Chapter Six

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

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 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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 Variable Interest Entities (VIEs)
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
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Variable Interest Entities (VIEs)
Examples of Variable Interests

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 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 VIEs activities are
strictly limited
Equity investors may serve simply to allow the VIE to
function as a legal entity

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 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 VIEs 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 VIEs debt,
assuming the risk of default.

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 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.
Sponsors economic interest vary depending on the VIEs
success Hence the term variable interest entity.

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 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 entitys economic performance.
Obligation to absorb significant losses of the entity.
Right to receive significant benefits of the entity.

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 Benefit of VIEs

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 VIEs creditor(s) from the
overall risk of the sponsor.

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 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.
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 Variable Interest Entity - Example

An outside investor provides $16 million in exchange

for a 100% nonvoting equity interest in Power Finance.
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.
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 Variable Interest Entity - Example

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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 Consolidation of VIEs

Similar to other combinations, valuation of assets,

liabilities, and noncontrolling interest should be based
on Fair Value.

When a VIEs total When a VIEs total

business fair value is business fair value is
less than its assessed net greater than its assessed net
asset value, a GAIN is asset value, Goodwill is
recognized. reported.

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 Disclosure Requirements
In Footnotes of ALL VIE Interests

Nature, purpose, size, & activities of the VIE

Significant judgments made Nature of restrictions on

in determining the need to assets and settlement of
consolidate a VIE or disclose liabilities, and the related
any involvement carrying value

Nature of risks, and how a VIE affects the financial position,

performance and cash flows of a Primary Beneficiary

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VIEs and International Standards
In May 2011, the
International Accounting
Standards Board issued
IFRS 10 - Consolidated
Financial Statements and
IFRS 12 - Disclosure of
Interests in Other Entities.
The standards include a
new definition of control
designed 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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 Learning Objective 6-2

Demonstrate the consolidation

procedures to eliminate all intra-entity
debt accounts and recognize any
associated gain or loss created
whenever one company acquires an
affiliates debt instrument from an
outside party.
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 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
despite their differing balances.
Corresponding receivable and payable and revenue
and interest from the consolidated financial
statements must be eliminated.
Gain/loss on effective retirement of the debt must be
recognized in the consolidated statements.

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Intra-Entity Debt Transactions - Example

Assume Alpha owns 80% of Omega.

On 1/1/12, Omega issued $1 million in 10-year bonds
at 9%.
Omega issued the bonds at $938,555, with effective
interest at 10%.
On 1/1/14, Alpha purchased the bonds for $1,057,466,
with effective interest at 8%.

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Intra-Entity Debt Transactions -
Example

Book value of Omega Companys bonds as of

December 31, 2013, the date immediately before the
day Alpha Company acquired the bonds

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 Intra-Entity Debt Transactions -
Example
Omega Companys bonds have been effectively retired. The
difference between the $1,057,466 payment and the January 1,
2014, carrying value of the liability must be recognized in the
consolidated statements as a gain or loss.

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. Then, the bond is retired and no further
reporting is necessary by the business combination after
January 1, 2014.

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 Intra-Entity Debt Transactions -
Example
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.
Alpha receives the $90,000 interest payments made by Omega.
To organize the accountants approach to this consolidation,
the subsequent financial recording made by each company is
analyzed.

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 Intra-Entity Debt Transactions -
Example
Omega records only two journal entries during 2014
assuming interest is paid each December 31to record the
interest expense cash payment and discount on bonds
payable.

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Intra-Entity Debt Transactions -
Example
In 2014, Alpha records its investment in
Omegas bonds and the interest income.

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 Intra-Entity Debt Transactions -
Example
To convert information from the individual companies to the
perspective of a single economic entity, we extinguish the debt (it is
no longer owed to a third-party). Any gains/losses are attributed to
the parent, thus, there is no effect on Noncontrolling Interest.

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 Intra-Entity Debt Transactions -
Example
Subsequent Years - Initial Value or Partial Equity Method
Adjust the BVs 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.

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 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.

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 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.

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 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 subs 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.
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Subsidiary Preferred Stock - Example -
The consolidation entry made in the year of
acquisition is shown below:

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Learning Objective 6-4

Prepare a consolidated
statement of cash flows.

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 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 entitys 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.

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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.

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 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:
Add back the noncontrolling interests share of the
subs net income.
Deduct dividends paid to the outside owners as cash
outflow.
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 Learning Objective 6-5

Compute basic and diluted

earnings per share for a
business combination.

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 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 parents
stock that can possibly dilute the reported figure must be
included in diluted EPS.

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 Consolidated Earnings Per Share
If potentially dilutive items exist on the subs
individual statements, then the portion of the
subs net income included in consolidated net
income may not be appropriate for the
computation of consolidated earnings per share.

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 Consolidated Earnings Per Share

Compute the subs 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.

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 Learning Objective 6-6

Demonstrate the accounting effects of

subsidiary stock transactions on
parents financial records and
consolidated financial statements.

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 Subsidiary Stock Transactions

A parents ownership percentage may be affected by

a subsidiarys 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.

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