Chapter Six Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Variable Interest Entities (VIE’s) LO 1 Known as Special Purpose Entities (SPE) Established as a separate business structure Trust Joint Venture Partnership Corporation Frequently has neither independent management nor employees Typical purposes help finance their operations at favorable rates Transfers of financial assets Leasing Hedging financial instruments Research and development Off-balance sheet financing Variable Interest Entities (VIE’s) Known as Special Purpose Entities (SPE) Established as a separate business structure Trust Joint Venture Partnership Corporation Frequently has neither independent management nor employees Typical purposes help finance their operations at favorable rates Transfers of financial assets Leasing Hedging financial instruments Research and development Off-balance sheet financing 6-2

Variable Interest Entities FASB standard FIN 46R3 requires the primary beneficiary (regardless of their ownership) to consolidate the VIE. Who is the “primary beneficiary”? The firm that has the: Power to direct the activities of the VIE that significantly impact the entity’s economic performance. Obligation to absorb significant losses of the entity. Right to receive significant benefits of the entity. Variable Interest Entities FASB standard FIN 46R3 requires the primary beneficiary (regardless of their ownership) to consolidate the VIE. Who is the “primary beneficiary”? The firm that has the: Power to direct the activities of the VIE that significantly impact the entity’s economic performance. Obligation to absorb significant losses of the entity. Right to receive significant benefits of the entity. 6-3

Disclosure Requirements – In Footnotes of ALL VIE Interests Nature, purpose, size, & activities of the VIE Significant judgments made in determining the need to consolidate a VIE or disclose any involvement Nature of restrictions on assets and settlement of liabilities, and the related carrying value Nature, purpose, size, & activities of the VIE Significant judgments made in determining the need to consolidate a VIE or disclose any involvement Nature of restrictions on assets and settlement of liabilities, and the related carrying value Nature of risks, and how a VIE affects the financial position, performance and cash flows of a Primary Beneficiary Nature of risks, and how a VIE affects the financial position, performance and cash flows of a Primary Beneficiary 6-4

VIE’s and International Standards In May 2011, the International Accounting Standards Board issued IFRS 10 - Consolidated Financial Statements and IFRS 12 - Disclosure of Interests in Other Entities. The standards include a new definition of control designed to encompass all possible ways (voting power, contractual power, decision making rights, etc.) in which one entity can exercise power over another. In May 2011, the International Accounting Standards Board issued IFRS 10 - Consolidated Financial Statements and IFRS 12 - Disclosure of Interests in Other Entities. The standards include a new definition of control designed to encompass all possible ways (voting power, contractual power, decision making rights, etc.) in which one entity can exercise power over another. 6-5

Intra-Entity Debt Transactions LO 2 A company CANNOT lend money to itself. Intra-entity investments in debt securities and related debt accounts must be eliminated in consolidation despite their differing balances. Corresponding receivable and payable and revenue and interest from the consolidated financial statements must be eliminated. Gain/loss on effective retirement of the debt must be recognized in the consolidated statements. Intra-Entity Debt Transactions Intra-entity investments in debt securities and related debt accounts must be eliminated in consolidation despite their differing balances. Corresponding receivable and payable and revenue and interest from the consolidated financial statements must be eliminated. Gain/loss on effective retirement of the debt must be recognized in the consolidated statements. 6-6 2

Subsidiary Preferred Stock LO 3 Preferred stock, usually nonvoting, possess certain “preferences” over common shares such as cumulative dividends, participation rights, and sometimes limited voting rights. Preferred shares are part of the sub’s stockholders’ equity, treated in consolidation similarly to common. The existence of subsidiary preferred shares does not complicate the consolidation process. The acquisition method values all business acquisitions (whether 100 percent or less acquired) at their full fair values. Preferred stock, usually nonvoting, possess certain “preferences” over common shares such as cumulative dividends, participation rights, and sometimes limited voting rights. Preferred shares are part of the sub’s stockholders’ equity, treated in consolidation similarly to common. The existence of subsidiary preferred shares does not complicate the consolidation process. The acquisition method values all business acquisitions (whether 100 percent or less acquired) at their full fair values. 6-7 4

