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This section addresses matters to consider when determining whether an entity is a variable interest entity subject to the VIE consolidation model.

10.3.1 Does the entity meet the definition of a VIE?

An entity is defined as a variable interest entity and is subject to consolidation if any one of the criteria described in ASC 810-10-15-14 is met. In evaluating whether single power plant entities are VIEs, project participants historically have focused on the impact of power purchase agreements and project financing. However, single power plant entities often have disproportionate profit sharing arrangements, protection for certain equity holders, or other structural considerations that may result in a conclusion that the entity is a VIE. Therefore, it is important to consider all of the criteria in ASC 810-10-15-14 when determining whether an entity is a VIE.
Figure 10-6 summarizes the definition of a VIE and describes some common single power plant entity structures that may meet one or more of the criteria.
Figure 10-6
The definition of a variable interest entity
Definition
Guidance
Common structures
ASC 810-10-15-14(a): Total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support.
  • Equity interests are those that are reported as equity in the entity’s financial statements.
  • Equity investment at risk should be assessed to determine sufficiency.
  • Entity has a power purchase agreement that is a variable interest (contract provides subordinated financial support)
  • Entity has subordinated debt or other interests that represent subordinated financial support
ASC 810-10-15-14(b): As a group, the holders of equity investment at risk lack any of the following characteristics:
(1) The power to direct the significant activities
(2) The obligation to absorb losses
(3) The right to receive residual returns
  • Applies if parties other than the equity holders at risk have power over the most significant activities of the entity.
  • Criterion may be met if equity holders are protected from losses or returns are capped or guaranteed.
  • Existence of kick-out or other participating rights may impact conclusion.
  • Power purchase agreement provides off-taker with power over significant activities (e.g., fuel, dispatch) and protects equity holders from loss and caps their returns
  • Power purchase agreement that requires off-taker to absorb losses and provides a right to benefits, with no voting rights
  • Power project with put or call options at specified prices on the power plant involving a non-equity holder (such as the off-taker)
ASC 810-10-15-14(c): Voting rights of equity holders are disproportionate to their obligation to absorb losses or right to benefits, and substantially all of the entity’s activities are conducted on behalf of an investor that has disproportionately few voting rights.
  • Criterion may be met if voting rights are not proportionate to the investment made and to the equity waterfall.
  • Qualitative and quantitative factors should be assessed when determining whether substantially all the activities are conducted on behalf of an investor with disproportionately few voting rights.
  • Partnership structures with a general partner that has voting and key decision-making powers but the initial investment was provided by limited partners (see UP 9.4 for further information about limited partnership investments)
Each of the VIE criteria is further discussed in the following sections.

10.3.1.1 Insufficient equity at risk

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

The total equity investment (equity investments in a legal entity are interests that are required to be reported as equity in that entity’s financial statements) at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders.

In evaluating whether an entity meets this criterion, the reporting entity should consider the equity investment at risk and whether it is sufficient. Factors to consider in performing this analysis are described below.
Equity investment at risk
Not all investments in an entity are “at risk.” To qualify as equity at risk, an investment must be accounted for as equity in the potential VIE’s financial statements. In addition, ASC 810-10-15-14(a) provides four characteristics of equity at risk:
•  Participates significantly in profits and losses, regardless of voting ability
•  Excludes equity interests issued in exchange for subordinated interests in other VIEs (i.e., the equity investment cannot be used to capitalize two entities at the same time)
•  Excludes amounts provided to the equity investor by the entity or others involved with the entity, unless the provider is a parent, subsidiary, or affiliate of the investor within a consolidated group
•  Excludes amounts financed for the equity investor (e.g., loans or guarantees) by the entity or others involved with the entity, unless the reporting entity providing the financing is a parent, subsidiary, or affiliate of the investor within a consolidated group
The parties should analyze the source of funding and the investors’ participation in income and losses of the entity to determine if an investment qualifies as at risk under this guidance.
Question 10-7
Does a funding commitment qualify as equity at risk?
PwC response
No. Commitments to fund the future operations of the entity, or promises to provide cash in the future in exchange for an equity interest (i.e., a stock subscription) are generally not considered equity under U.S. GAAP. Such amounts would not be reported as equity in the entity’s financial statements and should be excluded from the equity investment at risk. See CG 4.2 for further information on equity at risk.

