Search within this section
Select a section below and enter your search term, or to search all click Consolidation and equity method of accounting
Favorited Content
4.2 Identify the equity investment at risk
Publication date: 31 Dec 2022
us Consolidation guide
The reference to “equity” in the characteristics of a VIE refers to equity that is considered at risk. “Equity at risk” is a defined term and identifying it is an important first step in applying the VIE model.
Excerpt from ASC 810-10-15-14(a)
For this purpose, the total equity investment at risk has all of the following characteristics:
- Includes only equity investments in the legal entity that participate significantly in profits and losses even if those investments do not carry voting rights
- Does not include equity interests that the legal entity issued in exchange for subordinated interests in other VIEs
- 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
- 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.
Equity investments that are recorded in the equity section of the entity’s GAAP financial statements are the starting point for this evaluation. However, just because an investment is presented as equity does not necessarily mean that it qualifies as equity at risk. A careful analysis is necessary to ensure that an equity investment meets the conditions necessary to qualify as equity at risk.
Excerpt from ASC 810-10-15-14(a)
Equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements.
Figure CG 4-1 provides an overview of how the amount of an entity’s total equity investment at risk is calculated:
Figure CG 4-1
Calculating an entity’s total equity investment
Calculating an entity’s total equity investment
GAAP equity investment
|
|
Less:
|
Equity investments that do not participate significantly in the entity’s profits and losses (see ASC 810-10-15-14(a)(1))
|
Less:
|
Equity investments in an entity that are the source of subordinated financial support for another VIE (see ASC 810-10-15-14(a)(2))
|
Less:
|
Equity investments provided to the equity investor by the entity or other parties involved with the entity (see ASC 810-10-15-14(a)(3))
|
Less:
|
Equity investments financed for the equity investor by the entity or other parties involved with the entity (see ASC 810-10-15-14(a)(4))
|
An analysis should be performed to understand the nature of interests issued by a potential VIE, and to ensure that those interests would be reported as GAAP equity in the potential VIE’s financial statements. For example, if the potential VIE issued date-certain redeemable preferred stock that was required to be accounted for as a liability pursuant to ASC 480, those interests (the preferred stock) would not be recorded as GAAP equity and therefore would be excluded from equity at risk. However, if those preferred equity interests were presented as temporary equity pursuant to ASC 480-10-S99, Classification and Measurement of Redeemable Securities, they would be included in the calculation of equity at risk provided they meet all the requirements described later in this section.
Slight changes in the form of the equity, particularly certain preferred stock investments, may result in different conclusions as to whether such instruments qualify as equity at risk. Many entities are established with investments that economically are very similar to equity (e.g., subordinated debt), but are not reported as equity for GAAP financial reporting purposes. These investments cannot be considered part of the equity investment at risk.
In addition, commitments to fund the potential VIE’s future operations or promises to provide cash in the future in exchange for an equity interest (i.e., a stock subscription) are generally not considered GAAP equity as they would not be reported as equity in the potential VIE’s financial statements. An equity subscription receivable is generally accounted for by recording an equal and offsetting debit in the equity section of the entity’s financial statements, therefore, these equity investments do not qualify as equity investment at risk.
After the components of GAAP equity are identified, the next step is to assess whether the equity is considered at risk. A reporting entity must consider the four conditions set forth in ASC 810-10-15-14(a) to conclude that GAAP equity is at risk for purposes of applying the VIE model. If a potential VIE has more than one investor, a reporting entity must evaluate each investment separately against the four conditions.
4.2.1 Equity must participate significantly in profits/losses
Includes only equity investments in the legal entity that participate significantly in profits and losses even if those investments do not carry voting rights.
We believe the term “profits and losses” refers to GAAP profits and losses (as opposed to expected losses and expected residual returns). This means that the equity investment must share (or participate) in the net income or loss of the entity. Some equity investments may share only in the profits of the entity and are not exposed to the losses of the entity. In such circumstances, the equity investment would not be considered equity at risk.
Example CG 4-1 illustrates the determination of whether an equity investment with a guaranteed minimum return qualifies as equity at risk.
