NON-PROFIT ACCOUNTING HW

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Chapter Six

Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Learning Objective 6-1

Describe a variable interest entity, a primary beneficiary, and the factors used to decide when a variable interest entity is subject to consolidation.

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LO 6-1: Describe a variable interest entity, a primary beneficiary, and the factors used to decide when a variable interest entity is subject to consolidation.

Variable Interest Entities (VIEs)

Known as special purpose entities (SPEs).

Most VIEs are established for valid business purposes.

Established as a separate business structure:

Trust

Joint venture

Partnership

Corporation

VIEs sometimes have no independent management or employees.

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Several decades ago, many firms began establishing separate business structures to help finance their operations at favorable rates. These structures became commonly known as special purpose entities (SPEs), special purpose vehicles, or off-balance-sheet structures. In this text, we refer to all such entities collectively as variable interest entities, or VIEs.

A VIE can take the form of a trust, partnership, joint venture, or corporation, although sometimes it has neither independent management nor employees. Most are established for valid business purposes, and transactions involving VIEs have become widespread.

Variable Interest Entities (VIEs) (continued)

Common examples of VIE activities:

Transfers of financial assets

Leasing

Hedging financial instruments

Research and development

Benefits of VIE:

Often eligible for a lower interest rate

Low-cost financing of assets

Governing agreements limit activities and decision making.

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Common examples of VIE activities include transfers of financial assets, leasing, hedging financial instruments, research and development, and other arrangements. An enterprise often creates a VIE to accomplish a well-defined and limited business activity and to provide low-cost financing.

Low-cost financing of asset purchases is frequently a main benefit available through VIEs. Rather than engaging in the transaction directly, a business enterprise may establish a VIE to purchase and finance an asset acquisition. The VIE then leases the asset back to the business enterprise that established the VIE. This strategy saves the business enterprise money because the VIE is often eligible for a lower interest rate. This advantage is achieved for several reasons. First, the VIE typically operates with a very limited set of assets—in many cases, just one asset. By isolating an asset in a VIE, the asset’s risk is isolated from the business enterprise’s overall risk. Thus the VIE creditors remain protected by the specific collateral in the asset. Second, the governing documents can strictly limit the actions of a VIE. These limits further protect lenders by preventing the VIE from engaging in any activities not specified in its agreements. The VIE may have been created specifically by the primary beneficiary to provide it with low-cost financing.

Variable Interest Entities (VIEs)—Primary Beneficiary

Enterprise that created VIE may not own any of its voting stock.

Prior to current consolidation requirements, enterprises left VIEs unconsolidated in their financial reports.

Primary beneficiary typically exercises its financial control through governance documents or contractual agreements giving it decision-making authority over the VIE.

Primary beneficiary must consolidate in its financial statements the VIE’s assets, liabilities, revenues, expenses, and noncontrolling interest.

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Because governing agreements limit activities and decision making in most VIEs, ownership of a VIE’s common stock typically does not provide control of the VIE. In fact, the enterprise that created the VIE may own very little, if any, of the VIE’s voting stock. Prior to current consolidation requirements for VIEs, many enterprises left such entities unconsolidated in their financial reports because technically they did not own a majority of the entity’s voting stock. In utilizing the VIE as a conduit to provide financing, the related assets and debt were effectively removed from the enterprise’s balance sheet.

In general, the party that primarily benefits (or risks losses) from the economic activities of the VIE and has the power to direct the VIE’s activities is deemed to have a controlling financial interest in the VIE. We use the term primary beneficiary to designate the party with such financial control. The primary beneficiary (most often a business) typically exercises its financial control through governance documents or other contractual agreements that provide it with decision-making authority over the VIE. Once identified, the primary beneficiary must consolidate in its financial statements the VIE’s assets, liabilities, revenues, expenses, and noncontrolling interest.

Characteristics of VIEs

VIEs generally have assets, liabilities, and investors with equity interests.

Activities are strictly limited.

Role of equity investors can be minor; they may serve simply to allow the VIE to function as a legal entity.

Because they bear relatively low economic risk, investors may be provided only a small rate of return.

Another party, e.g., the primary beneficiary, contributes substantial resources—loans and/or guarantees—to enable the VIE to secure additional financing to accomplish its purpose.

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Similar to most business entities, VIEs generally have assets, liabilities, and investors with equity interests. Unlike most businesses, because a VIE’s activities and decision making can be strictly limited, the role of the equity investors can be fairly minor. Thus, the equity investors may serve simply as a technical requirement to allow the VIE to function as a legal entity. Because they bear relatively low economic risk, equity investors may be provided only a small rate of return.

The small equity investments in a VIE normally are insufficient to induce lenders to provide financing for the VIE. As a result, another party (e.g., the primary beneficiary) must contribute substantial resources—often loans and/or guarantees—to enable the VIE to secure additional financing needed to accomplish its purpose.

Characteristics of VIEs (continued)

Primary beneficiary may guarantee the VIE’s debt, assuming the risk of default.

Contractual arrangements may limit returns to equity holders, yet participation rights provide increased profit potential and risks to the primary beneficiary.

Beneficiary’s economic interests vary depending on the VIE’s success—hence the term variable interest entity.

Risks and rewards are not distributed according to stock ownership but according to other variable interests.

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For example, the primary beneficiary may guarantee the VIE’s debt, thus assuming the risk of default. Other contractual arrangements may limit returns to equity holders while participation rights provide increased profit potential and risks to the primary beneficiary. Risks and rewards such as these cause the primary beneficiary’s economic interest to vary depending on the created entity’s success—hence the term variable interest entity. In contrast to a traditional entity, a VIE’s risks and rewards frequently are distributed not according to stock ownership but according to other variable interests.

