456: ACCT CHAPTER 6 NOTES
VARIABLE INTEREST ENTITIES, INTERCOMPANY DEBT, CONSOLIDATED CASH FLOWS
VARIABLE INTEREST ENTITIES
VIEs typically take the form of a trust, partnership, joint venture, or corporation.
Purpose of VIEs - a limited and well-defined set of business activities.
WHAT IS A VIE?
Variable interests vary because of changes in the fair value of the underlying assets of the VIE
and the fact that the company may be required by contract to provide additional support in the
event of future losses in the VIE.
A VIE is required to be consolidated with the sponsoring/parent entity when
1. Total equity is NOT sufficient to support the financial activities. That is, equity
owners/investors cannot provide If the equity at risk is less than 10% of the VIEs assets,
then risk is insufficient.
2. If any one of the following characteristics of the equity holders is missing, then it is a VIE:
(a) Ability (direct or indirect) to govern the entitys activities
(b) Requirement to cover any losses when they occur
(c) Right to receive residual gains when they occur
The existence of any one of the three characteristics listed in (2.) above indicates a controlling
interest in a variable interest entity by the parent company.
Control of VIEs, by design, often does not rest with its equity holders. Instead, control is
exercised through contractual arrangements with the sponsoring/(parent) firm who becomes the
"primary beneficiary" of the entity and the financial statements must be consolidated.
EXAMPLE: TSQ Inc invests one million dollars in a VIE. Under contractual arrangements TSQ is
the primary beneficiary of the VIE and guarantees a 3.7% return to the NCI. Subsequent to
TSQs investment, the following balance sheet was prepared:
Equity = $6M; Total Assets = $40M. Equity Ratio = $6M / $40M = 15%
Assume that the oil tanker had a fair value of $42 million,
o
What is the amount of the goodwill or gain on bargain purchase to be recorded?
Noncontrolling interest fair value ......................................$ 5,000,000
Consideration transferred by TSQ........................................1,000,000
Total business fair value........................................................$6,000,000
Fair value of VIE net assets (42M-34M)...............................8,000,000
Goodwill/Gain on Bargain Purchase................................($2,000,000)
o
What amounts for the VIE would be shown on TSQs consolidated financial
statements?
Oil Tanker...........................................................................$42,000,000 Asset DR bal
Long-Term Debt.............................................................34,000,000 Liability CR bal
NCI........................................................................................5,000,000 Equity CR bal
TSQ Equity Interest............................................................1,000,000 Equity CR bal
Gain on Bargain Purchase .............................................2,000,000 Inc Stmt CR bal
Assume that the oil tanker had a fair value of $36 million, then what is the amount of the
goodwill or gain on bargain purchase to be recorded?
Noncontrolling interest fair value .......................................$5,000,000
Consideration transferred by TSQ........................................1,000,000
Total business fair value..........................................................6,000,000
Fair value of VIE net assets (36M-34M)...............................2,000,000
Goodwill/Gain on Bargain Purchase...................................$4,000,000
o
What amounts for the VIE would be shown on TSQs consolidated financial
statements?
Oil Tanker..............................................................................$36,000,000
Goodwill.....................................................................................4,000,000
Long-Term Debt..................................................................(34,000,000)
NCI...........................................................................................(5,000,000)
TSQ Equity Interest..............................................................(1,000,000)
DISCLOSURE REQUIREMENTS FOR VIES
The primary beneficiary must disclose:
I. Nature, purpose, size and activities of VIE
II. Details on the carrying value and classifications of the collateralized assets of the VIE
III.
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, FIN 46(R)]
Any entity holding a significant interest in a VIE must disclose:
I. Nature of involvement with VIE and when the involvement commenced
II. Nature, purpose, size and activities of VIE
III.
Entitys maximum to exposure loss
INTER-COMPANY DEBT TRANSACTIONS
Recall that consolidated financial statements must represent the various segments of the
company as a single unit, so all intercompany transactions must be eliminated. Loans between
only the parent and the subsidiary would be eliminated according to regular consolidation rules.
ACQUIRING SUBSIDIARYS/AFFILIATED COMPANYS DEBT FROM A 3 PARTY
Purchasing the debt of a subsidiary (affiliated company) on the open market or from another 3rd
party is considered, for consolidation purposes to be retiring the debt.
