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CHAPTER 6
VARIABLE INTEREST ENTITIES, INTRA-ENTITY DEBT, CONSOLIDATED CASH FLOWS,
AND OTHER ISSUES
Chapter Outline
I. Variable interest entities (VIEs)
A. VIEs typically take the form of a trust, partnership, joint venture, or corporation. In most
cases a sponsoring firm creates these entities to engage in a limited and well-defined set
of business activities. For example, a business may create a VIE to finance the acquisition
of a large asset. The VIE purchases the asset using debt and equity financing, and then
leases the asset back to the sponsoring firm. If their activities are strictly limited and the
asset is pledged as collateral, VIEs are often viewed by lenders as less risky than their
sponsoring firms. As a result, such arrangements can allow financing at lower interest
rates than would otherwise be available to the sponsor.
B. Control of VIEs, by design, sometimes does not rest with its equity holders. Instead,
control is exercised through contractual arrangements with the sponsoring firm who
becomes the "primary beneficiary" of the entity. These contracts can take the form of
leases, participation rights, guarantees, or other residual interests. Through contracting,
the primary beneficiary bears a majority of the risks and receives a majority of the rewards
of the entity, often without owning any voting shares.
C. An entity whose control rests with a primary beneficiary is addressed by FASB ASC
subtopic 810-10 Variable Interest Entities. The following characteristics indicate a
controlling financial interest in a variable interest entity.
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 if they occur,or
3. The right to receive the expected residual returns of the entity if they occur
The primary beneficiary bears the risks and receives the rewards of a variable interest
entity and is considered to have a controlling financial interest.
D. If a reporting entity has a controlling financial interest in a variable interest entity, it should
include the assets, liabilities, and results of the activities of the variable interest entity its
consolidated financial statements.
Proposed Accounting Standards Update on Variable Interest Entities
In November 2011 (updated January 2013), the FASB issued a proposed change for
evaluating whether an entity must consolidate a VIE. The proposed accounting standard
update, entitled Principal versus Agent Analysis, would introduce a separate qualitative
analysis to determine whether a reporting entity with the authority to make economic
decisions for a VIE uses its power in a principal or agent capacity. If the decision making
party is a principal (rather than an agent of another party) then it is the controlling party.
Alternatively, if the party that exercises decision-making power acts in the capacity of an
agent, under the proposed guidance that party would not consolidate the VIE. As this
latest FASB proposal demonstrates, the manner in which control is assessed continues to
evolve over time.
II. Intra-entity debt transactions
A. No special difficulty is created when one member of a business combination loans money
to another. The resulting receivable/payable accounts as well as the interest income
expense balances are identical and can be directly offset in the consolidation process.
B. The acquisition of an affiliate's debt instrument from an outside party does require special
handling so that consolidated financial statements can be produced.
1. Because the acquisition price will usually differ from the book value of the liability, a
gain or loss has been created by an effective retirement which is not recorded within
the individual records of either company.
2. Because of the amortization of any associated discounts and/or premiums, the interest
income reported by the buyer will not equal the interest expense of the debtor.
C. In the year of acquisition, the consolidation process eliminates intra-entity accounts (the
liability, the receivable, interest income, and interest expense) while the gain or loss (which
produced all of the discrepancies because of the initial difference) is recognized.
1. Although several alternatives exist, this textbook assigns all income effects resulting
from the retirement to the parent company, the party ultimately responsible for the
decision to reacquire the debt.
2. Any noncontrolling interest is, therefore, not affected by the adjustments utilized to
consolidate intra-entity debt.
D. After the year of effective retirement, all intra-entity accounts must be eliminated again in
each subsequent consolidation. However, when the parent uses the equity method, the
parent’s Investment in Subsidiary account is adjusted in consolidation rather than a gain or
loss account. If the parent employs an accounting method other than the equity method,
then the parent’s Retained Earnings are adjusted for the prior years’ income net effects of
the effective gain/loss on retirement.
1. The change in retained earnings is needed because a gain or loss was created in a
prior year by the effective retirement of the debt, but only interest income and interest
expense were recognized by the two parties.
2. The adjustment to retained earnings at any point in time is the original gain or loss
adjusted for the subsequent amortization of discounts or premiums.
III. Subsidiary preferred stock
A. Subsidiary preferred shares not owned by the parent are a part of noncontrolling interest.
B. The fair value of any subsidiary preferred shares not acquired by the parent is added to
the consideration transferred along with the fair value of the noncontrolling interest in
common shares to compute the acquisition-date fair value of the subsidiary.
IV. Consolidated statement of cash flows
A. Statement is produced from consolidated balance sheet and income statement and not
from the separate cash flow statements of the component companies.
B. Consolidated net income is the starting point for the cash flow from operating section—
including both the parent and noncontrolling interest share.
C. Intra-entity cash transfers are omitted from this statement because they do not occur with
an outside unrelated party.
