New Developments Summary

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1 August 16, 2010 NDS New Developments Summary Variable interest entity analysis ASC 810, Consolidation, as amended by ASU Introduction A reporting entity must assess whether its involvement with another legal entity requires the reporting entity to consolidate that legal entity and / or provide disclosures in accordance with guidance for variable interest entities. This bulletin outlines a reporting entity s step-by-step approach to the assessment of its involvement with a legal entity under the guidance in FASB Accounting Standards Codification TM (ASC) , Consolidation, Variable Interest Entities subsections (formerly FASB Interpretation 46 (revised December 2003), Consolidation of Variable Interest Entities), as amended by ASU , Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities (formerly FASB Statement 167, Amendments to FASB Interpretation No. 46(R)) ASU , Amendments for Certain Investment Funds The guidance in both ASU and ASU is identified in the Codification, as of August 12, 2010, as pending content linked to transition guidance in ASC The amended variable interest entity guidance is effective for fiscal years beginning after November 15, 2009 and for interim periods within those years. Early application is not permitted. Contents A. Background and overview... 3 Overview of VIE guidance, as amended by ASU and ASU Purpose of this bulletin... 5 B. General considerations... 6 Consider only substantive terms, transactions, and arrangements... 6 Document information sources, analysis, and conclusions... 6 Consideration of expected losses, expected residual returns, and expected variability... 7 Determine the assessment date... 9 Obtain an understanding of the legal entity s design... 9 Obtain necessary information Consideration of related parties C. Determine applicability of Variable Interest Entities subsections... 12

2 New Developments Summary 2 Step 1: Determine whether the reporting entity holds any explicit or implicit (direct or indirect) variable interest in the legal entity Step 2: Determine whether a scope exception applies Step 3: Determine whether the legal entity qualifies for the partial deferral of the ASU amendments to the Variable Interest Entities subsections Attributes of the investment fund entity Obligation to fund potentially significant losses of the investment fund entity Consideration of the legal structure of the reporting entity s interest Consideration of the purpose and design of the investment fund entity D. Identify variable interests in the legal entity Step 4: Identify the explicit and implicit variable interests in the legal entity and the holders of those interests Step 4.1: Identify the variable interests in the legal entity that are held by the reporting entity and its related parties Variable interests Implicit variable interests Fees paid to a decision maker or service provider Step 4.2: Determine whether interests in specified assets of a legal entity are variable interests in the legal entity as a whole Interests in specified assets Silos E. Determine whether the legal entity is a VIE Step 5: Identify the legal entity s equity investment at risk and the equity interests, if any, that are not at risk Step 6: Determine whether any of the conditions that identify a legal entity as a VIE exist Step 6.1: Determine whether the legal entity s total equity investment at risk is sufficient Subordinated financial support and insufficient equity investment at risk Step 6.2: Determine whether the legal entity s total equity investment at risk provides its holders, as a group, with the characteristics of a controlling financial interest The obligation to absorb the expected losses of the legal entity The right to receive the legal entity s expected residual returns Step 6.3: Determine whether substantially all the activities of the legal entity involve or are conducted on behalf of a single investor with disproportionately few voting rights Related party consideration for ASC (c) F. Identify the primary beneficiary of a VIE Step 7: Determine whether the reporting entity is the primary beneficiary of the VIE Step 7.1: Consider the VIE s purpose and design, including the risks the VIE was designed to create and pass through to its variable interest holders Step 7.2: Identify the activities that most significantly impact the VIE s economic performance Step 7.3: Determine whether the reporting entity has both of the characteristics of a controlling financial interest in the VIE Characteristics of a controlling financial interest in a VIE Identifying the most significant activities of a VIE Related party group Most significant activities of a VIE directed by multiple unrelated parties Kick-out, participating, and protective rights SEC staff views on nonsubstantive terms Obligation to absorb losses, or right to receive benefits, that are potentially significant... 32