Variable Interest Entities—Risk and Ownership

Variable interests increase a firm’s risk as the resources it provides (or guarantees) to the VIE increase.

With increased risks come incentives to restrict the VIE’s decision making.

A firm with variable interests will regularly limit the equity investors’ power through the VIE’s governance documents.

Investors are the owners of the VIE, but they may retain little responsibility of ownership risk and benefits.

Investors may cede financial control of a VIE to the variable interests in exchange for a guaranteed rate of return.

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Variable interests increase a firm’s risk as the resources it provides (or guarantees) to the VIE increase. With increased risks come incentives to restrict the VIE’s decision making. In fact, a firm with variable interests will regularly limit the equity investors’ power through the VIE’s governance documents.

Although the equity investors are technically the owners of the VIE, in reality they may retain little of the traditional responsibilities, risks, and benefits of ownership. In fact, the equity investors sometimes cede financial control of the VIE to those with variable interests in exchange for a guaranteed rate of return. Alternatively, equity ownership is also a variable interest, and a minority equity holder may be the primary beneficiary and end up consolidating the VIE.

Prior Consolidation of VIEs

In the past, assets, liabilities, and results of operations for VIEs and other entities frequently were not consolidated with those of the firm that controlled the entity.

These firms invoked a reliance on voting interests, as opposed to variable interests, to indicate a lack of a controlling financial interest.

As noted by GAAP literature, legacy FASB standard FIN 46R requires the primary beneficiary (regardless of their ownership) to consolidate the VIE.

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Prior to current financial reporting standards, assets, liabilities, and results of operations for VIEs and other entities frequently were not consolidated with those of the firm that controlled the entity. These firms invoked a reliance on voting interests, as opposed to variable interests, to indicate a lack of a controlling financial interest. As legacy FASB standard FIN 46R observed,

An enterprise’s consolidated financial statements include subsidiaries in which the enterprise has a controlling financial interest. That requirement usually has been applied to subsidiaries in which an enterprise has a majority voting interest, but in many circumstances, the enterprise’s consolidated financial statements do not include variable interest entities with which it has similar relationships. The voting interest approach is not effective in identifying controlling financial interests in entities that are not controllable through voting interests or in which the equity investors do not bear residual economic risk.

Examples of VIEs

EXHIBIT 6.1 Examples of Variable Interests

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Identification of a VIE

An entity qualifies as a VIE if either of the following conditions exists:

Total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders.

Equity investors in VIE, as a group, lack any one of three characteristics of a controlling financial interest:

1) The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.

2) The obligation to absorb the expected losses of the entity.

3) The right to receive expected residual returns of the entity.

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An entity qualifies as a VIE if either of the following conditions exists:

The total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. In most cases, if equity at risk is less than 10 percent of total assets, the risk is deemed insufficient.

The equity investors in the VIE, as a group, lack any one of the following three characteristics of a controlling financial interest:

The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.

The obligation to absorb the expected losses of the entity (e.g., the primary beneficiary may guarantee a return to the equity investors).

The right to receive the expected residual returns of the entity (e.g., the investors’ return may be capped by the entity’s governing documents or other arrangements with variable interest holders).

Identification of the Primary Beneficiary of the VIE

Once a firm has a relationship with a VIE, the firm must determine whether it qualifies as the VIE’s primary beneficiary.

An enterprise with a variable interest with a controlling financial interest in a VIE is the primary beneficiary and will have both of the following characteristics:

The power to direct the activities of a VIE that most significantly impact the entity’s economic performance.

The obligation to absorb losses that could potentially be significant to the VIE or the right to receive benefits from it that could be significant to the VIE.

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Once it is established that a firm has a relationship with a VIE, the firm must determine whether it qualifies as the VIE’s primary beneficiary. An enterprise with a variable interest that provides it with a controlling financial interest in a variable interest entity is the primary beneficiary and will have both of the following characteristics:

The power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance.

The obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.

Identification of the Primary Beneficiary of the VIE (continued)

These characteristics mirror those that the equity investors often lack in a VIE.

The primary beneficiary will absorb a significant share of the VIE’s losses or receive a significant share of the VIE’s residual returns or both.

The fact that the primary beneficiary may own no voting shares whatsoever becomes inconsequential because they do not effectively give equity investors power to exercise control.

Careful examination of the VIE’s governing documents and who bears risk is necessary to determine whether a reporting entity possesses control over a VIE.

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Note that these characteristics mirror those that the equity investors often lack in a VIE. Instead, the primary beneficiary will absorb a significant share of the VIE’s losses or receive a significant share of the VIE’s residual returns or both. The fact that the primary beneficiary may own no voting shares whatsoever becomes inconsequential because such shares do not effectively give the equity investors power to exercise control. Thus, a careful examination of the VIE’s governing documents, contractual arrangements among parties involved, and who bears the risk is necessary to determine whether a reporting entity possesses control over a VIE.

Example of a Primary Beneficiary and Consolidated VIE

Twin Peaks, a power company, seeks to acquire an electric generating plant for $400 million to expand its market share. It expects to sell the electricity generated by the plant acquisition at a profit to its owners.

Twin Peaks’s general credit rating allowed for a 4 percent annual interest rate on a debt issue. It explored establishing a separate legal entity whose sole purpose would be to own the electric generating plant and lease it back to Twin Peaks.

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Assume that Twin Peaks Electric Company seeks to acquire a generating plant for a negotiated price of $400 million from Ace Electric Company. Twin Peaks wishes to expand its market share and expects to be able to sell the electricity generated by the plant acquisition at a profit to its owners.

In reviewing financing alternatives, Twin Peaks observed that its general credit rating allowed for a 4 percent annual interest rate on a debt issue. Twin Peaks also explored the establishment of a separate legal entity whose sole purpose would be to own the electric generating plant and lease it back to Twin Peaks.