10.3.1.1.1 Subordinated financial support

ASC 810-10-25-45 indicates that if the equity investment at risk is less than 10% of the entity’s total assets, it is not considered sufficient to allow the entity to finance its activities without additional subordinated financial support unless the amount of equity can be demonstrated to be sufficient. This rebuttable presumption does not necessarily mean that equity at risk of more than 10% is automatically deemed sufficient. No matter the amount of equity at risk, both qualitative and quantitative factors should be considered to determine whether the amount of equity investment at risk is sufficient. One of the key considerations in making this assessment is whether subordinated financial support was required to obtain the entity’s financing. The following excerpt includes the definition of subordinated financial support.

Definition from ASC 810-10-20

Subordinated Financial Support: Variable interests that will absorb some or all of a variable interest entity’s (VIE’s) expected losses.

Given that variable interests absorb rather than create risk, virtually any variable interest may be considered subordinated financial support. Therefore, all variable interests and contractual relationships should be assessed to determine whether they are a form of subordinated financial support. For example, a power purchase agreement that is a variable interest is generally a form of subordinated financial support, triggering a conclusion that the entity is a VIE under ASC 810-10-15-14(a). A variable interest included in an agreement that contains a lease (such as a maintenance agreement) may also be a form of subordinated financial support. Other examples may include certain subordinated or other non-investment-grade debt, funding commitments, preferred interests, and other investments that do not qualify as equity at risk.

10.3.1.2 Equity holders lack power

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

As a group the holders of the equity investment at risk lack any one of the following three characteristics:
1. The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance. . . .
2. The obligation to absorb the expected losses of the legal entity. . . .
3. The right to receive the expected residual returns of the legal entity.

As further discussed in UP 10.4, the primary beneficiary of a VIE is the party that has the power to direct the activities of the VIE that most significantly impact its financial performance, and that also has a financial exposure that could potentially be significant to the entity (obligation to absorb losses or right to receive gains that could be significant to the VIE). Although many parties to the VIE may have significant financial exposure, only one party can meet both of these criteria. The evaluation of the equity holders at risk under ASC 810-10-15-14(b) is consistent with the approach to determining the primary beneficiary in that it considers the powers held by different parties. Consider the following simplified example.
EXAMPLE 10-1
Equity holder lacks power to direct the most significant activities
M&H Holding Company holds all of the equity interests in Foxglove Power Company (FPC). Big Bank provides financing under a 20-year debt agreement. All capacity, electric energy, and ancillary services from the plant are sold to Rosemary Electric & Gas Company under a tolling agreement, while the steam is sold to an oil refinery. The power purchase agreement provides REG with the right to control operations and maintenance and dispatch. Steam is approximately 15% of the revenue from the plant and the power purchase agreement is not a lease. For purposes of this example, the variable interests are:
• M&H — the equity interests
• Big Bank — the debt financing
• REG — the power purchase agreement
The oil refinery also has a variable interest as a result of the steam agreement.
Analysis
M&H determines that operations and maintenance and dispatch are the activities that most significantly impact the economic performance of FPC. Therefore, M&H concludes that FPC is a VIE because the tolling agreement gives a party other than the holders of the equity at risk (i.e., REG) the power to direct FPC’s most significant activities.

