed-price and, as a result, Company A absorbs the positive variability from changes in the fair value of the venture.
Conversely, if the strike price of the option is at “true” fair value of the underlying, then such an option is not a variable interest–since the option strike price fluctuates with the change in the fair value of the venture. Caution should be exercised with respect to fair value call options to ensure that the definition of fair value in the agreement is consistent with “true” fair value. Some agreements may define formulas for the strike price intended to approximate fair value or expectations of fair value (e.g., formulas based on trailing earnings before interest, depreciation and taxes). In many cases, these formulas may result in calculated amounts that are close to fair value, but do not represent fair value. If so, the option may be a variable interest.
3.3.4 Variable interests—forward contracts and supply arrangements
The determination of whether forward contracts or supply agreements are variable interests involves consideration of the design of the entity. The FASB has provided only high-level guidance to assist in these assessments.
Forward contracts to buy assets or to sell assets that are not owned by the VIE at a fixed price will usually expose the VIE to risks that will increase the VIE’s expected variability. Thus, most forward contracts to buy assets or to sell assets that are not owned by the VIE are not variable interests in the VIE.
A forward contract to sell assets that are owned by the VIE at a fixed price will usually absorb the variability in the fair value of the asset that is the subject of the contract. Thus, most forward contracts to sell assets that are owned by the VIE are variable interests with respect to the related assets. Because forward contracts to sell assets that are owned by the VIE relate to specific assets of the VIE, it will be necessary to apply the guidance in paragraphs 810-10-25-55 through 25-56 to determine whether a forward contract to sell an asset owned by a VIE is a variable interest in the VIE as opposed to a variable interest in that specific asset.
The contract first should be evaluated to determine whether it contains a lease. If the contract contains a lease, then refer to CG 3.5 for a further discussion of evaluating leases to determine if they are variable interests. Any remaining non-lease elements should also be analyzed to determine if they are variable interests.
If the contract does not contain a lease, the contract should be evaluated to determine whether it constitutes a derivative. If the forward contract meets the characteristics of a derivative under ASC 815-10, the contract should be evaluated considering the strong indicators for derivatives in the “by design” model (see CG 3.2).
For those forward contracts and supply arrangements that are not determined to be creators of variability according to the strong indicators for derivatives, a careful analysis of the terms of the contract and the design of the entity should be performed. The pricing of a contract (e.g., fixed price, fixed formula, cost plus) might affect the determination of whether the contract is a variable interest. If the purchase agreement contains any off-market terms, it may indicate that the arrangement is a variable interest, particularly if it provides financing or other support to an entity.
ASC 810-10-55-81 through ASC 810-10-55-86 provide an example of how a forward purchase contract (i.e., a contract to purchase assets in the future at a fixed price) may be evaluated when considering whether the contract creates or absorbs variability. However, we believe that forward contracts are some of the most difficult interests to evaluate under the VIE model. Whether or not fixed-price forward contracts absorb or create variability in an entity will often depend on whether there are significant other risks in the entity, other than the volatility in the pricing of the assets in a forward contract.
A forward or supply contract to buy assets at a fixed price (or fixed formula) will absorb the variability in the fair value of those assets. A contract that has certain types of a variable pricing mechanism (e.g., cost plus) may also be a variable interest. However, a variable exercise price does not automatically lead to a conclusion that such forward contacts are variable interests in the entity. Consideration of the risks associated with the underlying entity and its design must be considered in making this determination.
If a forward contract relates to specified assets that represent less than 50% of the fair value of the entity’s total assets, the contract would not be a variable interest in the entity (see CG 3.7).
Example CG 3-9 illustrates how a purchase and sale agreement may create a variable interest.
EXAMPLE CG 3-9
Purchase and sale agreement with a non-refundable deposit
Purchase and sale agreement with a non-refundable deposit
Company A enters into a fixed-price purchase and sale agreement with Company X under which Company A will buy from Company X land and a building. Company X’s sole assets are the land and the building that will be sold under the agreement. As part of the agreement, Company A is required to pay a non-refundable deposit to Company X. Company A also has the right to terminate the contract, subject to the loss of its deposit.
