In applying Step 1, examples of risks that may cause variability include, but are not limited to, credit risk, interest rate risk, foreign currency exchange risk, commodity price risk, equity price risk, and operations risk.
In applying Step 2, the enterprise should determine the purpose for which the entity was created and the variability the entity was designed to create and pass along to its interest holders. In making this determination, all of the following factors should be considered:
• The activities of the entity.
• The terms of the contracts the entity has entered into.
• The nature of the entity's interests issued.
• How the entity was marketed to potential investors.
• Which parties participated significantly in the design or redesign of the entity.
Additionally, in performing this analysis, an enterprise should review the terms of the contracts that the entity has entered into. This review may include a detailed analysis of original formation documents and any amendments, governing documents and any amendments, marketing materials, and other contractual arrangements entered into by the entity and provided to potential investors or other parties associated with the entity.
The FSP provides the following strong indicators of the variability that the entity was designed to create and pass along to its interest holders:
• When the term of the interests transfer all or a portion of the risk or return (or both) of certain assets or operations to the interest holder, the variability that is transferred strongly indicates a variability that the entity is designed to create and pass along to its interest holders (paragraph 10). Interests that absorb this risk or return are likely variable interests.
• Variability that is absorbed by an interest that is substantively subordinated strongly indicates a particular variability that the entity was designed to create and pass along to its interest holders (paragraph 11).
Interests that absorb this variability are likely variable interests.
• Variability associated with periodic interest receipts and/or payments on fixed rate investments that may or will be sold prior to maturity strongly indicates variability that the entity was designed to create and pass along to its interest holders (paragraph 12). Interests that absorb this variability are likely variable interests.
The FSP also provides guidance for determining whether certain derivative instruments are creators of variability or variable interests (see Certain Derivative Instruments on page 27).
Impact of FSP FIN 46(R)-6
Interest Rate Variability
Prior to the issuance of the FSP, there was diversity in practice when deciding when interest rate risk was a source of an entity's variability to be considered. According to the FSP, interest rate variability related to an entity's assets is generally not a risk an entity is designed to create and pass along to its interest holders when such risk is hedged through the use of a derivative instrument (e.g., an interest rate swap). Therefore, under the FSP, interest rate variability that is hedged, or that arises from assets that will be held by the entity until maturity, is generally not variability that should be considered when determining whether an interest is a creator or absorber of variability.
However, according to the FSP, there are circumstances that indicate an entity was designed to create and pass along interest rate risk to its interest holders. Examples that strongly indicate the presence of such a design objective include the following:
• Variations in cash proceeds to be received upon anticipated sales of fixed rate investments in an actively managed investment portfolio.
• Variations in the cash proceeds an entity will receive when it holds investments in a static pool that, by design, the entity will be required to sell prior to maturity to satisfy its obligations.
• Variations in fair value resulting from an "interest rate mismatch." The FSP provides an example in its appendix whereby an entity holds fixed rate assets and floating rate debt. The interest rate mismatch is not hedged and, therefore, the entity was designed to expose the debt and equity investors to changes in fair value of the investments. Therefore, the FSP concludes that interest rate risk associated with changes in the fair value of fixed rate periodic interest rate payments received must be considered.
Therefore, interests that absorb interest rate variability associated with any of these three circumstances generally would be considered variable interests.
Certain Derivative Instruments
According to paragraph 13 of the FSP, while certain derivative instruments (see Q&A 2(c)-12) absorb the variability an entity was designed to create and pass along to its interest holders, derivatives that have both of the following characteristics are generally considered creators of variability (not variable interests): (1) its underlying is an observable market rate, price, index of prices or rates, or other market observable variable (including the occurrence or
nonoccurrence of a specified market observable event), and (2) the derivative counterparty is senior in priority relative to other interest holders in the entity. As a result, it is likely that most "plain vanilla" interest rate or currency swaps that possess these characteristics will not be variable interests if the swap counterparty is not otherwise a holder of a variable interest in the entity.
