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Non-equity interests (e.g., debt) issued by voting entities generally do not absorb the entity’s losses until its equity interests are fully depleted. The VIE model indicates that an entity is considered a VIE if, as a group, the holders of the equity investment at risk lack the following:

ASC 810-10-15-14(b)(2)

The obligation to absorb the expected losses of the legal entity. The investor or investors do not have that obligation if they are directly or indirectly protected from the expected losses or are guaranteed a return by the legal entity itself or by other parties involved with the legal entity. See paragraphs 810-10-25-55 through 25-56 and Example 1 (see paragraph 810-10-55-42) for a discussion of expected losses.

This assessment should focus on whether the entity’s equity investors are exposed to its expected losses on a “first-dollar loss” basis.

Excerpt from ASC 810-10-15-14(b)

If interests other than the equity investment at risk provide the holders of that investment with these characteristics or if interests other than the equity investment at risk prevent the equity holders from having these characteristics, the entity is a VIE.

An evaluation of whether Characteristic 4 is present should focus on the equity interests as opposed to the identity of the equity investors. In most cases, a reporting entity should be able to make this assessment qualitatively.
When other variable interests that do not qualify as equity at risk absorb the entity’s expected losses before its equity at risk is fully depleted, we do not believe the entity should automatically be presumed to be a VIE.
We believe Characteristic 4 may be present if a potential VIE is designed such that its equity interests do not fully absorb the entity’s expected losses on a first-dollar loss basis. If other variable interests begin sharing in the entity’s expected losses before the equity investment at risk is fully depleted, and that sharing is part of the entity’s design, then the entity may be a VIE. An entity may also be a VIE under Characteristic 4 if it issued equity with puttable characteristics that are embedded in the terms of the interest.

4.6.1 Impact of implicit variable interests

ASC 810-10-25-48 through ASC 810-10-25-54 address if and when a reporting entity holds an implicit variable interest in a potential VIE. The existence of an implied variable interest may affect the determination of whether an entity should be considered a VIE, particularly with respect to Characteristic 4. For example, if a variable interest holder implicitly guaranteed the value of a potential VIE’s sole asset, then the entity would be considered a VIE under Characteristic 4. In that situation, the implied guarantee protects the holders of equity at risk from suffering the entity’s expected losses before the equity at risk is fully depleted.
See CG 3.6 for a further discussion of implicit variable interests.

