Development-Stage Entities
ASC 810-10-20 Expected Losses
4.05 How to Determine the Expected Losses and Expected Residual Returns of the Entity — Example
Q&A 4.04 describes the steps involved in the determination of an entity’s expected losses and expected residual returns.
Question
How would those steps be applied to an example?
Answer
The following example illustrates the steps in the determination of an entity’s expected losses and expected residual returns.
Example
Assume the following:
An entity (PowerCo) is created to hold a power plant with a fair market value of $10 million at inception. PowerCo is funded by two unrelated equity holders, each contributing $1 million, and the issuance of $8 million of debt as follows:
• $5 million in senior fixed-rate bonds with a 5 percent interest rate to a single unrelated party.
• $3 million in subordinated fixed-rate bonds with a 7.5 percent interest rate to a single unrelated party.
• The two bondholders are unrelated to each other or to the equity holders. The senior and subordinated bonds are due in a lump sum payment (“bullet maturity”) at the end of 25 years.
Further assume the following:
• PowerCo uses $9.95 million of the proceeds from equity contributions and debt to purchase a power plant. The other $50,000 of proceeds is used to pay a guarantee premium on the subordinated bond, as discussed below.
• As a condition of lending, the subordinated debt holder requires PowerCo to obtain a credit guarantee.
The guarantee will cover any shortfall of the subordinated debt principal payments up to $1 million.
PowerCo pays a third-party guarantor a premium of $50,000 for the guarantee.
• PowerCo enters into a forward contract to sell its output at market value to an unrelated third party.
PowerCo retains a significant amount of the operating risk associated with the power plant.
• An unrelated party, ManageCo, runs the plant and makes the day-to-day operating decisions. ManageCo has a five-year contract and receives a fixed fee of $90,000 per year, plus an additional 1 percent of net income before this fee, impairment expense, depreciation expense, and guarantor premiums or proceeds.
During its five-year term, ManageCo cannot be fired or relieved of its duties except for breach of contract.
Although PowerCo is a “business” as defined in ASC 805, the equity holders, the bond holders, and ManageCo participated significantly in the design of the entity. Therefore, they are not exempt from analyzing PowerCo to determine whether it is subject to the VIE model in ASC 810-10. See Q&A 1.20 for further discussion of the business scope exception.
This example assumes that a qualitative assessment was completed in accordance with ASC 810-10-25-45 but was not conclusive in the determination that PowerCo had sufficient equity investment at risk.
Step 1: Distinguish the nonvariable interests from the variable interests in the entity.
The following table analyzes interests in PowerCo to determine which are variable interests:
Equity
PowerCo’s equity does not create losses or residual returns. The equity is the most subordinated interest in PowerCo. If returns of PowerCo are less than expected, it absorbs losses (negative variability) first, and if returns of PowerCo are greater than expected, it will receive returns (positive variability) greater than those provided to more senior interests (i.e., the senior bond holder and the subordinated bond holder receive their principal and interest before the equity absorbs any residual returns of PowerCo). Thus, the equity interests are variable interests.
Subordinated Bond
The subordinated bond does not create losses or returns for PowerCo. Instead, it is a variable interest in PowerCo because it is subordinated to the senior bond and therefore would have to absorb losses (after the equity) if PowerCo does not generate enough cash to pay interest or principal on the bond.
Senior Bond
The analysis is the same as that for the subordinated bond above (i.e., the senior bond is a variable interest in PowerCo). Although the equity and subordinated bond would absorb PowerCo’s expected losses first, scenarios are possible in which returns are less than expected and for which the senior bond also will absorb losses. Therefore, the senior bond is a variable interest in PowerCo.
Subordinated Bond Guarantee
The subordinated bond guarantee is a variable interest in PowerCo because it must absorb losses if PowerCo does not generate enough cash to pay interest or principal on the subordinated bond. ASC 810-10-55-25 states, in part, “[t]o the extent the counterparties of guarantees . . . 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.” Although the guarantee gives rise to future cash flows of the entity, those cash flows are triggered by, and are intended to make up for, returns that are less than expected.
