Development-Stage Entities
ASC 810-10-20 Expected Losses
4.16 Allocation Methods That May Be Used to Determine Whether Fees Paid to Decision Makers or Service Providers Are Variable Interests
ASC 810-10-55-37 lists conditions that must be met for a reporting entity to determine that fees paid to a decision maker or a service provider do not represent a variable interest. The following two conditions (ASC 810-10-55-37(c) and 37(f)) require consideration of the amount of variability in the entity’s anticipated economic performance that will be absorbed by the decision maker or service provider:
c. The decision maker or service provider does not hold other interests in the VIE that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE’s expected losses or receive more than an insignificant amount of the VIE’s expected residual returns.
f. The anticipated fees are expected to absorb an insignificant amount of the variability associated with the VIE’s anticipated economic performance.
ASC 810-10-55-37 does not specify any particular approach that a reporting entity should use to determine whether these two conditions are met. Further, ASC 810-10-55-37A states, “For purposes of evaluating the conditions in [ASC 810-10-55-37], any interest in the entity that is held by a related party of the entity’s decision maker(s) or service provider(s) should be treated as though it is the decision maker’s or service provider’s own interest.”
Question
What are some acceptable approaches that a reporting entity may use to determine whether the conditions in ASC 810-10-55-37(c) and 37(f) are met?
Answer
A decision maker or service provider will generally be able to use a qualitative analysis to determine whether the conditions in ASC 810-10-55-37(c) and 37(f) are met; a quantitative analysis would not typically be necessary. ASC 810-10-55-37A states, in part, “For purposes of evaluating the conditions in [ASC 810-10-55-37], the quantitative approach . . . is not required and should not be the sole determinant as to whether a reporting entity meets such conditions.” However, if a reporting entity determines that a quantitative analysis is necessary, the decision maker or service provider generally should apply a variation of the “top-down” allocation method (described below) to all VIEs evaluated.
Before ASU 2009-17’s amendments to the VIE model in ASC 810-10, there were two fundamental allocation methods for identifying the primary beneficiary of a VIE: the top-down method and the “bottoms-up” method.
These methods were based on the allocation of expected losses and expected residual returns to the variable interests. Several variations of the top-down method were developed in practice. Under each method, a reporting entity must use the contractual cash inflow and outflow provisions between the VIE and the variable interest holders in allocating expected losses and expected residual returns to the variable interests. The following table summarizes the top-down and bottoms-up methods and their variations.
Method Comments
Top-Down The top-down method has many variations. Fundamentally, however, each variable interest holder calculates its expected losses and expected residual returns on the basis of the cash flows that would be allocated to it under each scenario.2 That is, the cash flows that are used to calculate the aggregate expected losses and aggregate expected residual returns of the VIE are allocated to each variable interest holder on the basis of the contractual provisions of its interests and the underlying assumptions used for each scenario.
In practice, variations in applying the top-down method are due to how the expected losses and expected residual returns are assigned to each variable interest holder when one party absorbs an expected loss while another receives an expected residual return in a single cash flow scenario. Although there may be more than one acceptable approach to applying the top-down method when expected losses and expected residual returns are allocated to multiple variable interest holders under a single cash flow scenario (i.e., one party absorbs an expected loss and another party receives an expected residual return in a single cash flow scenario), under any potential approach the total amount of the expected losses and expected residual returns allocated to each variable interest holder must equal the aggregate expected losses and aggregate expected residual returns of the VIE.
Bottoms-Up Under the bottoms-up method, the aggregate expected losses (and aggregate expected residual returns, if necessary) of the VIE are treated as a single cash flow scenario that is assumed to occur. That amount of expected losses and expected residual returns is allocated to each variable interest holder on the basis of the calculated fair value of each variable interest holder (i.e., the probability-weighted discounted expected cash flows) in the VIE, starting with the most subordinate variable interest to the most senior variable interest.
The bottoms-up method is limited by the fact that it does not consider the timing or causes of the expected losses and expected residual returns of the VIE when those amounts are allocated to the variable interest holders. Therefore, the bottoms-up method is not operational when different variable interest holders have different rights (obligations) regarding the receipt (absorption) of different risks that cause the variability of the VIE or when the timing of the occurrence of the risks that the entity was designed to pass on to the variable interest holders has a significant impact on the overall variability of the VIE that will be absorbed by the variable interest holders.
Although the calculation of expected losses and expected residual returns is not expected to be prevalent under the VIE model in ASC 810-10 (as amended), the top-down method may continue to be appropriate in the assessment of the conditions in ASC 810-10-55-37(c) and 37(f) if a reporting entity determines that a quantitative analysis is necessary for such evaluations. When a quantitative analysis is deemed necessary, a decision maker or service provider can select any reasonable top-down method of allocating a VIE’s expected losses and expected residual returns to the variable interest holders. However, given that the application of different variations of the top-down method could result in different conclusions under ASC 810-10-55-37(c) and 37(f), a reporting entity should apply a consistent variation of the “top down” method to all VIEs for which a quantitative analysis of ASC 810-10-55-37(c) and 37(f) is deemed necessary.
2 A “scenario” is a single cash flow outcome that is developed on the basis of the potential variability in the economic performance of a VIE, exclusive of cash flows received from or distributed to the variable interests in the VIE. Multiple cash flow scenarios are determined and probability-weighted in the calculation of the aggregate expected losses and aggregate expected residual returns of a VIE. See Q&A 4.10 for a discussion of the number of cash flow scenarios used in calculating the expected losses and expected residual returns of a VIE and Q&A 4.05 for
Because the bottoms-up method assumes that only the aggregate expected losses and aggregate expected residual returns of the VIE will occur, this method is appropriate only when (1) there is only one type of risk that is designed to be passed on to the variable interest holders or (2) the subordination of classes of variable interests to other variable interests is the same for all types of risks designed to be passed on to the variable interest holders, regardless of the timing of when those risks are absorbed by the variable interest holders. That is, no matter what type of risk causes the VIE’s loss or the timing of that loss, the loss must be absorbed in the ascending order of the various classes of variable interests’ priority claims.3 Because neither of the conditions necessary to apply the bottoms-up method will be expected to exist for decision-making or servicing contracts (because a decision maker or service contract generally will not absorb all the elements of the variability of a VIE, because the timing of the variability will affect the absorption, or both), the bottoms-up method is generally not appropriate when a quantitative analysis is deemed necessary to the evaluation of the conditions in ASC 810-10-55-37(c) and 37(f).
3 The aggregate expected losses of a VIE result from the probability weighting of numerous possible scenarios that could occur. The cause of each potential loss scenario is not known under the bottoms-up method because the expected losses of the VIE that are being allocated are treated as a single “hypothetical” scenario that is assumed to occur.