EXAMPLE CG 4-1
Determining whether an equity investment with a guaranteed minimum return qualifies as equity at risk
Determining whether an equity investment with a guaranteed minimum return qualifies as equity at risk
Company A contributed $1,000 of cash into Entity B at formation in exchange for 20% of Entity B’s common stock. Company A’s common equity investment participates pro rata in Entity B’s profits and losses; however, the terms of Company A’s interest stipulate that it must receive, at a minimum, an annual 8% rate of return on its investment.
Does Company A’s equity investment participate significantly in Entity B’s profits and losses?
Analysis
Generally, no. Although Company A’s equity investment may participate significantly in Entity B’s profits, the minimum guaranteed return demonstrates that Company A may not necessarily participate significantly in Entity B’s losses. As a result, assuming Company A’s guaranteed minimum return is substantive (i.e., Entity B has adequate equity that is (1) subordinated to Company A’s equity investment, and (2) capable of funding Company A’s guaranteed minimum return in periods where Company B incurs operating losses), Company A’s equity investment may not qualify as equity at risk.
Even when an equity investment participates in the profits and losses of a potential VIE, the investment’s level of participation must be “significant” for that equity investment to qualify as equity at risk. The determination of whether an equity investment participates significantly in profits and losses is based solely on the specific facts and circumstances. The following factors should be considered when making this assessment.
Fixed rates of return or low levels of returns or loss
Investments with a fixed rate of return generally do not participate significantly in the profits and losses of an entity. However, the substance of an arrangement should prevail over its form. If an equity investor is entitled to a fixed rate of return and that return is substantial relative to the entity’s overall equity return, the equity investment may participate significantly in the entity’s profits. To qualify as equity at risk, an equity investment must also participate significantly in the entity’s losses.
Determining whether an equity investment is substantive
An equity investment that participates in an entity’s profits and losses at a level that is consistent with its relative equity ownership (e.g., a 1% general partnership interest that participates in 1% of the entity’s profits and losses) would participate significantly in profits and losses as long as that equity investment is substantive.
Sometimes equity interests are issued for de minimis amounts and, as a result, that investor may not participate significantly in losses.
Example CG 4-2 illustrates the determination of whether a general partner interest participates significantly in a limited partnership’s profits and losses.
EXAMPLE CG 4-2
Determining whether a general partner interest participates significantly in a limited partnership’s profits and losses
Determining whether a general partner interest participates significantly in a limited partnership’s profits and losses
A general partner purchases a 1% general partner interest for $1,000, while 99 limited partners each receive a 1% interest for their contributions of $1,000,000 ($99 million in total).
Does the general partner’s interest participate significantly in the limited partnership profits and losses?
Analysis
No. Under this scenario, the general partner’s interest would not participate significantly in the profits and losses based on what the general partner paid for its 1% interest relative to the price paid by the LPs for their 1% interests (i.e., it is not substantive). In making this assessment, we believe the dollar amount and percentage of the investment relative to the total equity investments should be considered.
The general partner’s interest would be substantive and therefore qualify as equity at risk if (1) the general partner contributed $1 million for its 1% pro rata equity investment (like all other investors) and (2) the general partner’s investment participated pro rata in the limited partnership’s profits and losses. However, if the general partner’s percentage interest is trivial (i.e., 0.1%) then its investment would not be at risk irrespective of the price paid.
Guaranteed returns
Generally, when an equity investor’s returns are guaranteed by another party involved with the entity, the investor’s equity investment does not participate significantly in the losses of the entity.
Equity instruments that are redeemable or callable
Oftentimes, investors can put (redeem) their equity interests (purchased put options) or are required to sell their equity interests to a third party at the third party’s option (written call options). These put and call options are often exercisable at fixed prices or prices determined based on a formula. In determining whether these features would prevent an equity investment from participating significantly in the profits and losses of the entity, we believe a reporting entity should first determine whether those characteristics are embedded in the terms of the equity investment. Embedded terms are part of the equity investment’s features so they must be considered in the analysis. Freestanding puts and calls on equity may have to be included in the equity at risk analysis, as discussed further below.