3 New Developments Summary 3 G. Consolidation Step 8: If the reporting entity is the primary beneficiary of a VIE, obtain the information necessary to present consolidated financial statements Initial consolidation Consolidation upon loss of scope exception for lack of information Consolidation upon adoption of the amendments in ASU and ASU Consolidation upon loss of deferral H. Presentation and disclosures Step 9: Provide financial statement presentation and disclosures required by ASC , Variable Interest Entities subsections Presentation Disclosures I. Monitor for reconsideration Step 10: Monitor for reconsideration events Step 10.1: Reconsider the scope exception for lack of information Step 10.2: Reconsider whether a legal entity continues to qualify for the deferral in ASC Step 10.3: Reconsider whether a legal entity is a VIE Step 10.4: Reconsider whether the reporting entity is the primary beneficiary of a VIE Appendix A Status of authoritative guidance Appendix B Definitions Appendix C Presentation and disclosure requirements A. Background and overview A reporting entity must assess whether its involvement with another legal entity requires the reporting entity to consolidate that other entity and / or provide disclosures in accordance with guidance for variable interest entities. FASB Accounting Standards Codification TM (ASC) , Consolidation, Variable Interest Entities subsections (formerly FASB Interpretation 46 (revised December 2003), Consolidation of Variable Interest Entities), has been amended by the following FASB Accounting Standards Updates (ASUs): ASU , Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities, issued December 28, 2009, to codify FASB Statement 167, Amendments to FASB Interpretation No. 46(R), issued June 12, 2009 ASU , Amendments for Certain Investment Funds, issued February 26, 2010, to provide a limited partial deferral of the effective date of Statement 167 The guidance in both ASU and ASU is effective for fiscal years beginning after November 15, 2009 and for interim periods within those years. Early application is not permitted.

4 New Developments Summary 4 Codification references Except where specifically indicated otherwise, Codification references in this bulletin refer to guidance as amended by ASU and ASU As of August 12, 2010, the amended guidance from both ASUs is identified in the Codification as pending content and links to transition guidance in ASC (see Appendix A, Status of authoritative guidance ). Overview of VIE guidance, as amended by ASU and ASU A reporting entity that holds a direct or indirect (explicit or implicit) variable interest in a legal entity must determine whether the guidance in the Variable Interest Entities subsections of ASC applies to that legal entity before considering other consolidation guidance, such as ASC , Control of Partnerships and Similar Entities. However, if a reporting entity does not have a direct or indirect (explicit or implicit) variable interest in a legal entity, then the reporting entity is not the primary beneficiary of that legal entity and is not required to provide disclosures for that legal entity under ASC , Variable Interest Entities subsections. Under the amended guidance in ASC , Variable Interest Entities subsections, a legal entity is a variable interest entity (VIE) if any of the following conditions exists: The total equity investment at risk in the legal entity is not sufficient to permit the entity to finance its activities without additional subordinated financial support The legal entity s total equity investment at risk does not provide its holders, as a group, with all of the following characteristics: The power through voting or similar rights to direct the activities that most significantly impact the legal entity s economic performance The obligation to absorb the expected losses of the legal entity The right to receive expected residual returns of the legal entity Both of the following conditions exist: Voting rights of some equity investors are not proportional to their obligation to absorb expected losses and / or right to receive expected residual returns Substantially all the activities of the legal entity involve, or are conducted on behalf of, a single investor with disproportionately few voting rights A reporting entity that holds a variable interest in a VIE and has both of the following characteristics of a controlling financial interest in a VIE is the primary beneficiary of the VIE: Power: The power to direct the activities of the VIE that most significantly affect the VIE s economic performance Economic interest: The obligation to absorb losses, or the right to receive benefits, that could potentially be significant to the VIE The primary beneficiary of a VIE must consolidate the VIE. Regardless of whether it consolidates a VIE, however, a reporting entity with a variable interest in a VIE must provide disclosures about its involvement with the VIE.

5 New Developments Summary 5 Additional guidance Additional publications on variable interest entities include the following: NDS , Consolidation of variable interest entities: FASB Statement 167, which highlights how Statement 167 changed the guidance on variable interest entities NDS , FASB defers Statement 167 for interests in certain investment funds and make a clarification, which describes the limited partial deferral of Statement 167 Purpose of this bulletin This bulletin outlines a step-by-step approach to assessing whether a reporting entity must consolidate a legal entity and / or provide disclosures under ASC , Variable Interest Entities subsections, as amended by ASU and ASU However, all relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this bulletin. The assessment steps and related guidance are grouped in the following sections: Section Topic area Section B General considerations Section C Determine the applicability of ASC , Variable Interest Entities subsections (Steps 1 through 3) Section D Identify variable interests in the legal entity (Step 4) Section E Determine whether the legal entity is a VIE (Steps 5 and 6) Section F Identify the primary beneficiary of a VIE and consolidation (Step 7) Section G Consolidation (Step 8) Section H Presentation and disclosures (Step 9) Section I Monitor legal entities for reconsideration events (Step 10)

