1. Chapter Six
Variable Interest Entities, Intercompany Debt, and Other Consolidation Issues

2. Special Purpose Entities
A business entity formed to accomplish a single purpose.
Activities are strictly limited by contract.
Issues debt against future cash collections.
Sponsor Company
SPE
Transfers High Risk Assets

3. Common SPE Activities
LEA$E$
Research and
Development
Hedging Financial
Instruments
Transfers of
Financial Assets

4. Special Purpose Entities
As long as the SPE stays independent, an effective transfer of risk results.
SPE’s are generally consolidated.
Sponsor Company
SPE
Asset is leased to Sponsor.
An asset is acquired for low cost.
The SPE recognizes revenues.

5. Special Purpose Entities
Technically, the equity investors control the SPE. However, often the equity investors cede control to the variable interest parties in exchange for a guaranteed return.

6. Variable Interest Entities (VIE)
SPE equity investors often have very little role in controlling the SPE’s activities, which are often very restricted.
Because the sponsor’s risk/reward varies depending on the success of the SPE, these SPE’s are referred to as Variable Interest Entities.
Profit often accrues to the sponsor as a function of contractual agreements, rather than as a function of stock ownership.

7. Examples of Variable Interests
Exh.
6-1

8. Consolidation of VIE’s – ARB 51
. . . An enterprise’s consolidated financial statements include subsidiaries in which the enterprise has a controlling financial interest. - - ARB 51
Generally, this has applied to subs where the parent has VOTING control. 2

9. Consolidation of VIE’s – FIN 46
FIN 46 requires consolidation of a VIE when one of the following conditions exist:
If total equity at risk < 10%.
The equity investors in the VIE lack one of the following traits:
The ability to make decisions about the VIE’s activities.
The obligation to absorb the expected losses of the VIE.
The right to receive expected residual returns of the VIE. }
Traits of a Primary Beneficiary

10. Consolidation of VIE’s – FIN 46
If a “business enterprise has a controlling financial interest in a variable interest entity, assets, liabilities, and results of the activities of the (VIE) should be included with those of the (Primary Beneficiary). - - FIN 46 2

11. Procedures for Consolidation of VIE’s
Valuations of assets, liabilities, and noncontrolling interest should be based on FMV, except for two notable exceptions.
1. Assets transferred to the VIE from the Primary Beneficiary, should be measured as if they have never been transferred.

12. Procedures for Consolidation of VIE’s
Valuations of assets, liabilities, and noncontrolling interest should be based on FMV, except for two notable exceptions.
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.

13. Procedures for Consolidation of VIE’s
When the implied value of the VIE exceeds the assessed net assets, NO GOODWILL IS RECORDED!
The difference is recorded as an extraordinary loss by the primary beneficiary.

14. FIN 46 Disclosure Requirements
Carrying amount of assets pledged as collateral by the Primary Beneficiary
Nature, purpose, size, & activities of the VIE
Classification of assets pledged as collateral by the Primary Beneficiary
Lack of recourse if creditors of the VIE have no recourse to the general credit of the primary beneficiary.

15. 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. 2

16. Acquisition of Affiliate’s Debt from an Outside Party
Parent
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.
(1) 80% Ownership
Sub
(2) Assume the Sub issued bonds to outside investors. 3

17. Acquisition of Affiliate’s Debt from an Outside Party
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. 3

18. Acquisition of Affiliate’s Debt from an Outside Party
Big owns 90% of Little. On 1/1/00, Little issued $2 million of 6%, 10-year bonds. The current carrying amount on Little’s books at 1/1/04 is:
Bonds Payable = $2,000,000
Bond Discount = $161,043
Carrying Amount = $1,838,957
On 1/2/04, Big decides to re-purchase Little’s bonds from the market, effectively extinguishing the debt.
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19. Acquisition of Affiliate’s Debt from an Outside Party
On 1/2/04, 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 12/31/04, the consolidated entity must:
Record the loss of $262,557
Eliminate the related intercompany debt at BV
Eliminate the intercompany interest
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20. Acquisition of Affiliate’s Debt from an Outside Party
Entry B
This 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.