Example of a Primary Beneficiary and Consolidated VIE (continued)

The separate entity will isolate the electric generating plant from Twin Peaks’s other risky assets and liabilities and provide specific collateral.

An interest rate of 3 percent on the debt is available, producing before-tax savings of $4 million per year.

To obtain the lower interest rate, however, Twin Peaks must:

Guarantee the separate entity’s debt.

Maintain its own predefined financial ratios and restrict the amount of additional debt it can assume.

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Because the separate entity would isolate the electric generating plant from Twin Peaks’s other risky assets and liabilities and provide specific collateral, an interest rate of 3 percent on the debt is available, producing before-tax savings of $4 million per year. To obtain the lower interest rate, however, Twin Peaks must guarantee the separate entity’s debt. Twin Peaks must also maintain certain of its own predefined financial ratios and restrict the amount of additional debt it can assume.

Power Finance Co.

Twin Peaks establishes Power Finance Co., designed solely to own, finance, and lease the electric generating plant to Twin Peaks.

The documents governing the new entity specify the following:

The sole purpose of Power Finance is to purchase the Ace electric generating plant, provide equity and debt financing, and lease the plant to Twin Peaks.

An outside investor will provide $16 million in exchange for a 100 percent nonvoting equity interest in Power Finance.

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To take advantage of the lower interest rate, on January 1, 2017, Twin Peaks establishes Power Finance Co., an entity designed solely to own, finance, and lease the electric generating plant to Twin Peaks. The documents governing the new entity specify the following:

The sole purpose of Power Finance is to purchase the Ace electric generating plant, provide equity and debt financing, and lease the plant to Twin Peaks.

An outside investor will provide $16 million in exchange for a 100 percent nonvoting equity interest in Power Finance.

Power Finance Co. (continued)

Power Finance will issue debt in exchange for $384 million. Twin Peaks guarantees the debt because the $16 million equity investment is insufficient to attract low-interest debt financing.

Twin Peaks will lease the electric generating plant from Power Finance in exchange for payments of $12 million per year based on a 3 percent fixed interest rate for the debt and equity investors for an initial five-year lease term.

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Power Finance will issue debt in exchange for $384 million. Because the $16 million equity investment by itself is insufficient to attract low-interest debt financing, Twin Peaks will guarantee the debt.

Twin Peaks will lease the electric generating plant from Power Finance in exchange for payments of $12 million per year based on a 3 percent fixed interest rate for both the debt and equity investors for an initial lease term of five years.

Power Finance Co. (concluded)

At the end of the five-year lease term (or any extension), Twin Peaks must do one of the following:

Renew the lease for five years subject to the approval of the equity investor.

Purchase the electric generating plant for $400 million.

Sell the electric generating plant to an independent third party. If the proceeds of the sale are insufficient to repay the equity investor, Twin Peaks must make a payment of $16 million to the equity investor.

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At the end of the five-year lease term (or any extension), Twin Peaks must do one of the following:

Renew the lease for five years subject to the approval of the equity investor.

Purchase the electric generating plant for $400 million.

Conditions for Consolidation of Twin Peaks Electric Company and Power Finance Company

In evaluating whether Twin Peaks Electric Company must consolidate Power Finance Company, two conditions must be met:

Power Finance must qualify as a VIE by either:

An inability to secure financing without additional subordinated support or

A lack of either the risk of losses or entitlement to residual returns (or both).

Twin Peaks must qualify as the primary beneficiary of Power Finance.

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In evaluating whether Twin Peaks Electric Company must consolidate Power Finance Company, two conditions must be met. First, Power Finance must qualify as a VIE by either (1) an inability to secure financing without additional subordinated support or (2) a lack of either the risk of losses or entitlement to residual returns (or both). Second, Twin Peaks must qualify as the primary beneficiary of Power Finance.

Power Finance Company—VIE Status

In assessing the first condition, several factors point to VIE status for Power Finance:

Its owners’ equity comprises only 4 percent of total assets, far short of the 10 percent benchmark.

Twin Peaks guarantees Power Finance’s debt, suggesting insufficient equity to finance its operations without additional support.

The equity investor appears to bear almost no risk with respect to the operations of the Ace electric plant.

These characteristics indicate that Power Finance qualifies as a VIE.

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In assessing the first condition, several factors point to VIE status for Power Finance. Its owners’ equity comprises only 4 percent of total assets, far short of the 10 percent benchmark. Moreover, Twin Peaks guarantees Power Finance’s debt, suggesting insufficient equity to finance its operations without additional support. Finally, the equity investor appears to bear almost no risk with respect to the operations of the Ace electric plant. These characteristics indicate that Power Finance qualifies as a VIE.

Power Finance Company—VIE Status (continued)

For the second condition for consolidation, an assessment is made to determine whether Twin Peaks qualifies as Power Finance’s primary beneficiary.

Twin Peaks has the power to direct Power Finance’s activities, but to qualify for consolidation, Twin Peaks must also have the obligation to absorb losses or the right to receive returns from Power Finance.

Twin Peaks will pay a fixed fee to lease the electric generating plant, operate the plant, and sell the electric power in its markets.

If the business plan is successful, Twin Peaks will enjoy residual profits from operating while Power Finance’s equity investors receive the fixed fee.

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In evaluating the second condition for consolidation, an assessment is made to determine whether Twin Peaks qualifies as Power Finance’s primary beneficiary. Clearly, Twin Peaks has the power to direct Power Finance’s activities. But to qualify for consolidation, Twin Peaks must also have the obligation to absorb losses or the right to receive returns from Power Finance—either of which could potentially be significant to Power Finance. But what possible losses or returns would accrue to Twin Peaks? What are Twin Peaks’s variable interests that rise and fall with the fortunes of Power Finance?

