© The McGraw-Hill Companies, Inc., 2007 Slide 6-1 McGraw-Hill/Irwin Chapter Six Variable Interest Entities, Intercompany Debt, Consolidated Cash Flows, and Other Issues

© The McGraw-Hill Companies, Inc., 2007 Slide 6-2 McGraw-Hill/Irwin Variable Interest Entities 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

© The McGraw-Hill Companies, Inc., 2007 Slide 6-3 McGraw-Hill/Irwin Examples of Variable Interests Exh. 6-1

© The McGraw-Hill Companies, Inc., 2007 Slide 6-4 McGraw-Hill/Irwin Variable Interest Entities – FIN 46R 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

© The McGraw-Hill Companies, Inc., 2007 Slide 6-5 McGraw-Hill/Irwin Variable Interest Entities – FIN 46R 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!)

© The McGraw-Hill Companies, Inc., 2007 Slide 6-6 McGraw-Hill/Irwin Variable Interest Entity - Example As long as the VIE stays independent, an effective transfer of risk results. VIE’s are generally consolidated. As long as the VIE stays independent, an effective transfer of risk results. VIE’s are generally consolidated. An asset is acquired for low cost. Asset is leased to Sponsor. Sponsor Company VIE The VIE recognizes revenues.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-7 McGraw-Hill/Irwin Variable Interest Entities 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.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-8 McGraw-Hill/Irwin Procedures for Consolidation of VIE’s Valuations of assets, liabilities, and noncontrolling interest should be based on FV, except for two notable exceptions. 1. Assets transferred to the VIE from the Primary Beneficiary, should be measured as if they had never been transferred.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-9 McGraw-Hill/Irwin Procedures for Consolidation of VIE’s Valuations of assets, liabilities, and noncontrolling interest should be based on FV, except for two notable exceptions. 2. SFAS 141 requires allocation of the “cost” of an investment to the underlying assets and liabilities. Since no “cost” exists with a VIE, an IMPLIED VALUE should be used to substitute for the acquisition cost.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-10 McGraw-Hill/Irwin Procedures for Consolidation of VIE’s When the implied value of the VIE is less than the assessed fair values of the assets, then the assets are proportionately reduced.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-11 McGraw-Hill/Irwin Procedures for Consolidation of VIE’s When the implied value of the VIE exceeds the assessed fair values of the assets, the difference is reported as a)Goodwill (if the VIE is a business) b)An extraordinary loss (if the VIE is not “a business”) When the implied value of the VIE exceeds the assessed fair values of the assets, the difference is reported as a)Goodwill (if the VIE is a business) b)An extraordinary loss (if the VIE is not “a business”)

© The McGraw-Hill Companies, Inc., 2007 Slide 6-12 McGraw-Hill/Irwin FIN 46R – Definition of a business “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

© The McGraw-Hill Companies, Inc., 2007 Slide 6-13 McGraw-Hill/Irwin FIN 46 Disclosure Requirements – In Footnotes of Primary Benificiary Nature, purpose, size, & activities of the VIE Carrying amount of consolidated assets pledged as collateral by the Primary Beneficiary 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.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-14 McGraw-Hill/Irwin FIN 46 Disclosure Requirements – In Footnotes of non-primary Beneficiaries Nature, purpose, size, & activities of the VIE Nature of involvement with the VIE When involvement with the VIE began Maximum exposure to loss as a result of involvement with the VIE.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-15 McGraw-Hill/Irwin Intercompany Debt Transactions 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.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-16 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party (1) 80% Ownership Parent Sub (2) Assume the Sub issued bonds to outside investors. 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.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-17 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party The acquired debt must be treated as if it has been extinguished. Any related loss related to this “early extinguishment of debt” is recorded in the consolidated financial statements in the year of acquisition. (see APB Opinion 26) If material, the loss is treated as an extraordinary item. The acquired debt must be treated as if it has been extinguished. Any related loss related to this “early extinguishment of debt” is recorded in the consolidated financial statements in the year of acquisition. (see APB Opinion 26) If material, the loss is treated as an extraordinary item.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-18 McGraw-Hill/Irwin Big owns 90% of Little. On 1/1/06, Little issued $2 million of 6%, 10-year bonds. The current carrying amount on Little’s books at 1/1/07 is: Bonds Payable = $2,000,000 Bond Discount = $161,043 Carrying Amount = $1,838,957 On 1/2/07, Big decides to re-purchase Little’s bonds from the market, effectively extinguishing the debt. Big owns 90% of Little. On 1/1/06, Little issued $2 million of 6%, 10-year bonds. The current carrying amount on Little’s books at 1/1/07 is: Bonds Payable = $2,000,000 Bond Discount = $161,043 Carrying Amount = $1,838,957 On 1/2/07, Big decides to re-purchase Little’s bonds from the market, effectively extinguishing the debt. Acquisition of Affiliate’s Debt from an Outside Party Continue

