© The McGraw-Hill Companies, Inc., 2007 Slide 6-1 McGraw-Hill/Irwin Chapter Six Variable Interest...

© The McGraw-Hill Companies, Inc., 2007

Slide 6-1

McGraw-Hill/Irwin

Chapter Six

Variable Interest Variable Interest Entities, Entities,

Intercompany Intercompany Debt, Debt,

Consolidated Consolidated Cash Flows, and Cash Flows, and

Other IssuesOther Issues


Slide 6-2

McGraw-Hill/Irwin

Variable Interest Entities

Established as a separate business structure Trust Joint Venture Partnership Corporation

Frequently has neither independent management nor employees

Typical purposes Transfers of financial assets Leasing Hedging financial instruments Research and development


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Examples of Variable InterestsExh.6-1


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Variable Interest Entities – FIN 46R

Although most VIE’s were established for legitimate business purposes, abuses occurred, particularly in avoiding consolidated disclosure

FIN 46R, issued in December 2003, was designed to ensure appropriate accounting for these entities

FIN 46R provides a broader concept of control for purposes of producing consolidated financial statements


Slide 6-5

McGraw-Hill/Irwin

Variable Interest Entities – FIN 46R

Controlling financial interest on the part of a “primary beneficiary” is deemed to exist when the following characteristics are present: The direct or indirect ability to make

decisions about the entity’s activities The obligation to absorb any expected

losses of the entity The right to receive any expected residual

returns of the entity(When these are present, consolidated

financial statements must be produced!)


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McGraw-Hill/Irwin

Variable Interest Entity - Example

As long as the VIE stays independent, an effective transfer of risk results.

VIE’s are generally consolidated.

As long as the VIE stays independent, an effective transfer of risk results.

VIE’s are generally consolidated.

An asset is acquired for

low cost.

Asset is leased to Sponsor.

Sponsor Company

VIE

The VIE recognizes revenues.


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Variable Interest Entities

Technically, the equity investors control the VIE.

However, often the equity investors

cede control to the variable interest

parties in exchange for a

guaranteed return.

Technically, the equity investors control the VIE.

However, often the equity investors

cede control to the variable interest

parties in exchange for a

guaranteed return.


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Procedures for Consolidation of VIE’s

Valuations of assets, liabilities, and noncontrolling interest should be based on FV,

except for two notable exceptions.



1. Assets transferred to the

VIE from the Primary

Beneficiary, should be

measured as if they had never

been transferred.

1. Assets transferred to the

VIE from the Primary

Beneficiary, should be

measured as if they had never

been transferred.


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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.

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.


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McGraw-Hill/Irwin


When the implied When the implied value of the VIE is less value of the VIE is less than the assessed fair than the assessed fair values of the assets, values of the assets, then the assets are then the assets are

proportionately proportionately reduced.reduced.

When the implied When the implied value of the VIE is less value of the VIE is less than the assessed fair than the assessed fair values of the assets, values of the assets, then the assets are then the assets are

proportionately proportionately reduced.reduced.


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When the implied When the implied value of the VIE value of the VIE

exceeds the exceeds the assessed fair assessed fair values of the values of the assets, the assets, the

difference is difference is reported asreported as

a)a) Goodwill (if the VIE Goodwill (if the VIE is a business)is a business)

b)b) An extraordinary An extraordinary loss (if the VIE is loss (if the VIE is not “a business”)not “a business”)

When the implied When the implied value of the VIE value of the VIE

exceeds the exceeds the assessed fair assessed fair values of the values of the assets, the assets, the

difference is difference is reported asreported as

a)a) Goodwill (if the VIE Goodwill (if the VIE is a business)is a business)

b)b) An extraordinary An extraordinary loss (if the VIE is loss (if the VIE is not “a business”)not “a business”)


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FIN 46R – Definition of a business

“A self-sustaining integrated set of activities and assets conducted and managed for the purpose of providing a return to investors.”

A business consists of Inputs Processes applied to those inputs Resulting outputs used to generate

revenues


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FIN 46 Disclosure Requirements – In Footnotes of Primary Benificiary

Nature, purpose, size, & activities of

the VIE


the VIE

Carrying amount of consolidated assets

pledged as collateral by the Primary

Beneficiary

Carrying amount of consolidated assets

pledged as collateral by the Primary

Beneficiary

Classification of consolidated

assets pledged as collateral by the

Primary Beneficiary

Classification of consolidated

assets pledged as collateral by the

Primary Beneficiary

Lack of recourse if creditors (or beneficial interest holders) of the

VIE have no recourse to the general credit of the

primary beneficiary.

Lack of recourse if creditors (or beneficial interest holders) of the

VIE have no recourse to the general credit of the

primary beneficiary.


