CHAPTER 6

VARIABLE INTEREST ENTITIES, INTRA-ENTITY DEBT,

CONSOLIDATED CASH FLOWS, AND OTHER ISSUES
Chapter Outline
I.

Variable interest entities (VIEs)

A. VIEs typically take the form of a trust, partnership, joint venture, or corporation. In most
cases a sponsoring firm creates these entities to engage in a limited and well-defined set
of business activities. For example, a business may create a VIE to finance the acquisition
of a large asset. The VIE purchases the asset using debt and equity financing, and then
leases the asset back to the sponsoring firm. If their activities are strictly limited and the
asset is pledged as collateral, VIEs are often viewed by lenders as less risky than their
sponsoring firms. As a result, such arrangements can allow financing at lower interest
rates than would otherwise be available to the sponsor.
B. Control of VIEs, by design, sometimes does not rest with its equity holders. Instead,
control is exercised through contractual arrangements with the sponsoring firm who
becomes the "primary beneficiary" of the entity. These contracts can take the form of
leases, participation rights, guarantees, or other residual interests. Through contracting,
the primary beneficiary bears a majority of the risks and receives a majority of the rewards
of the entity, often without owning any voting shares.
C. An entity whose control rests with a primary beneficiary is addressed by FASB ASC
subtopic 810-10 Variable Interest Entities. The following characteristics indicate a
controlling financial interest in a variable interest entity.
1. The power, through voting rights or similar rights, to direct the activities of an entity that
most significantly impact the entitys economic performance.
2. The obligation to absorb the expected losses of the entity if they occur,or
3. The right to receive the expected residual returns of the entity if they occur
The primary beneficiary bears the risks and receives the rewards of a variable interest
entity and is considered to have a controlling financial interest.
D. If a reporting entity has a controlling financial interest in a variable interest entity, it should
include the assets, liabilities, and results of the activities of the variable interest entity its
consolidated financial statements.

Proposed Accounting Standards Update on Variable Interest Entities

In November 2011, the FASB issued a proposed change for evaluating whether an entity
must consolidate a VIE. The proposed accounting standard update, entitled Principal
versus Agent Analysis, would introduce a separate qualitative analysis to determine
whether a reporting entity with the authority to make economic decisions for a VIE uses its
power in a principal or agent capacity. If the decision making party is a principal (rather
than an agent of another party) then it is the controlling party. Alternatively, if the party that
exercises decision-making power acts in the capacity of an agent, under the proposed
guidance that party would not consolidate the VIE. As this latest FASB proposal
demonstrates, the manner in which control is assessed continues to evolve over time.

II. Intra-entity debt transactions

A. No special difficulty is created when one member of a business combination loans money
to another. The resulting receivable/payable accounts as well as the interest income
expense balances are identical and can be directly offset in the consolidation process.
B. The acquisition of an affiliate's debt instrument from an outside party does require special
handling so that consolidated financial statements can be produced.
1. Because the acquisition price will usually differ from the book value of the liability, a
gain or loss has been created which is not recorded within the individual records of
either company.
2. Because of the amortization of any associated discounts and/or premiums, the interest
income reported by the buyer will not equal the interest expense of the debtor.
C. In the year of acquisition, the consolidation process eliminates intra-entity accounts (the
liability, the receivable, interest income, and interest expense) while the gain or loss (which
produced all of the discrepancies because of the initial difference) is recognized.
1. Although several alternatives exist, this textbook assigns all income effects resulting
from the retirement to the parent company, the party ultimately responsible for the
decision to reacquire the debt.
2. Any noncontrolling interest is, therefore, not affected by the adjustments utilized to
consolidate intra-entity debt.
D. Even after the year of retirement, all intra-entity accounts must be eliminated again in each
subsequent consolidation. However, when the parent uses the equity method, the
parents Investment in Subsidiary account is adjusted in consolidation rather than a gain or
loss account. If the parent employs a non-equity method, then the parents Retained
Earnings are adjusted for the prior years income net effects of the effective gain/loss on
retirement.
1. The change in retained earnings is needed because a gain or loss was created in a
prior year by the retirement of the debt, but only interest income and interest expense
were recognized by the two parties.
2. The adjustment to retained earnings at any point in time is the original gain or loss
adjusted for the subsequent amortization of discounts or premiums.
III. Subsidiary preferred stock
A. Subsidiary preferred shares not owned by the parent are a part of noncontrolling interest.
B. The fair value of any subsidiary preferred shares not acquired by the parent is added to
the consideration transferred along with the fair value of the noncontrolling interest in
common shares to compute the acquisition-date fair value of the subsidiary.
IV. Consolidated statement of cash flows
A. Statement is produced from consolidated balance sheet and income statement and not
from the separate cash flow statements of the component companies.
B. Intra-entity cash transfers are omitted from this statement because they do not occur with
an outside, unrelated party.
C. The "Noncontrolling Interest's Share of the Subsidiary's Income'' is not included as a cash
flow. Dividends paid by the subsidiary to these outside owners are reported as a financing
activity.