© The McGraw-Hill Companies, Inc., 2007 Slide 6-19 McGraw-Hill/Irwin On 1/2/07, the market rate is 5%, and Big pays $2,101,514 for the bonds. Since Little’s carrying value is $1,838,957, there is an effective loss of $262,557 to be recorded by the consolidated entity. At 12/31/07, the consolidated entity must:  Record the loss of $262,557  Eliminate the related intercompany debt at BV  Eliminate the intercompany interest On 1/2/07, the market rate is 5%, and Big pays $2,101,514 for the bonds. Since Little’s carrying value is $1,838,957, there is an effective loss of $262,557 to be recorded by the consolidated entity. At 12/31/07, the consolidated entity must:  Record the loss of $262,557  Eliminate the related intercompany debt at BV  Eliminate the intercompany interest Acquisition of Affiliate’s Debt from an Outside Party Continue

© The McGraw-Hill Companies, Inc., 2007 Slide 6-20 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party 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. 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.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-21 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party 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. 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.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-22 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party 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. 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.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-23 McGraw-Hill/Irwin The treatment of subsidiary preferred stock in the consolidated financial statements depends on whether the shares are viewed as: Debt or Equity The parent’s acquisition of the preferred stock is accounted for in a manner similar to the accounting for the parent’s acquisition of the subsidiary’s bonds. The treatment of subsidiary preferred stock in the consolidated financial statements depends on whether the shares are viewed as: Debt or Equity The parent’s acquisition of the preferred stock is accounted for in a manner similar to the accounting for the parent’s acquisition of the subsidiary’s bonds. Subsidiary Preferred Stock

© The McGraw-Hill Companies, Inc., 2007 Slide 6-24 McGraw-Hill/Irwin Preferred Stock Treated as a Debt Instrument Preferred Stock is treated as if it were debt when it has no rights other than a cumulative dividend. Two entries are required to eliminate the preferred stock: Preferred Stock is treated as if it were debt when it has no rights other than a cumulative dividend. Two entries are required to eliminate the preferred stock: The first entry eliminates the preferred stock purchased by the parent, just as if it were retired.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-25 McGraw-Hill/Irwin Preferred Stock Treated as a Debt Instrument Preferred Stock is treated as if it were debt when it has no rights other than a cumulative dividend. Two entries are required to eliminate the preferred stock: Preferred Stock is treated as if it were debt when it has no rights other than a cumulative dividend. Two entries are required to eliminate the preferred stock: The second entry recognizes the noncontrolling interest in the preferred stock. The amount assigned to the noncontrolling interest is based on the call price.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-26 McGraw-Hill/Irwin On 2/1/07, Liberty Corporation acquires 60% of American News, Inc. Liberty pays $43,400,000 for 700,000 shares of ANI’s common stock (1,000,000 shares outstanding). Liberty pays $3,210,000 for 30,000 shares of ANI’s $100 par preferred stock (50,000 shares outstanding). The preferred stock has a call price of 109 and is viewed as Debt. Prepare the December 31, 2007 consolidation entries. On 2/1/07, Liberty Corporation acquires 60% of American News, Inc. Liberty pays $43,400,000 for 700,000 shares of ANI’s common stock (1,000,000 shares outstanding). Liberty pays $3,210,000 for 30,000 shares of ANI’s $100 par preferred stock (50,000 shares outstanding). The preferred stock has a call price of 109 and is viewed as Debt. Prepare the December 31, 2007 consolidation entries. Preferred Stock Treated as a Debt Instrument Continue

© The McGraw-Hill Companies, Inc., 2007 Slide 6-27 McGraw-Hill/Irwin Preferred Stock Treated as a Debt Instrument First Entry Eliminate Liberty’s investment in the preferred stock. The preferred stock is eliminated at cost. First Entry Eliminate Liberty’s investment in the preferred stock. The preferred stock is eliminated at cost. ?

© The McGraw-Hill Companies, Inc., 2007 Slide 6-28 McGraw-Hill/Irwin Preferred Stock Treated as a Debt Instrument First Entry Eliminate Liberty’s investment in the preferred stock. The preferred stock is eliminated at cost. First Entry Eliminate Liberty’s investment in the preferred stock. The preferred stock is eliminated at cost.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-29 McGraw-Hill/Irwin Preferred Stock Treated as a Debt Instrument Second Entry Recognize the noncontrolling interest in the preferred stock. Base it on the 109 call price. Second Entry Recognize the noncontrolling interest in the preferred stock. Base it on the 109 call price. ?

© The McGraw-Hill Companies, Inc., 2007 Slide 6-30 McGraw-Hill/Irwin Preferred Stock Treated as a Debt Instrument Second Entry Recognize the noncontrolling interest in the preferred stock. Base it on the 109 call price. Second Entry Recognize the noncontrolling interest in the preferred stock. Base it on the 109 call price.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-31 McGraw-Hill/Irwin So, what do we do when the Preferred Stock is viewed as Equity?