The FSP provides an exception to this indicator. If changes in the fair value or cash flows of the derivative instrument are expected to offset all, or essentially all, of the risk or return (or both) related to the majority of assets (excluding the derivative instrument) or operations of the entity, the design of the entity will need to be analyzed further to determine whether that instrument is a creator of variability or a variable interest. Therefore, many total return swaps, put options and call options related to a majority of the entity's assets or operations would likely be considered variable interests even if they possess the characteristics in paragraph 13 of the FSP.
Illustrative Examples
FSP FIN 46(R)-6 provides six examples to illustrate the application of the "by-design" approach. In each example, the FSP illustrates how to (1) analyze the nature of the risks in the entity, (2) determine the purpose for which the entity was created, and (3) determine the variability the entity was designed to create and pass along to its interest holders.
2(c)-11: Applying the Guidance in Paragraph 13 of FSP FIN 46(R)-6
Paragraph 13 of FSP FIN 46(R)-6 provides specific guidance on determining whether a derivative instrument is a variable interest. Specifically, paragraph 13 states, in part:
Certain Derivative Instruments — The following characteristics, if both are present, are strong indications that a derivative instrument is a creator of variability:
a. Its underlying is an observable market rate, price, index of prices or rates, or other market observable variable (including the occurrence or nonoccurrence of a specified market observable event).
b. The derivative counterparty is senior in priority relative to other interest holders in the entity.
If the changes in the fair value or cash flows of the derivative instrument are expected to offset all, or essentially all, of the risk or return (or both) related to a majority of the assets (excluding the derivative instrument) or operations of the entity, the design of the entity will need to be analyzed further to determine whether that instrument should be considered a creator of variability or a variable interest. For example, if a written call or put option or a total return swap, that possesses the characteristics in (a) and (b), relates to the majority of the assets owned by an entity, the design of the entity will need to be analyzed further to determine whether that instrument should be considered a creator of variability or a variable interest.
Under paragraph 13 of the FSP, an interest may be considered a creator of variability (that is, not a variable interest), even if that contract absorbs variability, so long as the instrument possesses specified characteristics and it does not absorb all or essentially all of the variability in the entity. The FASB intended the guidance in paragraph 13 to be narrow in scope, applying to only certain types of derivative contracts that possess specified characteristics. See Q&As 2(c)-12 and 2(c)-13 for further discussion on those characteristics. Paragraph 13 provides a threshold of "all or essentially all" that should be used in determining whether the contract is a creator or absorber of variability when a derivative that meets characteristics (a) and (b) of paragraph 13 relates to a majority of the entity's assets. That is, a derivative contract that absorbs all or essentially all of the variability of an entity would need to be analyzed further to determine whether that instrument should be considered a creator of variability or a variable interest.
Since the accounting afforded under paragraph 13 is unique, an enterprise should not apply its guidance when it has other involvement with the entity (e.g., holds equity, debt, or other contractual arrangements) nor should it analogize to its guidance for other types of contracts that do not possess the specified characteristics. Rather, an enterprise should apply the other provisions of the FSP as well as Interpretation 46(R) to all of its interests in determining what variability to consider in determining which interests are variable interests.
The following decision tree illustrates how an enterprise should apply the guidance in paragraph 13 of FSP FIN 46(R)-6:
The following examples illustrate the application of paragraph 13 of FSP FIN 46(R)-6. However, each transaction must be evaluated based on its own facts and circumstances.
Example 1
An entity is created and financed with equity and variable rate debt. The entity uses the proceeds to purchase BB–
rated fixed rate securities. In addition, the entity enters into a "plain vanilla" interest rate swap with an unrelated third party (swap counterparty) that economically converts the fixed rate securities to variable rate. The notional amount of the swap relates to a majority of the assets in the entity. The swap counterparty has no other involvement with the entity. Assume the interest rate swap possesses the following characteristics that are necessary to apply paragraph 13 of FSP FIN 46(R)-6:
