© the mcgraw-hill companies, inc., 2004 slide 6-1 mcgraw-hill/irwin chapter six variable interest...

© The McGraw-Hill Companies, Inc., 2004

Slide 6-1

McGraw-Hill/Irwin

Chapter Six

Variable Interest Variable Interest Entities, Entities,

Intercompany Intercompany Debt, Debt,

Consolidated Consolidated Statement of Statement of

Cash Flows, and Cash Flows, and Other IssuesOther Issues


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Special Purpose Entities

• A business entity formed to accomplish a single purpose.

• Activities are strictly limited by contract.

• A business entity formed to accomplish a single purpose.

• Activities are strictly limited by contract.

Sponsor Company SPE

Transfers High Risk Assets

Issues debt against future

cash collections.


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Common SPE Activities


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As long as the SPE stays independent, an effective transfer of risk results.

SPE’s are generally consolidated.

As long as the SPE stays independent, an effective transfer of risk results.

SPE’s are generally consolidated.

An asset is acquired for

low cost.

Asset is leased to Sponsor.

Sponsor Company

SPE

The SPE recognizes revenues.


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Technically, the equity investors control the SPE.

However, often the equity investors

cede control to the variable interest

parties in exchange for a

guaranteed return.

Technically, the equity investors control the SPE.

However, often the equity investors

cede control to the variable interest

parties in exchange for a

guaranteed return.


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Variable Interest Entities (VIE)

SPE equity investors often have very little role in SPE equity investors often have very little role in controlling the SPE’s activities, which are often controlling the SPE’s activities, which are often

very restricted.very restricted.

SPE equity investors often have very little role in SPE equity investors often have very little role in controlling the SPE’s activities, which are often controlling the SPE’s activities, which are often

very restricted.very restricted.

Profit often accrues to Profit often accrues to the sponsor as a the sponsor as a

function of contractual function of contractual agreements, rather than agreements, rather than

as a function of stock as a function of stock ownership.ownership.

Profit often accrues to Profit often accrues to the sponsor as a the sponsor as a

function of contractual function of contractual agreements, rather than agreements, rather than

as a function of stock as a function of stock ownership.ownership.

Because the sponsor’s risk/reward varies depending on the success of the

SPE, these SPE’s are referred to as Variable

Interest Entities.

Because the sponsor’s risk/reward varies depending on the success of the

SPE, these SPE’s are referred to as Variable

Interest Entities.


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Examples of Variable InterestsExh.6-1


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Consolidation of VIE’s – ARB 51

. . . An enterprise’s consolidated financial

statements include subsidiaries in which the

enterprise has a controlling financial interest. - - ARB 51

. . . An enterprise’s consolidated financial

statements include subsidiaries in which the

enterprise has a controlling financial interest. - - ARB 51

Generally, this has applied to subs where

the parent has VOTING control.


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Consolidation of VIE’s – FIN 46

FIN 46 requires consolidation of a VIE when one of the

following conditions exist: If total equity at risk < 10%. The equity investors in the VIE lack

one of the following traits: The ability to make decisions

about the VIE’s activities. The obligation to absorb the

expected losses of the VIE. The right to receive expected

residual returns of the VIE.

FIN 46 requires consolidation of a VIE when one of the

following conditions exist: If total equity at risk < 10%. The equity investors in the VIE lack

one of the following traits: The ability to make decisions

about the VIE’s activities. The obligation to absorb the

expected losses of the VIE. The right to receive expected

residual returns of the VIE.} Traits of a

Primary Beneficiary


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Consolidation of VIE’s – FIN 46

If a “business enterprise has a controlling financial

interest in a variable interest entity, assets,

liabilities, and results of the activities of the (VIE)

should be included with those of the (Primary

Beneficiary). - - FIN 46

If a “business enterprise has a controlling financial

interest in a variable interest entity, assets,

liabilities, and results of the activities of the (VIE)

should be included with those of the (Primary

Beneficiary). - - FIN 46


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Procedures for Consolidation of VIE’s

Valuations of assets, liabilities, and noncontrolling interest should be based on

FMV, except for two notable exceptions.



1. Assets transferred to the

VIE from the Primary

Beneficiary, should be

measured as if they have never

been transferred.

1. Assets transferred to the

VIE from the Primary

Beneficiary, should be

measured as if they have never

been transferred.


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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.

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.


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When the implied When the implied value of the VIE value of the VIE

exceeds the assessed exceeds the assessed net assets, net assets, NO NO GOODWILL IS GOODWILL IS RECORDEDRECORDED!!

The difference is The difference is recorded as an recorded as an

extraordinary loss by extraordinary loss by the primary the primary beneficiary.beneficiary.

When the implied When the implied value of the VIE value of the VIE

exceeds the assessed exceeds the assessed net assets, net assets, NO NO GOODWILL IS GOODWILL IS RECORDEDRECORDED!!

The difference is The difference is recorded as an recorded as an

extraordinary loss by extraordinary loss by the primary the primary beneficiary.beneficiary.


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FIN 46 Disclosure Requirements

Nature, purpose, size, & activities of

the VIE

Nature, purpose, size, & activities of

the VIE

Carrying amount of assets pledged as collateral by the

Primary Beneficiary

Carrying amount of assets pledged as collateral by the

Primary Beneficiary

Classification of assets pledged as collateral by the

Primary Beneficiary

Classification of assets pledged as collateral by the

Primary Beneficiary

Lack of recourse if creditors of the VIE have no recourse to the general credit of

the primary beneficiary.

Lack of recourse if creditors of the VIE have no recourse to the general credit of

the primary beneficiary.


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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.


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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?

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.


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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.


