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PARTIALLY OWNED CREATED SUBSIDIARIES

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Fair Value Method (the new kid)--must use if significant influence does NOT exist. ... new kid on. the block. Slide 3-9. 3. Variable Interest Entities (VIEs): Defined ... – PowerPoint PPT presentation

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Title: PARTIALLY OWNED CREATED SUBSIDIARIES


1
CHAPTER 3
  • PARTIALLY OWNED CREATED SUBSIDIARIES

2
FOCUS OF CHAPTER 3
  • Partially Owned Created Subsidiaries
  • Preparing Consolidated Statements
  • The Cost Method
  • The Equity Method
  • Unconsolidated Subsidiaries--Ways to Value the
    Parents Investment
  • Variable Interest Entities
  • Taxation of domestic subsidiaries.

3
Proportional vs. Full Consolidation At Opposite
Ends of the Spectrum
4
Parent Company Concept vs. Economic Unit Concept
Not Much Difference for Created Subsidiaries
5
Parent Company Concept (PCC) vs. Economic Unit
Concept (EUC)Definition Classification
Differences
1. Pumco ownership of Sumco 80.2. Sumcos
net income for 2006 100,0003. Pumcos net
income for 2006 from its own separate
operations 400,000.
PCC EUCConsol. net
income . . 480,000 500,000 NCI in Net
Income . . 20,000 20,000Classification
of NCI in Net Assets . . O/S Equity Equity
6
Unconsolidated Subsidiaries 100 Ownership
Situations
  • Permissible Valuation Methods(for when control
    has been lost)
  • Equity Method--but ONLY IF significant influence
    exists.
  • Cost Method--makes sense to use when realization
    of subs expected future earnings is doubtful.
  • The default method if NO significant influence
    exists.

7
Unconsolidated Subsidiaries Partial
Ownerships--NCI Shares Are NOT Publicly Traded
  • Permissible Valuation Methods(for when control
    has been lost)
  • Equity Method--but ONLY IF significant influence
    exists.
  • Cost Method.
  • The default method if NO significant influence
    exists.

8
Unconsolidated SubsidiariesPartial
Ownerships--NCI SharesARE Publicly Traded
Look for a new kid on the block.
  • Permissible Valuation Methods(for when control
    has been lost)
  • Equity Method--but ONLY IF significant influence
    exists.
  • Fair Value Method (the new kid)--must use if
    significant influence does NOT exist.

WSJ--12/31/06....33 7/8
9
Variable Interest Entities (VIEs)Defined
  • VIE A less than majority-owned entity that
    is subject to consolidation under the
    provisions of FASB Interpretation 46.
  • If certain conditions exist, the entity must be
    consolidated.
  • An entity that has a variable interest in
    aVIE--an interest that changes with changes in
    the VIEs net assets--must determine if it must
    consolidate the VIE.

10
Variable Interest Entities (VIEs)Variable
Interest Relationships
  • Variable Interest Relationships
  • Situations in which an entityReceives benefits
    and/or is exposed to risks similar to those
    received from having a majority ownership
    interest.
  • Result from contractual arrangements.

11
Variable Interest Entities (VIEs)Contractual
Arrangements
  • Contractual Arrangement Types
  • Options
  • Leases
  • Guarantees of asset recovery values
  • Guarantees of debt repayment
  • Contractual arrangements may exist simultaneously
    with a less than majority ownership in a VIE.

12
Variable Interest Entities (VIEs)Most are SPEs
  • Special Purpose Entities
  • Legally structured entities to serve a specific,
    predetermined, limited purpose.
  • May be a corporation, partnership, trust, or some
    other legal entity.
  • Creator is called the sponsor.
  • Usually thinly capitalized.
  • Most commonly used for securitizations (of
    receivables).

13
Variable Interest Entities (VIEs)SPEs
  • Special Purpose Entities
  • Not subject to consolidation provisions of FIN 46
    if sales recognition criteria of FAS 140 is met
    for transfer of assets to SPE.
  • If met, SPE is called a Qualifying SPE. (If not
    met, the proceeds from the transfer are treated
    as a loan.)
  • FAS 140 prohibits transferors from consolidating
    QSPEs (because risk exposure is considered
    insignificant).

14
Variable Interest Entities (VIEs)Potential
Variable Interests
  • Potential Variable Interests
  • Subordinated loans to a VIE.
  • Equity interests in a VIE (50 or less).
  • Guarantees to a VIEs lenders or equity holders
    (that reduce the true risk of these parties).
  • Written put options on a VIEs assets held by a
    VIE or its lenders or equity holders.
  • Forward contracts on purchases and sales.

15
Variable Interest Entities (VIEs)The Primary
Beneficiary
  • PRIMARY BENEFICIARY of a VIE must consolidate the
    VIE.
  • PRIMARY BENEFICIARY is the entity that
  • Will absorb a majority (more than 50) of the
    VIEs expected losses and/or
  • Will receive a majority (more than 50) of the
    VIEs expected residual returns.
  • Expected losses are given more weight than
    expected residual returns in certain situations.