As stated in the VIE agreement, Twin Peaks will pay a fixed fee to lease the electric generating plant. It will then operate the plant and sell the electric power in its markets. If the business plan is successful, Twin Peaks will enjoy residual profits from operating while Power Finance’s equity investors receive the fixed fee.

Power Finance Company—VIE Status (concluded)

If electricity prices fall, revenues generated may be insufficient to cover Twin Peaks’s lease payments, but the VIE equity investors are protected from this risk.

If the plant’s fair value increases significantly, Twin Peaks can exercise its option to purchase the plant at a fixed price and either resell it or keep it for its own future use.

If Twin Peaks sells the plant at a loss, it must pay the equity investors all of their initial investment, furthering the loss to Twin Peaks.

These elements point to Twin Peaks as the primary beneficiary of its VIE, meaning it must consolidate the VIE’s assets, liabilities, and results of operations with its own.

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On the other hand, if prices for electricity fall, Twin Peaks may generate revenues insufficient to cover its lease payments while Power Finance’s equity investors are protected from this risk. Moreover, if the plant’s fair value increases significantly, Twin Peaks can exercise its option to purchase the plant at a fixed price and either resell it or keep it for its own future use. Alternatively, if Twin Peaks were to sell the plant at a loss, it must pay the equity investors all of their initial investment, furthering the loss to Twin Peaks. Each of these elements points to Twin Peaks as the primary beneficiary of its VIE through variable interests. As the primary beneficiary, Twin Peaks must consolidate the assets, liabilities, and results of operations of Power Finance with its own.

Financial Reporting Principles for Consolidating VIEs—Initial Measurement Issues

Financial reporting principles for consolidating VIEs require asset, liability, and noncontrolling interest valuations.

These valuations initially, with few exceptions, are based on fair values.

If the total business fair value of the VIE exceeds the collective fair values of its net assets, goodwill is recognized.

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The financial reporting principles for consolidating variable interest entities require asset, liability, and noncontrolling interest valuations. These valuations initially, and with few exceptions, are based on fair values.

The fair-value principle applies to consolidating VIEs in the same manner as business combinations accomplished through voting interests. If the total business fair value of the VIE exceeds the collective fair values of its net assets, goodwill is recognized.

Initial Measurement Issues—Collective Fair Values

If the collective fair values of the net assets exceed the total business fair value, the primary beneficiary recognizes a gain on bargain purchase.

Assuming that the debt and noncontrolling interests are stated at fair values, Twin Peaks includes in its consolidated balance sheet:

Electric Generating Plant at $400 million.

Long-Term Debt at $384 million.

Noncontrolling interest of $16 million.

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Conversely, if the collective fair values of the net assets exceed the total business fair value, the primary beneficiary recognizes a gain on bargain purchase.

In the previous example, assuming that the debt and noncontrolling interests are stated at fair values, Twin Peaks simply includes in its consolidated balance sheet the Electric Generating Plant at $400 million, the Long-Term Debt at $384 million, and a noncontrolling interest of $16 million.

Consolidation of VIEs Subsequent to Initial Measurement

After the initial measurement, all intra-entity transactions between the primary beneficiary and the VIE must be eliminated in consolidation.

VIE’s income must be allocated among the parties involved (equity holders and the primary beneficiary).

The distribution of income is typically specified in contractual arrangements.

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After the initial measurement, consolidations of VIEs with their primary beneficiaries should follow the same process as if the entity were consolidated based on voting interests. Importantly, all intra-entity transactions between the primary beneficiary and the VIE (including fees, expenses, other sources of income or loss, and intra-entity inventory purchases) must be eliminated in consolidation. Finally, the VIE’s income must be allocated among the parties involved (i.e., equity holders and the primary beneficiary). For a VIE, contractual arrangements, as opposed to ownership percentages, typically specify the distribution of its income.

Learning Objective 6-2

Demonstrate the process to consolidate a primary beneficiary with a variable interest entity.

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LO 6-2: Demonstrate the process to consolidate a primary beneficiary with a variable interest entity.

Consolidation of a Primary Beneficiary and VIE Illustrated

Assume that on January 1, 2018, Prescott Corporation loans Valente, Inc., a business entity $2,200,000 due January 1, 2023.

Valente had been unable to secure the financing needed to continue its operations.

As part of the loan agreement, Valente agrees to provide to Prescott during the next five years:

5 percent annual interest (market rate) on the loan.

Decision-making power over Valente’s operating and financing activities.

100 percent participation rights to all of Valente’s profits less a $7,000 guaranteed annual dividend to Valente’s common shareholders.

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The next example considers (1) the issues that arise when a primary beneficiary obtains control through variable interests of an existing business and (2) financial reporting for a VIE in periods subsequent to obtaining control.

Assume that on January 1, 2018, Prescott Corporation provides a $2,200,000 loan to Valente, Inc., a business entity. The loan is due on January 1, 2023. Until receiving the loan from Prescott, Valente had been unable to secure from the debt market the financing needed to continue its operations.

As part of the loan agreement, Valente agrees to provide the following to Prescott during the next five years:

5 percent annual interest (market rate) on the loan from Prescott.

Decision-making power over Valente’s operating and financing activities.

100 percent participation rights to all of Valente’s profits less a $7,000 guaranteed annual dividend to Valente’s common shareholders.

Consolidation of a Primary Beneficiary and VIE—Agreement Options

At the end of the five-year agreement, Prescott has the option of either:

Acquiring ownership of Valente, Inc., for $500,000 or

Extending the original agreement for an additional five years.

As a result of the agreement, Valente is a variable interest entity, and Prescott is its primary beneficiary that requires consolidation.