Puttable or callable characteristics arising from a freestanding contract
When the puttable or callable characteristics result from a freestanding contract with a third party (i.e., a party that is not involved with the potential VIE) that was not executed as part of the entity’s purpose and design (e.g., as part of the equity investor’s normal trading activities), we do not believe the puttable or callable characteristics would preclude that equity interest from qualifying as equity at risk.
If, however, the equity investor executed the freestanding contract with the potential VIE or a party involved with the potential VIE as part of the purpose and design of the entity, we believe these characteristics would need to be considered in the analysis and may preclude the equity interest from qualifying as equity at risk if they substantively protect the investor from losses, or prohibit the investor from participating significantly in the entity’s profits.
If the puttable or callable characteristics are embedded in the terms of the contract, or arise from a freestanding contract executed as part of the design of the potential VIE, the following factors should be considered to determine whether the equity investment qualifies as equity at risk:
- The length of the period of time during which the put or call option may be exercised
- Terms associated with the put or call option, including the option’s strike price (e.g., fixed, variable, or fair market value)
If an equity investment is puttable or callable at the instrument’s then current fair value, or at a fixed price that is significantly out-of-the-money, that investment would likely participate significantly in the profits and losses of the potential VIE. In contrast, if the equity investment is puttable or callable at a fixed price that is in-the-money or at an amount that is not significantly out-of-the-money, we believe the investor may not participate significantly in the potential VIE’s profits and losses. This would preclude the underlying equity interest from qualifying as equity at risk.
Judgment may be required when an equity instrument is puttable or callable at an amount that is determined by a formula. Specifically, a reporting entity should consider whether the formula amount substantively limits the equity investor’s exposure to the entity’s profits or losses.
Question CG 4-1
Does a hybrid equity instrument that contains an embedded derivative requiring separation under the provisions of ASC 815-15-25 qualify as an equity investment at risk?
Does a hybrid equity instrument that contains an embedded derivative requiring separation under the provisions of ASC 815-15-25 qualify as an equity investment at risk?
PwC response
It depends. An embedded derivative that must be separated from its host contract pursuant to 815-15-25 must be classified as an asset or liability, and therefore would be excluded from the total equity investment at risk. However, the residual value ascribed to a host contract that is accounted for as GAAP equity might qualify as equity investment at risk, assuming the host contract meets the other necessary requirements. A reporting entity should determine whether the GAAP equity-classified host contract participates significantly in the potential VIE’s profits and losses to determine whether that equity investment qualifies as equity at risk. The equity classified host contract would not qualify as equity at risk if, for example, the separated derivative was a put option that is not significantly out-of-the-money. In that circumstance, the put option would protect the equity investor(s) from the entity’s expected losses, thereby disqualifying the equity classified host instrument from the potential VIE’s total equity investment at risk.
4.2.2 Equity issued for subordinated financial support in another VIE
Does not include equity interests that the legal entity issued in exchange for subordinated interests in other VIEs.
The objective of this provision is to ensure that a particular equity investment is not used to capitalize two entities (i.e., the equity investment should count only once).
Example CG 4-3 illustrates the determination of whether an equity investment acquired in exchange for a subordinated interest in another VIE qualifies as equity at risk.
EXAMPLE CG 4-3
Determining whether an equity investment acquired in exchange for a subordinated interest in another VIE qualifies as equity at risk
Determining whether an equity investment acquired in exchange for a subordinated interest in another VIE qualifies as equity at risk
Reporting Entity X contributed $1,000 of cash to Entity A, a VIE, at formation in exchange for a 30% equity interest in Entity A. Reporting Entity X then contributed its 30% equity interest in Entity A to Entity B in exchange for 40% of Entity B’s common equity.
Does Reporting Entity X’s common equity investment in Entity B qualify as equity at risk?
Analysis
No. Reporting Entity X’s equity investment in Entity B is not considered equity at risk since the equity investment was acquired in exchange for a subordinated interest issued by another VIE, Entity A.