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McGraw-Hill/Irwin

FIN 46 Disclosure Requirements – In Footnotes of non-primary Beneficiaries


the VIE


the VIE

Nature of involvement with the

VIE

Nature of involvement with the

VIE

When involvement with

the VIE began

When involvement with

the VIE began Maximum exposure to loss as a result of

involvement with the VIE.

Maximum exposure to loss as a result of

involvement with the VIE.


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McGraw-Hill/Irwin

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.


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Acquisition of Affiliate’s Debt from an Outside Party

(1) 80% Ownership

Parent

Sub(2) Assume the

Sub issued bonds to outside

investors.

In effect, the Sub has issued the

debt indirectly to the Parent. How should this be accounted for?

In effect, the Sub has issued the

debt indirectly to the Parent. How should this be accounted for?

(3) Investors sell the

bonds to the parent

company.


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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.

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.


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McGraw-Hill/Irwin

Big owns 90% of Little. On 1/1/06, Little issued $2 million of 6%, 10-year

bonds. The current carrying amount on Little’s books at 1/1/07 is:

Bonds Payable = $2,000,000

Bond Discount = $161,043

Carrying Amount = $1,838,957

On 1/2/07, Big decides to re-purchase Little’s bonds from the market,

effectively extinguishing the debt.

Big owns 90% of Little. On 1/1/06, Little issued $2 million of 6%, 10-year

bonds. The current carrying amount on Little’s books at 1/1/07 is:

Bonds Payable = $2,000,000

Bond Discount = $161,043

Carrying Amount = $1,838,957

On 1/2/07, Big decides to re-purchase Little’s bonds from the market,

effectively extinguishing the debt.


Continue


Slide 6-19

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On 1/2/07, the market rate is 5%, and Big pays $2,101,514 for the bonds. Since Little’s carrying value is $1,838,957,

there is an effective loss of $262,557 to be recorded by the consolidated entity.

At 12/31/07, the consolidated entity must: Record the loss of $262,557

Eliminate the related intercompany debt at BV

Eliminate the intercompany interest

On 1/2/07, the market rate is 5%, and Big pays $2,101,514 for the bonds. Since Little’s carrying value is $1,838,957,

there is an effective loss of $262,557 to be recorded by the consolidated entity.

At 12/31/07, the consolidated entity must: Record the loss of $262,557

Eliminate the related intercompany debt at BV

Eliminate the intercompany interest


Continue


Slide 6-20

McGraw-Hill/Irwin


Entry BThis 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.

Entry BThis 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.


Slide 6-21

McGraw-Hill/Irwin


Entry *B (Subsequent Years)

Adjust the BV’s 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.





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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 completely amortized.

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 completely amortized.


Slide 6-23

McGraw-Hill/Irwin

The treatment of subsidiary preferred stock in the consolidated financial

statements depends on whether the shares are viewed as:

Debt or EquityThe parent’s acquisition of the preferred stock is accounted for

in a manner similar to the accounting for the parent’s

acquisition of the subsidiary’s bonds.

The treatment of subsidiary preferred stock in the consolidated financial

statements depends on whether the shares are viewed as:

Debt or EquityThe parent’s acquisition of the preferred stock is accounted for

in a manner similar to the accounting for the parent’s

acquisition of the subsidiary’s bonds.

Subsidiary Preferred Stock


Slide 6-24

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Preferred Stock Treated as a Debt Instrument

Preferred Stock is treated as if it were 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.

The first entry eliminates the preferred stock purchased by the parent, just as if it were retired.


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The second entry recognizes the noncontrolling interest in the preferred stock. The amount assigned to the noncontrolling interest is based on the call price.

The second entry recognizes the noncontrolling interest in the preferred stock. The amount assigned to the noncontrolling interest is based on the call price.


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McGraw-Hill/Irwin

On 2/1/07, Liberty Corporation acquires 60% of American News, Inc. Liberty pays $43,400,000 for 700,000 shares of ANI’s

common stock (1,000,000 shares outstanding). Liberty pays $3,210,000 for 30,000 shares of ANI’s $100 par preferred

stock (50,000 shares outstanding).

The preferred stock has a call price of 109 and is viewed as Debt.

Prepare the December 31, 2007 consolidation entries.




The preferred stock has a call price of 109 and is viewed as Debt.

Prepare the December 31, 2007 consolidation entries.


Continue


Slide 6-27

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First Entry Eliminate Liberty’s investment in the preferred stock. The preferred stock is

eliminated at cost.


eliminated at cost.

?


Slide 6-28

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eliminated at cost.


eliminated at cost.


Slide 6-29

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Second Entry Recognize the noncontrolling interest in

the preferred stock. Base it on the 109 call price.



?


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Slide 6-31

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So, what do we do when

the Preferred Stock is

viewed as Equity?


