Ch 6 AA Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues: Questions

13. In many cases, EPS is computed based on the parent's portion of consolidated net income and parent company shares and convertibles. However, a different process must be used for some business combinations. When is this alternative approach required?

13. An alternative to the normal diluted earnings per share calculation is required whenever the subsidiary has dilutive convertible securities such as bonds or warrants. In this case, the potential impact of the conversion of subsidiary shares must be factored into the overall diluted earnings per share computation.

7. Several years ago, Bennett, Inc., bought a portion of the outstanding bonds of Smith Corporation, a subsidiary organization. The acquisition was made from an outside party. In the current year, how should these intra-entity bonds be accounted for within the consolidation process?

7. Because the bonds are still legally outstanding, they will continue to be found on both sets of financial records. Thus, each account (Bonds Payable, Investment in Bonds, Interest Expense, and Interest Income) must be eliminated within the consolidation process. Any gain or loss on the effective retirement as well as later effects on interest caused by amortization are also included to arrive at an adjustment to the beginning retained earnings (or the Investment account if the equity method is used) of the parent company.

1. What is a variable interest entity (VIE)?

1. A variable interest entity (VIE) is a business structure that is designed to accomplish a specific purpose. A VIE can take the form of a trust, partnership, joint venture, or corporation although typically it has neither independent management nor employees. The entity is frequently sponsored by another firm to achieve favorable financing rates.

10. Perkins Company acquires 90 percent of the outstanding common stock of the Butterfly Corporation as well as 55 percent of its preferred stock. How should these preferred shares be accounted for within the consolidation process?

10. Subsidiary outstanding preferred shares are part of the noncontrolling interest and are included in the consolidated financial statements at acquisition-date fair value and subsequently adjusted for their share of subsidiary income and dividends.

11. The income statement and the balance sheet are produced using a worksheet, but a consolidated statement of cash flows is not. What process is followed in preparing a consolidated statement of cash flows?

11. The consolidated cash flow statement is developed from consolidated balance sheet and income statement figures. Thus, the cash flows generated by operating, investing, and financing activities are identified only after the consolidation of these other statements.

12. How do noncontrolling interest balances affect the consolidated statement of cash flows?

12. The noncontrolling interest share of the subsidiary's net income is a component of consolidated net income. Consolidated net income then is adjusted for noncash and other items to arrive at consolidated cash flows from operations. Any dividends paid by the subsidiary to these outside owners are listed as a financing activity because an actual cash outflow occurs.

14. A subsidiary has (1) a convertible preferred stock and (2) a convertible bond. How are these items factored into the computation of earnings per share for the parent company?

14. Basic Earnings per Share. The existence of subsidiary convertible securities does not affect basic EPS. The parent's basic earnings per share is computed by dividing the parent's share of consolidated net income by the weighted average number of parent shares outstanding. Diluted Earnings per Share. The subsidiary's diluted earnings per share is computed by including both convertible items. The portion of the parent's controlled shares to the total shares used in this calculation is then determined. Only this percentage (of the income figure used in the subsidiary's computation) is added to the parent's income in arriving at the parent company's diluted earnings per share.

15. Why might a subsidiary decide to issue new shares of common stock to parties outside the business combination?

15. Several reasons could exist for a subsidiary to issue new shares of stock to outside parties. First, additional financing is brought into the company by any such sale. Also, stock issuance may be used to entice new individuals to join the organization. Additional management personnel, as an example, might be attracted to the company in this manner. The company could also be forced to sell shares because of government regulation. Many countries require some degree of local ownership as a prerequisite for operating within that country.

16. Washburn Company owns 75 percent of Metcalf Company's outstanding common stock. During the current year, Metcalf issues additional shares to outside parties at a price more than its per share consolidated value. How does this transaction affect the business combination? How is this impact recorded within the consolidated statements?

16. Because the new stock was issued at a price above the subsidiary's assigned consolidation value, the overall valuation for Metcalf's stock has been increased. Consequently, the Washburn's investment is increased to reflect this change. To measure the effect, the value of Washburn's investment is calculated both before and after the new issue. Because the increment is the result of a stock transaction, an increase is made to additional paid in capital. Although the subsidiary's shares (both new and old) are eliminated in the consolidation process, the increase in the parent's APIC (or gain or loss) carries into the consolidated figures. Also, the noncontrolling interest percentage of the subsidiary increases.

