CH 6- Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, & Other Issues

Subsidiary Stock Transactions

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.

•Financial reporting principles for consolidating VIEs require asset, liability, and noncontrolling interest valuations. These valuations initially, with few exceptions...

are based on fair values.

A consolidated statement of cash flows is based on

consolidated balance sheet and consolidated income statement.

•If the total business fair value of the VIE exceeds the collective fair values of its net assets...

goodwill is recognized.

•The distribution of income is typically specified...

in contractual arrangements.

If the collective fair values of the net assets exceed the total business fair value

the primary beneficiary recognizes a gain on bargain purchase

Benefits of VIEs

•Often eligible for a lower interest rate. •Low-cost financing of assets. note: Governing agreements limit activities and decision making.

What are Variable Interest Entities and are some examples?

-Aka Special Purpose Entities (SPEs) -Established as a sep business structure: -business structure examples include: Trust, Joint Venture, Partnership, and Corporation

Consolidated Statementof Cash Flows—Adjustments

•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.

Subsidiary Preferred Stock

•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.

•VIE's income must be allocated among...

the parties involved (equity holders and the primary beneficiary).

Acquisition of Affiliate's Debt from an Outside Party (cont)

•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. •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.

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 securities are present, diluted EPS also must be presented. •To compute diluted EPS, combine the effects of any dilutive securities with basic earnings per share.

Prior Consolidation of VIEs

•In the past, 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 GAAP literature, legacy FASB standard FIN 46R requires the primary beneficiary (regardless of their ownership) to consolidate the VIE.

Variable Interest Entity Disclosure Requirements (cont)

•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.

Characteristics of VIEs

•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 V I E's success— variable interest entity. •Risks and rewards are distributed according to other variable interests.

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. •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 VIE to secure additional financing to accomplish its purpose.

after initial measurement, all intra-entity transactions between the primary beneficiary and the VIE must...

•be eliminated in consolidation.

Main purpose of the statement of cash flows

•is to provide information about the entity's cash receipts and cash payments during a period.

Acquisition of Affiliate's Debt from an Outside Party

•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.

Identifying the 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: 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.

•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.

VIEs: Primary beneficiary

•Enterprise that created VIE may not own any of its voting stock. •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.

Computing Earnings per Share for a Business Combination

•The computation of EPS 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 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.

Identifying the Primary Beneficiary

•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.

Conditions to qualify as VIE:

•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: 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.

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.

VIE risk & ownership

•Variable interests increase a firm's risk as the resources it provides (or guarantees)- increased risks incentivize restriction 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, 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 a VIE with its primary beneficiary follows a similar process as if the entity

•were consolidated based on voting interests. •Because VIEs typically have noncontrolling interests, an appropriate allocation of the VIE's net income requires a close examination of the underlying contractual arrangements between the primary beneficiary and other holders of variable interests.

VIE activities include...

-transfers of financial assets -leasing -hedging financial instruments -R&D

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