21. Acquisition of Affiliate’s Debt from an Outside Party
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.

22. Acquisition of Affiliate’s Debt from an Outside Party
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.
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 amortized away completely.

23. Subsidiary Preferred Stock
The treatment of subsidiary preferred stock in the consolidated financial statements depends on whether the shares are viewed as:
Debt or Equity
The 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. 4

24. Preferred Stock Treated as a Debt Instrument
The Preferred Stock is treated as 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. 5

25. Preferred Stock Treated as a Debt Instrument
The Preferred Stock is treated as debt when it has no rights other than a cumulative dividend.
Two entries are required to eliminate the preferred stock:
The second entry recognizes the noncontrolling interest in the preferred stock. The amount assigned to the noncontrolling interest is based on the call price. 5

26. Preferred Stock Treated as a Debt Instrument
On 2/1/04, 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 at Debt.
Prepare the December 31, 2004 consolidation entries.
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27. Preferred Stock Treated as a Debt Instrument
First Entry
Eliminate Liberty’s investment in the preferred stock. The preferred stock is eliminated at cost. ?

28. Preferred Stock Treated as a Debt Instrument
First Entry
Eliminate Liberty’s investment in the preferred stock. The preferred stock is eliminated at cost.

29. Preferred Stock Treated as a Debt Instrument
Second Entry
Recognize the noncontrolling interest in the preferred stock. Base it on the 109 call price. ?

30. Preferred Stock Treated as a Debt Instrument
Second Entry
Recognize the noncontrolling interest in the preferred stock. Base it on the 109 call price.

31. So, what do we do when the Preferred Stock is viewed as Equity?

32. Subsidiary Preferred Stock Viewed as Equity
1. The purchase price in excess of book value of the preferred stock is allocated to specific accounts.
When preferred stock is viewed as equity . . .
2. The preferred stock is eliminated in the same way as common stock. 5

33. Subsidiary Preferred Stock Viewed as Equity
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 values from the subsidiary’s numbers. 5

34. Subsidiary Preferred Stock Viewed as Equity
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 2nd entry recognizes the portion of the acquisition cost allocated to assets.. 5

35. Subsidiary Preferred Stock Viewed as Equity
On 2/1/04, 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 at Equity.
Continue

36. Subsidiary Preferred Stock Viewed as Equity
ANI’s preferred stock participates in 10% of the annual income. ANI’s book value on 2/1/04 is $46 million. The book value includes:
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37. Subsidiary Preferred Stock Viewed as Equity
First, determine how much of ANI’s book value should be assigned to the preferred stock. In this case it is $5,200,000.
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38. Subsidiary Preferred Stock Viewed as Equity
Second, determine Goodwill related to Liberty’s acquisition of 60% of ANI’s preferred stock. Assume that ANI has a Patent worth $100,000.
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39. Subsidiary Preferred Stock Viewed as Equity
Consolidation Entry PS
Eliminate Liberty’s investment in ANI’s preferred stock. The preferred stock is eliminated at cost. ?

40. Subsidiary Preferred Stock Viewed as Equity
Consolidation Entry PS
Eliminate Liberty’s investment in ANI’s preferred stock. The preferred stock is eliminated at cost.

41. Subsidiary Preferred Stock Viewed as Equity
Consolidation Entry A1
Set up the land and the goodwill. ?

42. Subsidiary Preferred Stock Viewed as Equity
Consolidation Entry A1
Set up the land and the goodwill.

43. Consolidated Statement of Cash Flows
The consolidated statement of cash flows is based on the consolidated balance sheet and the consolidated income statement. 11

44. Consolidated Statement of Cash Flows
Noncontrolling Interest
Add back the noncontrolling interest’s share of the sub’s net income.
Deduct dividends paid to the outside owners as a cash outflow. 12

45. Consolidated Statement of Cash Flows
Amortization
Add amortization of goodwill and FMV allocations to Consolidated Net Income. 13

46. Consolidated Statement of Cash Flows
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. 14

47. 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. 15

48. 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. ? 16

49. I wonder if we could discuss a little “intercompany” loan?
End of Chapter 6
Uh, Chester?
I wonder if we could discuss a little “intercompany” loan? 17