Kick-out rights and participating rights
One of the characteristics that results in a conclusion that an entity is a VIE is that the equity holders do not have the power to direct the activities of the entity that most significantly impact its financial performance. This power may be conveyed through kick-out or participating rights and the existence of or lack of these rights may have a different impact on the VIE analysis depending on whether the entity should be evaluated as a corporation or as a limited partnership (see CG 2.3.3.2).
Assessment for entities evaluated as corporations
If an entity should be evaluated as a corporation and a decision maker arrangement exists, the evaluation of kick-out or participating rights can be summarized in the following three steps:
1. Determine if the decision maker arrangement is a variable interest. If it is not a variable interest, the arrangement does not prevent the equity holders from having the power to direct the activities of the entity that most significantly impact its economic performance.
2. Determine if a substantive kick-out or participating right exists that can be exercised unilaterally. If a substantive right to replace the decision maker can be unilaterally exercised by one party, the equity holders as a group would not lack the power over the significant activities that impact the economic performance.
3. Assess the rights of shareholders and determine if the holders of equity at risk have the power to direct the activities of the entity that most significantly impact its economic performance.
After considering the above three steps, a decision maker that has the power over the significant activities, and that cannot be replaced through a unilateral exercise right, would cause an entity to be a VIE.
For other than decision making arrangements, if an interest holder other than the holders of equity at risk has kick out or participating rights related to the significant activities that can be unilaterally exercised, the equity holders would not have the power over those activities and the entity would be a VIE.

Excerpt from ASC 810-10-15-14(b)(1)(i) – For legal entities other than limited partnerships

If no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation) over the activities of a legal entity that most significantly impact the entity’s economic performance, kick-out rights or participating rights (according to their VIE definitions) held by the holders of the equity investment at risk shall not prevent interests other than the equity investment from having this characteristic unless a single equity holder (including its related parties and de facto agents) has the unilateral ability to exercise such rights. Alternatively, interests other than the equity investment at risk that provide the holders of those interests with kick-out rights or participating rights shall not prevent the equity holders from having this characteristic unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those rights. A decision maker also shall not prevent the equity holders from having this characteristic unless the fees paid to the decision maker represent a variable interest

Assessment for entities evaluated as limited partnerships
If the entity should be viewed as a limited partnership, the reporting entity should determine whether the limited partners lack the power to direct the entity’s most significant activities as discussed in ASC 810-10-15-14(b)(1)(ii). In performing this analysis only rights that are substantive should be considered.

Excerpt from ASC 810-10-15-14(b)(1)(ii) – For limited partnerships

Partners lack the power through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance if neither of the below conditions exist;
(1) a simple majority or lower threshold of limited partners (including a single limited partner) with equity at risk is able to exercise substantive kick-out rights (according to their voting interest entity definition) through voting interests over the general partner(s), and
(2) Limited partners with equity at risk are able to exercise substantive participating rights (according to their voting interest entity definition) over the general partner(s).

If the limited partners do not hold kick-out rights that can be exercised through a simple majority vote or lower, or do not have substantive participating rights, the equity holders as a group would not have the power to direct the significant activities of the entity that impact economic performance and the entity would be a VIE.
Impact of protective rights

Partial definition from ASC 810-10-20

Protective Rights: Rights designed to protect the interests of the party holding those rights without giving that party a controlling financial interest in the entity to which they relate.

