Chapter Six Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education 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 6-2 Variable Interest Entities (VIE’s) Known as Special Purpose Entities (SPE) Established as a separate business structure – – – – Trust Joint Venture Partnership Corporation Frequently has neither independent management nor employees Typical purposes – – – – – help finance their operations at favorable rates Transfers of financial assets Leasing Hedging financial instruments Research and development Off-balance sheet financing 6-3 Variable Interest Entities (VIE’s) Examples of Variable Interests 6-4 Variable Interest Entities Characteristics of VIEs: Most established for legitimate business purposes Some created to avoid consolidated disclosure Generally have assets, liabilities, and investors with equity interests Role of equity investors can be minor if VIE’s activities are strictly limited Equity investors may serve simply to allow the VIE to function as a legal entity 6-5 Variable Interest Entities Characteristics continued VIEs bear relatively low economic risk, therefore equity investors are provided a small rate of return Another party (often the sponsoring firm that benefits from the VIE’s activities) contributes substantial resources – loans and/or guarantees – to enable a VIE to secure financing needed to accomplish its purpose The sponsoring firm may guarantee the VIE’s debt, assuming the risk of default 6-6 Variable Interest Entities Characteristics continued Contractual arrangements limit returns to equity holders yet participation rights provide increased profit potential and risks to sponsor Risks and rewards are not distributed according to stock ownership but by other variable interests Sponsor’s economic interest vary depending on the VIE’s success – Hence the term variable interest entity 6-7 Variable Interest Entities FASB standard FIN 46R3 requires the primary beneficiary (regardless of their ownership) to consolidate the VIE Who is the “primary beneficiary”? The firm that has the: –Power to direct the activities of the VIE that significantly impact the entity’s economic performance –Obligation to absorb significant losses of the entity –Right to receive significant benefits of the entity 6-8 Benefit of VIE’s A business sponsors a VIE to purchase and finance asset acquisition – The VIE leases the asset to the sponsor – VIE is often eligible for lower interest rate The VIE has limited assets This “asset isolation” and limited activity separates the VIE’s creditor(s) from the overall risk of the sponsor 6-9 Variable Interest Entity - Example Assume 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 To take advantage of lower interest rates, Twin Peaks creates Power Finance Co 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 6-10 Intra-Entity Debt Transactions Example Subsequent Years - Initial Value or Partial Equity Method Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization with Entry *B Also, the loss is now reflected in R/E, which must be adjusted for the difference in interest amounts 6-25 Intra-Entity Debt Transactions Example Subsequent Years –Equity Method When the parent applies the equity method, no adjustment to Retained Earnings is needed In this one case, the $100,747 debit in Entry *B is made to the Investment in Omega Company (instead of Retained Earnings) because the loss has become a component of that account 6-26 Learning Objective 6-3 Understand that subsidiary preferred stocks not owned by the parent are a component of the noncontrolling interest and are initially measured at acquisition-date fair value 6-27 Subsidiary Preferred Stock Preferred stock, 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, treated in consolidation similarly to common 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 6-28 Subsidiary Preferred Stock - Example The consolidation entry made in the year of acquisition is shown below: 6-29 Learning Objective 6-4 Prepare a consolidated statement of cash flows 6-30 Consolidated Statement of Cash Flows 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 consolidated statement of cash flows is based on the consolidated balance sheet and the consolidated income statement 6-31 Consolidated Statement of Cash Flows Intra-entity Transactions Intra-entity cash flows should not be included on the statement of cash flows The intra-entity cash flows are already eliminated from the balance sheet, so no additional effects appear on the statement of cash flows 6-32 Consolidated Statement of Cash Flows In the year of acquisition: The net cash outflow to acquire the subsidiary is reported (cash paid less subsidiary cash acquired) Any amounts acquired are not included in the increase or decrease of balance sheet accounts In all years: share of the sub’s net income Add back the noncontrolling interest’s Deduct dividends paid to the outside owners as cash outflow 6-33 Learning Objective 6-5 Compute basic and diluted earnings per share for a business combination 6-34 Consolidated Earnings Per Share 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 Any convertibles, warrants, or options for the parent’s stock that can possibly dilute the reported figure must be included in diluted EPS 6-35 Consolidated Earnings Per Share If potentially dilutive items exist on the sub’s individual statements, then the portion of the sub’s net income included in consolidated net income may not be appropriate for the computation of consolidated earnings per share 6-36 Consolidated Earnings Per Share Compute the sub’s own diluted EPS The earnings used in the computation are used in the determination of consolidated EPS The portion assigned to the computation is based on the percent of the subsidiary owned by the parent 6-37 Learning Objective 6-6 Demonstrate the accounting effects of subsidiary stock transactions on parent’s financial records and consolidated financial statements 6-38 Subsidiary Stock Transactions A parent’s ownership percentage may be affected by a subsidiary’s transactions in its own stock (additional issuances, or the purchase or treasury stock) The effects on the consolidated entity 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 6-39 ... of a Primary Beneficiary 6-14 VIE’s and International Standards In May 2011, the International Accounting Standards Board issued IFRS 10 Consolidated Financial Statements and IFRS 12 - The standards... Prepare a consolidated statement of cash flows 6-30 Consolidated Statement of Cash Flows Current accounting standards require that companies include a statement of cash flows among their consolidated