ACCT 450 Ch 6

Variable Interest Entities

*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

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.

Benefits 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.

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.

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. 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. -Slide 26

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.

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.

Asset Purchase options

Entitles holder to benefit from increases in asset fair values

Participation rights

Entitles holder to residual profits

Guarantees of debt

If a VIE cannot repay liabilities, honoring a debt guarantee will produce a loss

Subordinated debt instruments

If a VIE's cash flow is insufficient to repay all senior debt, subordinated debt may be required to absorb the loss

Lease residual value guarantee

If leased asset declines below the residual value, honoring the guarantee will produce a loss

Consolidated Earnings Per Share (formula)

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.

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.

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 acquisition method values all business acquisitions (whether 100 percent or less acquired) at their full fair values.

Consolidation of VIEs

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.

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.

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.

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.

Consolidation 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.

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.

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 -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. -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.

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 of risks, and how a VIE affects the financial position, performance and cash flows of a Primary Beneficiary