Chapter Six Intercompany Debt, Consolidated Statement of Cash Flows and Other Issues McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Variable Interest Entities 6-2 Established as a separate business structure Trust Joint Venture Partnership Corporation Frequently has neither independent management nor employees Typical purposes Transfers of financial assets Leasing Hedging financial instruments Research and development

Benefit of VIE’s Low-cost financing of asset purchases 6-3 Low-cost financing of asset purchases A business sponsors VIE to purchase and finance asset acquisition The VIE leases the asset to the sponsor VIE often eligible for lower interest rate Why? VIE operates with limited assets This “asset isolation” separates the VIE’s creditor(s) from the overall risk of the sponsor. Also, limited activities of the VIE reduce risk.

Examples of Variable Interests 6-4

Variable Interest Entities – FIN 46R 6-5 Although most VIE’s were established for legitimate business purposes, abuses occurred, particularly in avoiding consolidated disclosure FIN 46R, issued in December 2003, was designed to ensure appropriate accounting for these entities FIN 46R provides a broader concept of control for purposes of producing consolidated financial statements

Variable Interest Entities – FIN 46R 6-6 Controlling financial interest on the part of a “primary beneficiary” is deemed to exist when the following characteristics are present: The direct or indirect ability to make decisions about the entity’s activities The obligation to absorb any expected losses of the entity The right to receive any expected residual returns of the entity (When these are present, consolidated financial statements must be produced!)

Variable Interest Entity - Example 6-7 As long as the VIE stays independent, an effective transfer of risk results. VIE’s are generally consolidated. Sponsor Company VIE Asset is leased to Sponsor. An asset is acquired for low cost. The VIE recognizes revenues.

Variable Interest Entities 6-8 Technically, the equity investors control the VIE. However, often the equity investors cede control to the variable interest parties in exchange for a guaranteed return.

Procedures for Consolidation of VIE’s 6-9 Valuations of assets, liabilities, and noncontrolling interest should be based on FV As in a regular business combination either goodwill or a gain on bargain purchase typically will be recognized when consolidating a VIE.

FIN 46R – Definition of a business 6-10 “A self-sustaining integrated set of activities and assets conducted and managed for the purpose of providing a return to investors.” A business consists of Inputs Processes applied to those inputs Resulting outputs used to generate revenues

FIN 46 Disclosure Requirements – In Footnotes of Primary Beneficiary 6-11 Carrying amount of consolidated assets pledged as collateral by the Primary Beneficiary Nature, purpose, size, & activities of the VIE Classification of consolidated assets pledged as collateral by the Primary Beneficiary Lack of recourse if creditors (or beneficial interest holders) of the VIE have no recourse to the general credit of the Primary Beneficiary.

FIN 46 Disclosure Requirements – In Footnotes of non-primary Beneficiaries 6-12 Nature of involvement with the VIE Nature, purpose, size, & activities of the VIE When involvement with the VIE began Maximum exposure to loss as a result of involvement with the VIE.

Intercompany Debt Transactions 6-13 Direct loans between affiliated parties create no special consolidation problems. Eliminate the corresponding receivable and payable from the consolidated financial statements. Also eliminate the effects of any related interest. 2

Acquisition of Affiliate’s Debt from an Outside Party 6-14 Parent In effect, the Sub has issued the debt indirectly to the Parent. How should this be accounted for? (3) Investors sell the bonds to the parent company. (1) 80% Ownership Sub (2) Assume the Sub issued bonds to outside investors. 3

Acquisition of Affiliate’s Debt from an Outside Party 6-15 The acquired debt must be treated as if it has been extinguished. Any related gain or loss related to this “early extinguishment of debt” must be immediately recognized by the consolidated entity. 3

Acquisition of Affiliate’s Debt from an Outside Party 6-16

Acquisition of Affiliate’s Debt from an Outside Party 6-17

Acquisition of Affiliate’s Debt from an Outside Party 6-18

Acquisition of Affiliate’s Debt from an Outside Party 6-19 Entry B This entry is made at the end of the year that the debt is “extinguished” We will assume that any gains/losses from this transaction belong to the parent. Thus, there will be no effect on Noncontrolling Interest.