Slide 6-32

McGraw-Hill/Irwin

Subsidiary Preferred StockViewed as Equity

2. The preferred stock 2. The preferred stock is eliminated in the is eliminated in the

same way as common same way as common stock. stock.

2. The preferred stock 2. The preferred stock is eliminated in the is eliminated in the

same way as common same way as common stock. stock.

1. The purchase price in excess of book

value of the preferred stock is allocated to specific accounts.

1. The purchase price in excess of book

value of the preferred stock is allocated to specific accounts. When When

preferred preferred stock is stock is

viewed as viewed as equity . . .equity . . .

When When preferred preferred stock is stock is

viewed as viewed as equity . . .equity . . .


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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 value from the subsidiary’s numbers.

The 1st entry eliminates the preferred stock book value from the subsidiary’s numbers.


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The 2The 2ndnd entry recognizes the portion of the entry recognizes the portion of the acquisition cost allocated to assets.acquisition cost allocated to assets.

The 2The 2ndnd entry recognizes the portion of the entry recognizes the portion of the acquisition cost allocated to assets.acquisition cost allocated to assets.


Slide 6-35

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The preferred stock has a call price of 109 and is viewed as Equity.




The preferred stock has a call price of 109 and is viewed as Equity.


Continue


Slide 6-36

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ANI’s preferred stock participates in 10% of the annual income. ANI’s

book value on 2/1/07 is $46 million. The book value includes:

ANI’s preferred stock participates in 10% of the annual income. ANI’s

book value on 2/1/07 is $46 million. The book value includes:


Continue


Slide 6-37

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Continue

First, determine how much of ANI’s book value First, determine how much of ANI’s book value should be assigned to the preferred stock. In should be assigned to the preferred stock. In

this case it is $5,200,000.this case it is $5,200,000.

First, determine how much of ANI’s book value First, determine how much of ANI’s book value should be assigned to the preferred stock. In should be assigned to the preferred stock. In

this case it is $5,200,000.this case it is $5,200,000.


Slide 6-38

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Continue

Second, determine Goodwill related to Liberty’s acquisition of 60% of ANI’s preferred stock. Assume that ANI has Land worth $100,000.

Second, determine Goodwill related to Liberty’s acquisition of 60% of ANI’s preferred stock. Assume that ANI has Land worth $100,000.


Slide 6-39

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?

Consolidation Entry PS Eliminate Liberty’s investment in ANI’s preferred stock. The preferred stock is

eliminated at cost.


eliminated at cost.


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eliminated at cost.


eliminated at cost.


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?

Consolidation Entry A1 Set up the land and the goodwill.



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Consolidated Statement of Cash Flows

The consolidated statement of cash flows

is based on the consolidatedconsolidated balance

sheet and the consolidatedconsolidated income

statement.


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Noncontrolling InterestAdd back the

noncontrolling interest’s share of the sub’s net income.

Deduct dividends paid to the outside owners as a cash outflow.

Noncontrolling InterestAdd back the

noncontrolling interest’s share of the sub’s net income.

Deduct dividends paid to the outside owners as a cash outflow.



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AmortizationAdd any

amortizations and FV allocations to Consolidated Net

Income.

AmortizationAdd any

amortizations and FV allocations to Consolidated Net

Income.



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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.


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Consolidated Earnings Per Share

If potentially dilutive items exist on the sub’s own financial statements, then the portion of

the sub’s net income included in consolidated net income may not be appropriate for the computation of consolidated earnings per share.


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?

Consolidated Earnings Per Share

Compute the sub’s 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.


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Subsidiary Stock Transactions

The effects on a parent of a subsidiary’s transactions in its own stock Reported as adjustments to APIC Not reported as a gain or loss of the

consolidated entity


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Summary

Variable Interest Entities are created to fulfill special purposes. Often, control of these entities resides in contractual arrangements rather than voting rights. FIN 46R requires consolidation when a business has a controlling financial interest in a VIE.

When one member of a combination acquires the debt of another, the debt is effectively retired

Preferred stock of a subsidiary will often resemble debt more than equity. If it is viewed thus, parent held shares are eliminated from the consolidated worksheets as if the stock had been retired.


Slide 6-51

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Possible Criticisms

There are at least four theoretical approaches to assigning the gains or losses created by early retirement of subsidiary debt: One approach is to assume that only the debtor is

affected by the retirement A second approach is to assign it to the investor A third approach is to split the assignment Finally, a fourth approach says to assign it entirely

to the parent

WHAT DO YOU THINK????


Slide 6-52

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Uh, Chester? Uh, Chester?

I wonder if we I wonder if we could discuss a could discuss a

little little “intercompany” “intercompany”

loan?loan?

End of Chapter 6

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