6 New Developments Summary 6 The sequence of the above steps may vary depending on the circumstances, and some steps may be altogether unnecessary in a particular analysis. In applying the framework, consider the following: A documented understanding of all relevant facts and circumstances is necessary for each part of the assessment The reporting entity is likely to consider whether its own involvement with a legal entity constitutes a variable interest in the legal entity, as well as the nature of that involvement, to determine whether and to what extent additional analysis is necessary A legal entity is a VIE because its equity investment at risk is clearly insufficient to support its activities without additional subordinated financial support. In that case, further consideration of other conditions to identify the entity as a VIE would not be necessary. However, information that would have been used to assess those other conditions might be essential in other parts of the analysis, for example, to identify variable interests in the entity, to determine whether a scope exception applies to that entity, or to identify the primary beneficiary of that VIE. In some circumstances, ongoing reconsideration of whether the reporting entity is the primary beneficiary of a VIE would not include reconsideration of whether the legal entity is a VIE. B. General considerations General considerations addressed in this section are essential elements of any assessment of a legal entity under ASC , Variable Interest Entities subsections and apply broadly to more than one step of the assessment. Consider only substantive terms, transactions, and arrangements ASC A through 15-13B emphasizes that only substantive terms, transactions, and arrangements (both contractual and noncontractual) shall be considered in any analysis under ASC , Variable Interest Entities subsections. The FASB added this emphasis to address concerns that the form of an entity might indicate that it is not a VIE, or that a reporting entity is not the primary beneficiary, when the substance of the arrangement indicates otherwise. SEC staff views on nonsubstantive terms As described in Section F, SEC staff speeches have emphasized the need to exercise judgment when considering the substance of an arrangement. The staff provided examples of arrangements that might include nonsubstantive terms that should be disregarded when determining who has a controlling financial interest in a VIE. The staff indicated that the analysis of such arrangements warrants an increased level of skepticism. Document information sources, analysis, and conclusions The application of ASC , Variable Interest Entities subsections requires a reporting entity to make significant assumptions and judgments that consider the relevant facts and circumstances as of a particular assessment date. A reporting entity s comprehensive documentation of the assumptions made, conclusions reached, and facts and circumstances considered in making those assumptions and reaching those conclusions is important for the following reasons:

7 New Developments Summary 7 The documentation provides evidence that all relevant critical information was considered and supports the conclusions reached in the event of a challenge to the accounting based on those conclusions. It may be difficult, if not impossible, to reconstruct at a later date an appropriate analysis of uncertainties that existed on the assessment date. Even if it is possible to reconstruct at a later date the appropriate analysis as of the assessment date, it will likely take significantly more time and effort to complete either a qualitative or quantitative analysis than to conduct that analysis at the assessment date. The documentation provides a basis for determining whether a subsequent event is a reconsideration event and for assessing how that event changes the design of the entity or the relationships of the interests in the entity. A diagram of a legal entity s arrangements, such as those illustrated in Cases A through H in ASC through 55-86, can be a useful tool to help document the nature of arrangements and relationships considered in the analysis. Consideration of expected losses, expected residual returns, and expected variability Expected losses, expected residual returns, and expected variability are not amounts reported in an entity s financial statements (that is, the terms do not refer to net losses or net income); rather, they are economic concepts used to identify variable interests and VIEs. A calculation of a legal entity s expected losses and expected residual returns might be necessary to determine whether a legal entity is a VIE, but not to determine the primary beneficiary of a VIE. Primary beneficiary determination One of the characteristics that identifies the primary beneficiary of a VIE is the obligation to absorb losses, or the right to receive benefits, that could potentially be significant to the VIE. Losses and benefits considered in the primary beneficiary assessment do not refer to expected losses and expected residual returns, as defined in ASC A reporting entity may consider its exposure or rights to a VIE s expected losses or expected residual returns to identify the primary beneficiary. However, the reporting entity is prohibited from using only expected losses and expected residual returns to determine whether it has an obligation to absorb losses, or the right to receive benefits, that are potentially significant to a VIE. The Codification defines expected losses, expected residual returns, and expected variability for ASC , Variable Interest Entities subsections as follows: Expected losses and expected residual returns refer to amounts derived from expected cash flows as described in FASB Concepts Statement 7, Using Cash Flow Information and Present Value in Accounting Measurements. However, expected losses and expected residual returns refer to amounts discounted and otherwise adjusted for market factors and assumptions rather than to undiscounted cash flow estimates. A legal entity that has no history of net losses and expects to continue to be profitable in the foreseeable future can be a variable interest entity (VIE). A legal entity that expects to be profitable will have expected losses. A VIE's expected losses are the expected negative variability