16
Variable Interest Entities (VIEs)The Primary
Beneficiary
  • Only one PRIMARY BENEFICIARY can exist for
    a VIE (by definition).
  • Potential for Erroneously Determined Multiple
    Primary Beneficiaries Does Exist
  • When one or more variable interest holders(VIH)
    has incomplete information about the VIEs other
    VIH.
  • Different VIH make different judgments about
    their variable interests.

17
Variable Interest Entities (VIEs)Determining if
an Entity is a VIE
  • IN GENERAL, an entity is subject to
    consolidation if, by design, any of three
    conditions exists. These conditions focus on
    1. Sufficiency of equity investment at risk.
    2. Characteristics of the holders of equity
    investment at risk. 3. Whether certain
    disproportionalities exist among the
    equity investors.

18
Variable Interest Entities (VIEs)Determining if
an Entity is a VIE
  • Condition 1 Equity investment at risk is not
    sufficient to permit the entity to finance its
    activities without additional subordinated
    financial support (SFS).
  • SFS is defined as variable interests that will
    absorb some or all of an entitys expected losses
    (example a debt guarantee or an equity
    guarantee).
  • In general, the equity at risk is deemed
    sufficient if it is at least 10 of total assets.
    (May need more than 10.)

19
Variable Interest Entities (VIEs)Determining if
an Entity is a VIE (cont.)
  • Condition 2 The holders of the equity
    investment at risk (as a group) lack any of the
    following characteristics
  • The ability to make decisions about an entitys
    activities.
  • The obligation to absorb the entitys expected
    losses.
  • The right to receive the entities expected
    residual returns.

20
Variable Interest Entities (VIEs)Determining if
an Entity is a VIE (cont.)
  • Condition 3 Certain disproportionalities exist
    among the equity investors.
  • Example Certain equity holders possess voting
    rights that are not proportional to their
    obligation to share the VIEs losses.

21
Variable Interest Entities (VIEs)Consolidation
Procedures
  • Major Points in Consolidating
  • 1 Eliminate primary beneficiarys
    interest in the VIE.
  • 2 Report VIEs assets liabilities at fair
    values--not their book values.
  • 3 Report goodwill if it exists.
  • 4 Extinguish negative goodwill/ BPE if
    it exists.
  • 5 Report noncontrolling interest at FV.
  • 6 Eliminate intercompany transactions.

22
Variable Interest Entities (VIEs)Disclosures
Required When Involved
  • Disclosures for Primary Beneficiaries (that do
    not hold a majority voting interest)
  • 1 VIEs nature, purpose, size, activities.
  • 2 Carrying value and classification of
    consolidated assets that are collateral
    for the VIEs obligations.
  • 3 Lack of recourse if creditors (or
    beneficial interest holders) of a
    consolidated VIE have no recourse to the
    general credit of the primary
    beneficiary.

23
Variable Interest Entities (VIEs)Disclosures
Required When Involved
  • Disclosures for Nonprimary Beneficiaries
  • 1 Nature of involvement with VIE and
    when involvement began.
  • 2 VIEs nature, purpose, size, activities.
  • 3 The entitys maximum exposure to loss
    as a result of its involvement with the
    VIE.

24
Review Question 1
  • Which of the following is NOT permitted under
    GAAP?A. The economic unit concept.B. The
    parent company concept.C. Full
    consolidation.D. Proportional
    consolidation.E. None of the above.

25
Review Question 1--With Answer
  • Which of the following is NOT permitted under
    GAAP?A. The economic unit concept.B. The
    parent company concept.C. Full
    consolidation.D. Proportional
    consolidation.E. None of the above.

26
Review Question 2
  • The noncontrolling interest (NCI) is reported
    OUTSIDE consolidated stockholders equity
    underA. The economic unit concept.B. The
    parent company concept.C. Full
    consolidation.D. Proportional
    consolidation.E. None of the above.

27
Review Question 2--With Answer
  • The noncontrolling interest (NCI) is reported
    OUTSIDE consolidated stockholders equity
    underA. The economic unit concept.B. The
    parent company concept.C. Full
    consolidation.D. Proportional
    consolidation.E. None of the above.

28
Review Question 3
  • The noncontrolling interest (NCI) is reported AS
    PART OF consolidated stockholders equity
    underA. The economic unit concept.B. The
    parent company concept.C. Full
    consolidation.D. Proportional
    consolidation.E. None of the above.

29
Review Question 3--With Answer
  • The noncontrolling interest (NCI) is reported AS
    PART OF consolidated stockholders equity
    underA. The economic unit concept.B. The
    parent company concept.C. Full
    consolidation.D. Proportional
    consolidation.E. None of the above.