The inclusion of protective rights in an agreement does not impact the analysis of whether an entity is a VIE in the same way as kick-out or participating rights. Protective rights are common in project financing agreements and in long-term power purchase agreements, which often include provisions allowing the debt holder or power off-taker to assume operational responsibility for the plant if the operator defaults. Rights that are exercisable only in the event of default are protective rights and would not trigger the conclusion that an entity is a VIE. The definition in ASC 810-10-20 includes examples of protective rights as follows:
•  Approval or veto rights that do not affect the activities that most significantly impact the entity’s economic performance. Protective rights often apply to fundamental changes in the entity’s activities, such as: (1) sale of important assets or activities that change the credit profile of the entity; or (2) capital expenditures over a certain limit or the issuance of new equity or debt.
•  The ability to remove the primary beneficiary in cases such as bankruptcy or breach of contract.
•  Limitations on operating activities that may restrict certain activities but do not provide a controlling financial interest (such as rights held by a franchisor over activities of a franchisee).
These concepts are further illustrated in the following simplified examples.
EXAMPLE 10-2
Protective kick-out rights
Assume the same facts as in Example 10-1. However, M&H Holding Company has the responsibility to obtain fuel for Foxglove Power Company and it also controls operations and maintenance (as opposed to Rosemary Electric & Gas Company). M&H concludes that fuel procurement and operations and maintenance are the most significant activities affecting the potential profit or loss of FPC. As a result of this change, further assessment is required to determine whether FPC is a VIE.
The power purchase agreement provides REG with the right to assume operational responsibility for the facility in the event of a default under the contract. M&H considers how this right impacts the evaluation of whether FPC is a VIE.
Analysis
REG’s ability to remove M&H in the event of a default under the contract is an example of a protective right and does not impact the evaluation of whether FPC is a VIE. The parties should further assess whether FPC is a VIE under one of the other provisions of ASC 810-10-15-14.
EXAMPLE 10-3
Operational kick-out rights
Assume the same facts as in Example 10-2, however, the power plant is held in a partnership entity, Foxglove Power Partners (FPP). M&H Holding Company holds a 2% general partnership interest and manages the day-to-day operations of the plant. FPP has class A limited partnership interests held by three limited partners. It also has class B limited partnership shares held by one limited partner. The class B shares are mandatorily redeemable and are accounted for as a liability by FPP. As such, the class B shares are not considered equity at risk because the interest is not classified as equity by FPP.
The limited partners provided their own equity and together have approval over all major operating decisions, including financing, the annual budget, operations and maintenance schedules, and major contracts. In addition, they have the ability to rescind the general partner’s management agreement (without cause) through a simple majority vote.
Analysis
As discussed in CG 2.3.3.2, in this case, since the entity is a partnership and functions like a partnership, the limited partners would need to hold substantive kick-out rights for the entity to not be a VIE under ASC 810-10-15-14(b)(1). Substantive kick-out rights exist and can be exercised by a simple majority vote or lower threshold. Therefore, the criteria under ASC 810-10-15-14(b)(1) are not met (although the partners also need to consider whether FPP is a VIE under one of the other provisions of ASC 810-10-15-14). However, if the rights were held by only the limited partner with the mandatorily redeemable shares such that it had the ability to act unilaterally, FPP would be a VIE.

Obligation to absorb losses/right to receive returns
In accordance with ASC 810-10-15-14(b)(2) and (b)(3), an entity also meets the definition of a VIE if the equity holders lack the obligation to absorb expected losses or the right to receive the expected residual returns of the entity. When evaluating these provisions, a reporting entity should consider:
•  Expected losses — consider whether the equity holders as a group are required to absorb the entity’s expected losses on a “first-dollar loss” basis until the equity is depleted. In other words, there should not be a mechanism or arrangement that protects the equity holders from losses on their investment.
•  Expected residual returns — an entity is a VIE if the equity investors’ return is capped or other variable interest holders share in the residual cash flows at an amount that is considered significant relative to the level of expected residual returns.
Sample features that may trigger VIE accounting under this guidance include:
•  A guarantee on returns of an equity investment by the entity itself, or by other parties that are involved with the entity, that provides the equity holder with protection against losses (e.g., a return on investment may be guaranteed for tax-equity holders in a renewable energy “flip” structure, when the investment is equity under U.S. GAAP)
•  A residual value guarantee that provides the equity holders with protection against losses (e.g., a plant lessee guarantees a specified power plant value at the end of the power purchase agreement)
•  A put option held by the entity at a specified price that provides the equity holder with protection against losses (e.g., the entity holds an option to put the power plant to the off-taker at some point during or at the end of the power purchase agreement at a specified price)
•  A call option written by the entity may function to limit the equity holders’ right to receive residual profits (e.g., if the power plant can be called by the off-taker at some point during or at the end of the power purchase agreement at a specified price)
•  An arrangement whereby the power plant off-taker shares in profits from sales of other by-products by the entity, thereby capping the equity holders’ ability to earn returns
Some of these arrangements may also trigger VIE accounting under ASC 810-10-15-14(a) because they may provide subordinated financial support or indicate the equity investment was not at risk.