Note that although the guarantor is a variable interest holder, the guarantor need not analyze its interest under the VIE model in ASC 810-10 because PowerCo meets the definition of a business in ASC 805 (provided that the guarantor was not significantly involved in the design of the entity).
Power Plant
The power plant is PowerCo’s primary asset. The operations of the power plant create variability because it will generate and incur cash flows related to the operation of the business. Thus, the power plant creates variability in cash flows that will be absorbed by the variable interest holders and the power plant is not a variable interest.
Third-Party Customers
The design of PowerCo is important to the determination of whether the third-party customer holds a variable interest in PowerCo. According to ASC 810-10-25-35, the determination of whether a forward contract to sell electricity is a variable interest is based, in part, on whether (1) its “underlying is an observable market rate, price, index of prices or rates, or other market observable variable” and (2) the “counterparty is senior in priority relative to other interest holders in the legal entity.” In addition, if changes in the cash flows or fair value of the forward contract are expected to offset all, or essentially all, of the electricity price risk and operating risk related to the power plant, further analysis of the design of PowerCo would be required. Criteria (1) and (2) above are met in this instance, and although PowerCo sells the electricity at market value, it still retains a significant amount of operations risk associated with the power plant; therefore, the forward contract is considered a creator of variability and is not a variable interest. This conclusion would change if the forward contract was designed to reimburse PowerCo for all or essentially all of the costs related to operating the power plant. (For more information, see ASC 810-10-55-81 through 55-86.)
ManageCo Service Contract
The ManageCo service contract is a variable interest. The VIE model in ASC 810-10 provides guidance on determining whether the fee stream paid to a decision maker or service provider is a variable interest. In this case, the ManageCo contract is a variable interest in accordance with ASC 810-10-55-37 through 37A. After consideration of all relevant facts and circumstances, the ManageCo contract fails to meet all the conditions of a nonvariable interest in ASC 810-10-55-37 through 37A.
On the basis of the above analysis, the following assets and contracts create variability in PowerCo (and are not variable interests):
• The estimated cash flows from the operations of the power plant (including the sales to third parties).
• The estimated changes in the fair value of the power plant not reflected in net income or loss.
The following liabilities, contracts, and equity absorb or receive the variability created by the above (and are variable interests in the entity):
• The equity.
• The senior bond.
• The subordinated bond.
• The subordinated bond guarantee.
• ManageCo (through its fees).
As stated in the table above, only the holders of the equity, the senior bond, the subordinated bond, and ManageCo will analyze whether PowerCo is a VIE and whether any of them is the primary beneficiary. The guarantor of the subordinated debt does not need to analyze its interest held because PowerCo meets the definition of a business in ASC 805 and none of the conditions in ASC 810-10-15-17(d) are met with respect to its variable interest in PowerCo. However, the variable interest holders will treat all of the interests that absorb or receive variability as variable interests within the scope of the VIE model in ASC 810-10 when calculating the expected cash flows of the entity.
Step 2: Develop the scenarios of estimated cash flows attributable to nonvariable interests under the VIE model.
Cash flow scenarios must be developed on the basis of all of the possible variations in the operating results of PowerCo. PowerCo uses the “indirect method” (as illustrated in Q&A 4.06) to calculate the estimated cash flows for each scenario. Note that the calculation of expected cash flows for each scenario only should include the cash flows created by the entity. That is, as noted in Q&A 4.01, the result for each cash flow scenario should reflect the cash flows available to variable interest holders for that scenario, as identified in step 1 above. In this case, PowerCo only will consider cash flows related to the operations of the plant and the changes in fair value of the power plant that otherwise are not reflected in net income or loss (i.e., the estimated termination value of the power plant at the end of the estimated cash flow period). PowerCo starts its calculation with amounts derived under GAAP; therefore, it must adjust its cash flow estimates to exclude the impact on GAAP amounts of cash flows related to the variable interests (i.e., any cash flow to or from the holders of equity, debt, the guarantee, or the management contract).
For simplicity, this example assumes only three possible scenarios for PowerCo — best case (Scenario 1), most likely case (Scenario 2), and worst case (Scenario 3). However, in practice, a reporting entity will need to consider many more scenarios. See Q&A 4.10 for guidance on the number of scenarios needed to calculate the expected cash flows of an entity under the VIE model.