Acquisition of Affiliate’s Debt from an Outside Party 6-20 Entry *B (Subsequent Years) Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization. Also, the loss is now reflected in R/E, which must also be adjusted for the difference in interest amounts.

Acquisition of Affiliate’s Debt from an Outside Party 6-21 Entry *B (Subsequent Years) Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization. Also, the loss is now reflected in R/E, which must also be adjusted for the difference in interest amounts. Note that, over the remaining life of the bonds, the book values will eventually converge to the point where the adjustment to R/E will be completely amortized.

Subsidiary Preferred Stock 6-22 The treatment of subsidiary preferred stock in the consolidated financial does little to complicate the consolidation process. Subsidiary preferred shares not owned by the parent are a component of the noncontrolling interest. Subsidiary preferred shares owned by the parent are eliminated in consolidation against the Investment in Preferred Stock account. 4

Consolidation in the Presence of Subsidiary Preferred Stock 6-23

Consolidation in the Presence of Subsidiary Preferred Stock 6-24

Consolidation in the Presence of Subsidiary Preferred Stock 6-25

Consolidated Statement of Cash Flows 6-26 The consolidated statement of cash flows is based on the consolidated balance sheet and the consolidated income statement. 11

Consolidated Statement of Cash Flows 6-27 Noncontrolling Interest Deduct dividends paid to the outside owners as a cash outflow from financing activities. 12

Consolidated Statement of Cash Flows 6-28 Amortization Add any amortizations of excess acquisition-date FV allocations to consolidated net income in computing cash flows from operating activities. 13

Consolidated Statement of Cash Flows 6-29 Intercompany Transactions Intercompany cash flows should not be included on the statement of cash flows. The intercompany cash flows are already eliminated from the balance sheet, so no additional effects appear on the statement of cash flows. 14

Consolidated Statement of Cash Flows When a business combination occurs in the current period: Any changes in operating assets and liabilities are reported net of effects of acquired businesses in computing the necessary adjustments to convert consolidated net income to operating cash flows. Any adjustments arising from the subsidiary’s revenues or expenses (e.g., depreciation, amortization) must reflect only post-acquisition amounts. Acquired in-process research and development costs are not considered cash outflows from operating activities. Therefore, the expense is added back to consolidated net income in determining cash flows from operating activities. Any cash payments for acquired in-process r&d are classified as investing activities.

Consolidated Earnings Per Share 6-31 If potentially dilutive items exist on the sub’s own financial 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. 15

Consolidated Earnings Per Share 6-32 Compute the sub’s own diluted EPS. The earnings used in the above computation are used in the determination of consolidated EPS. The portion assigned to the computation is based on the % of the sub owned by the parent. ? 16

Subsidiary Stock Transactions 6-33 The effects on a parent of a subsidiary’s transactions in its own stock Reported as adjustments to APIC Not reported as a gain or loss of the consolidated entity

Summary 6-34 Variable Interest Entities are created to fulfill special purposes. Often, control of these entities resides in contractual arrangements rather than voting rights. FIN 46R requires consolidation when a business has a controlling financial interest in a VIE. When one member of a combination acquires the debt of another, the debt is effectively retired. Subsidiary preferred stock not owned by the parent is considered part of the noncontrolling interest. EPS calculations exclude any income attributable to the noncontrolling interest. The preparation of a consolidated statement of cash flows requires special adjustments in the period a subsidiary is acquired for Changes in operating asset and liability accounts Acquired in-process research and development

Possible Criticisms 6-35 There are at least four theoretical approaches to assigning the gains or losses created by the early retirement of subsidiary debt: One approach is to assume that only the debtor is affected by the retirement A second approach is to assign them to the investor A third approach is to split the assignment between the debtor and investor Finally, a fourth approach says to assign them entirely to the parent (investor) WHAT DO YOU THINK????