10.3.1.3 Nonsubstantive voting rights

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

The equity investors as a group also are considered to lack the characteristic in (b)(1) if both of the following conditions are present:
1. The voting rights of some investors are not proportional to their obligations to absorb the expected losses of the legal entity, their rights to receive the expected residual returns of the legal entity, or both.
2. Substantially all of the legal entity’s activities . . . either involve or are conducted on behalf of an investor that has disproportionately few voting rights.

This criterion is intended to identify entities that are structured so that a reporting entity can avoid consolidation under the voting interest model by providing nonsubstantive voting rights to another party. Examples of structures that may trigger VIE accounting under this provision include:
  • A partnership structure that provides the general partner with all of the voting and key decision-making powers while the initial investment was provided by the limited partnership interests
  • A partnership arrangement whereby two partners each provide initial equity of 50% and retain 50% voting rights; however, the profit sharing is disproportionate (e.g., one party receives 90% of profits after the initial investment is repaid)
In such cases, reporting entities need to consider whether the activities are being conducted on behalf of the party with disproportionately fewer voting rights. See CG 4.2 for further information.

10.3.2 Reconsideration of whether an entity is a variable interest entity

Under the VIE consolidation model, a reporting entity is required to assess whether it is involved with a VIE on the date that it initially becomes involved with an entity. In addition, ASC 810-10-35-4 requires reconsideration of the initial determination of whether an entity is a VIE in response to certain events:
  • Governing documents or contractual arrangements are modified, resulting in a change in the characteristics or adequacy of the equity at risk.
  • All or part of the equity is returned to the equity holders and other investors become exposed to expected losses.
  • The entity adds new activities or assets that increase expected losses, or curtails or modifies activities to decrease expected losses.
  • The entity receives additional equity that is at risk.
  • The equity holders as a group lose the power to direct the activities of the entity that most significantly impact its economic performance.
Financing and operational adjustments over the life of a single power plant entity may result in certain entities changing between the VIE accounting model and the voting interest model. For example, reconsideration triggers for single power plant entities include expiration of a power purchase agreement or pay-off of project financing. In some cases, these events may cause the reporting entity to conclude that the entity is no longer a VIE.
In addition, the guidance specifically states that losses in excess of expected losses would not result in a reconsideration event.

10.3.3 Does a scope exception apply?

Prior to concluding that it is involved in a variable interest entity, a reporting entity should consider whether one of the ASC 810 scope exceptions is applicable. Entities that qualify for one of the exceptions in ASC 810-10-15-12 or 15-17 are not subject to the VIE consolidation model.
Figure 10-7
Exceptions to the VIE consolidation model
ASC 810-10-15-12 and 15-17 provides the following scope exceptions:
  • Not-for-profit organizations, unless used in a manner similar to a VIE to circumvent the requirements of the VIE consolidation model
  • Employee benefit plans
  • Investments accounted for at fair value in accordance with specialized guidance in the AICPA Audit and Accounting Guide, Investment Companies
  • Separate accounts of life insurance companies
  • Grandfathered entities with an “information out” exception
  • Entities qualifying for the business scope exception
  • Governmental organizations
The VIE consolidation model does not apply if an entity qualifies for one of these scope exceptions.
The last three exceptions included above are the most commonly considered when evaluating single power plant entities. Key considerations in applying these exceptions are further discussed below.

