1. Chapter 10 Electronic Presentations in Microsoft ® PowerPoint ® Prepared by James Myers, C.A. University of Toronto © 2008 McGraw-Hill Ryerson Limited

2. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 2 Chapter 10 Other Consolidation Reporting Issues

3. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 3 Learning Objectives –Identify a variable interest entity and prepare consolidated statements for a primary beneficiary and its variable interest entity –Explain how the definitions of assets and liabilities can be used to support the consolidation of variable interest entities –Describe and apply the current accounting standards that govern the reporting of interests in joint ventures

4. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 4 Learning Objectives –Explain how the gain recognition principle supports the recognition of a portion of gains occurring on transactions between the venturer and the joint venture –Understand the future income tax implications to the accounting for a business combination –Describe the Handbook’s requirements for segment disclosures and apply the quantitative thresholds to determine reportable segments

5. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 5 Variable Interest Entities A Variable Interest Entity (“VIE”) is a type of Special Purpose Entity (“SPE”). A Special Purpose Entity (“SPE”) is an entity (e.g. corporation) set up by a sponsor to accomplish a very specific and limited business activity. Using assets transferred to them by their sponsors, SPE’s can often secure lower cost debt financing because credit risk is limited to the SPE’s assets, not the broader assets of the sponsor, and because the business activity of the SPE is restricted. With the debt proceeds, the SPE can then pay the sponsor for the transferred assets. The sponsor is therefore “monetizing” previously illiquid assets, by turning them into cash.

6. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 6 Consolidation of Variable Interest Entities Prior to Accounting Guideline 15 (AcG-15) “Consolidation of Variable Interest Entities” issued in June 2003, the assets, liabilities, and results of operation of SPE’s frequently were not consolidated with the sponsor that effectively controlled the SPE In avoiding consolidation sponsors relied on Handbook section 1590 which states that control is achieved by owning the majority of the voting shares Effective control could also be obtained by SPE sponsors through “variable interests” (Exhibit 10.1); sponsors often owned few, if any, voting shares of the SPE. Enron failed to consolidate many SPE’s that it controlled through variable interests.

7. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 7 Exhibit 10.1

8. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 8 Consolidation of Variable Interest Entities A VIE is a type of SPE. The primary risks and rewards of ownership of a VIE are not based on equity ownership but rather on the variable interests conveyed by contractual arrangements. The equity investors typically receive a guaranteed rate of return as a reward for providing the sponsor with contractual control of the VIE.

9. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 9 Consolidation of Variable Interest Entities According to AcG-15, an entity qualifies as a VIE if either of the following conditions exists: 1.The total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any parties. In most cases, if equity at risk is less than 10 percent of the entity’s total assets, the risk is deemed insufficient.

10. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 10 Consolidation of Variable Interest Entities 2.The equity investors in the VIE lack any of the following three characteristics of a controlling financial interest: The direct or indirect ability to make decisions about an entity’s activities through voting or similar rights The obligation to absorb the expected losses of the entity if they occur (e.g. another firm may guarantee a return to the equity investors) The right to receive the expected residual returns of the entity (e.g. the equity investors’ returns may be capped by the entity’s governing documents)

11. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 11 Consolidation of Variable Interest Entities In assessing whether an enterprise should consolidate the assets, liabilities, revenues, and expenses of a VIE, Acg-15 next relies on an expanded notion of a controlling financial interest Three characteristics are indicative of an enterprise qualifying as a primary beneficiary with a controlling financial interest in a VIE and which should therefore consolidate the VIE.

12. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 12 Consolidation of Variable Interest Entities Primary beneficiaries of VIE’s are those entities which bear the majority of the risks and rewards of VIE ownership by the following means: –The direct or indirect ability to make decisions about the entity’s activities –The obligation to absorb the expected losses of the entity if they occur –The right to receive the expected residual returns of the entity if they occur

13. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 13 Consolidation of Variable Interest Entities Initial measurement issues – the financial report principles for consolidating VIEs require assets, liabilities, and noncontrolling interests (NCI) to be initially recorded at fair values with two notable exceptions: –First, if any assets have been transferred from the primary beneficiary to the VIE, these assets will be measured at the carrying value before the transfer [i.e. the primary beneficiary cannot record a gain on transfers to VIE’s] –Second, the asset valuation procedures in AcG-15 also rely in part on the allocation principles described in Handbook sec. 1581

14. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 14 Consolidation of Variable Interest Entities Since control was obtained by means other than share ownership, need to determine implied value (representing consideration given) of 100% of VIE = consideration paid by primary beneficiary + reported values of any previously held interests + fair value of NCI of VIE Compare implied value to assessed value (consideration received) = carrying value of amount invested by primary beneficiary + fair value of VIE net assets prior to investment by primary beneficiary

15. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 15 Consolidation of Variable Interest Entities If implied value < assessed value then assets are reduced proportionally for the difference. If implied value > assessed value the difference is reported as goodwill when the VIE is a self-sustaining profit-oriented business or as a loss when the VIE is not a business. Primary beneficiaries and others holding variable interests in a VIE should disclose the nature and extent of their involvement with the VIE.

16. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 16 Consolidation of Variable Interest Entities Consolidation issues subsequent to initial measurement – after the initial measurement, consolidation of VIEs with their primary beneficiary should follow the same process as if the entity were consolidated based on voting interests –All intercompany transactions must be eliminated –The implied purchase price discrepancy must be amortized –The income of the VIE must be allocated among the parties involved

17. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 17 Joint Ventures

18. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 18 Joint Ventures Joint Ventures are a common mechanism where two or more companies with common interests arrange to do business together on a “venture” basis, generally on an expensive or risky project where they can share expertise as well as risk. –Generally, a separate business entity is formed, which may or may not be incorporated, with a pre- determined life after which it will be wound up. –The venturers continue in their own businesses; the venture tends to carry on a “new” business under the supervision of the venturers, such as entering a new market or developing a new oil well

19. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 19 Joint Ventures The CICA Handbook defined as follows: –A joint venture is an “economic activity” resulting from a contractual arrangement whereby two or more venturers jointly control the economic activity This activity is typically a business venture –Joint control of an economic activity is the contractually agreed sharing of the continuing power to determine the strategic operating, investing and financing policies Any one venturer is prevented, by the shareholders’ agreement, from exercising control regardless of the percentage of investment held in the joint venture.

20. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 20 Joint Ventures The venturers are the parties to the joint venture, have joint control over that venture, have the right and ability to obtain future economic benefits from the resources of the joint venture and are exposed to the related risks. The combination of the joint right and ability to obtain future economic benefits and exposure to the related risks suggests that neither accounting model, full consolidation or the equity method, is fully appropriate.

21. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 21 Joint Ventures Joint ventures are unique and require a unique accounting treatment: –The characteristic of joint control distinguishes interests in joint ventures from investments in other activities where an investor may exercise control or significant influence. A contract between the venturers (e.g. shareholders agreement) is generally required, but not in all cases: –Activities conducted with no formal contractual arrangements which are jointly controlled in substance are joint ventures

22. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 22 Accounting for an investment in a Joint Venture Section 3055 in the Handbook is concerned only with the financial reporting for an interest in a joint venture by a venturer This section requires the venturer to report an investment in a joint venture by the proportionate consolidation method Proportionate consolidation is an application of the proprietary concept of reporting

23. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 23 Accounting for an investment in a Joint Venture The proprietary approach incorporates the balances of the investee into the consolidated financial statements at fair value at the date of acquisition, but only to the extent of the proportion acquired because the investor shares in the risks and rewards of ownership in direct proportion to the shareholding percentage. Since not consolidating 100% of the assets and liabilities, income, and expense of the joint venture, but only the portion held of each, there is no NCI in proportionate consolidation.

24. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 24 Accounting for an investment in a Joint Venture The venturer’s proportion of unrealized upstream as well as downstream profits, revenues, expenses, receivables, and payables with the joint venture are eliminated; the portion representing the interest of the other arm’s-length venturers can be considered realized. Upon formation of a joint venture, determine the portion of gains, if any, that a venturer can recognize on contributing assets to the venture in exchange for its interest.

25. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 25 Accounting for an investment in a Joint Venture Determination of gain on assets contributed by a venturer on formation of a joint venture: –Split the gain between the portion represented by the venturer’s interest in the JV and the portion represented by the interest of the other venturers. –Reclassify both portions of the gain from income on the venturer’s books to deferred gain. –The venturer’s portion of the deferred gain is netted against the related asset balance and can never be taken into income until the asset is sold to unrelated outsiders –The deferred gain represented by the interest of the other venturers is amortized to income over the service life of the related asset.

26. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 26 Accounting for an investment in a Joint Venture Determination of gain on assets contributed by a venturer on formation of a joint venture: –If the venturer receives cash from the other venturers for the contributed asset a portion of the gain can be recognized in income immediately. –Example: Venturer A contributes land (fair value $700,000 - cost $200,000 = gain $500,000) to JV and receives $130,000 in cash while Venturer B contributes cash of $855,000 to JV. Cash received by Venturer A

27. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 27 Accounting for an investment in a Joint Venture Example of gain on assets contributed by a venturer on formation of a joint venture: –Venturer A contributes land (fair value $700,000 - cost $200,000 = gain $500,000) to JV and receives $130,000 in cash while Venturer B contributes cash of $855,000 to JV. Total assets of JV = $700+$855-$130 = $1,425 of which A contributed value of ($700-$130)/1,425 = 40% interest held by A in JV; B = 60% interest in JV. Cash received by Venturer A funded by Venturer B represents a partial culmination of earnings to A

28. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 28 Accounting for an investment in a Joint Venture Example of gain, cont’d: Venturer A can therefore record in income immediately a gain equal to: Cash from other venturer x gain Fair value of asset contributed = 130/700 x $200,000 = $37,143 The remaining deferred gain of $200,000 - $37,143 = $162,857 is reflected on proportionate consolidation as follows: –A’s 40% x $200,000 = $80,000  offset against land –B’s 60% x $200,000 = $120,000 less $37,143 recognized in income = $82,857  amortize to income over expected service life of land to the JV.

29. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 29 Future Income Taxes and Business Combinations

30. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 30 Future Income Taxes and Business Combinations At any point in time, there may be differences between the tax basis of an asset or liability and its carrying amount, e.g. a capital asset’s net book value can differ from its tax undepreciated capital cost temporarily, until both are fully depreciated. Such differences occur when the purchase discrepancy is allocated in a business combination; this affects the consolidated book values but not the tax bases since each company files separate, non- consolidated financial statements for tax purposes. The temporary difference in carrying value for book purposes compared to tax purposes gives rise to future income taxes which must be recognized in the consolidated financial statements.

31. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 31 Future Income Taxes and Business Combinations Under Handbook Section 3465, future tax assets or liabilities should be reflected on the balance sheet as the amount of the temporary difference multiplied by the tax rate. If asset book value tax value, future tax asset (FTA) arises. If asset book value > tax value, or liability book value < tax value, future tax liability (FTL) arises.

32. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 32 Future Income Taxes and Business Combinations The differences between consolidated book values and individual company tax values therefore give rise to FTA or FTL which should be reflected as part of the purchase discrepancy allocation on acquisition of a subsidiary. These “new” FTA or FTL balances reflecting the acquisition date fair values of the subsidiary’s assets and liabilities replace the “old” future income taxes recorded by the subsidiary company based on its historical costs.

33. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 33 Future Income Taxes and Business Combinations Example –In a business combination, the carrying amount of an asset is reflected at its fair value of $20,000. In the general ledger of the subsidiary, the asset has a book value of $12,000 and a tax basis of $9,000, which is unaffected by the business combination. Assume a tax rate of 40% –The “old” future tax liability (FTL) of (12,000 - 9,000) * 40% = $1,200 on the subsidiary’s G/L must be eliminated –A “new” FTL must be reported in the consolidated financial statements in the amount of (20,000 - 9,000) * 40% = $4,400 –The “new” FTL is included in the purchase discrepancy allocation and therefore goodwill increases.

34. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 34 Future Income Taxes and Business Combinations A business combination may increase the likelihood that loss carry forwards or other tax deductible amounts may be claimed –Other previously unrecognized future income tax assets (of either parent or subsidiary) may be recognized at the time of a business combination, providing that it is more likely than not that the benefits will be realized –These future income tax assets are identifiable assets and are therefore recorded but under Section 1582 will not be included in the allocation of the purchase price and therefore will not affect goodwill.

35. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 35 Segmented Disclosures

36. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 36 Segmented Disclosures When consolidated financial statements are prepared, a significant amount of detail is aggregated and not disclosed separately –This detail could be very useful for analysts and other users of the financial statements –Yet, providing individual financial statements of subsidiaries and consolidation adjustment details may overwhelm and confuse. –Managers do not wish competitors to have too much confidential or sensitive data. Segmented reporting is an efficient method of communicating just enough pertinent detail.

37. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 37 Segmented Disclosures Operating segments of a consolidated enterprise are identified based on a management approach that recognizes the way management has organized the business components in assessing performance and making strategic decisions. –An operating segment is defined as one: That engages in business activities that earn revenues and incur expenses Whose operating results are regularly reviewed by management For which discrete financial information is available.

38. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 38 Segmented Disclosures Separate disclosure is required for segments when one or more of these thresholds is met: –Reported revenue, both external and intersegment, is 10 percent or more of the combined revenue, internal and external, of all segments –The absolute amount of reported profit or loss is 10 percent or more of the greater, in absolute amount, of: the combined reported profit of all operating segments that did not report a loss, or the combined reported loss of all operating segments that did report a loss –Its assets are 10 percent or more of the combined assets of all operating segments

39. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 39 Segmented Disclosures General information is required: –Factors used to identify the enterprise's reportable segments, including the basis of organization Address whether management has organized the enterprise around differences in products and services, geographic areas, regulatory environments, or a combination of factors and whether operating segments have been aggregated –Types of products and services from which each reportable segment derives its revenues –Comparative balances for the prior year are presented

40. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 40 Segmented Disclosures –A measure of profit (loss) –Each of the following if the specific amount are included in the measure of profit (loss) above Revenues from external customers Intersegment revenues Interest revenue and expense Amortization of capital assets Unusual revenues, expenses, and gains (losses) Equity income from significant influence investment Income taxes Extraordinary items Significant noncash items other that the amortization above

41. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 41 Segmented Disclosures –Total assets –The amount of significant influence investments, if such investments are included in segment assets –Total expenditures for additions to capital assets and goodwill –An explanation of how a segment’s profit (loss) and assets have been measured, and how common costs and jointly used assets have been allocated, and of the accounting policies that have been used –Reconciliation of the following Total segment revenue to consolidated revenues Total segment profit (loss) to consolidated net income (loss) Total segment assets to consolidated assets

42. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 42 Segmented Disclosures The following information must also be disclosed, unless such an information has already been clearly provided as part of segment disclosures This additional information is also required when the company has only a single reportable segment –The revenue from external customers for each product or service, or for each group of similar products and services, whenever practical –The revenue from external customers broken down between those from the company’s home country and those from all foreign countries

43. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 43 Segmented Disclosures Where revenue from an individual country is material, it must be separately disclosed –Goodwill and capital assets broken down between those located in Canada and those located in foreign countries Where assets located in an individual country is material, it must be separately disclosed –When a company’s sales to a single external customer are 10 percent or more of total revenues, the company must disclose this fact, as well as the total amount of revenues from each customer and which operating segment reported such revenues. The identity of the customer does not have to be disclosed

44. Chapter 10 © 2008 McGraw-Hill Ryerson Limited 44 Exhibit 10.2