© The McGraw-Hill Companies, Inc., 2007 Slide 6-32 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity 2. The preferred stock is eliminated in the same way as common stock. 1. The purchase price in excess of book value of the preferred stock is allocated to specific accounts. When preferred stock is viewed as equity...

© The McGraw-Hill Companies, Inc., 2007 Slide 6-33 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity Preferred Stock is often viewed as Equity when it has rights other than a cumulative dividend, often including a conversion feature or participation rights. The 1 st entry eliminates the preferred stock book value from the subsidiary’s numbers.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-34 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity Preferred Stock is often viewed as Equity when it has rights other than a cumulative dividend, often including a conversion feature or participation rights. The 2 nd entry recognizes the portion of the acquisition cost allocated to assets.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-35 McGraw-Hill/Irwin On 2/1/07, Liberty Corporation acquires 60% of American News, Inc. Liberty pays $43,400,000 for 700,000 shares of ANI’s common stock (1,000,000 shares outstanding). Liberty pays $3,210,000 for 30,000 shares of ANI’s $100 par preferred stock (50,000 shares outstanding). The preferred stock has a call price of 109 and is viewed as Equity. On 2/1/07, Liberty Corporation acquires 60% of American News, Inc. Liberty pays $43,400,000 for 700,000 shares of ANI’s common stock (1,000,000 shares outstanding). Liberty pays $3,210,000 for 30,000 shares of ANI’s $100 par preferred stock (50,000 shares outstanding). The preferred stock has a call price of 109 and is viewed as Equity. Subsidiary Preferred Stock Viewed as Equity Continue

© The McGraw-Hill Companies, Inc., 2007 Slide 6-36 McGraw-Hill/Irwin ANI’s preferred stock participates in 10% of the annual income. ANI’s book value on 2/1/07 is $46 million. The book value includes: Subsidiary Preferred Stock Viewed as Equity Continue

© The McGraw-Hill Companies, Inc., 2007 Slide 6-37 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity Continue First, determine how much of ANI’s book value should be assigned to the preferred stock. In this case it is $5,200,000.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-38 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity Continue Second, determine Goodwill related to Liberty’s acquisition of 60% of ANI’s preferred stock. Assume that ANI has Land worth $100,000.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-39 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity ? Consolidation Entry PS Eliminate Liberty’s investment in ANI’s preferred stock. The preferred stock is eliminated at cost. Consolidation Entry PS Eliminate Liberty’s investment in ANI’s preferred stock. The preferred stock is eliminated at cost.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-40 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity Consolidation Entry PS Eliminate Liberty’s investment in ANI’s preferred stock. The preferred stock is eliminated at cost. Consolidation Entry PS Eliminate Liberty’s investment in ANI’s preferred stock. The preferred stock is eliminated at cost.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-41 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity ? Consolidation Entry A1 Set up the land and the goodwill. Consolidation Entry A1 Set up the land and the goodwill.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-42 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity Consolidation Entry A1 Set up the land and the goodwill. Consolidation Entry A1 Set up the land and the goodwill.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-43 McGraw-Hill/Irwin Consolidated Statement of Cash Flows consolidated consolidated The consolidated statement of cash flows is based on the consolidated balance sheet and the consolidated income statement.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-44 McGraw-Hill/Irwin Noncontrolling Interest Add back the noncontrolling interest’s share of the sub’s net income. Deduct dividends paid to the outside owners as a cash outflow. Noncontrolling Interest Add back the noncontrolling interest’s share of the sub’s net income. Deduct dividends paid to the outside owners as a cash outflow. Consolidated Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2007 Slide 6-45 McGraw-Hill/Irwin Amortization Add any amortizations and FV allocations to Consolidated Net Income. Amortization Add any amortizations and FV allocations to Consolidated Net Income. Consolidated Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2007 Slide 6-46 McGraw-Hill/Irwin Consolidated Statement of Cash Flows 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.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-47 McGraw-Hill/Irwin Consolidated Earnings Per Share 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.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-48 McGraw-Hill/Irwin ? Consolidated Earnings Per Share 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.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-49 McGraw-Hill/Irwin Subsidiary Stock Transactions 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

© The McGraw-Hill Companies, Inc., 2007 Slide 6-50 McGraw-Hill/Irwin Summary 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 Preferred stock of a subsidiary will often resemble debt more than equity. If it is viewed thus, parent held shares are eliminated from the consolidated worksheets as if the stock had been retired.

© The McGraw-Hill Companies, Inc., 2007 Slide 6-51 McGraw-Hill/Irwin Possible Criticisms There are at least four theoretical approaches to assigning the gains or losses created by 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 it to the investor  A third approach is to split the assignment  Finally, a fourth approach says to assign it entirely to the parent WHAT DO YOU THINK????

© The McGraw-Hill Companies, Inc., 2007 Slide 6-52 McGraw-Hill/Irwin Uh, Chester? I wonder if we could discuss a little “intercompany” loan? End of Chapter 6