In addition, for simplicity, this example assumes that the cash flows of PowerCo have been estimated over a five-year period. However, in practice, a reporting entity must use judgment to determine the appropriate period over which cash flows reasonably can be estimated. At the end of the five-year period, the assets of the entity (e.g., the power plant) are assumed to be sold at fair market value under each scenario and the proceeds from the sale are incorporated into the estimated cash flow scenarios. In other words, the termination value of the entity must be considered in each cash flow scenario. For each scenario, assume that the power plant is depreciated over 20 years. Q&A 4.06 illustrates the calculations of cash flow scenarios for PowerCo under Scenario 3. The following table shows the results for all three scenarios:
Table 1 — Undiscounted Cash Flows Undiscounted Cash Flows
to Be Received From or Paid to the Entity by
Variable Interests Year 1 Year 2 Year 3 Year 4 Year 5 Total
Scenario 1 $ 1,485,000 $ 1,755,000 $ 1,420,000 $ 1,238,000 $ 9,552,000 $ 15,450,000
Scenario 2 1,435,000 1,255,000 1,320,000 1,038,000 8,172,000 13,220,000
Scenario 3 785,000 755,000 720,000 588,000 5,866,400 8,714,400
Step 3: Calculate the expected cash flows of the entity under the VIE model.
To arrive at the expected cash flows of the entity under the VIE model in ASC 810-10, a reporting entity must weigh the probability of each cash flow outcome associated with each of the three scenarios (this approach is consistent with the approach to calculating expected cash flows under Concepts Statement 7). Probabilities are assigned on the basis of the likelihood of the occurrence of that scenario compared with that of all other scenarios.
The selection of probabilities should be based on all facts and circumstances (the sum of the probabilities assigned to the scenarios must equal 100 percent). (For more information, see Q&A 4.10.) Table 2 below shows the calculation of the expected cash flows of PowerCo under the VIE model. The calculation of the discounted cash flows is shown in step 4.
Table 2 — Undiscounted Expected Cash Flows
PowerCo
Undiscounted Estimated Cash Flows
(A) Probability
(B)
Probability-Weighted Expected Cash Flows
(A × B)
Scenario 1 $ 15,450,000 25% $ 3,862,500
Scenario 2 13,220,000 50 6,610,000
Scenario 3 8,714,400 25 2,178,600
Undiscounted expected cash flows under
the VIE model in ASC 810-10 100% $ 12,651,100
Step 4: Calculate the expected variability (i.e., expected losses and expected residual returns) in expected cash flows for each scenario.
Expected losses and expected residual returns under the VIE model in ASC 810-10 are determined by first using the risk-free rate to discount the outcomes under each relevant scenario and then summing the discounted amounts.
The mean of the discounted amounts can be calculated from the sum; the results of the calculations for all three scenarios can be compared against this mean. The following table illustrates the calculation of the discounted expected cash flows for the three scenarios:
Table 3 — Discounted Expected Cash Flows
PowerCo
Discounted Estimated Cash Flows
(A)* Probability
(B)
Probability-Weighted Discounted Expected
Cash Flows (A × B)
Scenario 1 $ 12,735,519 25% $ 3,183,880
Scenario 2 10,902,195 50 5,451,098
Scenario 3 7,134,616 25 1,783,654
Discounted expected cash flows under
the VIE model in ASC 810-10 100% $ 10,418,632
* Table 4 below illustrates the calculation of discounted estimated cash flows for Scenario 3.
Table 4 — Undiscounted Cash Flows (Scenario 3) Discounted Cash
Flows Attributable to
Nonvariable Interests Year 1 Year 2 Year 3 Year 4 Year 5 Total
Cash flows to be received from or paid to the entity
by nonvariable interests $ 785,000 $ 755,000 $ 720,000 $ 588,000 $ 5,866,400 $ 8,714,400
Discount rate* 5% 5% 5% 5% 5%
Discounted cash flows $ 747,619 $ 684,807 $ 621,963 $ 483,749 $ 4,596,478 $ 7,134,616
* The discount rate used was held constant at 5 percent for all years for simplicity. However, a reporting entity should use the implied yield currently available on zero-coupon U.S. government issues, with a remaining term equal to the term associated with the cash flows being valued (see Q&A 4.11 for further discussion of discount rates). The same forward interest rate curve should be used for each scenario. That is, one of the variables in each scenario cannot be a fluctuation in the discount rate (i.e., use of a different yield curve).
