Chapter Six: Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

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.

Variable Interest Entities (VIEs)—Primary Beneficiary

-Enterprise that created VIE may not own any of its voting stock. -Prior to current consolidation requirements, enterprises left VIEs 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 VIE. -Primary beneficiary must consolidate in its financial statements the VIE's assets, liabilities, revenues, expenses, and noncontrolling interest.

Financial Reporting Principles for Consolidating VIEs—Initial Measurement Issues

-Financial reporting principles for consolidating VIEs 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 VIE exceeds the collective fair values of its net assets, goodwill is recognized.

Variable Interest Entities—Risk and Ownership

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

Consolidation of VIEs Subsequent to Initial Measurement

-After the initial measurement, all intra-entity transactions between the primary beneficiary and the VIE must be eliminated in consolidation. -VIE'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—Adjustments

-Adjustments arising from subsidiary's revenues or expenses (e.g., depreciation, amortization) must reflect only postacquisition 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.

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.

Subsidiary Stock Transactions

Account for changes in parent's ownership interest following FASB ASC (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.

Identification of a VIE

An entity qualifies as a VIE 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 VIE, as a group, lack any one of three characteristics of a controlling financial interest:

Variable Interest Entity Disclosure Requirements

Enhanced disclosures are required for any enterprise that holds a variable interest in a VIE, including: -VIE's nature, purpose, size, and activities. -Significant judgments and assumptions an enterprise makes in determining whether it must consolidate a VIE and/or disclose information about its involvement in a VIE. -Nature of restrictions on a consolidated VIE'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. -Nature of, and changes in, the risks associated with an enterprise's involvement with the VIE. -How an enterprise's involvement with the VIE affects the enterprise's financial position, financial performance, and cash flows.

Benefits of VIE:

-Often eligible for a lower interest rate -Low-cost financing of assets

Common examples of VIE activities:

-Transfers of financial assets -Leasing -Hedging financial instruments -Research and development

Established as a separate business structure:

-Trust -Joint venture -Partnership -Corporation

Consolidated Earnings per Share

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

Characteristics of VIEs

-VIEs 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 VIE 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, e.g., the primary beneficiary, contributes substantial resources—loans and/or guarantees—to enable the VIE to secure additional financing to accomplish its purpose. -Primary beneficiary may guarantee the VIE'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 VIE's success—hence the term *variable interest entity*. -Risks and rewards are not distributed according to stock ownership but according to other variable interests.

An enterprise with a variable interest with a controlling financial interest in a VIE is the primary beneficiary and will have both of the following characteristics:

1) The power to direct the activities of a VIE that most significantly impact the entity's economic performance. 2) The obligation to absorb losses that could potentially be significant to the VIE or the right to receive benefits from it that could be significant to the VIE.

Equity investors in VIE, 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.

Subsidiary Preferred Stock—Noncontrolling Interest

-High paid $1 million for common and $62,400 for preferred stock. -At acquisition date, the 20 percent noncontrolling interest in the common shares had a fair value of $250,000. -The 40 percent preferred stock noncontrolling interest had a fair value of $41,600. -Consolidation entries S and A recognize the noncontrolling interest as the total acquisition-date fair values of $250,000 for common stock and $41,600 for preferred shares. *Consolidated Entries S and A (combined)* C/S (Low).........................................................400,000 P/S (Low).......................................................... 100,000 APIC (Low)......................................................200,000 R/E (Low)......................................................... 516,000 Land.................................................................... 100,000 Goodwill........................................................... 38,000 Investment in Low's C/S.......................1,000,0000 Investment in Low's P/S........................ 62,400 Noncontroling Intrest............................ 291,600

Acquisition Period Statement of 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 postacquisition 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.

Variable Interest Entities (VIEs)

-Known as *special purpose entities* (SPEs). -Most VIEs are established for valid business purposes. -Established as a separate business structure: -VIEs sometimes have no independent management or employees. -Common examples of VIE activities: -Benefits of VIE: -Governing agreements limit activities and decision making.

Subsidiary Preferred Stock Example

-On January 1, 2017, High Company purchased 80 percent of Low Company's outstanding common stock and 60 percent of its nonvoting, cumulative, preferred stock, acquiring control. -Low owns land, undervalued in its records by $100,000, and all other assets and liabilities have fair values equal to their book values. -Low's capital structure prior to acquisition: C/S, $20 par value (20,000)............................. $400,000 P/S, 6% cumulative w/ $100 par value........ 100,000 APIC............................................................................ 200,000 R/E................................................................................ 516,000 Total stockholder's equity (BV)....................... 1,216,000

Acquisition of Affiliate's Debt from an Outside Party

-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. -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.

Identification of the Primary Beneficiary of the VIE

-Once a firm has a relationship with a VIE, the firm must determine whether it qualifies as the VIE's primary beneficiary. -An enterprise with a variable interest with a controlling financial interest in a VIE is the primary beneficiary and will have both of the following characteristics: -These characteristics mirror those that the equity investors often lack in a VIE. -The primary beneficiary will absorb a significant share of the VIE's losses or receive a significant share of the VIE'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 VIE's governing documents and who bears risk is necessary to determine whether a reporting entity possesses control over a VIE.

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.

Computing Earnings per Share for a Business Combination

-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. -Stock warrants, convertible debt, warrants, or options for the parent's stock that can possibly dilute the reported figure must be included in diluted EPS.

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.