Implicit Variable Interests and “Activities Around the Entity” — Illustration Question

What is an implicit variable interest, and how does a reporting entity determine whether it holds one?

Answer

Table 1 in Q&A 2.01 provides examples of contracts or arrangements that may result in a reporting entity’s holding a variable interest in a VIE. Variable interests held by a reporting entity may be explicit, implicit, or both. ASC 810-10-25-48 through 25-54 clarify that a reporting entity should consider whether it holds an implicit variable interest in a potential VIE.

The identification of explicit variable interests involves determining which contractual, ownership, or other pecuniary interests in an entity directly absorb or receive the variability of the entity. An implicit variable interest acts the same as an explicit variable interest except that it involves the absorbing, receiving, or both of variability indirectly, rather than directly, from the entity. Therefore, the identification of an implicit variable interest involves determining whether a reporting entity may be indirectly absorbing or receiving the variability of the entity.

At the 2004 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff used the phrase

“activities around the entity.” This expression refers to certain transactions and relationships between a direct interest holder in a potential VIE and other enterprises that indirectly alter the holder’s exposure to the risks-and-rewards profile of the direct interest holder’s investment.

The SEC staff stated:

We have seen a number of questions about whether certain aspects of a relationship that a variable interest holder has with a variable interest entity (VIE) need to be considered when analyzing the application of FIN 46R [codified in ASC 810-10]. These aspects of a relationship are sometimes referred to as “activities around the entity.” It might be helpful to consider a simple example. Say a company (Investor A) made an equity investment in a potential VIE and Investor A separately made a loan with full recourse to another variable interest holder (Investor B). We have been asked whether the loan in this situation can be ignored when analyzing the application of FIN 46R. The short answer is no. First, FIN 46R specifically requires you to consider loans between investors as well as those between the entity and the enterprise in determining whether equity investments are at risk, and whether the at risk holders possess the characteristics . . . defined in paragraph 5 of FIN 46R [codified as ASC 810-10-15-14]. It is often difficult to determine the substance of a lending relationship and its impact on a VIE analysis on its face. You need to evaluate the substance of the facts and circumstances. The presence of a loan between investors will bring into question, in this example, whether Investor B’s investment is at risk and depending on B’s ownership percentage and voting rights, will influence whether the at risk equity holders possess the characteristics of a controlling financial interest.

Other “activities around the entity” that should be considered when applying FIN 46R include equity investments between investors, puts and calls between the enterprise and other investors and non-investors, service arrangements with investors and non-non-investors, and derivatives such as total return swaps. There may be other activities around the entity that need to be considered which I have not specifically mentioned. These activities can impact the entire analysis under FIN 46R including the assessment of whether an entity is a VIE as well as who is the primary beneficiary.

In another situation involving activities around the entity, investors became involved with an entity because of the availability of tax credits generated from the entity’s business. Through an arrangement around the entity, the majority of the tax credits were likely to be available to one specific investor. Accordingly, the staff objected to an analysis by this investor that 1) did not include the tax credits as a component of the investor’s variable interest in the entity and 2) did not consider the impact of the tax credits and other activities around the entity on the expected loss and expected residual return analysis.

At the 2005 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff emphasized that although FSP FIN 46(R)-5 (codified in ASC 810-10-25-48 through 25-54) focuses on noncontractual interests in a leasing transaction between related parties, implicit interests can also result from contractual arrangements between a reporting entity and unrelated variable interest holders. The SEC staff provided the following questions for reporting entities to consider in determining whether an implicit variable interest exists:

• Was the arrangement entered into in contemplation of the entity’s formation?

• Was the arrangement entered into contemporaneously with the issuance of a variable interest?

• Why was the arrangement entered into with a variable interest holder instead of with the entity?

• Did the arrangement reference specified assets of the [VIE]?

Implicit variable interests and “activities around the entity” may affect the determination of:

1. Whether an investor has provided additional financial support (see Q&A 1.28).

2. Whether a reporting entity holds a variable interest (see Q&As 2.10–2.13 for examples of transactions and relationships that are not directly with an entity that require consideration).

