Title: PARTIALLY OWNED CREATED SUBSIDIARIES
1 CHAPTER 3
- PARTIALLY OWNED CREATED SUBSIDIARIES
2FOCUS 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.
3Proportional vs. Full Consolidation At Opposite
Ends of the Spectrum
4Parent Company Concept vs. Economic Unit Concept
Not Much Difference for Created Subsidiaries
5Parent 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
6Unconsolidated 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.
7Unconsolidated 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.
8Unconsolidated 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
9Variable 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.
10Variable 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.
11Variable 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.
12Variable 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).
13Variable 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).
14Variable 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.
15Variable 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.
16Variable 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.
17Variable 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.
18Variable 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.)
19Variable 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.
20Variable 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.
21Variable 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.
22Variable 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.
23Variable 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.
24Review 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.
25Review 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.
26Review 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.
27Review 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.
28Review 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.
29Review 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.
30Review 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.......
31Review 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
32Review 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..
_________
33Review 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
34Review 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.
35Review 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.
36Review 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.
37Review 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.
38End of Chapter 3(Appendix 3B follows)
- Time to Clear Things Up--Any Questions?
39Appendix 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
40Appendix 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.
41Appendix 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.
42Review 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.
43Review 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.