RD
Key Points
1. The difference between the book value of the debt and the price paid to acquire the debt is
to be recorded as a gain or loss on the extinguishment of debt and recognized
immediately.
2. The investment and debt accounts must be eliminated annually. The amounts will change
every year.
3. Interest revenue/expense and interest payable/receivable must be eliminated. The
amounts will change every year.
Example On 1 Jan 2010 Pansy issued $10,000,000 in bonds to the public. The coupon rate on
the bonds was 6% and the bonds were issued at a time when the prevailing market rate was
6.5%. Interest is paid annually. Three years after issuance, on 1 Jan 2013, Daffodil Co (an
affiliated company of Pansy) purchased $7.5 million of these bonds on the open market at a
market interest rate of 5.1%.
1.
Assuming the bonds had a life of 20 years, compute the price at which the bonds were
issued and the amount of discount or premium.
Issue price = $9,449,075 (see excel spreadsheet)
Discount or Premium = Difference between the face value and issue price.
If face value > issue price discount
If face value < issue price premium
Amount of Discount = $550,925
TABLE
2.
Compute the book value of all the bonds on 1 Jan 2013 and the book value of the bonds
that Daffodil purchased.
BV of all bonds = $9,494,472
BV of bonds Daffodil purchased (75%) = $7,120,854
3.
Compute the price that Daffodil paid to acquire the $7,500,000 of Pansy bonds.
$8,255,347 - Price Daffodil paid
TABLE
4.
Compute all the interest expense that Pansy would record for 2013 and the interest expense
related to the bonds Daffodil acquired.
Pansy records $617,141 Total interest Expense
$617,141 * 75% = $462,856 interest expense on bonds Daffodil purchased.
5.
Compute the interest income that Daffodil would record in 2013.
$8,255,347 * 5.1% = 421,023 see table 2
6.
Compute the book value of the bonds on Pansys books at 31 Dec 2013
9,511,613 see table 1
7.
Compute the book value of the bonds on Daffodils books at 31 Dec 2013
8,226,370 see table 2
8.
Prepare the consolidation entry B required on 31 Dec 2013
Date
31 Dec
2013
B
Account Name
Debit
Bonds Payable (9,511,613 * 75%)
7,133,710
Interest Income (2013)
Loss on Retirement of Bonds*
Credit
421,023
1,134,493
Interest Expense (617,141 * 75%)
462,856
Invest in Pansy Bonds (12/31/2013)
8,226,370
* 8,255,347 (9,494,472 * 75%) = 8,255,347 7,120,854 = 1,134,493
9.
Prepare the consolidation entry for 2014, entry *B
Date
*B
2014
Account Name
Bonds Payable (75% * 9,529,868)
Interest Income
Retained Earnings*
Interest Expense (75% *
618,255)
Invest in Pansy Bonds
Debit
Credit
7,147,401
419,545
1,092,660
463,691
8,195,915
* 2013 Loss Balance 2013 interest expense + 2013 interest income
= $1,134,493 462,856 + 421,023 = 1,092,660
CONSOLIDATED STATEMENT OF CASH FLOWS
The consolidated statement of cash flows is prepared from the consolidated balance sheet and
consolidated income statement figures. Note the following:
1)
Amortizations (consolidation entry E) these are non-cash expenses so would be:
a)
Added back to net income if the indirect method is used
b)
Not included as an operating cash outflow if the direct method is used
2)
Intercompany Transactions require no special adjustments. Cash flowing from the parent
to the subsidiary or v.v., does not impact the cash of the entity taken as a whole.
3)
Subsidiary dividends paid:
Only dividends paid to the NCI affect the cash of the consolidated entity and would be
reported as a financing cash outflow.
4)
Acquisition year adjustments to cash flows
a)
Investing activity: the net cash outflow (cash paid subsidiary cash balance) for
acquiring the subsidiary
b)
If an acquisition occurs over more than one period, then changes in the operating
assets and liabilities (often current assets and liabilities) are reported net of the effects
of the acquisition.
c)
Adjustments to subsidiary revenues/expenses are to reflect only those earned or
incurred subsequent to the acquisition.
Prepare the cash flow statement using the information given in the excel worksheet.
* Depr/Amort Exp Amort Exp = Depr Exp