Consolidated Statement of Cash Flows Current accounting standards require that companies include a statement of cash flows among their consolidated financial reports. The main purpose of the statement of cash flows is to provide information about the entity’s cash receipts and cash payments during a period. The consolidated statement of cash flows is based on the consolidated balance sheet and the consolidated income statement. Consolidated Statement of Cash Flows Current accounting standards require that companies include a statement of cash flows among their consolidated financial reports. The main purpose of the statement of cash flows is to provide information about the entity’s cash receipts and cash payments during a period. The consolidated statement of cash flows is based on the consolidated balance sheet and the consolidated income statement. 6-8 11

Consolidated Statement of Cash Flows Intra-entity Transactions Intra-entity cash flows should not be included on the statement of cash flows. The intra-entity cash flows are already eliminated from the balance sheet, so no additional effects appear on the statement of cash flows. Consolidated Statement of Cash Flows Intra-entity Transactions Intra-entity cash flows should not be included on the statement of cash flows. The intra-entity cash flows are already eliminated from the balance sheet, so no additional effects appear on the statement of cash flows. 6-9 14

Consolidated Statement of Cash Flows In the year of acquisition: The net cash outflow to acquire the subsidiary is reported (cash paid less subsidiary cash acquired). Any amounts acquired are not included in the increase or decrease of balance sheet accounts. In all years: Add back the noncontrolling interest’s share of the sub’s net income. Deduct dividends paid to the outside owners as cash outflow. Consolidated Statement of Cash Flows In the year of acquisition: The net cash outflow to acquire the subsidiary is reported (cash paid less subsidiary cash acquired). Any amounts acquired are not included in the increase or decrease of balance sheet accounts. In all years: Add back the noncontrolling interest’s share of the sub’s net income. Deduct dividends paid to the outside owners as cash outflow. 6-10 12

Consolidated Earnings Per Share LO 5 The computation of EPS for a business combination follows the general rules. Consolidated net income attributable to the parent company owners along with the number of outstanding parent shares provides the basis for calculating basic EPS. Any convertibles, warrants, or options for the parent’s stock that can possibly dilute the reported figure must be included in diluted EPS. Consolidated Earnings Per Share The computation of EPS for a business combination follows the general rules. Consolidated net income attributable to the parent company owners along with the number of outstanding parent shares provides the basis for calculating basic EPS. Any convertibles, warrants, or options for the parent’s stock that can possibly dilute the reported figure must be included in diluted EPS. 6-11 15

Consolidated Earnings Per Share If potentially dilutive items exist on the sub’s individual 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. Consolidated Earnings Per Share If potentially dilutive items exist on the sub’s individual 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. 6-12 15

Consolidated Earnings Per Share Compute the sub’s own diluted EPS. The earnings used in the computation are used in the determination of consolidated EPS. The portion assigned to the computation is based on the percent of the subsidiary owned by the parent. Consolidated Earnings Per Share Compute the sub’s own diluted EPS. The earnings used in the computation are used in the determination of consolidated EPS. The portion assigned to the computation is based on the percent of the subsidiary owned by the parent. 6-13 16

Subsidiary Stock Transactions LO 6 A parent’s ownership percentage may be affected by a subsidiary’s transactions in its own stock (additional issuances, or the purchase or treasury stock). The effects on the consolidated entity are recorded by the parent as an adjustment to APIC and the investment account. Not reported as a gain or loss of the consolidated entity. Subsidiary Stock Transactions A parent’s ownership percentage may be affected by a subsidiary’s transactions in its own stock (additional issuances, or the purchase or treasury stock). The effects on the consolidated entity are recorded by the parent as an adjustment to APIC and the investment account. Not reported as a gain or loss of the consolidated entity. 6-14

Summary VIE’s are created to fulfill special purposes. GAAP requires consolidation by the primary beneficiary of the VIE. When debt of a related party is acquired, the debt is effectively retired. Preferred stock of a subsidiary will often resemble debt more than equity, and parent- held shares will be eliminated from consolidation as if the stock had been retired. Summary VIE’s are created to fulfill special purposes. GAAP requires consolidation by the primary beneficiary of the VIE. When debt of a related party is acquired, the debt is effectively retired. Preferred stock of a subsidiary will often resemble debt more than equity, and parent-held shares will be eliminated from consolidation as if the stock had been retired. 6-15