1. The interest rate swap meets the definition of a derivative, as described in paragraphs 6–9 of Statement 133.
2. The interest rate swap's underlying is an observable market rate.
3. The swap counterparty is senior in priority to the entity's other interest holders.
Does the enterprise have other
Are changes in the fair value or cash flows of the derivative instrument expected to offset all, or essentially
all, of the risk or return (or both) related to a majority of the assets (excluding the derivative instrument)
The design of the entity should be analyzed further to determine if the
The interest rate swap would likely be considered a creator of variability even though that swap absorbs interest rate variability. Although the notional amount of the swap relates to a majority of the assets of the entity, changes in the cash flows or fair value of the swap are not expected to offset all, or essentially all, of the risk or return (or both) related to the investments because the fair value and cash flows of the entity's investments are expected to be affected by risk factors other than changes in interest rate risk (e.g., credit risk of the fixed rate securities). The swap is designed to offset only interest rate risk, which does not comprise essentially all of the overall risk in the entity.
Example 2
An entity is formed to construct and hold a single plant that will produce electricity. The plant has an estimated useful life of 40 years. The cost of the plant is financed with equity (10 percent) and non-recourse debt (90 percent).
An enterprise enters into a forward contract to buy 100 megawatts of the electricity produced by the plant (that is not contingent on the output of the entity) for 20 years. The forward contract is at a variable price, reimbursing the entity for a portion of operating and maintenance costs. The contract was entered into during the formation of the entity. The enterprise has no other involvement with the entity. The entity can choose to purchase its raw materials needed to produce the electricity on the spot market at the time needed, or prior to need. Assume the forward contract possesses the following characteristics necessary to apply paragraph 13 of FSP FIN 46(R)-6:
1. The forward contract meets the definition of a derivative, as described in paragraphs 6–9 of Statement 133 (see Q&A 2(c)-16 for discussion of power purchase arrangements).
2. The forward contract's underlying (electricity) has an observable market price.
3. The enterprise is senior in priority to the entity's other interest holders.
The enterprise has identified construction risk, raw material price risk, electricity price risk, operating risk, and credit risk as risks to which the entity is designed to be exposed.
The forward contract would likely be considered a creator of variability even though the contract absorbs variability associated with electricity price risk and a portion of operating risk. Although the forward contract relates to a majority of the operations of the entity, changes in the cash flows or fair value of the forward contract are not expected to offset all, or essentially all, of the risk or return (or both) related to the output of the entity because the fair value and cash flows of the entity's asset are expected to be affected by risk factors other than changes in
electricity price risk and operating risk (i.e., construction risk, raw material price risk, credit risk). The forward contract is designed to absorb electricity price risk and a portion of operating risk, which does not comprise essentially all of the risk in the entity.
Example 3
An entity is created solely for the purposes of holding common stock in a public company. The entity enters into a total return swap agreement with an unrelated third party in which the entity pays to the third party the return on all of the common stock held by entity at certain pre-determined dates, and the third party pays to the entity a fixed periodic amount. The enterprise has no other involvement in the entity. Assume the swap possesses the following characteristics necessary to apply paragraph 13 of FSP FIN 46(R)-6:
1. The swap meets the definition of a derivative, as defined in paragraphs 6–9 of Statement 133.
2. The swap's underlying (common stock of the entity) is publicly traded and therefore has an observable market price.
3. The swap counterparty is senior in priority to the other interest holders.
While the total return swap possesses the characteristics described above, it offsets all, or essentially all, of the risk or return (or both) related to the majority of the assets (common stock) held by the entity because the fair value and cash flows of the entity's investment will vary solely with changes in the price of the common stock, and are not
expected to be affected by other risk factors. Under the swap agreement, the third party is absorbing all of that price risk and the entity's residual interest holders are receiving a fixed return. Therefore, based on a further analysis of the design of the entity, the total return swap would likely be considered a variable interest (see also Q&A 2(c)-1.4).
2(c)-12: Meaning of the Term "Derivative Instrument" in Paragraph 13 of FSP FIN 46(R)-6 Paragraph 13 of FSP FIN 46(R)-6 states that if certain derivative instruments have the characteristics described in (a) and (b) of that paragraph, the presence of both of these characteristics are strong indications that the derivative is a creator of variability and therefore not a variable interest.
Question
What is meant by the term derivative instrument as used in paragraph 13 of FSP FIN 46(R)-6 and how does that compare to the use of the same term in Appendix B of Interpretation 46(R)?
