ACCT 401 EXAM 3 POWERPOINT

Characteristics of V I Es 1

•V I Es generally have assets, liabilities, and investors with equity interests. •Activities are strictly limited. •Role of equity investors can be minor; they may serve simply to allow the V I E to function as a legal entity. •Because they bear relatively low economic risk, investors may be provided only a small rate of return. •Another party, for example, the primary beneficiary, contributes substantial resources—loans and/or guarantees—to enable the V I E to secure additional financing to accomplish its purpose.

Intra-Entity Transactions—Land Transfers 2

2)The gain recorded by the seller is closed into Retained Earnings at the end of the year. As a consolidated entity, the account is artificially increased by a related party. The buyer's Land account and the seller's Retained Earnings account continue to contain the intra-entity gain. 3)The gain on the original transfer is recognized in consolidated net income only when the land is subsequently disposed of to an outside party. Appropriate consolidation techniques must eliminate the intra-entity gain each period until the time of resale.

Unrealized Gross Profit—Effect on Noncontrolling Interest

According to F A S B A S C paragraph 810-10-45-6: •Amount of intra-entity profit or loss to be eliminated is not affected by the existence of a noncontrolling interest. •Complete elimination of the intra-entity profit or loss is consistent with the underlying assumption that consolidated financial statements represent the financial position and operating results of a single economic entity. •Elimination of the intra-entity profit or loss may be allocated proportionately between the parent and noncontrolling interests.

Subsidiary Stock Transactions

Account for changes in parent's ownership interest following F A S B A S C (para. 810-10-45-23) guidelines: Separate adjustments must be recorded to maintain reciprocity between a subsidiary's stockholders' equity accounts and a parent's investment balance. Changes in parent's ownership interest, if controlling interest is retained, are accounted for as equity transactions. •The consolidated effects 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.

Identification of a V I E

An entity qualifies as a V I E if either of the following conditions exists: •Total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. •Equity investors in V I E, as a group, lack any one of three characteristics of a controlling financial interest: 1)The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity's economic performance. 2)The obligation to absorb the expected losses of the entity. 3)The right to receive expected residual returns of the entity.

Eliminating Intra-Entity Gains—Land Transfers (Entry TL)

Assume that on July 1, 2021, Hastings sold land that originally cost $60,000 to Patrick, a related party, at a $100,000 transfer price. •The seller reports a $40,000 gain. •The buyer records the land at the $100,000 acquisition price. •At the end of this fiscal period, the intra-entity effect of this transaction must be eliminated for consolidation purposes.

Variable Interest Entities (V I Es) 1

Commonly known as special purpose entities (S P Es). Most V I Es are established for valid business purposes. Established as a separate business structure: •Trust. •Joint venture. •Partnership. •Corporation. -V I Es sometimes have no independent management or employees.

Intra-Entity Transactions—Land Transfers 1

Consolidation procedures for intra-entity land transfers partially parallel those for the events occurring in an intra-entity inventory transfer.The worksheet process must adjust the account balances as a single economic entity. The sequence of events in an intra-entity land sale: 1)The original seller of the land reports a gain, even though the transaction occurred between related parties. The acquiring company capitalizes the inflated transfer price.

Deferral and Subsequent Recognition of Intra-Entity Gains

Financial reporting objectives remain unchanged for intra-entity sales of depreciable assets: •Defer intra-entity gains. •Re-establish historical cost balances. •Recognize appropriate income within the consolidated financial statements. •Defer gains created by intra-entity transfers until the subsequent use or resale of the asset consummates the original transaction.

Examples of V I Es

Variable interests in a variable interest entity are contractual, ownership, or other pecuniary interests in an entity that change with changes in the entity's net asset value. Variable interests absorb portions of a variable interest entity's expected losses if they occur or receive portions of the entity's expected residual returns if they occur. The following are some examples of variable interests and the related potential losses or returns:

Intra-Entity Beginning Inventory Profit Adjustment—Downstream Sales When Parent Uses Equity Method

Worksheet Entry TI and Entry G are standard, regardless of the circumstances of the consolidation, but Entry *G differs. IF: 1)The original transfer is downstream (parent's). AND 2)The parent applies the equity method for internal accounting purposes. THEN: Investment in Subsidiary account replaces parent's beginning Retained Earnings in consolidation entry *G.