8 New Developments Summary 8 in the fair value of its net assets exclusive of variable interests and not the anticipated amount or variability of the net income or loss. A VIE's expected residual returns are the expected positive variability in the fair value of its net assets exclusive of variable interests. Expected variability is the sum of the absolute values of the expected residual return and the expected loss. Expected variability in the fair value of net assets includes expected variability resulting from the operating results of the legal entity. The examples in ASC through illustrate the calculation of expected losses and expected residual returns. A variable interest in a legal entity is a contractual, ownership, or other pecuniary interest in the legal entity that either exposes its holder to the economic risks of the legal entity or provides its holder with the right to the economic rewards of the legal entity. Those risks and rewards are the possible economic returns that fall short of, or exceed, the expected economic return. Such shortfalls (referred to as expected negative variability or expected losses ) and excesses (referred to as expected positive variability or expected residual returns ) are the expected variability from the expected return. For example, the estimated current fair value of a building owned by an entity represents the return expected if the building were sold today. However, the building s actual price if sold may be more or less than expected, which would cause the entity s return to vary from the expected amount. Thus, ownership of the building creates variability in that entity because the variability in the returns to the entity from the building would correspondingly affect returns to holders of variable interests in that entity. Fair value considerations The application of ASC , Variable Interest Entities subsections is based on assessment-date fair values (for example, fair values of an entity s assets, equity investment at risk, and other variable interests in the entity). The amount of variability (that is, the expected losses and expected residual returns) in those fair values also is based on market factors and assumptions. In conducting both qualitative and quantitative assessments under ASC , Variable Interest Entities subsections, a reporting entity must consider Which risks create variability in a legal entity The amount of such variability (that is, the expected losses and expected residual returns) Which interests in the entity would absorb that variability Those assessments should be based on assumptions consistent with assessment-date fair values, not on carrying amounts or other entity-specific measures. Therefore, in a quantitative assessment, an entity may need to adjust its estimated cash flow scenarios to reflect market-participant assumptions inherent in the fair values of the variable interests in the entity. Generally, in calculating the variability of an entity using the expected cash flow approach, the total of the probability-weighted discounted estimated cash flows is the expected outcome at fair value (as illustrated in ASC through 55-49, that total is $757,143), which should approximate the assessment-date fair value of the variable interests in the entity. The total expected losses and expected residual returns at fair value are the negative and positive expected variability in the fair value of those variable interests. The examples in ASC through illustrate the calculation of an entity s expected variability using the expected cash flow approach for determining the fair value of an asset. The expected cash flow approach uses all reasonably possible cash flows instead of the single most likely cash flow

9 New Developments Summary 9 scenario. In other words, the risk of uncertain cash flows inherent in the fair value of the net assets or variable interests is reflected in the range of cash flow scenarios used to calculate expected losses and expected residual returns. Determine the assessment date The assessments required under ASC , Variable Interest Entities subsections should be made as of a specific date. An assessment is required as of the date an event that triggers an assessment occurs. An entity may not select a more convenient date for an assessment, such as the end of a reporting period. An assessment should consider facts and circumstances that existed as of the assessment date, for example, as of the date the reporting entity initially becomes involved with the legal entity or upon a later reconsideration date. If financial information used in an assessment is as of a date that differs from the assessment date, for example, the end of a reporting period, then the reporting entity should adjust the financial information to reflect the impact of transactions and events that have occurred between the financial information date and the assessment date. VIE assessment A reporting entity must assess whether the legal entity is a VIE as of the date of the reporting entity s initial involvement with it and subsequently as of the date any reconsideration event listed in ASC occurs. Primary beneficiary assessment If a reporting entity holds a variable interest in a legal entity that is VIE, then the reporting entity must assess whether it is the primary beneficiary of the VIE as of the date of its initial involvement with the VIE and continuously thereafter. Thus, consolidation could be required as of any date within a reporting period, depending on the facts and circumstances. A change in facts and circumstances could affect the determination of whether a reporting entity is the primary beneficiary of a VIE without triggering reconsideration of whether the legal entity is a VIE. For example, the transfer of a VIE s outstanding debt from the existing creditor to an unrelated party, without any modification of the debt agreement s terms and conditions, would neither change the design of the entity nor trigger reconsideration of whether the entity is a VIE. However, the new debt holder would need to consider whether it is the primary beneficiary of the entity as of the date of transfer. Transition for initial adoption of amendments in ASU and A reporting entity must reassess its existing involvements with other legal entities on the initial adoption of the amendments in ASU and ASU A reporting entity s reassessment date for an existing legal entity may or may not be as of the effective date of those amendments depending on the transition method applied to that legal entity in accordance with ASC (See NDS for additional discussion of the transition provisions of Statement 167.) Obtain an understanding of the legal entity s design The design of a legal entity, including the purpose of the entity and the nature of its risks, activities, and contractual arrangements, affects the determination of Which interests in the legal entity are variable interests Whether a scope exception or deferral applies Whether the legal entity is a VIE