30
Review Question 4
  • On 1/1/06, Parco invested 900,000 in Sarco
    (90-owned). For 2006, Sarco (1) earned
    60,000, (2) declared dividends of 50,000, and
    (3) paid dividends of 40,000. What amounts does
    Parco report?
    Cost EquityInvestment
    income for 2006.....
    Investment in Sarco at Y/E......Retained
    earnings increase.......

31
Review Question 4--With Answer
  • On 1/1/06, Parco invested 900,000 in Sarco
    (90-owned). For 2006, Sarco (1) earned
    60,000, (2) declared dividends of 50,000, and
    (3) paid dividends of 40,000. What amounts does
    Parco report?
    Cost EquityInvestment
    income for 2006.....
    Investment in Sarco at Y/E......Retained
    earnings increase.......

45,000 54,000
900,000 909,000
45,000 54,000
32
Review Question 5
  • On 1/1/06, Parco invested 900,000 in Sarco
    (90-owned) and NCI shareholders invested
    100,000. For 2006, Sarco (1) earned 60,000,
    (2) declared dividends of 50,000, and (3) paid
    dividends of 40,000. What amounts does Parco
    report for the items below?
    NCI in net
    income for 2006... _________
    NCI in net assets at 12/31/06..
    _________Con. retained earnings increase..
    _________

33
Review Question 5--With Answer
  • On 1/1/06, Parco invested 900,000 in Sarco
    (90-owned) and NCI shareholders invested
    100,000. For 2006, Sarco (1) earned 60,000,
    (2) declared dividends of 50,000, and (3) paid
    dividends of 40,000. What amounts does Parco
    report for the items below?
    NCI in net
    income for 2006... 6,000
    NCI in net assets at 12/31/06..
    101,000 Con. retained earnings increase..
    54,000

34
Review Question 6
  • A 100-owned subsidiary is NOT consolidated. The
    parent could definitely NOT useA. The cost
    method B. The equity method. C. The lower of
    cost or market method. D. The fair market
    value method. E. None of the above.

35
Review Question 6--With Answer
  • A 100-owned subsidiary is NOT consolidated. The
    parent could definitely NOT useA. The cost
    method B. The equity method. C. The lower of
    cost or market method. D. The fair market
    value method. E. None of the above.

36
Review Question 7
  • A LESS THAN 100-owned subsidiary is NOT
    consolidated--the NCI shares ARE publicly traded.
    The parent definitely could NOT useA. The
    cost methodB. The equity method.C. The fair
    market value method.D. None of the above.

37
Review Question 7--With Answer
  • A LESS THAN 100-owned subsidiary is NOT
    consolidated--the NCI shares ARE publicly traded.
    The parent definitely could NOT useA. The
    cost methodB. The equity method.C. The fair
    market value method.D. None of the above.

38
End of Chapter 3(Appendix 3B follows)
  • Time to Clear Things Up--Any Questions?

39
Appendix 3B Domestic Subs Recording Taxes at
Parent Level on Subs Income
  • Double vs. Triple Taxation--Ways to Easily Avoid
    the THIRD Tax
  • Own 80 or More of Subs Stock
  • Can file a consolidated tax return or
  • File separate tax returns--parent uses a dividend
    received deduction of 100.

Sub files its own IRS Form 1120
40
Appendix 3B Consolidated Tax Returns--Advantages
Vs. Disadvantages
  • Major Advantages
  • Can offset Xs LOSS against Ys INCOME.
  • Can offset Xs CAPITAL LOSS against Ys CAPITAL
    GAIN.
  • Avoids Sec. 482 transfer pricing problems.
  • Major Disadvantages
  • Xs loss on intercompany sale is deferred.
  • Complexity.

41
Appendix 3B Domestic Subs Less Than 80
Ownership Situations
Sub must file its own IRS Form 1120
  • Triple Taxation CANNOT be Entirely Avoided
  • Dividend received deduction is only 80.
  • FASB Parent must record any triple tax inthe
    year in which sub earns its income--NO
    EXCEPTIONS ARE ALLOWED FOR DOMESTIC SUBSIDIARIES.

42
Review Question 3B-1
  • Pemco owns 60 of Semco. For 2006, Semco (1)
    earned 100,000, (2) declared dividends of
    75,000, and (3) paid dividends of 55,000. What
    additional income taxes must Pemco record on its
    books because of this investment (income tax rate
    is 40)?A. -0-.B. 4,800.C. 15,000.D.
    18,000.E. 24,000.

43
Review Question 3B-1--With Answer
  • Pemco owns 60 of Semco. For 2006, Semco (1)
    earned 100,000, (2) declared dividends of
    75,000, and (3) paid dividends of 55,000. What
    additional income taxes must Pemco record on its
    books because of this investment (income tax rate
    is 40)?A. -0-.B. 4,800 (60,000 - 48,000
    DRD) x 40).C. 15,000.D. 18,000.E.
    24,000.
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