Consolidations—Downstream versus Upstream Transfers (Entry *G)

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Consolidations—Downstream versus Upstream Transfers (Entry S)

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Intra-Entity Gross Profit—Entry G Portion of Inventory Remains

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Intra-Entity Inventory Downstream Transfer—Entry TI and Entry G

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Intra-Entity Transactions—Upstream Inventory Transfers 2

•As a result, the intra-entity profit reallocation across time affects both the subsidiary's reported net income and the noncontrolling interest. •Because the intra-entity sales are upstream, the $4,000 beginning intra-entity gross profit (Entry *G) deferral no longer involves a debit to the parent's Investment in Bottom account.

Intra-Entity Transactions—Depreciable Asset Transfers (Entry ED)

•Deferred intra-entity profits on depreciable asset transfers are achieved on the consolidated worksheet through a credit to depreciation expense. •Entry ED eliminates overstatement of depreciation expense caused by the inflated price.

Intra-Entity Transactions 2

•From a consolidated perspective, an intra-entity transfer is the internal movement of inventory that creates no net change in the financial position of the business combination taken as a whole. •In producing consolidated financial statements, transfers are eliminated. •Consolidated statements reflect only transactions with outside parties. •The entire impact of the intra-entity transfer must be identified and then removed.

Acquisition Period Statementof Cash Flow

•If a business combination occurs during a particular reporting period, the consolidated cash flow statement must reflect several considerations. •Cash purchases of businesses are an investing activity. The net cash outflow is reported as the amount paid at acquisition. •Adjustment to accrual-based income must reflect only post acquisition amounts for the subsidiary. •Changes in operating balance sheet accounts (accounts receivable, inventory, accounts payable, etc.) must be computed net of the amounts acquired in the combination.

Consolidated Earnings per Share

•If the reporting entity has no dilutive options, warrants, or other convertible items, only basic E P S is presented on the face of the income statement. •If any dilutive securities are present, diluted E P S also must be presented. •To compute diluted E P S, combine the effects of any dilutive securities with basic earnings per share.

Variable Interest Entity Disclosure Requirements 2

•Nature of, and changes in, the risks associated with an enterprise's involvement with the V I E. •How an enterprise's involvement with the V I E affects the enterprise's financial position, financial performance, and cash flows.

Identification of the Primary Beneficiary of the V I E 1

•Once a firm has a relationship with a V I E, the firm must determine whether it qualifies as the V I E's primary beneficiary. •An enterprise with a variable interest with a controlling financial interest in a V I E is the primary beneficiary and will have both of the following characteristics: 1)The power to direct the activities of a V I E that most significantly impact the entity's economic performance. 2)The obligation to absorb losses that could potentially be significant to the V I E or the right to receive benefits from it that could be significant to the V I E.

Characteristics of V I Es 2

•Primary beneficiary may guarantee the V I E's debt, assuming the risk of default. •Contractual arrangements may limit returns to equity holders, yet participation rights provide increased profit potential and risks to the primary beneficiary. •Beneficiary's economic interests vary depending on the V I E's success—hence the term variable interest entity. •Risks and rewards are not distributed according to stock ownership but according to other variable interests.

Computing Earnings per Share for a Business Combination

•The computation of E P S for a business combination follows the general rules. •Consolidated net income (less preferred dividends) attributable to the parent company owners along with the number of outstanding parent shares provides the basis for calculating basic E P S. •Stock warrants, convertible debt, warrants, or options for the parent's stock that can possibly dilute the reported figure must be included in diluted E P S.

Intra-Entity Transactions—Depreciable Asset Transfers in the Years Following the Transfer

•The intra-entity gain and excess depreciation expense remain on the separate books and are closed into Retained Earnings of the respective companies at year-end. •Equipment is carried on the individual books at a different amount than on the consolidated books. •The amounts change each year as depreciation is computed. For every subsequent period, separately reported figures must be adjusted on the worksheet to present the consolidated totals from a single entity's perspective.

