Chapter 3 PowerPoint VIEs

Joint Ventures (4 Bullet Points)

-Formed by two or more companies for specialized projects -Often requires specialized skill and significant debt financing -Structure legally separates the projects' risk from that of the sponsors -Allows financing to be obtained at a lower cost

An entity is a VIE if:

-It must obtain guarantees from other parties to obtain debt financing -Equity holders do not have the usual rights and responsibilities of equity ownership

Leasing (4 bullet points)

-SPE created to purchase long-term assets -Funding for purchases obtained through loans -SPE leases assets to the company -SPE uses lease payments to pay interest and principal on the debt

A decision to consolidate an SPE is viewed as an

application of the same control concepts used for equity investments.

Special Purpose Entities (SPEs) Often obtain most financing from

debt

Special Purpose Entities (SPEs) Provide the opportunity to hide

debt and losses from investors

Under U.S. GAAP, a company must evaluate its relationships with SPEs to

determine if consolidation is appropriate.

Special Purpose Entities (SPEs) Often have a small outside

equity interest that obtains a secure return with little or no risk

Special Purpose Entities (SPEs) Control may be obtained with

little or no equity investment (An equity investment generally refers to the buying and holding of shares of stock on a stock market by individuals and firms in anticipation of income from dividends and capital gains, as the value of the stock rises.)

Special Purpose Entities (SPEs) Frequently have no

separate management or employees

Special Purpose Entities (SPEs) Legal structures formed for...

specific business activities

Variable Interest Model Introduced in 2003 by FASB to address

the concept of control for off-balance-sheet entities

If qualitative analysis is not conclusive

use quantitative analysis may be used -Is the level of equity sufficient to absorb expected losses?

Special Purpose Entities (SPEs) Often not consolidated under

voting interest model

Equity investors as a group lack characteristics of a controlling financial interest if (2)

Voting rights are not proportional to their obligation to absorb expected losses of the entity, their rights to receive the expected residual returns of the entity, or both, and Substantially all of the entity's activities either involve or are conducted on behalf of an investor that has disproportionately few voting rights

Equity method investment or consolidate?

When a company owns a stake that is less than controlling but still allows it to exert significant influence over the business, it must use the equity method of accounting. Generally accepted accounting principles requires a company to use consolidated accounting when it owns a controlling stake in another business. In general, a controlling stake is one that involves ownership of more than 50 percent of a business.

Total equity investment at risk does not allow the entity to..

finance its activities without additional subordinated financial support provided by other parties

The decision to consolidate directly affects the...

financial statements of the consolidating company.

When is consolidation required? Exceptions?

The key concept is CONTROL Usually control is obtained through equity ownership, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity (voting interest model) Control may exist with less than majority ownership of outstanding voting shares The key concept is CONTROL Exceptions: Control is temporary, or Control is not present

(IFRS: When to Consolidate) Control is achieved by all three of these elements:

Power over the investee Exposure or rights to the investee's variable returns Ability to use power over the investee to influence the amount of returns to the investor

Is an Entity a VIE? Two qualitative ways to establish sufficiency

Provide evidence that entity can obtain financing on its own Show that equity level is comparable with entities who can obtain financing without outside support

IFRS: When to Consolidate Only basis for consolidation for all entities is ___

Control

Who Must Consolidate a VIE? explain.

Under U.S. GAAP, the "primary beneficiary" of a VIE must consolidate it Attributes of primary beneficiary -Power to direct VIE's significant activities, and -Obligation to absorb significant losses/right to receive significant benefits of VIE

Evaluation of financial relationships consists of a two-step process:

(1) Determine if entity's equity investors are likely not the controlling interest. -These entities are variable interest entities (VIEs) -If entity is not a VIE, the voting interest model applies (2) If the entity is a VIE, determine if the company controls the VIE. -The controlling company is the VIE's primary beneficiary -The primary beneficiary consolidates the VIE

Variable Interest Model Provides guidance for.. (Give 2 points)

(1) Identifying SPEs that meet the definition of a variable interest entity, and (2) Determining whether such entities must be consolidated

A variable-interest entity (VIE) is an entity that has one of the following characteristics: (3)

1) Insufficient equity investment at risk. 2) Stockholders lack decision-making rights. 3) Stockholders do not absorb the losses or receive the benefits of a normal stockholder.

Examples of Special Purpose Entities?

1) Securitizations 2) Leasing 3) Joint Ventures

Equity investment at risk lacks any one of the following: (3)

Direct or indirect ability, through voting or similar rights, to make decisions about an entity's success Obligation to absorb expected entity losses Right to receive expected residual returns of the entity

Examples of how control is achieved (4)

Equity voting rights Rights to appoint or remove key personnel Power to appoint or remove the majority of board members Power to cast the majority of votes at board meetings

Assume Finance Corporation's assets and liabilities are reported at fair value. Manufacturing Company pays $10,000,000 in cash to Finance Corporation's shareholders for Finance Corporation's assets and liabilities, and then consolidates the assets and liabilities of Finance Corporation with its own assets and liabilities Entry to record investment?

Investment in Finance Corp 10,000,000 Cash 10,000,000

Securitizations

May be set up by a financial services company to buy loans or customer receivables from its clients.