Does Company A have a variable interest in Company X arising from the purchase and sale agreement?
Analysis
Yes. Company A will absorb some level of variability in the fair value of the land and the building as a result of entering into the purchase and sale agreement with Company X and providing a non-refundable deposit. Even if Company A has the unilateral right to cancel the agreement, it still has economic upside because the agreement to purchase the land and the building is at a fixed price.
3.3.5 Variable interests—other derivative instruments
ASC 810-10-55-29 through ASC 810-10-55-31 provide additional implementation guidance to assist reporting entities in evaluating whether a derivative instrument is a variable interest. This guidance augments the framework for analyzing these contracts (discussed in CG 3.3.3 and CG 3.3.4) and should be considered from that perspective.
Derivative instruments held or written by a VIE should be analyzed in terms of their option-like, forward-like, or other variable characteristics. If the instrument creates variability, in the sense that it exposes the VIE to risks that will increase expected variability, the instrument is not a variable interest. If the instrument absorbs or receives variability, in the sense that it reduces the exposure of the VIE to risks that cause variability, the instrument is a variable interest.
Derivatives, including total return swaps and similar arrangements, can be used to transfer substantially all of the risk or return (or both) related to certain assets of a VIE without actually transferring the assets. Derivative instruments with this characteristic shall be evaluated carefully.
Some assets and liabilities of a VIE have embedded derivatives. For the purpose of identifying variable interests, an embedded derivative that is clearly and closely related economically to its asset or liability host is not to be evaluated separately.
Determining whether a derivative contract is a variable interest may involve significant judgment. This analysis should take into account the entity’s activities and design, and the role the derivative is intended to play in that context. For example, is the contract designed to hedge other exposures of the entity or, conversely, is it intended to expose the entity to incremental risks. As discussed in ASC 810-10-55-31, an embedded derivative that is not clearly and closely related to its asset or liability host should be evaluated to determine if it is a variable interest.
When examining debt instruments, the following embedded derivatives would not typically be evaluated separately as variable interests:
- Call options
- Put options
- Caps or floors on interest rates
- Other interest rate indexes
- Credit-sensitive payments or indexes to the issuer’s creditworthiness
In these cases, the economic characteristics of the embedded derivatives typically are clearly and closely related to the debt instrument. However, in instances where the relevant terms introduce significant leverage or are based on factors that are not economically related to the debt instrument, the embedded feature would likely be considered other than clearly and closely related, in which case the feature should be examined to determine whether it is a variable interest. This conclusion would apply in situations where the debt includes a derivative indexed to one of the following:
- Another party’s credit (that is, a party other than the instrument’s issuer)
- Movements in commodities
- Equity prices (e.g., the S&P 500 index)
3.3.6 Variable interests—assets of the entity
Assets held by a VIE almost always create variability and, thus, are not variable interests. However, as discussed separately in this Subsection, assets of the VIE that take the form of derivatives, guarantees, or other similar contracts may be variable interests.
Examples of assets that may be variable interests are derivatives, purchased guarantees, and similar contracts. In addition, an asset may have an embedded derivative feature that might be considered a variable interest, as discussed in ASC 810-10-55-32.
3.3.7 Variable interests—license, royalties, and similar arrangements
Generally, licenses, royalties, and similar arrangements are linked to an entity’s performance indicators (e.g., revenue, EBITDA). As a result, such contracts typically obligate the entity to make payments in amounts that correspond, in varying degrees, to changes in the fair value of the entity’s net assets. As such, these arrangements may absorb variability in the entity and, as such, may represent variable interests. A reporting entity should consider the design of the entity, including whether the license or similar arrangement was intended to create variability that is passed on to other interest holders or to absorb variability of the entity. Additionally, a reporting entity should assess whether a license or similar arrangement that absorbs variability is a variable interest in specified assets or a variable interest in the entity as a whole. See CG 3.7 for further discussion on variable interests in specified assets.
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