17. Assume the same information as in question (16) except that Metcalf issues a 10 percent stock dividend instead of selling new shares of stock. How does this transaction affect the business combination?

17. A stock dividend does not alter the assigned consolidated subsidiary value and, thus, creates no effect on Washburn's investment account or on the consolidated figures. Hence, no entry is recorded by the parent company in connection with the subsidiary's stock dividend.

2. What are variable interests in an entity and how might they provide financial control over an entity?

2. Variable interests are contractual, ownership, or other pecuniary interests in an entity that change with changes in the entity's net asset value. Variable interests will 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. Variable interests typically are accompanied by contractual arrangements that provide decision making power to the owner of the variable interests. Examples of variable interests include debt guarantees, lease residual value guarantees, participation rights, and other financial interests.

3. When is a sponsoring firm required to consolidate the financial statements of a VIE with its own financial statements?

3. The following characteristics are indicative of an enterprise qualifying as a primary beneficiary with a controlling financial interest in a VIE. -The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity's economic performance. -The obligation to absorb the expected losses of the entity if they occur, or -The right to receive the expected residual returns of the entity if they occur

4. A parent company acquires from a third party bonds that had been issued originally by one of its subsidiaries. What accounting problems are created by this purchase?

4. Because the bonds were purchased from an outside party, the acquisition price is likely to differ from the book value of the debt in the subsidiary's records. This difference creates accounting challenges in handling the intra-entity transaction. From a consolidated perspective, the debt is retired; a gain or loss is reported with no further interest being recorded. In reality, each company continues to maintain these bonds on their individual financial records. Also, because discounts and/or premiums are likely to be present, these account balances as well as the interest income/expense will change from period to period because of amortization. For reporting purposes, all individual accounts must be eliminated with the gain or loss being reported so that the events are shown from the vantage point of the consolidated entity.

5. In question (4), why is the consolidation process simpler if the bonds had been acquired directly from the subsidiary than from a third party?

5. If the bonds are acquired directly from the affiliate company, all reciprocal accounts will be equal in amount. The debt and the receivable will be in agreement so that no gain or loss is created. Interest income and interest expense should also reflect identical amounts. Therefore, the consolidation process for this type of intra-entity debt requires no more than the offsetting of the various reciprocal balances.

6. When a company acquires an affiliated company's debt instruments from a third party, how is the gain or loss on extinguishment of the debt calculated? When should this balance be recognized?

6. The gain or loss to be reported is the difference between the price paid and the book value of the debt on the date of acquisition. For consolidation purposes, this gain or loss should be recognized immediately on the date of acquisition.

8. One company purchases the outstanding debt instruments of an affiliated company on the open market. This transaction creates a gain that is appropriately recognized in the consolidated financial statements of that year. Thereafter, a worksheet adjustment is required to correct the beginning balance of consolidated Retained Earnings (or the parent's Investment in Subsidiary account when the equity method is employed). Why is the amount of this adjustment reduced from year to year?

8. The original gain is never recognized within the financial records of either company. Thus, within the consolidation process for the year of acquisition, the gain is directly recorded whereas (for each subsequent year) it is entered as an adjustment to beginning retained earnings (or the Investment account if the equity method is used). In addition, because the book value of the debt and the investment are not in agreement, the interest expense and interest income balances being recorded by the two companies will differ each year because of the amortization process. This amortization effectively reduces the difference between the individual retained earnings balances and the total that is appropriate for the consolidated entity. Consequently, a smaller change is needed each period to arrive at the balance to be reported. For this reason, the annual adjustment to beginning retained earnings (or the Investment account if the equity method is used) gradually decreases over the life of the bond.

9. A parent acquires the outstanding bonds of a subsidiary company directly from an outside third party. For consolidation purposes, this transaction creates a gain of $45,000. Should this gain be allocated to the parent or the subsidiary? Why?

9. No set rule exists for assigning the income effects from intra-entity debt transactions although several different theories exist and include: (1) assignment of the entire amount to the debtor, (2) assignment of the entire amount to the buyer, and (3) allocation of the gain or loss between the two parties in some manner. This textbook attributes the entire income effect (the $45,000 gain in this case) to the parent company. Assignment to the parent is justified because that party is ultimately responsible for the decision to retire the debt from the public market. The answer to the discussion question included in this chapter analyzes this question in more detail.