4.6.2 Examples of how to evaluate an entity under Characteristic 4

The following examples illustrate how to assess whether the entity being evaluated for consolidation is considered a VIE under Characteristic 4.
Disproportionate loss sharing arrangements
Disproportionate sharing of expected losses among the holders of equity at-risk do not cause an entity to be a VIE under Characteristic 4. The assessment of whether Characteristic 4 is present should be based on an analysis of the holders of equity at risk, as a group, as opposed to individual at risk equity investors.
Disproportionate sharing arrangements among individual equity investors do not shield the holders of equity investment at risk, as a group, from absorbing the entity’s expected losses. Such arrangements change the manner in which the individual holders of equity at risk absorb the entity’s expected losses. Although holders of equity at risk may individually be protected from the entity’s expected losses to some extent, the group would continue to be exposed the entity’s expected losses on a first-dollar basis. This may also indicate that Characteristic 3 is present as individual investors may have disproportionate economic interests and voting rights. Refer to CG 4.5 for further details on Characteristic 3.
Debt guarantees
A debt guarantee generally would be considered a variable interest under the VIE model because it may absorb some portion of the entity’s expected losses. As a result, a reporting entity must determine whether the guarantee was incorporated into the design of the entity to protect the entity’s equity investors from absorbing the potential VIE’s expected losses on a first-dollar loss basis.
Debt guarantees are generally not called upon until the equity investment at risk is fully depleted. Therefore, debt guarantees typically do not cause the entity to be a VIE under Characteristic 4. Reporting entities should, however, carefully consider whether the existence of a debt guarantee causes an entity to be a VIE under Characteristic 1. Refer to CG 4.3 for further discussion.
Residual value guarantees provided by a lessee
In many leasing transactions, a lessor may require the lessee to provide a residual value guarantee on the asset that is subject to the lease arrangement. The residual value guarantee is intended to protect the equity investors of the lessor from any decline in the fair value of the leased asset. In other words, the residual value guarantee will absorb losses before the equity at risk is fully depleted.
To determine whether a lessee provided residual value guarantee causes an entity to be a VIE under Characteristic 4, a reporting entity should first consider whether the residual value guarantee represents a variable interest in the lessor entity. If the residual value guarantee is a variable interest in the lessor entity, and that variable interest absorbs the lessor entity’s expected losses before its equity at risk is fully depleted, Characteristic 4 would be present and the lessor entity would be a VIE.
When a lessee provides a residual value guarantees on specified assets that represent less than 50% of the fair value of the potential VIE’s total assets, the residual value guarantee would not be considered a variable interest in the entity (the residual value guarantee would represent a variable interest in specified assets). If the residual value guarantee does not represent a variable interest in the entity, Characteristic 4 would not be present and the lessor entity would not be a VIE.
Conversely, a lessee provided residual value guarantee would be considered a variable interest when the guarantee is provided on the lessor’s entity’s sole asset, or specified assets that represent greater than 50% of the fair value of the lessor’ entity’s total assets. If the residual value guarantee is a variable interest, then the lessor entity would be a VIE under Characteristic 4.
Refer to CG 3.7 for further discussion around the distinction between variable interests in specified assets versus variable interests in an entity.
Residual value guarantees on an entity’s assets provided by an equity investor
An equity investor may provide a residual value guarantee on an asset that the investee (a legal entity) holds. If the fair value of the asset subject to the residual value guarantee represents greater than 50% of the fair value of the entity’s total assets, the residual value guarantee would be a variable interest in the entity and the arrangement may cause the entity to be a VIE under Characteristic 4. Although the investor may have the economic obligation to absorb the entity’s losses on a first-dollar basis, the obligation stemming from the residual value guarantee is not embedded in the terms of the investor’s equity interest and would begin absorbing the entity’s expected losses before the equity at risk is fully depleted.
Insurance contracts
Entities routinely enter into insurance arrangements to insulate themselves from risk of loss arising from unforeseen events (e.g., fires, storms) or unplanned interruptions of their business operations. Examples of such arrangements include property and casualty and business interruption insurance. Applying Characteristic 4 to these contracts on a literal basis would cause many traditional companies to be considered VIEs.
Although normal and customary insurance arrangements protect an entity’s equity investors from risk of loss, we do not believe Characteristic 4 is intended to capture such situations. If these normal and customary insurance arrangements protect the equity investors from risk of loss stemming from the occurrence of unusual events, as opposed to losses that occur in the normal course of business (i.e., the predominant risks the entity was designed to create and pass along to its variable interest holders), we do not believe such arrangements would cause an entity to be a VIE under Characteristic 4. The group of at risk equity investors must, however, be exposed to risk of loss arising in the normal course of business to demonstrate that an entity is not a VIE under Characteristic 4.
Total-return swaps
Total-return swaps are an example of a variable interest that generally causes an entity to be a VIE under Characteristic 4. If a total-return swap protects the group of at risk equity investors from an entity’s expected losses, then Characteristic 4 would be present and the entity would be considered a VIE.
Example CG 4-22 illustrates the assessment of the impact of a total-return swap under Characteristic 4.
EXAMPLE CG 4-22
Assessing the impact of a total-return swap under Characteristic 4
Company A (1) issues debt of $250 and common stock of $50, and (2) acquires a bond with a fair value of $300. Assume that Company A enters into a total-return swap with Bank B. The terms of the arrangement provide that Bank B will pay 85% of the total return of the bond in exchange for a LIBOR-based return. That is, if the bond’s value declines by one dollar, the Bank B will pay the entity 85%.
Does the total-return swap cause Company A to be a VIE under Characteristic 4?
Analysis
Yes. The equity interests are protected from 85% of the asset’s losses. As a result, the entity would be deemed a VIE under this characteristic.

Cost-plus sales contracts
Sometimes manufacturers or service providers, acting in the capacity of a vendor, sell goods or services at a price that allows the vendor to recoup some or all of its operating costs plus a fixed margin. These arrangements are commonly referred to as “cost-plus” sales contracts.
Cost-plus sales contracts may cause the entity selling the goods or services (the vendor) to be a VIE under Characteristic 4 if the arrangement protects the vendor’s equity investors from absorbing the entity’s expected losses. The most straightforward example of where a cost-plus sales contract protects a vendor’s equity investors from suffering its expected losses is when the vendor sells all of its goods or services to a single customer at a price that varies based on its operating costs plus a fixed or variable mark-up. In that situation, the vendor’s customer would bear all of the entity’s operating risk through its variable pricing structure, thereby insulating the vendor’s equity investors from risk of loss.
Example CG 4-23 illustrates the assessment of the impact of a cost-plus sales contract under Characteristic 4.
EXAMPLE CG 4-23
Assessing the impact of a cost-plus sales contract under Characteristic 4
Company A and Company B formed Corporation X, each contributing $1,000 of cash in exchange for a 50% equity interest at formation. Corporation X also executed a sales agreement with Company A at formation, the terms of which require Company A to purchase 90% of the goods Corporation X manufactures. The price paid by Company A is equal to the costs to produce the goods, plus a 7% markup.
Does the supply agreement cause Corporation X to be a VIE under Characteristic 4?
Analysis
Yes. The sales contract, which is not part of Corporation X’s equity at risk, protects its equity investors from substantially all of its operating risks. Although Company A and Company B are exposed to 10% of Corporation X’s operating risks, this is not significant enough to overcome the level of protection provided based on the design of the entity. As such, Characteristic 4 would be present and Corporation X would be a VIE.