10 New Developments Summary 10 Which entity is the primary beneficiary of a VIE The guidance in ASC through (formerly FASB Staff Position FIN 46R-6, Determining the Variability to be Considered in Applying FASB Interpretation No. 46(R) ) specifically requires that the determination of the variability to be considered in applying the guidance in ASC , Variable Interest Entities subsections must be based on an analysis of the design of the legal entity, as outlined in the following two steps: First step: Analyze the nature of the risks that cause variability in the legal entity. Such risks may include, but are not limited to the following: Credit risk Interest rate risk (including prepayment risk) Foreign-currency exchange risk Commodity price risk Equity price risk Operations risk Second step: Determine the purpose(s) for which the legal entity was created and the variability (created by the risks identified in the first step) that the legal entity is designed to create and pass along to its interest holders, considering: The activities of the legal entity The terms of the contracts the legal entity has entered into The nature of the legal entity s interests issued How the legal entity s interests were negotiated with, or marketed to, potential investors Which parties participated significantly in the design or redesign of the legal entity Obtain necessary information Extensive amounts of information about a legal entity and the parties involved with the legal entity are usually required to understand the design of the legal entity, the purpose for which the legal entity was created, and the variability the legal entity was designed to create and pass along to its interest holders. Obtaining such information is essential to the determination of Whether the legal entity is a VIE Whether a reporting entity holds a variable interest in a VIE Which interests in the legal entity are variable interests Whether a reporting entity is the primary beneficiary of a VIE For example, ASC and indicate that information required to understand the design of the legal entity, the purpose for which the legal entity was created, and the variability the legal entity was designed to create and pass along to its interest holders includes, but is not limited to Original formation documents Governing documents

11 New Developments Summary 11 Marketing materials Contractual arrangements entered into by the legal entity and provided to potential investors or other parties associated with the legal entity Additional information essential to a reporting entity s analysis includes, but may not be limited to, the following: The nature and activities of other parties involved with the legal entity, as well as their relationship to the reporting entity Agreements between the parties involved with the legal entity that could affect the determination of whether equity investment in the legal entity is considered to be at risk, in accordance with ASC Assessment-date fair values of the variable interests in the entity and of the assets and net assets of the entity exclusive of variable interests Estimated cash flow information sufficient to estimate expected losses and expected residual returns, as defined in ASC , for a quantitative assessment, if necessary, of whether a legal entity is a VIE Other economic or market information necessary to assess qualitatively or quantitatively the sufficiency of equity investment at risk Consideration of related parties A reporting entity must consider related parties in applying the following guidance: The partial deferral of the amendments in ASU for certain investment funds (see the transition guidance in ASC (aa) related to Statement 167) The scope exceptions for not-for-profit entities and certain businesses (ASC ) The identification of variable interests, such as, implicit variable interests and fees paid to a decision maker or service provider The determination of whether the entity s equity investment is at risk (ASC (a)(1)-(4)) The determination of whether the entity is a VIE (ASC (c)) The determination of which party is the primary beneficiary of a VIE (ASC through 25-44) For purposes of ASC , Variable Interest Entities subsections, the term related parties includes those parties identified as related parties in ASC 850, Related Party Disclosures, as well as de facto principals and de facto agents described in ASC The ASC Glossary definition of related parties includes the following: Affiliates, including subsidiaries and commonly controlled entities Equity method investees Trusts for the benefit of employees, such as pensions and profit-sharing trusts that are managed by or under the trusteeship of management. Principal owners