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At the end of the five-year agreement, Prescott has the option of either acquiring ownership of Valente, Inc., for $500,000 or extending the original agreement for an additional five years. As a result of the agreement, Valente is a variable interest entity and Prescott is its primary beneficiary. Upon consummation of the variable interest agreement, Prescott’s and Valente’s balance sheets appear on the following slide.

Primary Beneficiary and VIE—Balance Sheets

At January 1, 2018, Prescott estimated the fair value of Valente’s common stock at $143,000.

The $125,000 difference between the fair value of the common stock and Valente’s book value ($143,000 – $18,000) was attributed entirely to the patented technology with a five-year estimated remaining life.

Prescott’s and Valente’s balance sheets

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At January 1, 2018, Prescott estimated the fair value of Valente’s common stock at $143,000. The $125,000 difference between the fair value of the common stock and Valente’s book value ($143,000 – $18,000) was attributed entirely to the patented technology with a five-year estimated remaining life.

Consolidation Worksheet: Date of Acquisition

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Exhibit 6.3 shows the consolidation worksheet for Prescott (the primary beneficiary) and Valente (the variable interest entity) at January 1, 2018, the date Prescott obtained financial control over Valente.

Consolidation Worksheet: Subsequent to Initial Measurement

EXHIBIT 6.4 Consolidation Worksheet for Primary Beneficiary and VIE (Post-Control)

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Following the first year of operations, Exhibit 6.4 shows the consolidation worksheet for December 31, 2018, at the end of the first year in which Prescott obtained control of the variable interest entity. At the end of the year, Valente paid the guaranteed $7,000 dividend to its equity holders.

Worksheet entries, as seen in Exhibit 6.4, are used to consolidate the financial statements of Prescott Corporation and its VIE, Valente, as of December 31, 2018.

Consolidation Worksheet Process: Subsequent to Initial Measurement

Consolidation of a VIE with its primary beneficiary follows a similar process as if the entity were consolidated based on voting interests.

All intra-entity transactions between the primary beneficiary and the VIE (including fees, expenses, other sources of income or loss, and intra-entity transfers) must be eliminated in consolidation.

Because VIEs typically have noncontrolling interests, an appropriate allocation of the VIE’s net income requires a close examination of the underlying contractual arrangements between the primary beneficiary and other holders of variable interests.

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Overall, as shown by Exhibit 6.4, consolidation of a VIE with its primary beneficiary follows a similar process as if the entity were consolidated based on voting interests. Importantly, all intra-entity transactions between the primary beneficiary and the VIE (including fees, expenses, other sources of income or loss, and intra-entity transfers) must be eliminated in consolidation. Because VIEs typically have noncontrolling interests, an appropriate allocation of the VIE’s net income requires a close examination of the underlying contractual arrangements between the primary beneficiary and other holders of variable interests.

Variable Interest Entity Disclosure Requirements

Enhanced disclosures are required for any enterprise that holds a variable interest in a VIE, including:

VIE’s nature, purpose, size, and activities.

Significant judgments and assumptions an enterprise makes in determining whether it must consolidate a VIE and/or disclose information about its involvement in a VIE.

Nature of restrictions on a consolidated VIE’s assets and on the settlement of its liabilities reported by an enterprise in its statement of financial position, including the carrying amounts of such assets and liabilities.

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VIE disclosure requirements are designed to provide users of financial statements with more transparent information about an enterprise’s involvement in a VIE. The enhanced disclosures are required for any enterprise that holds a variable interest in a VIE. Included among the enhanced disclosures are requirements to show:

The VIE’s nature, purpose, size, and activities.

The significant judgments and assumptions made by an enterprise in determining whether it must consolidate a VIE and/or disclose information about its involvement in a VIE.

The nature of restrictions on a consolidated VIE’s assets and on the settlement of its liabilities reported by an enterprise in its statement of financial position, including the carrying amounts of such assets and liabilities.

Variable Interest Entity Disclosure Requirements (continued)

Nature of, and changes in, the risks associated with an enterprise’s involvement with the VIE.

How an enterprise’s involvement with the VIE affects the enterprise’s financial position, financial performance, and cash flows.

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The nature of, and changes in, the risks associated with an enterprise’s involvement with the VIE.

How an enterprise’s involvement with the VIE affects the enterprise’s financial position, financial performance, and cash flows.

Comparisons with International Accounting Standards

Under U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS):

Controlling financial interest is the critical concept in assessing consolidation by a reporting enterprise and VIEs.

Current reporting standards differ across these jurisdictions.

IFRS has one model for all entities regardless of whether control is evidenced by voting interests or variable interests.

U.S. GAAP has separate models for assessing control for variable interest entities and voting interest entities.

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Under both U.S. GAAP and IFRS, a controlling financial interest is the critical concept in assessing whether an entity should be consolidated by a reporting enterprise. FASB and IASB so far have employed different criteria to determine the existence of control. IFRS employs a single consolidation model for all entities regardless of whether control is evidenced by voting interests or variable interests. In contrast, U.S. GAAP employs separate models for assessing control for variable interest entities and voting interest entities. As a result, current reporting standards differ across jurisdictions for enterprises seeking to determine whether to consolidate another entity.

Comparisons with International Accounting Standards (continued)

Financial Accounting Standard Board (FASB) continues to deliberate its consolidation policies and procedures.

International Accounting Standards Board (IASB) has issued updated standards IFRS 10, “Consolidated Financial Statements,” and IFRS 12, “Disclosure of Interests in Other Entities,” that cover and define control to encompass all possible ways (voting power, contractual power, decision-making rights, etc.) in which one entity can exercise power over another.

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While the FASB continues its deliberations on consolidation policies and procedures, the IASB has issued two updated standards in this area.

