Chapter Six

1
Chapter Six
Variable Interest Entities, Intercompany Debt,
Consolidated Statement of Cash Flows, and Other
Issues
2
Special Purpose Entities

• A business entity formed to accomplish a single
  purpose.
• Activities are strictly limited by contract.

3
Common SPE Activities
LEAE
Research and Development
Hedging Financial Instruments
Transfers of Financial Assets
4
Special Purpose Entities

• As long as the SPE stays independent, an
  effective transfer of risk results.
• SPEs are generally consolidated.

Asset is leased to Sponsor.
An asset is acquired for low cost.
The SPE recognizes revenues.
5
Special Purpose Entities
Technically, the equity investors control the
SPE. However, often the equity investors cede
control to the variable interest parties in
exchange for a guaranteed return.
6
Variable Interest Entities (VIE)
SPE equity investors often have very little role
in controlling the SPEs activities, which are
often very restricted.
Because the sponsors risk/reward varies
depending on the success of the SPE, these SPEs
are referred to as Variable Interest Entities.
Profit often accrues to the sponsor as a function
of contractual agreements, rather than as a
function of stock ownership.
7
Examples of Variable Interests
Exh. 6-1
8
Consolidation of VIEs ARB 51
. . . An enterprises consolidated financial
statements include subsidiaries in which the
enterprise has a controlling financial interest.
- - ARB 51
Generally, this has applied to subs where the
parent has VOTING control.
9
Consolidation of VIEs FIN 46

• FIN 46 requires consolidation of a VIE when one
  of the following conditions exist
• If total equity at risk lt 10.
• The equity investors in the VIE lack one of the
  following traits
• The ability to make decisions about the VIEs
  activities.
• The obligation to absorb the expected losses of
  the VIE.
• The right to receive expected residual returns of
  the VIE.

Traits of a Primary Beneficiary
10
Consolidation of VIEs FIN 46
If a business enterprise has a controlling
financial interest in a variable interest entity,
assets, liabilities, and results of the
activities of the (VIE) should be included with
those of the (Primary Beneficiary). - - FIN 46
11
Procedures for Consolidation of VIEs
Valuations of assets, liabilities, and
noncontrolling interest should be based on FMV,
except for two notable exceptions.
1. Assets transferred to the VIE from the
Primary Beneficiary, should be measured as if
they have never been transferred.
12
Procedures for Consolidation of VIEs
Valuations of assets, liabilities, and
noncontrolling interest should be based on FMV,
except for two notable exceptions.
2. SFAS 141 requires allocation of the cost of
an investment to the underlying assets and
liabilities.Since no cost exists with a VIE,
an IMPLIED VALUE should be used to substitute for
the acquisition cost.
13
Procedures for Consolidation of VIEs
When the implied value of the VIE exceeds the
assessed net assets, NO GOODWILL IS
RECORDED! The difference is recorded as an
extraordinary loss by the primary beneficiary.
14
FIN 46 Disclosure Requirements
Carrying amount of assets pledged as collateral
by the Primary Beneficiary
Nature, purpose, size, activities of the VIE
Classification of assets pledged as collateral by
the Primary Beneficiary
Lack of recourse if creditors of the VIE have no
recourse to the general credit of the primary
beneficiary.
15
Intercompany Debt Transactions

• Direct loans between affiliated parties create no
  special consolidation problems.
• Eliminate the corresponding receivable and
  payable from the consolidated financial
  statements.
• Also eliminate the effects of any related
  interest.

16
Acquisition of Affiliates Debt from an Outside
Party
In effect, the Sub has issued the debt indirectly
to the Parent. How should this be accounted for?
17
Acquisition of Affiliates Debt from an Outside
Party

• The acquired debt must be treated as if it has
  been extinguished.
• Any related loss related to this early
  extinguishment of debt is recorded in the
  consolidated financial statements in the year of
  acquisition. (see APB Opinion 26)
• If material, the loss is treated as an
  extraordinary item.