D. Dividends paid by the subsidiary to the noncontrolling interest are reported as a financing
activity.
V. Consolidated earnings per share
A. This computation normally follows the pattern described in intermediate accounting
textbooks. For basic EPS, consolidated net income is divided by the weighted-average
number of parent shares outstanding. If convertibles (such as bonds or warrants) exist for
the parent shares, their weight must be included in computing diluted EPS but only if
earnings per share is reduced.
1. The subsidiary's diluted earnings per share are computed first to arrive at (1) an
earnings figure and (2) a shares figure.
2. The portion of the shares figure belonging to the parent is computed. That percentage
of the subsidiary's diluted earnings is then added to the parent's net income in order to
complete the earnings per share computation.
VI. Subsidiary stock transactions
A. If the subsidiary issues new shares of stock or reacquires its own shares as treasury
stock, a change is created in the book value underlying the parent's investment account.
The increase or decrease should be reflected by the parent as an adjustment to this
balance.
B. The book value of the subsidiary that corresponds to the parent's ownership is measured
before and after the transaction with any alteration recorded directly to the investment
account. The parent's additional paid-in capital (or retained earnings) account is normally
adjusted although the recognition of a gain or loss is an alternate accounting treatment.
C. Treasury stock acquired by the subsidiary may also necessitate a similar adjustment to the
parent's investment account. In addition, any subsidiary treasury stock is eliminated within
the consolidation process.
Answer to Discussion Question: Who Lost this $300,000?
This case is designed to give life to a theoretical accounting issue: If a subsidiary's debt is retired,
should the resulting gain or loss be assigned to the parent or to the subsidiary? The case
illustrates that there is no clear-cut solution. This lack of an absolute answer makes financial
accounting both intriguing and frustrating.
assignment to either separate party.
Students should choose and justify one method. Discussion often centers on the following:
Parent company officials made the actual choice that created the book loss. Therefore,
assigning the $300,000 to the subsidiary directs the impact of their decision to the wrong
party. In effect, the subsidiary had nothing to do with this transaction (as indicated in the case)
so that its share of consolidated net income should not be affected by the $300,000 loss.
Both parties were involved in the transaction so that some allocation of the loss is required. If,
at the time of repurchase, a discount existed within the subsidiary's accounts, this figure would
Answers to Questions
1. A variable interest entity (VIE) is a business structure that is designed to accomplish a specific
2. Variable interests are contractual, ownership, or other pecuniary interests in an entity that
change with changes in the entity's net asset value. Variable interests will absorb portions of a
variable interest entity's expected losses if they occur or receive portions of the entity's
3. The following characteristics are indicative of an enterprise qualifying as a primary beneficiary
with a controlling financial interest in a VIE.
4. Because the bonds were purchased from an outside party, the acquisition price is likely to
differ from the book value of the debt in the subsidiary's records. This difference creates
accounting challenges in handling the intra-entity transaction. From a consolidated
perspective, the debt is retired; a gain or loss is reported with no further interest being
5. If the bonds are acquired directly from the affiliate company, all reciprocal accounts will be
equal in amount. The debt and the receivable will be in agreement so that no gain or loss is
6. The gain or loss to be reported is the difference between the price paid and the book value of
7. Because the bonds are still legally outstanding, they will continue to be found on both sets of
financial records. Thus, each account (Bonds Payable, Investment in Bonds, Interest
8. The original gain is never recognized within the financial records of either company. Thus,
within the consolidation process for the year of acquisition, the gain is directly recorded
whereas (for each subsequent year) it is entered as an adjustment to beginning retained
earnings (or the Investment account if the equity method is used). In addition, because the
Investment account if the equity method is used) gradually decreases over the life of the bond.
9. No set rule exists for assigning the income effects from intra-entity debt transactions although
several different theories exist and include: (1) assignment of the entire amount to the debtor,
(2) assignment of the entire amount to the buyer, and (3) allocation of the gain or loss
in more detail.
10. Subsidiary outstanding preferred shares are part of the noncontrolling interest and are
11. The consolidated cash flow statement is developed from consolidated balance sheet and
12. The noncontrolling interest share of the subsidiary’s net income is a component of
consolidated net income. Consolidated net income then is adjusted for noncash and other
13. An alternative to the normal diluted earnings per share calculation is required whenever the
14. Basic Earnings per Share. The existence of subsidiary convertible securities does not affect
basic EPS. The parent’s basic earnings per share is computed by dividing the parent’s share
of consolidated net income by the weighted average number of parent shares outstanding.