The International Accounting Standards Board IFRS 10, “Consolidated Financial Statements,” and IFRS 12, “Disclosure of Interests in Other Entities,” cover situations where financial control exists either through a majority voting share or other means. These standards define control to encompass all possible ways (voting power, contractual power, decision-making rights, etc.) in which one entity can exercise power over another.

Learning Objective 6-3

Demonstrate the consolidation procedures to eliminate all intra-entity debt accounts and recognize any associated gain or loss created whenever one company acquires an affiliate’s debt instrument from an outside party.

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LO 6-3: Demonstrate the consolidation procedures to eliminate all intra-entity debt accounts and recognize any associated gain or loss created whenever one company acquires an affiliate’s debt instrument from an outside party.

Intra-Entity Debt Transactions

A company CANNOT lend money to itself.

Intra-entity investments in debt securities and related debt accounts must be eliminated in consolidation.

Corresponding receivable and payable and revenue and interest from the consolidated financial statements must be eliminated.

Because no money is owed to or from an outside party, these reciprocal accounts must be eliminated in each subsequent consolidation.

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Before delving into this topic, note that direct loans used to transfer funds between affiliated companies create no unique consolidation problems. Regardless of whether bonds or notes generate such amounts, the resulting receivable/payable balances are necessarily identical. Because no money is owed to or from an outside party, these reciprocal accounts must be eliminated in each subsequent consolidation. A worksheet entry simply offsets the two corresponding balances. Furthermore, the interest revenue/expense accounts associated with direct loans also agree and are removed in the same fashion.

Acquisition of Affiliate’s Debt from an Outside Party

The purchase of an affiliate’s debt instrument from an outside third party can create difficulties in consolidation.

If the parent purchases all or part of outstanding subsidiary bonds in the open market, from a consolidated view, the combined entity has reacquired its own bonds.

Although the individual companies continue to carry the debt and investment on their individual financial records, from a consolidation viewpoint, this liability is effectively retired as of the debt reacquisition date.

The debt is no longer owed to a party outside the business combination. Subsequent interest payments are simply intra-entity cash transfers.

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The difficulties encountered in consolidating intra-entity liabilities relate to a specific type of transaction: the purchase of an affiliate’s debt instrument from an outside third party. For example, a subsidiary may have issued bonds in the past that continue to be traded in the open market. If the parent then purchases all or a portion of these outstanding subsidiary bonds in the open market, from a consolidated view, the combined entity (parent and subsidiary) has reacquired its own bonds. Nonetheless, because the companies maintain independent accounting systems, the parent records an Investment in Bonds account as well as periodic interest income. The subsidiary shows the bonds as still outstanding and records periodic interest expense.

Although the individual companies continue to carry both the debt and the investment on their individual financial records, from a consolidation viewpoint, this liability is effectively retired as of the debt reacquisition date. From that date forward, the debt is no longer owed to a party outside the business combination. Subsequent interest payments are simply intra-entity cash transfers.

Acquisition of Affiliate’s Debt from an Outside Party (continued)

If the purchase price equals the corresponding carrying amount of the liability, an affiliate’s bond or note acquired from an unrelated party poses no significant consolidation problems.

Reciprocal balances within the individual records would always be identical in value and easily offset in each subsequent consolidation.

If the cost paid to purchase the debt is more or less than the liability carrying amount on issuing the company’s financial records, this gain or loss must be recognized immediately by the consolidated entity.

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Acquiring an affiliate’s bond or note from an unrelated party poses no significant consolidation problems if the purchase price equals the corresponding carrying amount of the liability. Reciprocal balances within the individual records would always be identical in value and easily offset in each subsequent consolidation.

Realistically, though, such reciprocity rarely occurs when a debt instrument is purchased from a third party. A variety of economic factors typically produce a difference between the price paid for the investment and the carrying amount of the obligation. The debt is originally sold under market conditions at a particular time. Any premium or discount associated with this issuance is then amortized over the life of the bond, creating a continuous adjustment to its carrying amount. The acquisition of this instrument at a later date is made at a price influenced by current economic conditions, prevailing interest rates, and myriad other financial and market factors.

Therefore, the cost paid to purchase the debt could be either more or less than the carrying amount of the liability currently found within the issuing company’s financial records. To the business combination, this difference is a gain or loss because the acquisition effectively retires the bond; the debt is no longer owed to an outside party. For external reporting purposes, this gain or loss must be recognized immediately by the consolidated entity.

Intra-Entity Debt Transactions Example—Alpha and Omega

Alpha Company owns 80 percent interest in Omega Company’s outstanding voting stock.

On January 1, 2015, Omega issued $1 million in 10-year bonds at 9 percent.

Omega sold the bonds at $938,555 to yield an effective interest of 10 percent.

On January 1, 2017, Alpha purchased the bonds back for $1,057,466, with effective interest at 8 percent.

The difference between the $1,057,466 payment and the January 1, 2017, carrying value of the liability must be recognized in the consolidated statements as a gain or loss.

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Assume that Alpha Company possesses an 80 percent interest in the outstanding voting stock of Omega Company. On January 1, 2015, Omega issued $1 million in 10-year bonds paying cash interest of 9 percent annually. Because of market conditions prevailing on that date, Omega sold the debt for $938,555 to yield an effective interest rate of 10 percent per year. Shortly thereafter, the interest rate began to fall, and by January 1, 2017, Omega made the decision to retire this debt prematurely and refinance it at a currently lower rate. To carry out this plan, Alpha purchased all of these bonds in the open market on January 1, 2017, for $1,057,466. This price was based on an effective yield of 8 percent, which is assumed to be in line with the interest rates at the time. The difference between the $1,057,466 payment and the January 1, 2017, carrying amount of the liability must be recognized in the consolidated statements as a gain or loss.