18
Acquisition of Affiliates Debt from an Outside
Party

• Big owns 90 of Little. On 1/1/00, Little issued
  2 million of 6, 10-year bonds. The current
  carrying amount on Littles books at 1/1/04 is
• Bonds Payable 2,000,000
• Bond Discount 161,043
• Carrying Amount 1,838,957
• On 1/2/04, Big decides to re-purchase Littles
  bonds from the market, effectively extinguishing
  the debt.

19
Acquisition of Affiliates Debt from an Outside
Party

• On 1/2/04, the market rate is 5, and Big pays
  2,101,514 for the bonds. Since Littles
  carrying value is 1,838,957, there is an
  effective loss of 262,557 to be recorded by the
  consolidated entity.
• At 12/31/04, the consolidated entity must
• Record the loss of 262,557
• Eliminate the related intercompany debt at BV
• Eliminate the intercompany interest

20
Acquisition of Affiliates Debt from an Outside
Party

• Entry B
• This entry is made at the end of the year that
  the debt is extinguished
• We will assume that any gains/losses from this
  transaction belong to the parent. Thus, there
  will be no effect on Noncontrolling Interest.

21
Acquisition of Affiliates Debt from an Outside
Party

• Entry B (Subsequent Years)
• Adjust the BVs of the Bonds Payable and the
  Investment in Bonds to reflect amortization.
• Also, the loss is now reflected in R/E, which
  must also be adjusted for the difference in
  interest amounts.

22
Acquisition of Affiliates Debt from an Outside
Party

• Entry B (Subsequent Years)
• Adjust the BVs of the Bonds Payable and the
  Investment in Bonds to reflect amortization.
• Also, the loss is now reflected in R/E, which
  must also be adjusted for the difference in
  interest amounts.

Note that, over the remaining life of the bonds,
the book values will eventually converge to the
point where the adjustment to R/E will be
amortized away completely.
23
Subsidiary Preferred Stock
The treatment of subsidiary preferred stock in
the consolidated financial statements depends on
whether the shares are viewed as Debt or
Equity The parents acquisition of the preferred
stock is accounted for in a manner similar to the
accounting for the parents acquisition of the
subsidiarys bonds.
24
Preferred Stock Treated as a Debt Instrument

• The Preferred Stock is treated as debt when it
  has no rights other than a cumulative dividend.
• Two entries are required to eliminate the
  preferred stock

The first entry eliminates the preferred stock
purchased by the parent, just as if it were
retired.
25
Preferred Stock Treated as a Debt Instrument

• The Preferred Stock is treated as debt when it
  has no rights other than a cumulative dividend.
• Two entries are required to eliminate the
  preferred stock

The second entry recognizes the noncontrolling
interest in the preferred stock. The amount
assigned to the noncontrolling interest is based
on the call price.
26
Preferred Stock Treated as a Debt Instrument

• On 2/1/04, Liberty Corporation acquires 60 of
  American News, Inc. Liberty pays 43,400,000 for
  700,000 shares of ANIs common stock (1,000,000
  shares outstanding). Liberty pays 3,210,000 for
  30,000 shares of ANIs 100 par preferred stock
  (50,000 shares outstanding).
• The preferred stock has a call price of 109 and
  is viewed at Debt.
• Prepare the December 31, 2004 consolidation
  entries.

27
Preferred Stock Treated as a Debt Instrument

• First Entry
• Eliminate Libertys investment in the preferred
  stock. The preferred stock is eliminated at cost.

?
28
Preferred Stock Treated as a Debt Instrument

• First Entry
• Eliminate Libertys investment in the preferred
  stock. The preferred stock is eliminated at cost.

29
Preferred Stock Treated as a Debt Instrument

• Second Entry
• Recognize the noncontrolling interest in the
  preferred stock. Base it on the 109 call price.

