Identifying a Variable Interest
2.01 Determining Whether a Holding Is a Variable Interest
ASC 810-10-20 defines variable interests in a VIE, in part, as “contractual, ownership, or other pecuniary interests in a VIE that change with changes in the fair value of the VIE’s net assets exclusive of variable interests.” (For more information about the meaning of the term “net assets” under the VIE model in ASC 810-10, see Q&A 4.02.) In addition, ASC 810-10-55-19 states that variable interests absorb or receive the expected variability created by assets, liabilities, or contracts of a VIE that are not, themselves, variable interests.
Generally, assets and operations of an entity create its variability while its liabilities and equity interests absorb that variability. Other contracts or arrangements entered into by the entity may appear both to create and to absorb variability (e.g., interest rate swaps) because they can be assets or liabilities depending on prevailing market conditions. In addition, a contract or arrangement may absorb many different types of risks (e.g., credit risk, interest rate risk, and foreign currency exchange risk).
Question
What are some examples of interests that generally would or would not be considered variable interests?
Answer
Table 1 and Table 2 below indicate when an interest held by a reporting entity generally would or would not, respectively, be considered a variable interest pursuant to the VIE model in ASC 810-10. Determining whether a reporting entity’s interest in another entity is a variable interest is only one step in applying this model. In the following situations, for example, holders of certain types of variable interests may be exempt from the VIE model’s consolidation requirements or may require special treatment:
• A reporting entity, or the entity in which it has an interest, may qualify for one of the scope exceptions in ASC 810-10-15-12 or ASC 810-10-15-17.
• A reporting entity’s variable interest in specified assets of a VIE may not be considered a variable interest in that entity (as described in ASC 810-10-25-55 and 25-56). However, a reporting entity’s variable interest in specified assets of a VIE may need to be “siloed,” as described in ASC 810-10-25-57.
Determining whether an interest holder has a variable interest in an entity requires an economic analysis of the associated rights and obligations (such as the two-step analysis in Q&A 2.02). The principle behind this analysis is that variable interests absorb or receive portions of a VIE’s variability in results. For a hybrid instrument (see ASC 815-15-25-1), the host instrument and the embedded feature should be evaluated separately if the embedded feature is not clearly and closely related (see ASC 815-15-25-26 through 25-29) to the host (see Q&A 2.21 for further discussion).
ASC 810-10-25-22 discusses the “by-design” approach to determining which variability to consider in the evaluation of whether an interest is a variable interest (i.e., an interest that absorbs variability in the entity).
Therefore, the determination of whether a particular interest is a variable interest will be affected by which variability is considered in performing the analysis. The by-design approach requires analysis of (1) the entity’s design, including the nature of the risks in the entity; (2) why the entity was created; and (3) the variability that the entity is designed to create and pass along to its interest holders. In performing this analysis, a reporting entity should review in detail the terms of the contracts that the entity has entered into, including the original formation documents, governing documents, marketing materials, and other contractual arrangements entered into by the entity and provided to potential investors or other parties associated with the entity. ASC 810-10-55-55 through 55-86 provide additional guidance, including indicators and examples, to help reporting entities apply this approach.
Table 1 below lists examples (not all-inclusive) of financial instruments and other contracts with an entity that generally would be considered variable interests in that entity. For purposes of this table, remember that the determination of whether a particular interest is a variable interest depends on the design of the entity and the role of that interest. Also note that “entity” means the potential VIE in which the reporting entity holds an interest.
Table 1 — Examples of Variable Interests Financial Instruments or Other
Contracts Comments
Trade accounts payable. Generally, liabilities of an entity do represent variable interests in the entity. However, trade accounts payable that are short-term, fixed in amount, not junior to any other liability, and not concentrated with a small number of vendors generally should not be treated as a variable interest in the entity because such types of trade accounts payable are routine and have little variability. A trade accounts payable that does not fit this description may be a variable interest in the entity.
Long-term liabilities of an entity (e.g., fixed-rate debt, floating-rate debt, mandatorily redeemable preferred stock).
A debt holder’s interest absorbs the variability in the value of an entity’s assets because the debt holder is exposed to that entity’s ability to pay (i.e., credit risk) and may be exposed to interest rate risk, depending on the design of the entity.
Equity of an entity (e.g., mezzanine equity, preferred stock, common stock, partnership capital).
If the equity interest is equity investment at risk pursuant to ASC 810-10-15-14(a), it is a variable interest that absorbs the variability associated with changes in the entity’s NAV. If the equity interest is not at risk pursuant to ASC 810-10-15-14(a), it is usually a variable interest if it exposes the equity owner to the VIE’s variability.
Table 1 — Examples of Variable Interests (continued) Financial Instruments or Other
Contracts Comments
Guarantees held by an entity.* The guarantee agreement transfers all or a portion of the risk of specified assets (or liabilities) of the entity to the guarantor, resulting in the guarantor’s absorbing the variability in values of those specified assets (or liabilities). See ASC 810-10-25-21 through 25-36 for more information. For a discussion of implicit variable interests, see Q&As 2.12 and 2.13.