Acquisition of Affiliate's Debt from an Outside Party 1

•The purchase of an affiliate's debt instrument from an outside third party can create difficulties in consolidation. •If the parent purchases all or part of outstanding subsidiary bonds in the open market, from a consolidated view, the combined entity has reacquired its own bonds. •Although the individual companies continue to carry the debt and investment on their individual financial records, from a consolidation viewpoint, this liability is effectively retired as of the debt reacquisition date. •The debt is no longer owed to a party outside the business combination. Subsequent interest payments are simply intra-entity cash transfers.

Net Income Attributable to the Noncontrolling Interest

•When intra-entity transfers are downstream, deferred intra-entity gross profits relate solely to the parent company and have no effect on the subsidiary or outside ownership. •The noncontrolling interest's share of consolidated net income is unaffected by the downstream intra-entity profit deferral and subsequent recognition.

Eliminating Intra-Entity Gains—Land Transfers (Entry *GL Sale to Outside Party)

•When the company eventually sells the land to an outsider, it must recognize the gain deferred at the time of the original transfer. •On the worksheet, the gain is removed one last time from beginning Retained Earnings (or the investment account, if applicable). In this instance, though, the worksheet entry reclassifies the amount as a recognized gain.

Variable Interest Entities—Risk and Ownership

•Variable interests increase a firm's risk as the resources it provides (or guarantees) to the V I E increase. •With increased risks come incentives to restrict the V I E's decision making. •A firm with variable interests will regularly limit the equity investors' power through the V I E's governance documents. •Investors are the owners of the V I E, but they may retain little responsibility of ownership risk and benefits. •Investors may cede financial control of a V I E to the variable interests in exchange for a guaranteed rate of return.

Intra-Entity Transactions—Upstream Inventory Transfers 1

•A different set of consolidation procedures is necessary if the intra-entity transfers are upstream. •Upstream gross profits are attributed to the subsidiary (Bottom) not the parent (Top). •When the inventory transfers are upstream from subsidiary to parent, only ownership percentage of the profit deferral and subsequent recognition is allocated to the parent's equity earnings and investment account.

Intra-Entity Transactions—Upstream Inventory Transfers (Entry *G)

•As of January 1, 2021, $16,000 of transfers remain in Top's inventory, and $4,000 of gross profit is unearned. Bottom's beginning Retained Earnings are overstated by $4,000, the gross profit from 2020 intra-entity transfers. •A credit to Cost of Goods Sold increases consolidated net income to recognize the profit in 2021 from sales to outsiders as follows:

Intra-Entity Transactions 1

•Companies that make up a business combination frequently retain their legal identities as separate operating centers and maintain their own record-keeping. •Inventory sales between the companies are recorded in the accounting system of both parties. The seller records revenue, and the buyer enters the purchase into its accounts. •For internal reporting purposes, recording an inventory transfer as a sale/purchase provides vital data to help measure the operational efficiency of each enterprise.

Sales and Purchases—Intra-EntityEntry TI

•Cost of Goods Sold is reduced under the assumption that the Purchases account usually is closed out prior to the consolidation process. •Total recorded (intra-entity) sales is deleted regardless of whether the transfer was downstream (from parent to subsidiary) or upstream (from subsidiary to parent).

Variable Interest Entities (V I Es)—Primary Beneficiary

•Enterprise that created V I E may not own any of its voting stock. •Prior to current consolidation requirements, enterprises left V I Es unconsolidated in their financial reports. •Primary beneficiary typically exercises its financial control through governance documents or contractual agreements giving it decision-making authority over the V I E. •Primary beneficiary must consolidate in its financial statements the V I E's assets, liabilities, revenues, expenses, and noncontrolling interest.

Intra-Entity Transactions—Upstream Inventory Transfers (Entry S)

•Entry S eliminates a portion of the parent's investment account and provides the initial noncontrolling interest balance. •The entry removes stockholders' equity accounts of the subsidiary as of the beginning of the current year.