12 New Developments Summary 12 Management Members of the immediate families of principal owners and management Other parties the reporting entity deals with if one party controls or can significantly influence the management or operating policies of the other party to the extent that one party may be prevented from fully pursuing its separate interests Another party that either (1) can significantly influence the management or operating policies of the transacting parties or (2) has an ownership interest in one of the transacting parties and can significantly influence the other to the extent that a transacting party may be prevented from fully pursing its separate interests De facto agents identified in ASC include the following: A party that cannot finance it operations without subordinated financial support from the reporting entity (ASC (a)) A party that received its interests in the entity as a contribution or loan from the reporting entity (ASC (b)) An officer, employee, or member of the reporting entity s governing board (ASC (c)) A party whose ability to manage the economic risks or rewards from its interests in a VIE is constrained by the reporting entity s prior-approval right for the sale, transfer, or encumbrance of those interests. However, a de facto agency relationship is not created by both the reporting entity and the party holding prior-approval rights that are based on mutually agreed terms by willing, independent parties. (ASC (d)) A party that has a close business relationship like the relationship between a professional service provider and one of its significant clients (ASC (e)) C. Determine applicability of Variable Interest Entities subsections This section outlines steps to determine whether the consolidation and disclosure guidance in ASC , Variable Interest Entities subsections, as amended by ASU , applies to a reporting entity s involvement with a separate legal entity. Step 1: Determine whether the reporting entity holds any explicit or implicit (direct or indirect) variable interest in the legal entity The identification of all variable interests in a legal entity and the holders of those interests is covered in Step 4 of the assessment (see Section D). However, if a reporting entity does not have a direct or indirect (explicit or implicit) variable interest in a legal entity, then the reporting entity is not the primary beneficiary of that legal entity and is not required to provide the variable interest entity disclosures for that legal entity under ASC Therefore, a reporting entity should determine, as early as possible in the analysis, if it has a variable interest in a legal entity to determine whether any further assessment of that legal entity is necessary under ASC , Variable Interest Entities subsections. Step 2: Determine whether a scope exception applies ASC provides the following exceptions to consolidation that apply to both variable interest and voting interest entities:

13 New Developments Summary 13 An employer shall not consolidate an employee benefit plan subject to the guidance in either ASC 712, Compensation Nonretirement Postemployment Benefits, or ASC 715, Compensation Retirement Benefits Investments carried at fair value in accordance with the special guidance in ASC 946, Financial Services Investment Companies, are not consolidated A non-governmental reporting entity shall not consolidate either of the following A governmental organization A financing entity established by a governmental organization unless the financing entity is not a governmental organization and is used in a manner to circumvent the provisions of ASC , Variable Interest Entities subsections ASC exempts the following entities from consolidation under ASC , Variable Interest Entities subsections, but such entities may be subject to consolidation under other GAAP: Not-for-profit entities as defined in ASC Separate accounts of life insurance entities described in ASC 944, Financial Services Insurance Legal entities created before December 31, 2003 for which the reporting entity lacks sufficient information to apply ASC , Variable Interest Entities subsections A legal entity that is a business as defined in ASC for which none of the following conditions exist (ASC (d)): The reporting entity and / or its related parties (excluding de facto agents) participated significantly in the design or redesign of the legal entity. (This condition does not apply if the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee.) The legal entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties. The reporting entity and its related parties provide more than half of the total of equity, subordinated debt, and other subordinated financial support to the legal entity based on the fair values of the interests in the legal entity. The legal entity s activities relate primarily to securitizations, other forms of asset-backed financings, or single-lessee leasing arrangements. This scope exception applies as long as the all of the above conditions are met. Step 3: Determine whether the legal entity qualifies for the partial deferral of the ASU amendments to the Variable Interest Entities subsections ASU indefinitely defers the effective date of the recognition and measurement provisions in ASC that were amended by ASU for a reporting entity s interest(s) in certain investment funds. A reporting entity must evaluate its interest in each investment fund separately to determine eligibility for the deferral. As a result, a reporting entity s interest in investment fund A may qualify for the deferral, while its interest in investment fund B may not. The terms of the indefinite partial deferral in ASU are codified in ASC For a legal entity that qualifies for the deferral, the reporting entity must

14 New Developments Summary 14 Determine whether the legal entity is a VIE and whether the reporting entity is the primary beneficiary based on the guidance in ASC , Variable Interest Entities subsections, as it existed before its amendment by ASU (codification of Statement 167). If the legal entity is not a VIE based on the guidance as it existed before the ASU amendments, then other authoritative guidance, such as the guidance in ASC , Control of Partnerships and Similar Entities, would be applied to determine whether the reporting entity should consolidate the legal entity. (See Appendix A.) Provide disclosures in accordance with ASC , Variable Interest Entities subsections, as amended by ASU , if the legal entity is a VIE under the guidance in ASC as it existed before the ASU amendments (see Step 7 and Appendix C) Applicability of deferral to a reporting entity s interest in money market funds The deferral applies to a reporting entity s interest in an entity that is required to comply with, or operate in accordance with, requirements that are similar to those included in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. Applicability of deferral to a reporting entity s interest in other investment funds The evaluation of whether a reporting entity s interest in other investment funds is subject to the deferral requires an evaluation of the attributes of the investment fund entity and the reporting entity s involvement with the investment fund entity. A reporting entity s interest in other investment funds is subject to the deferral if all of the following conditions are met: The investment fund entity meets either of the following conditions: The entity has all of the attributes of an investment company in ASC (a) through (d) The entity does not have all of the attributes of an investment company in ASC , but follows the practice of its industry to issue financial statements using guidance consistent with the measurement principles for investment companies in ASC 946. Regardless of whether an entity has the attributes of an investment company or applies investment company accounting, the amended guidance in ASC stipulates that the deferral does not apply to a securitization entity, an asset-backed financing entity, or an entity that was formerly considered a qualifying special purpose entity (QSPE) as defined in ASC 860, Transfers and Servicing. The reporting entity does not have an implicit or explicit obligation to fund losses of the investment fund entity that could potentially be significant to the reporting entity. The FASB has indicated that an investment in an entity, regardless of the size of the investment, does not, by itself, disqualify that entity for the deferral, provided that the investment fund entity meets all other requirements of the deferral. Attributes of the investment fund entity The FASB clarifies in the Basis for Conclusions for ASU that investment fund entities with the following characteristics do not qualify for the deferral: Entities with multiple levels of subordinated investors, which the FASB considers to be asset-backed financing entities Entities with characteristics similar to those of a VIE described in Example 5 in ASC through (originally issued as examples in Statement 167)