3. Whether an investor’s equity is at risk, as described in ASC 810-10-15-14(a) (see Q&As 3.10 and 3.14).

4. Whether the entity is a VIE, as described in ASC 810-10-15-14.

5. Whether the reporting entity’s obligation to absorb losses or right to receive benefits of the VIE could potentially be significant to the VIE, as described in ASC 810-10-25-38A(b).

In many cases, an implicit arrangement in the design of an entity protects a variable interest holder from absorbing losses in a VIE, limits the holder’s ability to receive residual returns in a VIE, or both. Entities can also be designed to enable a reporting entity to circumvent the provisions of the VIE model in ASC 810-10 by placing a party (often a related party) between the reporting entity and a VIE. In all cases, the role of a contract or arrangement in the design of an entity must be carefully evaluated, with a focus on its substance rather than on its legal form or accounting designation. ASC 810-10-15-13A states:

For purposes of applying the Variable Interest Entities Subsections, only substantive terms, transactions, and arrangements, whether contractual or noncontractual, shall be considered. Any term, transaction, or arrangement shall be disregarded when applying the provisions of the Variable Interest Entities Subsections

if the term, transaction, or arrangement does not have a substantive effect on any of the following:

a. A legal entity’s status as a VIE b. A reporting entity’s power over a VIE

c. A reporting entity’s obligation to absorb losses or its right to receive the benefits of the entity.

[Emphasis added]

In the following diagram, anything within the circle represents arrangements that are potential explicit variable interests in Entity X. Arrangements between the investors and other enterprises outside the circle represent

“activities around the entity” and are potential implicit variable interests in Entity X .

D E

Fixed-Price

Put Option Total

Return

C Swap F

Fixed- Price Call

Option

Back-to-Back Asset Guarantee Investor A

($1 million)

Investor B ($1 million)

50%

Owned

50%

Owned

Entity X Asset

Guarantee

Investors A and B hold the only potential explicit variable interests in Entity X as a result of their equity investments of $1 million and Investor B’s asset guarantee. However, a reporting entity must consider whether any

arrangements outside the circle represent an implicit variable interest in Entity X — i.e., Reporting Entities C, D, E, and F should “look through” the counterparty to determine whether the role of their interest is to absorb variability of Entity X.

ASC 810-10-55-87 through 55-89 include an example illustrating the determination of when an implicit variable interest may exist in a leasing arrangement. (For more information, see Q&A 2.13.)

In addition to the questions discussed at the December 2005 AICPA Conference, questions for a reporting entity to consider in determining whether it holds an implicit variable interest include the following:

• Does a related party, through an ownership interest or by virtue of holding a significant role in the operations, have the ability to require (or have substantial influence over a decision to require) the reporting entity to reimburse the related party for its losses?

• Is there an economic motivation for the reporting entity to protect the related party or its variable interest holders from potential losses?

• Does the related-party relationship lack the following: (1) conflict-of-interest policies, (2) significant regulatory requirements that create disincentives, (3) fiduciary responsibilities clauses, or (4) other similar restrictions that would prevent or deter a reporting entity from forcing a related party to absorb losses?

• Are there situations in which losses have been sustained in the past and, though not contractually required to be, were absorbed by the reporting entity?

• Are the unrelated parties (e.g., creditors, legal advisers) unaware of the relationships between the parties?

• Do other parties (e.g., a lender) involved with the reporting entity believe that there are implicit variable interests (e.g., guarantees)?

• Have implicit variable interests existed in past relationships that are similar to the current arrangement?

The determination of whether an interest is an implicit variable interest will depend on the role of that interest in the design of the entity and should be based on facts and circumstances. The following Q&As may help a reporting entity determine whether an interest represents an implicit variable interest:

• Investor C (purchased call option): Q&A 2.10.

• Investor D (written put option): Q&A 2.10.

• Investor E (total return swap): Q&A 2.11.

• Investor F (back-to-back asset guarantee): Q&A 2.12.