Consolidation of V I Es Subsequent to Initial Measurement

•After the initial measurement, all intra-entity transactions between the primary beneficiary and the V I E must be eliminated in consolidation. •V I E's income must be allocated among the parties involved (equity holders and the primary beneficiary). •The distribution of income is typically specified in contractual arrangements.

Consolidated Statement of Cash Flows

•Current accounting standards require that companies include a statement of cash flows among the consolidated financial reports. •Main purpose of the statement of cash flows is to provide information about the entity's cash receipts and cash payments during a period. •It is also designed to show why an entity's net income is different from its operating cash flows. •A consolidated statement of cash flows is based on the consolidated balance sheet and consolidated income statement.

Depreciable Asset Transfers—Additional Issues

•Downstream sales are assumed to have no effect on any noncontrolling interest values. The parent rather than the subsidiary made the sale. •The impact on net income created by upstream sales must be considered in computing the balances attributed to these outside owners. •Many acceptable alternatives exist for assignment of income created within a consolidation process. The authors chose to assign all income to the original seller.

Financial Reporting Principles for Consolidating V I Es—Initial Measurement Issues

•Financial reporting principles for consolidating V I Es require asset, liability, and noncontrolling interest valuations. •These valuations initially, with few exceptions, are based on fair values. •If the total business fair value of the V I E exceeds the collective fair values of its net assets, goodwill is recognized.

Intra-Entity Gross Profit—Entry G All Inventory Remains at Year-End

•If all transferred inventory is retained by the business combination at year-end, Entry G eliminates the effects of the seller's gross profit that is unrealized in the buyer's ending inventory in Year 1.

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. •Corresponding receivable and payable and revenue and interest from the consolidated financial statements must be eliminated. •Because no money is owed to or from an outside party, these reciprocal accounts must be eliminated in each subsequent consolidation.

Consolidated Accounts Affected by Intra-Entity Inventory Transfers

Accounts affected by intra-entity transactions: •Revenues. •Cost of Goods Sold. •Net Income Attributable to the Noncontrolling Interest. •Retained Earnings at the Beginning of the Year •Inventory. •Noncontrolling Interest in Subsidiary at End of Year.

Variable Interest Entities (V I Es) 2

Common examples of V I E activities: •Transfers of financial assets. •Leasing. •Hedging financial instruments. •Research and development. Benefits of V I E: •Often eligible for a lower interest rate. •Low-cost financing of assets. -Governing agreements limit activities and decision making.

Variable Interest Entity Disclosure Requirements 1

Enhanced disclosures are required for any enterprise that holds a variable interest in a V I E, including: •V I E's nature, purpose, size, and activities. •Significant judgments and assumptions an enterprise makes in determining whether it must consolidate a V I E and/or disclose information about its involvement in a V I E. •Nature of restrictions on a consolidated V I E's assets and on the settlement of its liabilities reported by an enterprise in its statement of financial position, including the carrying amounts of such assets and liabilities.

Initial Measurement Issues—Collective Fair Values

If the collective fair values of the net assets exceed the total business fair value, the primary beneficiary recognizes a gain on bargain purchase. Assuming that the debt and noncontrolling interests are stated at fair values, Twin Peaks includes in its consolidated balance sheet: •Electric Generating Plant at $400 million. •Long-Term Debt at $384 million. •Noncontrolling interest of $16 million.

Effects of Alternative Investment Methods on Consolidation

If the parent uses either the initial value or the partial equity method, many of the consolidation procedures are identical to those used in the equity method, with two exceptions. •Consolidation entry *C is required in periods subsequent to acquisition to convert the parent's beginning Retained Earnings to a full-accrual consolidated total. •Consolidation entry *G corrects the overstatement in the subsidiary's beginning Retained Earnings and appropriately recognizes the profit in the current year.