V. Consolidated earnings per share

A. This computation normally follows the pattern described in intermediate accounting
textbooks. For basic EPS, consolidated net income is divided by the weighted-average
number of parent shares outstanding. If convertibles (such as bonds or warrants) exist for
the parent shares, their weight must be included in computing diluted EPS but only if
earnings per share is reduced.
1. The subsidiary's diluted earnings per share are computed first to arrive at (1) an
earnings figure and (2) a shares figure.
2. The portion of the shares figure belonging to the parent is computed. That percentage
of the subsidiary's diluted earnings is then added to the parent's income in order to
complete the earnings per share computation.
VI. Subsidiary stock transactions
A. If the subsidiary issues new shares of stock or reacquires its own shares as treasury
stock, a change is created in the book value underlying the parent's investment account.
The increase or decrease should be reflected by the parent as an adjustment to this
balance.
B. The book value of the subsidiary that corresponds to the parent's ownership is measured
before and after the transaction with any alteration recorded directly to the investment
account. The parent's additional paid-in capital (or retained earnings) account is normally
adjusted although the recognition of a gain or loss is an alternate accounting treatment.
C. Treasury stock acquired by the subsidiary may also necessitate a similar adjustment to the
parent's investment account. In addition, any subsidiary treasury stock is eliminated within
the consolidation process.

Answer to Discussion Question: Who Lost this $300,000?

This case is designed to give life to a theoretical accounting issue: If a subsidiary's debt is retired,
should the resulting gain or loss be assigned to the parent or to the subsidiary? The case
illustrates that there is no clear-cut solution. This lack of an absolute answer makes financial
accounting both intriguing and frustrating.
The assignment decision is only necessary in the presence of a noncontrolling interest.
Regardless of the ownership level all intra-entity balances are eliminated on the worksheet with a
gain or loss recognized. Not until the consolidated net income is allocated across the controlling
interest and the noncontrolling interest does the assignment decision have an impact.
We assume that financial and operating decisions are made in the best interest of the business
entity as a whole. This debt would not have been retired unless corporate officials believed that
Penston/Swansan would benefit from the decision. Thus, an argument can be made against any
assignment to either separate party.
Students should choose and justify one method. Discussion often centers on the following:

Parent company officials made the actual choice that created the book loss. Therefore,
assigning the $300,000 to the subsidiary directs the impact of their decision to the wrong
party. In effect, the subsidiary had nothing to do with this transaction (as indicated in the case)
so that its share of consolidated net income should not be affected by the $300,000 loss.

The debt was that of the subsidiary. Because the subsidiary's debt is being retired, all of the
$300,000 should be attributed to that party. Financial records measure the results of
transactions and the retirement simply culminates an earlier transaction made by the
subsidiary. The parent is doing no more than acting as an agent for the subsidiary (as
indicated in the case). If the subsidiary had acquired its own debt, for example, no question as
to the assignment would have existed. Thus, changing that assignment simply because the
parent agreed to be the acquirer is not justified.
Both parties were involved in the transaction so that some allocation of the loss is required. If,
at the time of repurchase, a discount existed within the subsidiary's accounts, this figure would
have been amortized to interest expense (if the debt had not been retired). Thus, the
$300,000 loss was accepted now in place of the later amortization. This reasoning then
assigns this portion of the loss to the subsidiary. Because the parent agreed to pay more than
face value, that remaining portion is assigned to the buyer.

Source: Advanced Accounting, Hoyle 11th ed. Instructors Manual