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Big owns 90% of Little. On 1/1/00, Little issued $2 million of 6%, 10-year

bonds. The current carrying amount on Little’s books at 1/1/04 is:

Bonds Payable = $2,000,000

Bond Discount = $161,043

Carrying Amount = $1,838,957

On 1/2/04, Big decides to re-purchase Little’s bonds from the market,

effectively extinguishing the debt.

Big owns 90% of Little. On 1/1/00, Little issued $2 million of 6%, 10-year

bonds. The current carrying amount on Little’s books at 1/1/04 is:

Bonds Payable = $2,000,000

Bond Discount = $161,043

Carrying Amount = $1,838,957

On 1/2/04, Big decides to re-purchase Little’s bonds from the market,

effectively extinguishing the debt.


Continue


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On 1/2/04, 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 12/31/04, the consolidated entity must: Record the loss of $262,557

Eliminate the related intercompany debt at BV

Eliminate the intercompany interest

On 1/2/04, 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 12/31/04, the consolidated entity must: Record the loss of $262,557

Eliminate the related intercompany debt at BV

Eliminate the intercompany interest


Continue


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Entry BThis 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 BThis 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.


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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.





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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 amortized away completely.

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 amortized away completely.


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The treatment of subsidiary preferred stock in the consolidated financial

statements depends on whether the shares are viewed as:

Debt or EquityThe 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 EquityThe 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


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Preferred Stock Treated as a Debt Instrument

The Preferred Stock is treated as 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 first entry eliminates the preferred stock purchased by the parent, just as if it were retired.


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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 second entry recognizes the noncontrolling interest in the preferred stock. The amount assigned to the noncontrolling interest is based on the call price.


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On 2/1/04, 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 at Debt.

Prepare the December 31, 2004 consolidation entries.




The preferred stock has a call price of 109 and is viewed at Debt.

Prepare the December 31, 2004 consolidation entries.


Continue


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First Entry Eliminate Liberty’s investment in the preferred stock. The preferred stock is

eliminated at cost.


eliminated at cost.

?


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eliminated at cost.


eliminated at cost.


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Second Entry Recognize the noncontrolling interest in

the preferred stock. Base it on the 109 call price.



?


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So, what do we do when

the Preferred Stock is

viewed as Equity?


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Subsidiary Preferred StockViewed as Equity

2. The preferred stock 2. The preferred stock is eliminated in the is eliminated in the

same way as common same way as common stock. stock.

2. The preferred stock 2. The preferred stock is eliminated in the is eliminated in the

same way as common same way as common stock. stock.

1. The purchase price in excess of book

value of the preferred stock is allocated to specific accounts.

1. The purchase price in excess of book

value of the preferred stock is allocated to specific accounts. When When

preferred preferred stock is stock is

viewed as viewed as equity . . .equity . . .

When When preferred preferred stock is stock is

viewed as viewed as equity . . .equity . . .


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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 1st entry eliminates the preferred stock book values from the subsidiary’s numbers.

The 1st entry eliminates the preferred stock book values from the subsidiary’s numbers.


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The 2The 2ndnd entry recognizes the portion of the entry recognizes the portion of the acquisition cost allocated to assets..acquisition cost allocated to assets..

The 2The 2ndnd entry recognizes the portion of the entry recognizes the portion of the acquisition cost allocated to assets..acquisition cost allocated to assets..


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The preferred stock has a call price of 109 and is viewed at Equity.




The preferred stock has a call price of 109 and is viewed at Equity.


Continue


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ANI’s preferred stock participates in 10% of the annual income. ANI’s

book value on 2/1/04 is $46 million. The book value includes:

ANI’s preferred stock participates in 10% of the annual income. ANI’s

book value on 2/1/04 is $46 million. The book value includes:


Continue


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Continue

First, determine how much of ANI’s book value First, determine how much of ANI’s book value should be assigned to the preferred stock. In should be assigned to the preferred stock. In

this case it is $5,200,000.this case it is $5,200,000.

First, determine how much of ANI’s book value First, determine how much of ANI’s book value should be assigned to the preferred stock. In should be assigned to the preferred stock. In

this case it is $5,200,000.this case it is $5,200,000.


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Continue

Second, determine Goodwill related to Liberty’s acquisition of 60% of ANI’s preferred stock.

Assume that ANI has a Patent worth $100,000.

Second, determine Goodwill related to Liberty’s acquisition of 60% of ANI’s preferred stock.

Assume that ANI has a Patent worth $100,000.


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?

Consolidation Entry PS Eliminate Liberty’s investment in ANI’s preferred stock. The preferred stock is

eliminated at cost.


eliminated at cost.


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eliminated at cost.


eliminated at cost.


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?

Consolidation Entry A1 Set up the land and the goodwill.



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Consolidated Statement of Cash Flows

The consolidated statement of cash flows

is based on the consolidatedconsolidated balance

sheet and the consolidatedconsolidated income

statement.


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Noncontrolling InterestAdd back the

noncontrolling interest’s share of the sub’s net income.

Deduct dividends paid to the outside owners as a cash outflow.

Noncontrolling InterestAdd back the

noncontrolling interest’s share of the sub’s net income.

Deduct dividends paid to the outside owners as a cash outflow.



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AmortizationAdd amortization of

goodwill and FMV allocations to

Consolidated Net Income.

AmortizationAdd amortization of

goodwill and FMV allocations to

Consolidated Net Income.



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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.


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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.


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?

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.


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Uh, Chester? Uh, Chester?

I wonder if we I wonder if we could discuss a could discuss a

little little “intercompany” “intercompany”

loan?loan?

End of Chapter 6

© the mcgraw-hill companies, inc., 2004 slide 6-1 mcgraw-hill/irwin chapter six variable interest...

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