Put options held by an entity and similar arrangements on specified assets owned by the entity.*
Same as guarantees held by an entity. The put option writer is exposed to the variability in the values of the assets held by the entity. However, whether a derivative or a contract with the characteristics of a derivative is a variable interest in an entity depends on the design of the entity and the characteristics of that instrument. See ASC 810-10-25-21 through 25-36 for more information.
Stand-alone call options written by an entity on specified assets owned by that entity.*
The holder of such a stand-alone call option absorbs positive variability in the value of the specified assets under that call option agreement in scenarios in which the call option would be exercised. However, whether a derivative or a contract with the characteristics of a derivative is a variable interest in an entity depends on the design of the entity and the characteristics of that instrument. See ASC 810-10-25-21 through 25-36 for more information.
Fixed-price forward contracts to sell specified assets owned by an entity.*
The counterparty to the forward contract absorbs variability in the fair value of the entity’s specified assets underlying the forward contract. However, whether a derivative or a contract with the characteristics of a derivative is a variable interest in an entity depends on the design of the entity and the characteristics of that instrument. See ASC 810-10-25-21 through 25-36 for more information.
Total return swaps on specified assets owned by an entity.*
The total return swap transfers all or a portion of the risk of specified assets (or liabilities) of the entity to the swap counterparty, resulting in the counterparty absorbing the variability created by those specified assets (or liabilities).
Other derivatives. Whether a derivative is a variable interest in an entity depends on the design of the entity and the characteristics of that instrument. ASC 810-10-25-21 through 25-36 provide additional guidance on determining whether other derivatives are variable interests.
Fees paid to a decision maker. These fees would be considered variable interests if they fail to meet one or more of the six conditions in ASC 810-10-55-37 through 37A.
Fees paid to a service provider. These fees would be considered variable interests if they fail to meet one or more of the six conditions in ASC 810-10-55-37 through 37A.
Stand-alone residual value guarantees of an entity’s leased assets, written call options covering such leased assets, or both.*
These contracts transfer all or a portion of the risk of specified assets of the entity to the guarantor, resulting in the guarantor absorbing the variability of those specified assets.
Operating leases (in which the entity is the lessor) with an embedded residual value guarantee, a non-fair-value-based purchase option (a lessee call option), or both.*
Because the embedded guarantee and purchase option are not clearly and closely related to the cash flows of the operating lease, the operating lease (i.e., the host contract) and the embedded items should be evaluated separately. The embedded items result in a variable interest,* as explained above. However, the host contract, an economic equivalent of an account receivable, creates variability for the entity and therefore is not a variable interest. See Q&A 2.13 for a discussion of an implicit variable interest.
Operating leases (in which the entity is the lessee).
An operating or capital lease represents an economic liability of the lessee entity (the potential VIE). That is, the lessor is exposed to the lessee entity’s ability to pay under the terms of the agreement; therefore, a lessor’s interest in a lease generally is a variable interest in the lessee entity. See Q&A 2.04 for more information.
Supply agreements with a variable cost component (when the entity is the supplier/seller).
For supply agreements designed to reimburse all or a portion of actual costs incurred, the counterparty to the supply agreement absorbs variability in the entity. Investors in the entity are partially protected from absorbing losses because the counterparty is reimbursing the entity for actual costs incurred.
* ASC 810-10-25-55 and 25-56 indicate that variable interests in a specified asset whose value is less than half of the total fair value of a VIE’s assets are not considered variable interests in that entity.
Table 2 below lists examples (not all-inclusive) of financial instruments and other contracts with an entity that generally would not be considered variable interests in that entity. As in Table 1, note that determining whether a particular interest is a variable interest depends on the design of the entity and the role of that interest. Also note that “entity” means the potential VIE in which the reporting entity holds an interest.
Table 2 — Examples of Nonvariable Interests Financial Instruments or Other
Contracts Comments
Assets of an entity. Assets typically are the major source of an entity’s variability and are therefore not considered variable interests. However, see Table 1 for purchased guarantees, put options, and similar items that may be assets but are considered variable interests in the entity or in specified assets pursuant to ASC 810-10-25-55 and 25-56.
Options, guarantees, and similar financial instruments or contracts written by an entity.
When the entity writes (sells) an option, a guarantee, or a similar contract, those contracts normally create variability (e.g., an entity writes a put option on an asset owned by another party). Therefore, they are normally nonvariable interests to the counterparty, except for stand-alone call options written by an entity on specified assets owned by that entity, as discussed in Table 1.
Other derivatives. Whether a derivative is a variable interest in an entity depends on the design of the entity and the characteristics of that instrument. ASC 810-10-25-21 through 25-36 provide additional guidance on determining whether other derivatives are variable interests.
Fixed-price forward contracts to purchase assets not owned by an entity, fixed-price contracts to sell assets not owned by an entity.
Typically, forward contracts that relate to assets the entity does not own create variability because they expose the entity to changes in the fair value of the assets underlying the forward purchase or sale contracts.
Operating leases in which an entity is the lessor, in the absence of a residual value guarantee, a non-fair-value-based purchase option (i.e., a lessee call option), or other similar provisions.
The operating lease is the economic equivalent of an account receivable; therefore, it exposes the entity to variability (e.g., lessee performance). See Q&A 2.03 for more information.