If, however, Entity A was not a VIE, then Reporting Entity X’s equity interest in Entity B would be considered equity at risk assuming all other criteria in ASC 810-10-15-14(a) were met.
4.2.3 Equity provided by parties involved with the entity
Does not include amounts provided to the equity investor directly or indirectly by the legal entity or by other parties involved with the 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.
An equity investment is not at risk if the cash (or other assets) used to make the investment was obtained through fees, a charitable contribution, or other forms of payment made to the investor from another party involved with the entity. Stated differently, only an equity investment made by an equity investor that has “skin in the game” is considered equity at risk.
A literal reading of the guidance suggests that all fees paid to an equity investor by the potential VIE, or by others involved with the potential VIE, would reduce the entity’s equity investment at risk. We believe that the facts and circumstances should be considered when determining whether such fees are, in substance, a return of capital and therefore reduce the amount of equity at risk.
ASC 810 provides examples of payments to an equity investor that can result in a reduction in an investor’s at-risk equity, including upfront fees, third-party reimbursements, and fees paid over time.
Upfront fees
Generally, fees paid concurrent with the formation of an entity (or shortly thereafter) would be considered a return of the amounts invested by the equity investor. Examples of such fees include structuring, syndication, management, or development fees.
Payments and fees paid by any party that was involved with the entity should be evaluated to determine whether they disqualify the investor’s equity investment, in whole or in part, from being at risk.
Example CG 4-4 illustrates the impact of upfront fees paid to an equity investor on the calculation of total equity investment at risk.
EXAMPLE CG 4-4
Impact of upfront fees paid to an equity investor on the calculation of total equity investment at risk
Impact of upfront fees paid to an equity investor on the calculation of total equity investment at risk
Company A contributed $15 of cash to Entity B at formation in exchange for 100% of Entity B’s common equity. Entity B subsequently obtained $85 of nonrecourse debt and paid Company A $10, which represents a fee for development services Company A will perform in the future. The fee paid to Company A is fair value for the future services to be provided.
Does the fee paid by Entity B to Company A prevent Company A’s equity investment, in whole or in part, from being considered equity at risk?
Analysis
Yes. Company A’s equity investment at risk must be reduced by the amount of upfront fees received from Entity B for future development services. As such, the equity investment at risk would be $5, calculated as Company A’s $15 capital contribution less the $10 upfront development fee received from Entity B for future development services.
Example CG 4-5 illustrates the determination of whether a general partner’s equity investment qualifies as equity at risk when purchased using fees received from the entity.
EXAMPLE CG 4-5
Determining whether a general partner’s equity investment qualifies as equity at risk when purchased using fees received from the entity
Determining whether a general partner’s equity investment qualifies as equity at risk when purchased using fees received from the entity
A general partner forms a limited partnership and receives a $100 syndication fee. The general partner then contributes $10 for a 1% general partner interest.
Does the general partner’s 1% equity interest qualify as equity at risk?
Analysis
No. The general partner’s investment would not qualify as equity at risk since an upfront fee received from the limited partnership for services provided was used to fund the purchase of its interest.
Third-party reimbursements
Generally, payments that an equity investor receives from the entity that are used to pay an unrelated third party for a service performed for the entity would not affect the amount of the investor’s equity investment that would be considered at risk. The investor would not benefit from the monies received, so the amount invested in the entity would still be considered equity at risk.
Fees paid over time
If an equity investor is entitled to future fees that are at market and commensurate (refer to CG 3.4.1 for further discussion), its equity at risk would not be reduced by any portion of the future fees. In contrast, if the investor is entitled to future fees that are above market, and the investor is unconditionally entitled to such fees, then the present value of the total expected fee that exceeds the market rate should be treated as a reduction of the potential VIE’s total equity at risk. We believe such amounts represent, in substance, a guaranteed return on the investor’s equity interest.