15. Several reasons could exist for a subsidiary to issue new shares of stock to outside parties.
First, additional financing is brought into the company by any such sale. Also, stock issuance
16. Because the new stock was issued at a price above the subsidiary’s assigned consolidation
value, the overall valuation for Metcalf's stock has been increased. Consequently, the
Washburn's investment is increased to reflect this change. To measure the effect, the value of
17. A stock dividend does not alter the assigned consolidated subsidiary value and, thus, creates
Answers to Problems
5. D
6. D Cash flow from operations:
Net income......................................................................... $45,000
Depreciation....................................................................... 10,000
Trademark amortization.................................................... 15,000
7. C Cash flow from financing activities:
Dividends to parent’s interest........................................... ($12,000)
8. C
9. C Post-issue subsidiary valuation ($800,000 + $250,000) $1,050,000
Arcola’s new ownership percentage (40,000 ÷ 50,000) 80%
Arcola’s share of post-issue subsidiary valuation $ 840,000
Arcola’s pre-issue equity balance 800,000
Increase to Arcola’s investment account $ 40,000
Eliminate interest expense on "retired" debt
($60,200 × 10%) ........................................................... 6,020
Eliminate interest income on "retired" debt
($56,000 × 12%) ........................................................... (6 ,720)
Consolidated net income ................................................. $589 ,450
14. A For 2014, the adjustment to beginning retained earnings should recognize
the gain on the retirement of the debt, the elimination of the 2013 interest
expense, and the elimination of the 2013 interest income.
Gain on Retirement of Bond:
Gain on retirement of bonds .............................................. $ 340 ,000
Interest Expense on Intra-Entity Debt—2013
Cash interest expense (9% × $4,000,000) ................................... $360,000
Premium amortization ($30,000 per year total × 40%
retired portion of bonds) ........................................................ (12 ,000)
15. D Consideration transferred for preferred stock ....................................... $ 424,000
Consideration transferred for common stock ....................................... 3,960,000
16. B Consideration transferred for preferred stock ....................................... $214,000
Consideration transferred for common stock ....................................... 1,253,280
Noncontrolling interest fair value for common ...................................... 835 ,520
17. B Parent’s reported sales .................................................... $480,000
Subsidiary's reported sales ............................................. 264,000
18. B Subsidiary’s unamortized fair value of prior to new share issue
(12,000 × $49) .............................................................. $588,000
Parent's ownership ........................................................... 100%
19. A Because the parent acquired 80 percent of the new shares, its proportional
20. C Adjusted acquisition-date sub. fair value at 1/1/14
Consideration transferred ................................................................. $592,000
Noncontrolling interest acquisition-date fair value ......................... 148,000
Increase in Stamford book value....................................................... 80,000
Stock issue proceeds......................................................................... 150,000
21. D Adjusted acquisition-date fair value ($820,000 – $192,000) .................. $628,000
New parent ownership (32,000 shs. ÷ 32,000 shs.) ................................ 100%
22. (10 minutes) (Qualification of Primary Beneficiary of a VIE)
Consolidation of a variable interest entity is required if a firm has a variable interest
that gives the firm
The power, through voting rights or similar rights, to direct the activities of an
entity that most significantly impact the entity’s economic performance.
23. (30 minutes) (VIE Qualifications for Consolidation)
a. The purpose of consolidated financial statements is to present the financial position
and results of operations of a group of businesses as if they were a single entity.
23. (continued)
The total equity at risk is not sufficient to permit the entity to finance its
activities without additional subordinated financial support from other parties.
In most cases, if equity at risk is less than 10% of total assets, the risk is
deemed insufficient.
The equity investors in the VIE lack any one of the following three
characteristics of a controlling financial interest.
other arrangements with variable interest holders).
Consolidation of a variable interest entity is required if a firm has a variable interest
that gives the firm
The power, through voting rights or similar rights, to direct the activities of an
entity that most significantly impact the entity’s economic performance.
c. Risks of the construction project that has TecPC has effectively shifted to the
owners of the VIE:
At the end of the 1st five-year lease term, if the parent opts to sell the facility, and
the proceeds are insufficient to repay the VIE investors, TecPC may be required to
pay up to 85% of the project's cost. Thus, a potential 15% risk.
Risks that remain with TecPC
23. (continued)
d. TecPC possesses the following characteristics of a primary beneficiary:
24. (10 minutes) (Consolidation of variable interest entity.)
a. Implied valuation and excess allocation for Softplus.
Noncontrolling interest fair value $ 60,000
Consideration transferred by Pantech 20,000
PanTech recognizes the $20,000 excess net asset fair value as a bargain purchase and
records all of SoftPlus’ assets and liabilities at their individual fair values.
Cash $20,000
Marketing software 160,000
Computer equipment 40,000
b. Implied valuation and excess allocation for Softplus.
Noncontrolling interest fair value 60,000
Consideration transferred by Pantech 20,000
When the fair value of a VIE (that is a business) is greater than assessed asset
values, all identifiable assets and liabilities are reported at fair values (unless a
previously held interest) and the difference is treated as goodwill.
Cash $20,000
Marketing software 120,000
Computer equipment 40,000
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