15 New Developments Summary 15 Examples of other investment fund entities that are not eligible for the deferral ASC provides explicit examples of investment fund entities that are not eligible for the deferral. Those entities include structured investment vehicles (SIVs), collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), commercial paper conduits, credit card securitizations, residential or commercial mortgage-backed entities, and government-sponsored mortgage entities. Examples of other investment fund entities that may be eligible for the deferral ASC also provides examples of entities that might be eligible for the deferral, which include mutual funds, hedge funds, mortgage real estate investment funds, private equity funds, and venture capital funds. However, those entities must be evaluated to determine if all of the eligibility conditions have been met. Evaluating the legal entity in which a reporting entity has an interest In some cases a reporting entity may need to look through the investments of a potential VIE in order to determine whether it is eligible for the deferral for certain investment fund entities under ASC For example, if a reporting entity has an investment in a real estate investment trust (REIT) that, in turn, has investments in securitization entities or asset-backed financing entities for which the REIT would be the primary beneficiary based on the guidance in ASC , as amended by ASU (codification of Statement 167), we believe that the reporting entity s interest in the REIT would not be eligible for the deferral under ASC , since the activities are related to securitization. Obligation to fund potentially significant losses of the investment fund entity The determination of whether the reporting entity s interest in an investment fund entity obligates the reporting entity to fund losses of that entity that could potentially be significant to that entity requires consideration of the following: The legal structure of the reporting entity s interest The purpose and design of the investment fund entity Implicit and explicit guarantees provided by the reporting entity and its related parties The Basis for Conclusions for ASU indicates how certain interests, structures, and agreements, described below, should be considered in such an assessment. Consideration of the legal structure of the reporting entity s interest The Basis for Conclusions for ASU states that if a reporting entity s exposure to the obligations of an investment fund, such as a partnership is limited based on the legal structure of its interest, the entity may qualify for the deferral. For instance, if a general partner has unlimited liability with respect to its interest in a limited partnership, which in turn has general recourse debt obligations, the FASB believes that the general partner would not be deemed to have exposure to losses of the partnership that could potentially be significant to the partnership, as long as both of the following conditions exist: The general partner has no assets other than its interest in the limited partnership. The partnership s creditors have no recourse to assets of the financial reporting entity (general partner s investor).

16 New Developments Summary 16 Consideration of the purpose and design of the investment fund entity The Basis for Conclusions further indicates that a claw back arrangement, where an investment manager may be required to refund prior fee payments made by the reporting entity up to the amount of fees previously received, does not violate the deferral criteria. In addition, the Basis for Conclusions indicates that an investor s (reporting entity s) agreement to make future capital contributions to the investment fund entity should be analyzed based on facts and circumstances. For example, a capital commitment requirement to fund the entity over time, as the investment manager finds suitable investments, would not violate the deferral criteria for that entity. However, if such a commitment could relate to funding losses, it would be considered an obligation to fund the entity s losses, even if all of the investors must contribute on a pro rata basis. D. Identify variable interests in the legal entity Step 4: Identify the explicit and implicit variable interests in the legal entity and the holders of those interests Step 4.1: Identify the variable interests in the legal entity that are held by the reporting entity and its related parties Obtain an understanding of The nature, terms, conditions, rights, and obligations of the variable interests The nature of and relationships, if any, between the holders of the variable interests Consider specific guidance on the identification of variable interests provided in the FASB Codification, including General guidance (ASC through 25-33; ASC through 55-26; ASC ; and Example 3 in ASC through 55-86) Certain derivative instruments (ASC through and ASC through 55-31) Implicit variable interests (ASC through and Example 4 in ASC through 55-89) Decision maker or service provider fee arrangements (ASC through 55-38) Operating leases (ASC ) Variable interest of one VIE in another VIE (ASC through 55-41) Interests in specified assets of a VIE (ASC through 25-58) Variable interests Variable interests in a VIE are contractual, ownership, or other pecuniary interests that will absorb portions of a VIE's expected losses or receive portions of the VIE s expected residual returns. Variable interests in a VIE change with changes in the fair value of the VIE s net assets exclusive of variable interests. The identification of variable interests involves determining which assets, liabilities, or contracts create the entity s variability and which assets, liabilities, equity, and other contracts absorb or receive that