Years Following Downstream Intra-Entity Depreciable Asset Transfers

If the transfer is downstream and the parent uses the equity method, then their Retained Earnings balance has already been reduced for the gain, and we adjust the Investment account instead. The following worksheet consolidation entries would be made for a downstream sale assuming that: 1)Able is the parent. 2)Able has applied the equity method to account for its investment in Baker.

Intra-Entity Transactions—Land Transfers (Entry *GL)

•The effects of the original transaction remain in the financial records of the individual companies for as long as the property is held. •The gain recorded by Hastings carries through to Retained Earnings while Patrick's Land account retains the inflated transfer price. •For every subsequent consolidation until the land is eventually sold, the elimination process must be repeated.

Consolidated Statementof Cash Flows—Adjustments

•Adjustments arising from subsidiary's revenues or expenses (for example, depreciation, amortization) must reflect only post acquisition amounts. •Proper presentation of cash flows requires no special adjustments for intra-entity transfers. •Subsidiary dividends paid to a noncontrolling interest are a component of cash outflows from financing activities.

Acquisition of Affiliate's Debt from an Outside Party 2

•If the purchase price equals the corresponding carrying amount of the liability, an affiliate's bond or note acquired from an unrelated party poses no significant consolidation problems. • Reciprocal balances within the individual records would always be identical in value and easily offset in each subsequent consolidation. •If the cost paid to purchase the debt is more or less than the liability carrying amount on issuing the company's financial records, this gain or loss must be recognized immediately by the consolidated entity.

Prior Consolidation of V I Es

•In the past, assets, liabilities, and results of operations for V I Es and other entities frequently were not consolidated with those of the firm that controlled the entity. •These firms invoked a reliance on voting interests, as opposed to variable interests, to indicate a lack of a controlling financial interest. •As noted by G A A P literature, legacy F A S B standard FIN 46R requires the primary beneficiary (regardless of their ownership) to consolidate the V I E.

Subsidiary Preferred Stock

•Preferred shares, 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 and are treated in consolidation similarly to common shares. •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.

Depreciable Asset Transfers—Year of Transfer (Entry TA)

•The $30,000 intra-entity gain and $3,000 overstated depreciation expense must be eliminated. •In the year of transfer, consolidation entries TA and ED are applicable with both upstream and downstream transfers. •Entry TA removes intra-entity gain and returns equipment accounts to balances based on original historical cost.

Recognizing the Effect on Noncontrolling Interest—Land Transfers

•If the original sale was a DOWNSTREAM transaction, it has no effect on the noncontrolling interest. •If the transfer is made UPSTREAM, it is attributed to the subsidiary and the noncontrolling interest. •All noncontrolling interest balances are computed on the reported earnings of the subsidiary after adjustment for any upstream transfers.

Intra-Entity Gross Profit—Entry *G 1

•The overstatement is removed from beginning inventory in the financial statements with Entry *G. The asterisk indicates that a previous year transfer created the intra-entity gross profits. •Buyer's Cost of Goods Sold and seller's Retained Earnings accounts as of the beginning of Year 2 contain intra-entity profit and must both be reduced in Entry *G.

Eliminating Intra-Entity Gains—Land Transfers Downstream and Upstream

•The reduction in Retained Earnings is changed to an increase in the Investment in Subsidiary account when the original sale is downstream and the parent has applied the equity method. •In that situation, equity method adjustments have already corrected the timing of the parent's intra-entity gain, which has created a reduction in the Investment account that is appropriately allocated to the subsidiary's Land account on the worksheet. •Conversely, if sales were upstream, the Retained Earnings of the seller (the subsidiary) continue to be overstated even if the parent applies the equity method.

Identification of the Primary Beneficiary of the V I E 2

•These characteristics mirror those that the equity investors often lack in a V I E. •The primary beneficiary will absorb a significant share of the V I E's losses or receive a significant share of the V I E's residual returns or both. •The fact that the primary beneficiary may own no voting shares whatsoever becomes inconsequential because they do not effectively give equity investors power to exercise control. •Careful examination of the V I E's governing documents and who bears risk is necessary to determine whether a reporting entity possesses control over a V I E.