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.

Describe a variable interest entity, a primary beneficiary, and 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. Describe a variable interest entity, a primary beneficiary, and the factors used to decide when a variable interest entity is subject to consolidation.

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 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

Variable Interest Entities (VIE’s) Examples of Variable Interests

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 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

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. 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.

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. 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.

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. 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.

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. 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.

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. 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., an entity designed solely to purchase the electric generating plant, provide equity and debt financing, and lease the plant to Twin Peaks.

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. • An outside investor will provide $16 million in exchange for a 100 percent 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.

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. 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.

Consolidation of VIE’s Similar to other combinations, valuation of assets, liabilities, and noncontrolling interest should be based on Fair Value. When a VIE’s total business fair value is greater than its assessed net asset value, Goodwill is reported. When a VIE’s total business fair value is less than its assessed net asset value, a GAIN is recognized. Similar to other combinations, valuation of assets, liabilities, and noncontrolling interest should be based on Fair Value. When a VIE’s total business fair value is less than its assessed net asset value, a GAIN is recognized. When a VIE’s total business fair value is greater than its assessed net asset value, Goodwill is reported.

Disclosure Requirements – In Footnotes of ALL VIE Interests Nature, purpose, size, & activities of the VIE Significant judgments made in determining the need to consolidate a VIE or disclose any involvement Nature of restrictions on assets and settlement of liabilities, and the related carrying value Nature, purpose, size, & activities of the VIE Significant judgments made in determining the need to consolidate a VIE or disclose any involvement Nature of restrictions on assets and settlement of liabilities, and the related carrying value Nature of risks, and how a VIE affects the financial position, performance and cash flows of a Primary Beneficiary Nature of risks, and how a VIE affects the financial position, performance and cash flows of a Primary Beneficiary

VIE’s 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. 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.

Demonstrate the consolidation 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 affiliate’s debt instrument from an outside party. Demonstrate the consolidation procedures to eliminate all intra-entity debt accounts and recognize any associated gain or loss created whenever one company acquires an affiliate’s debt instrument from an outside party.

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. Intra-Entity Debt Transactions 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. 2

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%. 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%.

Intra-Entity Debt Transactions - Example Book value of Omega Company’s bonds as of December 31, 2013, the date immediately before the day Alpha Company acquired the bonds Carrying value of Omega Company’s bonds is $946,651 as of December 31, 2013, the date immediately before the day Alpha Company acquired the bonds.

Intra-Entity Debt Transactions - Example Omega Company’s 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. Intra-Entity Debt Transactions - Example Omega Company’s 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.

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 accountant’s approach to this consolidation, the subsequent financial recording made by each company is analyzed. 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 accountant’s approach to this consolidation, the subsequent financial recording made by each company is analyzed.

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

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

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. 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.

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. Intra-Entity Debt Transactions - Example 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 be adjusted for the difference in interest amounts.

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. Intra-Entity Debt Transactions - Example 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 be adjusted for the difference in interest amounts.

Understand that subsidiary preferred stocks not owned by 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. 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.

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. 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. 4

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

Prepare a consolidated statement of cash flows. Learning Objective 6-4 Prepare a consolidated statement of cash flows. Prepare a consolidated statement of cash flows.

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. 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. 11

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. 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. 14

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 interest’s share of the sub’s net income. Deduct dividends paid to the outside owners as cash outflow. 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 interest’s share of the sub’s net income. Deduct dividends paid to the outside owners as cash outflow. 12

Compute basic and diluted earnings per share for a Learning Objective 6-5 Compute basic and diluted earnings per share for a business combination. Compute basic and diluted earnings per share for a business combination.

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. 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. 15

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. 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. 15

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. 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. 16

Learning Objective 6-6 Demonstrate the accounting effects of subsidiary stock transactions on parent’s financial records and consolidated financial statements. Compute basic and diluted earnings per share for a business combination.

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. 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.