Intra-Entity Debt Transactions Example—Bond Retirement

Alpha paid $110,815 in excess of the recorded liability ($1,057,466 – $946,651) due to periodic amortization, and the consolidated entity must recognize a loss of this amount.

The bond is retired, and no further reporting is necessary by the business combination after January 1, 2017.

Neither company separately accounts for the event in this manner.

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Because Alpha paid $110,815 in excess of the recorded liability ($1,057,466 − $946,651), the consolidated entity must recognize a loss of this amount. After the loss has been acknowledged, the bond is considered to be retired, and no further reporting is necessary by the business combination after January 1, 2017. Despite the simplicity of this approach for consolidation, neither company separately accounts for the event in this manner.

Intra-Entity Debt Transactions Example—After Bond Retirement

Omega retains the $1 million debt balance within its separate financial records and amortizes the remaining discount each year using the effective rate method.

Annual cash interest payments of $90,000 (9 percent) continue to be made.

Alpha records the investment at the historical cost of $1,057,466, an amount that also requires periodic amortization.

Alpha receives the $90,000 interest payments made by Omega.

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Omega retains the $1 million debt balance within its separate financial records and amortizes the remaining discount each year. Annual cash interest payments of $90,000 (9 percent) continue to be made. At the same time, Alpha records the investment at the historical cost of $1,057,466, an amount that also requires periodic amortization. Furthermore, as the owner of these bonds, Alpha receives the $90,000 interest payments made by Omega.

Learning Objective 6-4

Understand that subsidiary preferred stock not owned by the parent is a component of the noncontrolling interest and is initially measured at acquisition-date fair value.

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LO 6-4: Understand that subsidiary preferred stock not owned by the parent is a component of the noncontrolling interest and is initially measured at acquisition-date fair value.

Preferred shares, usually nonvoting, possess certain “preferences” over common shares such as cumulative dividends, participation rights, and sometimes limited voting rights.

Preferred shares are part of the sub’s stockholders’ equity and are treated in consolidation similarly to common shares.

The existence of subsidiary preferred shares does not complicate the consolidation process. The acquisition method values all business acquisitions (whether 100 percent or less acquired) at their full fair values.

Subsidiary Preferred Stock

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Although both small and large corporations routinely issue preferred shares, their presence within a subsidiary’s equity structure adds a new dimension to the consolidation process. What accounting should be made of a subsidiary’s preferred stock and the parent’s payments that are made to acquire these shares?

Recall that preferred shares, although typically nonvoting, possess other “preferences” over common shares such as a cumulative dividend preference or participation rights. Some preferred shares even offer limited voting rights. Regardless, preferred shares are part of the subsidiary’s stockholders’ equity and are treated as such in consolidated financial reports.

The existence of subsidiary preferred shares does little to complicate the consolidation process. The acquisition method measures all business acquisitions (whether 100 percent or less than 100 percent acquired) at their full fair values. In accounting for the acquisition of a subsidiary with preferred stock, the essential process of determining the acquisition-date business fair value of the subsidiary remains intact. Any preferred shares not owned by the parent simply become a component of the noncontrolling interest and are included in the subsidiary business fair-value calculation. The acquisition-date fair value for any subsidiary common and/or preferred shares owned by outsiders becomes the basis for the noncontrolling interest valuation in the parent’s consolidated financial reports.

On January 1, 2017, High Company purchased 80 percent of Low Company’s outstanding common stock and 60 percent of its nonvoting, cumulative, preferred stock, acquiring control.

Low owns land, undervalued in its records by $100,000, and all other assets and liabilities have fair values equal to their book values.

Low’s capital structure prior to acquisition:

Subsidiary Preferred Stock Example

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To illustrate, assume that on January 1, 2017, High Company acquires control over Low Company by purchasing 80 percent of its outstanding common stock and 60 percent of its nonvoting, cumulative, preferred stock. Low owns land undervalued in its records by $100,000, but all other assets and liabilities have fair values equal to their book values.

High paid $1 million for common and $62,400 for preferred stock.

At acquisition date, the 20 percent noncontrolling interest in the common shares had a fair value of $250,000.

The 40 percent preferred stock noncontrolling interest had a fair value of $41,600.

Consolidation entries S and A recognize the noncontrolling interest as the total acquisition-date fair values of $250,000 for common stock and $41,600 for preferred shares.

Subsidiary Preferred Stock—Noncontrolling Interest

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High paid $1 million for the common shares and $62,400 for the preferred shares. On the acquisition date, the 20 percent noncontrolling interest in the common shares had a fair value of $250,000 and the 40 percent preferred stock noncontrolling interest had a fair value of $41,600.

Consolidation entries S and A recognize the noncontrolling interest as the total of acquisition-date fair values of $250,000 for the common stock and $41,600 for the preferred shares.

Learning Objective 6-5

Prepare a consolidated statement of cash flows.

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LO 6-5: Prepare a consolidated statement of cash flows.

Consolidated Statement of Cash Flows

Current accounting standards require that companies include a statement of cash flows among the consolidated financial reports.

Main purpose of the statement of cash flows is to provide information about the entity’s cash receipts and cash payments during a period.

It is also designed to show why an entity’s net income is different from its operating cash flows.

A consolidated statement of cash flows is based on the consolidated balance sheet and consolidated income statement.

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Current accounting standards require that companies include a statement of cash flows among their consolidated financial reports. The main purpose of the statement of cash flows is to provide information about the entity’s cash receipts and cash payments during a period. The statement is also designed to show why an entity’s net income is different from its operating cash flows. For a consolidated entity, the cash flows relate to the entire business combination including the parent and all of its subsidiaries.

The consolidated statement of cash flows is not prepared from the individual cash flow statements of the separate companies. Instead, the consolidated income statements and balance sheets are first brought together on the worksheet.