Answer
The term derivative instrument, as it is used in paragraph 13 of FSP FIN 46(R)-6, refers only to those instruments that meet the definition of a derivative set forth in paragraphs 6–9 of Statement 133. This conclusion was confirmed through discussions with the FASB staff. Such derivative instruments would also include those instruments that might not otherwise be subject to the requirements of Statement 133 in accordance with paragraph 10 of that Statement.
Therefore, only an enterprise that holds an instrument that meets the Statement 133 definition of a derivative may use the guidance in paragraph 13 in FSP FIN 46(R)-6 for determining whether that instrument is a variable interest.
If an enterprise cannot use the guidance in paragraph 13 of FSP FIN 46(R)-6, the design of the entity should be analyzed further under the FSP and Interpretation 46(R) to determine whether the instrument is considered a creator of variability or a variable interest.
It should be noted that Appendix B of Interpretation 46(R) provides examples of variable interests that are subject to the Interpretation's provisions. These examples include instruments that have derivative-like features, including guarantees, written put options, liquidity agreements, and forward contracts (paragraphs B10–B16). While these instruments may or may not meet the definition of a derivative under Statement 133, they are still subject to the provisions of Interpretation 46(R) and FSP FIN 46(R)-6. However, only those instruments that meet the definition of a derivative under Statement 133 can apply paragraph 13 of FSP FIN 46(R)-6.
2(c)-13: Meaning of the Term "Market Observable Variable" in Paragraph 13 of FSP FIN 46(R)-6 In determining whether an enterprise that has no other involvement with an entity can apply paragraph 13 of FSP FIN 46(R)-6 to a derivative instrument, it must first determine whether the instrument meets the definition of a derivative in paragraphs 6–9 of Statement 133. If the instrument does meet the definition of a derivative, the enterprise must then determine whether the instrument possesses the following characteristics:
1. The derivative instrument's underlying is an observable market rate, price, index of prices or rates, or other "market observable variable" (including the occurrence or nonoccurrence of a specified market observable event).
2. The derivative counterparty is senior in priority relative to other interest holders in the entity.
Question
What is meant by the term "market observable variable" as used in paragraph 13(a) of FSP FIN 46(R)-6?
Answer
To be a market observable variable, the market price, index, rate, or other variable underlying a derivative must be verifiable through an active, liquid market. A derivative whose underlying is a variable that is entity-specific (such as an entity's sales or service revenues) or a variable that is not based on market events (such as the occurrence of a hurricane or an earthquake) would not meet the conditions in paragraph 13 of FSP FIN 46(R)-6 even if the contract met the definition of a derivative in paragraphs 6–9 of FASB Statement 133. This conclusion was confirmed through discussions with the FASB staff.
For example, commodities that trade on an active market, such as a commodities exchange, would be deemed to have an observable market price. However, a manufactured product that is sold by an enterprise and its competitors in the marketplace, but not through an active, liquid market, would not be deemed to have an observable market price.
Another example is an interest rate index such as LIBOR, which would be deemed to be a market observable interest rate index. Conversely, a bank's prime rate would not be considered a market observable interest rate index because it is determined by the bank and not in an active, liquid, market.
The concept of "market observable variable" used in paragraph 13 of FSP FIN 46(R)-6 should not be analogized to the notion of "observable inputs" used in FASB Statement No. 157, Fair Value Measurements. Under Statement 157,
"observable inputs" are not limited to variables that are verifiable in active, liquid markets.
2(c)-14: Meaning of the Term "Essentially All" in Paragraph 13 of FSP FIN 46(R)-6
An instrument that possesses characteristics specified in paragraph 13 of FSP FIN 46(R)-6 but is expected to offset all, or "essentially all," of the risk or return (or both) related to the majority of the assets or operations of the entity, needs to be further analyzed to determine whether the instrument is a creator of variability or a variable interest.
Question
How does an enterprise determine whether an instrument offsets "essentially all" of the risk in an entity?
Answer
An enterprise must consider whether the instrument offsets "essentially all" of the overall risk in the entity. The
An enterprise must consider whether the instrument offsets "essentially all" of the overall risk in the entity. The