Some element of all commercial pricing arrangements is based on the vendor’s operating costs plus a profit margin. Assessing whether such arrangements indicate the presence of Characteristic 4 should be based on the relevant facts and circumstances. This analysis becomes more complicated when the vendor sells goods or services to different customers or when it renegotiates pricing with customers on a recurring basis.
We believe cost-plus sales arrangements with pricing schemes that reset periodically may indicate that the vendor’s equity investors are insulated from all operating risk, thereby causing the entity to be a VIE under Characteristic 4. Determining whether Characteristic 4 is present would ultimately require consideration of the level of protection the vendor’s at risk equity investors are provided through the arrangement.
Purchased fixed-price put options on an entity’s assets
An entity may purchase protection against a decline in the fair value of one or more assets it holds. If this downside protection is obtained through a fixed-price put option on the entity’s assets, a reporting entity should determine whether the put option represents a variable interest in the entity or a variable interest in specified assets. If the put option represents a variable interest in specified assets, then the purchased put option does not protect the group of at-risk equity investors from the entity’s expected losses. Consequently, the entity would not be a VIE under Characteristic 4.
Conversely, a fixed-price put option that is a variable interest in the entity as a whole may demonstrate that Characteristic 4 is present and the entity would be a VIE. A purchased fixed-price put option on an entity’s assets represents a variable interest in the entity as a whole when the puttable assets underlying the option represent greater than 50% of the entity’s assets on a fair value basis. If the put option is a variable interest in the entity and begins to share in the entity’s expected losses before the equity investment at risk is fully depleted, Characteristic 4 would be present and the entity would be a VIE.
Purchased fixed-price put options on an entity’s equity interests
A purchased fixed-price put option on an entity’s equity interest may cause either the equity interest to not qualify as equity at risk or the entity to be a VIE under Characteristic 4. If the put feature is embedded in the terms of the equity interest (e.g., the entity issues puttable shares to the equity investor), the equity interest will likely not be equity at risk since the equity interest will not participate in losses of the entity. If the put feature is not embedded in the terms of the equity interest (e.g., the equity investor buys a put option from one of the other equity investors of the entity) the equity interest would be equity at risk, assuming all the other equity at risk conditions are met. However, if the terms of the put are substantive (e.g., in-the-money put with a reasonable term), the put feature would cause the equity interest to be protected from losses and therefore the entity would be a VIE under Characteristic 4.
In contrast, an equity investor may purchase a put option from a third party to insulate itself from a degradation in the fair value of the potential VIE’s equity value. If that downside protection is obtained through a freestanding contract that was entered into as part of the equity investor’s normal trading activities, it is unlikely that Characteristic 4 would be present. Although the current holder of that equity interest may be protected against all or some portion of the entity’s expected losses, the put would not be considered a VI because it was not acquired as part of the purpose and design of the entity. As such, we do not believe such arrangements would cause an entity to be a VIE under Characteristic 4.
Other instruments that provide protection to the equity investment at risk
Other examples of variable interests in an entity that would cause an entity to be a VIE under Characteristic 4 are:
  • Guarantees of the entity’s assets when that guarantee is a variable interest in the entity and not in specified assets (refer to CG 3.7 for discussion of variable interests in specified assets)
  • A purchase agreement or option with a non-refundable deposit that protects the equity investment at risk from a portion of the market decline (to the extent of the deposit).
Question CG 4-7
Company A enters into a purchase and sale agreement with Company X, whereby Company A will buy from Company X land and a building, its sole assets. Company A is required to pay a significant non-refundable deposit to Company X and has the right to terminate the contract, subject to the loss of its deposit. Should Company X be considered a VIE?
PwC response
Yes. The purchase and sale agreement requires Company A (buyer) to make a significant non-refundable deposit to Company X (seller) where Company X’s sole asset is the real estate subject to the agreement. The non-refundable deposit absorbs some of Company X’s variability and transfers some of the risks and rewards of ownership to Company A. The protection provided to the seller through the non-refundable deposit causes Company X to be a VIE under Characteristic 4. In essence, the non-refundable deposit provides protection to Company X’s at-risk equity investors from declines in value of the underlying asset on a first-dollar loss basis before the equity investment at risk is fully depleted. Once the non-refundable deposit is depleted, the at-risk equity investors would begin participating in further declines in the fair value of the entity’s asset.
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