17 New Developments Summary 17 variability. Those items that absorb or receive variability are the entity s variable interests. The role of an item often depends on the design of the entity. A variable interest may be an explicit or implicit interest in any legal entity. Variable interests could include, but are not limited to, the following: Ownership interests that may be variable interests include equity investments in any legal entity. Contractual arrangements that create potential variable interests include, but are not limited to, the following: Loans and other debt instruments issued by the legal entity Leasing arrangements Residual guarantees and purchase options at specified prices Obligations that protect holders of variable interests, such as Guarantees of the value of the legal entity s assets or liabilities Written put options on the legal entity s assets Commitments to provide liquidity Agreements to replace the legal entity s impaired assets Fees paid to a decision maker or service provider Some supply or purchase contracts Franchise arrangements Put options Forward contracts to sell the legal entity s assets Total return swaps issued by the legal entity Swaps and other freestanding derivatives Embedded derivatives that are not clearly and closely related economically to their asset or liability host contract Implicit variable interests An implicit variable interest is an implied pecuniary interest in a legal entity that acts the same as an explicit variable interest; that is, the interest absorbs or receives the legal entity s variability. An implicit variable interest can exist if the reporting entity can be required to protect a variable interest holder in a legal entity from absorbing losses incurred by the legal entity. The SEC staff has highlighted the need to consider activities around the entity when identifying potential variable interests. Such activities can also affect the assessment of whether an entity is a variable interest entity as well as which reporting entity is the primary beneficiary. Examples of activities or arrangement that may give rise to implicit interests include: Loans between investors in the entity. Because it is often difficult to determine the substance of a lending relationship and its impact on an analysis under the ASC , Variable Interest Entities

18 New Developments Summary 18 subsections, a company should evaluate the substance of the facts and circumstances in determining the lending relationship s impact on such an analysis. Puts and calls between the reporting entity and other investors and noninvestors in the legal entity Service arrangements with investors and noninvestors Derivatives such as total return swaps Availability to investors of tax credits generated from the legal entity s business. In a situation where investors became involved with an entity because of the availability of tax credits generated from the entity s business, the SEC staff objected if the investor did not include the tax credits in its analysis, both as a component of the investor s variable interest in the entity as well as the impact of the credits on the expected loss and expected residual return analysis. The SEC staff has emphasized that a company could have an implicit variable interest in a VIE despite having no direct contractual interest in that entity. The identification of an implicit variable interest remains a matter of judgment. However, the staff provided the following list of questions that should be considered, as a starting point, when determining whether a contractual arrangement with a variable interest holder is an implicit interest in the entity itself: 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 specific assets of the VIE? Fees paid to a decision maker or service provider Under the guidance in ASC , as amended by ASU and ASU , fees paid to a decision maker or service provider are considered variable interests, unless all of the following conditions are met: The fees are compensation for services and are commensurate with the level of effort required. Substantially all of the fees are at or above the same level of seniority as the entity s other operating liabilities, such as trade payables. The decision maker or service provider does not hold other interests in the VIE that would either (1) absorb more than an insignificant amount of the entity s expected losses or (2) receive more than an insignificant amount of the entity s expected residual returns. All of the service arrangement s terms, conditions, or amounts are customarily included in arrangements for similar services negotiated at arm s length. The total amount of anticipated fees is insignificant relative to the VIE s anticipated economic performance. The anticipated fees are expected to absorb an insignificant amount of the variability associated with the VIE s anticipated economic performance. Interests in a legal entity held by a decision maker s or service provider s related parties are considered to be the decision maker s or service provider s own interests for the purpose of evaluating all of the conditions in ASC However, for that evaluation, related parties should not include either an employee or an employee benefit plan of the decision maker or service provider (and its other related