10.3.3.1 “Information out”

ASC 810-10-15-17(c) provides a scope exception for VIEs created prior to December 31, 2003, where the reporting entity is unable to obtain sufficient information to make a VIE assessment or to perform the related accounting, after making an exhaustive effort. This exception applies as long as the reporting entity is unable to obtain the necessary information. However, the assertion that it is unable obtain the information should be validated on a regular basis. In addition, any significant change in the entity’s contractual or other arrangements (e.g., negotiation of a new power purchase agreement) would generally preclude continued use of this exception because contract changes should permit incorporation of provisions that allow access to necessary information.
In addition, ASC 810-10-50-16 requires a reporting entity applying this exception to make certain specific disclosures. See FSP 18 for further information about the applicable disclosure requirements.

10.3.3.2 The “so-called” business scope exception

The VIE consolidation model provides a scope exception for entities that meet the definition of a business under ASC 805. Many single power plant entities may appear to qualify for this exception. However, the conditions for this exception are difficult to meet in practice. ASC 810-10-15-17(d) prohibits a reporting entity from using the business scope exception in any of the following situations:
  • The reporting entity (including related parties) participated significantly in the design or re-design of the entity, unless the entity is a joint venture under joint control of the reporting entity and one or more third parties
  • The entity is designed so that substantially all of its activities involve or are conducted on behalf of the reporting entity (including related parties)
  • The reporting entity (including related parties) provides more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the entity
  • The activities of the entity are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements
These additional requirements severely limit the circumstances in which the business scope exception may be applied. See CG 2.3.4 for further information. Considerations in applying this exception to single power plant entities include:
Is the entity a business under ASC 805?
Reporting entities should first assess whether the variable interest entity meets the definition of a business. If the reporting entity concludes that the potential VIE is a business, it should then evaluate whether it meets any of the exceptions to ASC 810-10-15-17(d) as discussed below. See UP 8.2 for information on assessing whether a single power plant entity meets the definition of a business, including specific considerations for an entity in the development stage.
Is the entity a single-lessee entity, or are its activities a form of asset-backed financing?
Single power plant entities are usually structured with one or more equity investors, a debt investor or other source of additional financing and, in many cases, a power purchaser. In a typical single power plant entity, the project debt is collateralized with the assets of the entity and is non-recourse to the equity owners. In such cases, this debt is considered to be a key element of the design, and the activities of the entity would be considered to be a form of asset-backed financing; thus, the business scope exception cannot be applied.
In other cases, the power purchase agreement qualifies as a lease in accordance with ASC 840. Single-lessee entities are also precluded from applying the business scope exception under ASC 810-10-15-17(d)(4).
What is the reporting entity’s involvement with the entity?
If the entity is a business and it is not involved in asset-backed financing or single-lessee arrangements, the reporting entity should assess its other involvement with the entity. The business scope exception is not applicable if the reporting entity (or its related parties) participated substantially in the design of the entity, if the entity’s activities are substantially for the reporting entity, or if the reporting entity provides more than half of the entity’s financial support. For many single power plant entities, this will also preclude application of the business scope exception because the interest holders participated in the design of the entity and/or the purpose and design of the entity are primarily for the reporting entity.
Question 10-8
Is the business scope exception ever applicable to a single power plant entity?
PwC response
Generally, no. As discussed above, there are significant limitations to the application of the business scope exception. As a result, we would rarely expect the business scope exception to be applied to single power plant entities. The exception may be applicable to entities holding multiple power plants, but only if the reporting entity was not involved in the design of the entities and the activities of the entities are not performed on the reporting entity’s behalf.

10.3.3.3 Governmental organizations

In most cases, a reporting entity otherwise required to apply the VIE consolidation model should not consolidate a governmental organization or a financing entity established by a governmental organization. The term “governmental organization” is defined in the AICPA Audit and Accounting Guide, State and Local Governments. Because of the prevalence of public power organizations, reporting entities may become involved in contractual arrangements with governmental organizations. In such cases, the reporting entity should consider whether this exception is applicable. See CG 2.2.3 for additional discussion on governmental organizations.
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