Under certain arrangements, an entity may grant “sweat equity” to certain parties at the date on which an entity is established. Rather than granting this equity in exchange for cash, the equity may be granted for recognition of the party’s past or potential future efforts in the arrangement. For example, entities established for the acquisition, development, or construction of real estate or technology start-ups often grant “sweat equity” to developers/builders/founders for their efforts after the inception of the arrangement.
Question CG 4-2
Would “sweat equity” meet the criteria for being included in the equity investment at risk?
Would “sweat equity” meet the criteria for being included in the equity investment at risk?
PwC response
No. Sweat equity is not considered equity at risk. In effect, sweat equity is financed for the equity investor (service provider) by the potential VIE.
4.2.4 Equity financed by the entity or other parties involved with the entity
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.
The purpose of this condition is to exclude from the equity at risk amounts funded from sources other than the equity investor. The burden of the investors to absorb potential losses decreases when the entity, or other parties that are involved with the entity, provide loans or guarantees of loans to the equity investors.
In these circumstances, the funding that supports the entity is provided by parties providing the loan to the equity investor or guaranteeing debt financing used by the equity investor to fund its interest, as opposed to the equity investors. ASC 810 specifically prohibits equity investments from qualifying as equity at risk when the source of funds used by the equity investor to acquire its equity interest are provided by (1) the potential VIE or (2) other parties involved with the potential VIE, unless those other parties are included in the same set of consolidated financial statements as the equity investor.
If the borrowed funds were received from an individual or entity that is not involved with the potential VIE, then the equity investment acquired using the borrowed funds would be considered equity at risk, assuming it meets all other necessary conditions.
A reporting entity that makes a contribution or loan to another party that is used to acquire an equity interest in a potential VIE may also create a de facto agency relationship as discussed in CG 5.4. This may have significant ramifications when determining whether a decision-making fee is a variable interest (refer to CG 3.4), and whether a variable interest holder is the primary beneficiary of a VIE (refer to CG 5).
Example CG 4-6 illustrates the determination of whether an equity investor’s interest is at risk when purchased using borrowed funds from a party involved with the VIE.
EXAMPLE CG 4-6
Determining whether an equity investor’s interest is at risk when purchased using borrowed funds from a party involved with the VIE
Determining whether an equity investor’s interest is at risk when purchased using borrowed funds from a party involved with the VIE
Investor A loans Investor B $500, and Investor B uses the $500 to acquire a 50% interest in Partnership X. Investor A contributes $500 in cash and also receives a 50% interest in Partnership X. Investor A and Investor B are each required to consent to all decisions related to Partnership X’s activities that most significantly impact its economic performance (i.e., power is shared).
Analysis
Investor B’s equity investment is excluded from total equity investment at risk because Investor A provided the financing for that investment. In addition, Investor A and Investor B would be considered VIE related parties (de facto agents), which could have ramifications if Partnership X is a VIE and neither Investor A nor Investor B meet both conditions necessary to be the primary beneficiary of Partnership X on a stand-alone basis.
4.2.5 Equity at risk — activities around the entity
Conceptually, reporting entities are required to consider activities “around the entity” to capture circumstances where entities are structured to avoid consolidation. Examples of relationships or transactions “around the entity” that should be considered when assessing whether an investor’s equity interest qualifies as equity at risk include the following:
- Loans between an entity’s equity investors
- Purchased and sold put and call options
- Service arrangements with investors and non-investors
- Derivatives financial instruments (e.g., total-return swaps)
If relationships and transactions “around the entity” prevent the holders of equity at risk from participating significantly in the entity’s profits and losses, then those equity investments should be excluded from the calculation of equity at risk. If those transactions or relationships cause some or all of the entity’s equity investments to be excluded from equity investment at risk, this could lead to the conclusion that the entity is VIE due to insufficient capitalization. Refer to CG 3.6 for further discussion.
Once the holders of equity investment at risk have been identified, the reporting entity should determine whether any of the five characteristics of a VIE as described in ASC 815-10-15-14 are present. If a single VIE characteristic is present, then the entity is a VIE and the reporting entity must determine whether it is the VIE’s primary beneficiary (as discussed further in CG 5).
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
Link copied