Acquisition Period Statement of Cash Flow

If a business combination occurs during a particular reporting period, the consolidated cash flow statement must reflect several considerations.

Cash purchases of businesses are an investing activity. The net cash outflow is reported as the amount paid at acquisition.

Adjustment to accrual-based income must reflect only postacquisition amounts for the subsidiary.

Changes in operating balance sheet accounts (accounts receivable, inventory, accounts payable, etc.) must be computed net of the amounts acquired in the combination.

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If a business combination occurs during a particular reporting period, the consolidated cash flow statement must properly reflect several considerations. Cash purchases of businesses are an investing activity. The net cash outflow (cash paid less subsidiary cash acquired) is reported as the amount paid in a business acquisition.

Keeping in mind that the focus is on the consolidated entity’s cash flows (not just the parent’s), consolidated net income is the starting point for the indirect calculation of consolidated operating cash flows. Recall that consolidated net income includes only postacquisition subsidiary revenues and expenses. Therefore, the adjustment to the accrual-based income number must also reflect only postacquisition amounts for the subsidiary.

Any changes in operating balance sheet accounts (accounts receivable, inventory, accounts payable, etc.) must be computed net of the amounts acquired in the combination.

Consolidated Statement of Cash Flows—Adjustments

Adjustments arising from subsidiary’s revenues or expenses (e.g., depreciation, amortization) must reflect only postacquisition amounts.

Proper presentation of cash flows requires no special adjustments for intra-entity transfers.

Subsidiary dividends paid to a noncontrolling interest are a component of cash outflows from financing activities.

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Any adjustments arising from the subsidiary’s revenues or expenses (e.g., depreciation, amortization) must reflect only postacquisition amounts. Intra-entity sales and purchases do not change the amount of cash held by the business combination when viewed as a whole. Because the statement of cash flows is derived from the consolidated balance sheet and income statement, the impact of all transfers is already removed. Therefore, the proper presentation of cash flows requires no special adjustments for intra-entity transfers.

The cash outflow from subsidiary dividends only leaves the consolidated entity when paid to the noncontrolling interest. Thus dividends paid by a subsidiary to its parent do not appear as financing outflows. However, subsidiary dividends paid to the noncontrolling interest are a component of cash outflows from financing activities.

Learning Objective 6-6

Compute basic and diluted earnings per share for a business combination.

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LO 6-6: Compute basic and diluted earnings per share for a business combination.

Consolidated Earnings per Share

If the reporting entity has no dilutive options, warrants, or other convertible items, only basic EPS is presented on the face of the income statement.

If any dilutive convertibles are present, diluted EPS also must be presented.

To compute diluted EPS, combine the effects of any dilutive securities with basic earnings per share.

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If the reporting entity has no dilutive options, warrants, or other convertible items, only basic EPS is presented on the face of the income statement. However, diluted EPS also must be presented if any dilutive convertibles are present. Compute diluted EPS by combining the effects of any dilutive securities with basic earnings per share. Stock options, stock warrants, convertible debt, and convertible preferred stock often qualify as dilutive securities.

Computing Earnings per Share for a Business Combination

The computation of EPS for a business combination follows the general rules.

Consolidated net income attributable to the parent company owners along with the number of outstanding parent shares provides the basis for calculating basic EPS.

Stock warrants, convertible debt, warrants, or options for the parent’s stock that can possibly dilute the reported figure must be included in diluted EPS.

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In most instances, the computation of EPS for a business combination follows the same general pattern. Consolidated net income attributable to the parent company owners along with the number of outstanding parent shares provides the basis for calculating basic EPS. Any convertibles, warrants, or options for the parent’s stock that can possibly dilute the reported figure must be included as described earlier in determining diluted EPS.

Learning Objective 6-7

Demonstrate the accounting effects of subsidiary stock transactions on the parent’s financial records and consolidated financial statements.

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LO 6-7: Demonstrate the accounting effects of subsidiary stock transactions on the parent’s financial records and consolidated financial statements.

Subsidiary Stock Transactions

Account for changes in parent’s ownership interest following FASB ASC (para. 810-10-45-23) guidelines:

Separate adjustments must be recorded to maintain reciprocity between a subsidiary’s stockholders’ equity accounts and a parent’s investment balance.

Changes in parent’s ownership interest, if controlling interest is retained, are accounted for as equity transactions.

The consolidated effects are recorded by the parent as an adjustment to APIC and the investment account.

Not reported as a gain or loss of the consolidated entity.

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Subsidiary stock transactions can alter the level of parent ownership. When a subsidiary subsequently buys or sells its own stock, a nonoperational increase or decrease occurs in the company’s fair and book value. Because the transaction need not involve the parent, the parent’s investment account does not automatically reflect the effect of this change. However, the parent’s percentage ownership of the subsidiary may change. Thus, a separate adjustment must be recorded to maintain reciprocity between the subsidiary’s stockholders’ equity accounts and the parent’s investment balance. The parent reports a change in stockholders’ equity (i.e., Additional Paid-In Capital) for effects from subsidiary stock transactions. GAAP literature states that

[c]hanges in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary shall be accounted for as equity transactions (investments by owners and distributions to owners acting in their capacity as owners). Therefore, no gain or loss shall be recognized in consolidated net income or comprehensive income. The carrying amount of the noncontrolling interest shall be adjusted to reflect the change in its ownership interest in the subsidiary. Any difference between the fair value of the consideration received or paid and the amount by which the noncontrolling interest is adjusted shall be recognized in equity attributable to the parent. [FASB ASC (para. 810-10-45-23)]

Consistent with this view, this textbook treats the effects from subsidiary stock transactions on the consolidated entity as adjustments to Additional Paid-In Capital.