?
30
Preferred Stock Treated as a Debt Instrument

• Second Entry
• Recognize the noncontrolling interest in the
  preferred stock. Base it on the 109 call price.

31
So, what do we do when the Preferred Stock is
viewed as Equity?
32
Subsidiary Preferred StockViewed as Equity
1. The purchase price in excess of book value of
the preferred stock is allocated to specific
accounts.
When preferred stock is viewed as equity . . .
2. The preferred stock is eliminated in the same
way as common stock.
33
Subsidiary Preferred StockViewed as Equity

• Preferred Stock is often viewed as Equity when it
  has rights other than a cumulative dividend,
  often including a conversion feature or
  participation rights.

The 1st entry eliminates the preferred stock book
values from the subsidiarys numbers.
34
Subsidiary Preferred StockViewed as Equity

• Preferred Stock is often viewed as Equity when it
  has rights other than a cumulative dividend,
  often including a conversion feature or
  participation rights.

The 2nd entry recognizes the portion of the
acquisition cost allocated to assets..
35
Subsidiary Preferred StockViewed as Equity

• On 2/1/04, Liberty Corporation acquires 60 of
  American News, Inc. Liberty pays 43,400,000 for
  700,000 shares of ANIs common stock (1,000,000
  shares outstanding). Liberty pays 3,210,000 for
  30,000 shares of ANIs 100 par preferred stock
  (50,000 shares outstanding).
• The preferred stock has a call price of 109 and
  is viewed at Equity.

36
Subsidiary Preferred StockViewed as Equity

• ANIs preferred stock participates in 10 of the
  annual income. ANIs book value on 2/1/04 is 46
  million. The book value includes

37
Subsidiary Preferred StockViewed as Equity
First, determine how much of ANIs book value
should be assigned to the preferred stock. In
this case it is 5,200,000.
38
Subsidiary Preferred StockViewed as Equity
Second, determine Goodwill related to Libertys
acquisition of 60 of ANIs preferred stock.
Assume that ANI has a Patent worth 100,000.
39
Subsidiary Preferred StockViewed as Equity
Consolidation Entry PS Eliminate Libertys
investment in ANIs preferred stock. The
preferred stock is eliminated at cost.
?
40
Subsidiary Preferred StockViewed as Equity
Consolidation Entry PS Eliminate Libertys
investment in ANIs preferred stock. The
preferred stock is eliminated at cost.
41
Subsidiary Preferred StockViewed as Equity
Consolidation Entry A1 Set up the land and the
goodwill.
?
42
Subsidiary Preferred StockViewed as Equity
Consolidation Entry A1 Set up the land and the
goodwill.
43
Consolidated Statement of Cash Flows

• The consolidated statement of cash flows is based
  on the consolidated balance sheet and the
  consolidated income statement.

44
Consolidated Statement of Cash Flows

• Noncontrolling Interest
• Add back the noncontrolling interests share of
  the subs net income.
• Deduct dividends paid to the outside owners as a
  cash outflow.

45
Consolidated Statement of Cash Flows
Amortization Add amortization of goodwill and FMV
allocations to Consolidated Net Income.
46
Consolidated Statement of Cash Flows

• Intercompany Transactions
• Intercompany cash flows should not be included on
  the statement of cash flows.
• The intercompany cash flows are already
  eliminated from the balance sheet, so no
  additional effects appear on the statement of
  cash flows.

47
Consolidated Earnings Per Share

• If potentially dilutive items exist on the
  subs own financial statements, then the portion
  of the subs net income included in consolidated
  net income may not be appropriate for the
  computation of consolidated earnings per share.

48
Consolidated Earnings Per Share

• Compute the subs own diluted EPS.
• The earnings used in the above computation are
  used in the determination of consolidated EPS.
• The portion assigned to the computation is based
  on the of the sub owned by the parent.

?
49
End of Chapter 6
Uh, Chester? I wonder if we could discuss a
little intercompany loan?