In Table 3 above, the discounted expected cash flows were calculated to be $10,418,632. ASC 810-10-55-44 and 55-45 refer to this amount as “fair value.” Under certain circumstances, the fair value of all the variable interests is one check of the reasonableness of the calculation of discounted expected cash flows. In this example, fair value is assumed to be the sum of what the variable interest holders paid or contributed for their interests. However, since the analysis may need to be performed at many times other than inception (e.g., reconsideration events under ASC 810-10-35-4), a readily observable market value or transaction price may not be available but should be estimated.
The approximate fair value of the variable interests is as follows:
Table 5 — Fair Value of the Variable Interests
Variable Interest Holder Fair Value
Equity holders $ 2,000,000
Senior bond holder 5,000,000
Subordinated bond holder 3,000,000
Third-party guarantor – *
ManageCo 417,048 **
Total fair value $ 10,417,048
* The third-party guarantor has a fair value of zero because the entity gave up value of $50,000 in the form of a premium for a promise to pay in the future.
The discounted probability-weighted cash flows are ($50,000) for honoring the guarantee.
** ManageCo has a fair value based on its discounted probability-weighted fees to be received from the VIE.
Because the discounted expected cash flows of $10,418,632 approximate the fair value of the variable interests in the entity of $10,417,048, the underlying assumptions used in developing the estimated cash flows appear to be appropriate. A reporting entity can also compare the discounted expected cash flows of each variable interest with its fair value at inception to determine whether the assumptions and probabilities used appear proper. The next step in determining the expected losses and expected residual returns is to calculate the expected variability in expected cash flows for each scenario in accordance with the VIE model.
The following table illustrates the calculation of the variability for the three scenarios:
Table 6 — Calculation of Expected Losses and Expected Returns
PowerCo
Probability-Weighted Discounted Expected Cash
Flows Probability Variability* Expected Losses Expected
Residual Returns
Scenario 1 $ 3,183,880 25% $ 579,222 $ 579,222
Scenario 2 5,451,098 50 241,782 241,782
Scenario 3 1,783,654 25 (821,004) (821,004)
$ 10,418,632 100% $ (821,004) $ 821,004
* Variability is calculated as follows (example for Scenario 1):
Expected cash flows above $ 10,418,632
Multiply by probability of scenario 25%
Probability-weighted amount 2,604,658
Probability-weighted discounted expected cash
flows in Scenario 1 3,183,880
Less probability-weighted amount (2,604,658)
Variability 579,222
Negative variability results in an expected loss scenario, and positive variability results in an expected residual return scenario. The term “expected losses” does not refer to what an entity or variable interest holder expects to lose but to the variability in the cash flows to be absorbed by the variable interest holder. All entities, therefore, have expected losses (as indicated in ASC 810-10-55-50 through 55-54, even profitable entities have expected losses).
Typically, the more risk involved in the activities of the entity, the larger its expected losses and expected residual returns.
Conclusion
The expected losses are compared with the total equity investment at risk under ASC 810-10-15-14(a) to determine whether the entity is a VIE because it lacks sufficient equity. In Table 6 above, the expected losses of the entity are $821,004. Because PowerCo has equity investment at risk of $2 million, its equity is sufficient to cover the expected losses of the entity.
Note that sufficient equity investment at risk is just one of the characteristics that must be met for a reporting entity to conclude that an entity is not a VIE; the conditions in ASC 810-10-15-14(b) and 14(c) are additional obstacles an entity must clear. For instance, under ASC 810-10-15-14(b)(1), the equity investment at risk must allow the group of equity investors to have 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.” In the example in this Q&A, if a conclusion was reached that ManageCo had the power to direct the most significant activities, PowerCo would be deemed a VIE because the equity group would lack the power to direct the activities that most significantly affect the entity’s economic performance, as described in ASC 810-10-15-14(b)(1).