Chapter Six Variable Interest Entities Intra Entity Debt

Chapter Six Variable Interest Entities, Intra. Entity Debt, Consolidated Cash Flows, and Other Issues Copyright © 2015 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Variable Interest Entities (VIE’s) Learning Objective 6 -1: Describe a variable interest entity, a primary beneficiary, and the factors used to decide when a variable interest entity is subject to consolidation. Ø Known as Special Purpose Entities (SPE) Ø Established as a separate business structure – Trust – Partnership - Joint Venture - Corporation Ø Frequently has neither independent management nor employees Ø Typical purposes – help finance their operations at favorable rates – Transfers of financial assets - Leasing – Hedging financial instruments - Research and development Ø Off-balance sheet financing 6 -2

Variable Interest Entities (VIE’s) Examples of Variable Interests 6 -3

Intra-Entity Debt Transactions Learning Objective 6 -2: Demonstrate the consolidation procedures to eliminate all intraentity debt accounts and recognize any associated gain or loss created whenever one company acquires an affiliate’s debt instrument from an outside party. A company CANNOT lend money to itself. Ø Intra-entity investments in debt securities and related debt accounts must be eliminated in consolidation despite their differing balances. Ø Corresponding receivable and payable and revenue and interest from the consolidated financial statements must be eliminated. 6 -4

Intra-Entity Debt Transactions - Example Gain/loss on effective retirement of the debt must be recognized in the consolidated statements. Alpha owns 80% of Omega. On 1/1/12, Omega issued $1 million in 10 -year bonds at 9%. Omega issued the bonds at $938, 555, with effective interest at 10%. On 1/1/14, Alpha purchased the bonds for $1, 057, 466, with effective interest at 8%. Book value of Omega Company’s bonds as of December 31, 2013, the date before Alpha Company acquired the bonds. 6 -5

Intra-Entity Debt Transactions Example Omega records only two journal entries during 2014 assuming interest is paid each December 31 to record the interest expense cash payment and discount on bonds payable. 6 -6

Intra-Entity Debt Transactions Example In 2014, Alpha records its investment in Omega’s bonds and the interest income. 6 -7

Intra-Entity Debt Transactions Example To convert information from the individual companies to the perspective of a single economic entity, we extinguish the debt (it is no longer owed to a third-party). Any gains/losses are attributed to the parent, thus, there is no effect on Noncontrolling Interest. 6 -8

Intra-Entity Debt Transactions Example Subsequent Years - Initial Value or Partial Equity Method Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization with Entry *B. Also, the loss is now reflected in R/E, which must be adjusted for the difference in interest amounts. 6 -9

Intra-Entity Debt Transactions Example Subsequent Years –Equity Method Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization with Entry *B. Also, the loss is now reflected in R/E, which must be adjusted for the difference in interest amounts. 6 -10

Subsidiary Preferred Stock Learning Objective 6 -3: Understand that subsidiary preferred stocks not owned by the parent are a component of the noncontrolling interest and are initially measured at acquisition-date fair value. Preferred stock, usually nonvoting, possess “preferences” over common shares such as cumulative dividends, participation rights, and sometimes limited voting rights. They are part of the sub’s stockholders’ equity, treated in consolidation similarly to common. Existence of subsidiary preferred shares does not complicate the process. The acquisition method values all business acquisitions (whether 100 percent or less) at full fair values. 6 -11

Subsidiary Preferred Stock - Example The consolidation entry made in the year of acquisition is shown below: 6 -12

Consolidated Statement of Cash Flows Learning Objective 6 -4: Prepare a 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 -13

Consolidated Statement of Cash Flows Intra-entity cash flows should not be included on the statement of cash flows. Intra-entity cash flows are already eliminated from the balance sheet, so no additional effects appear on the statement of cash flows. In the year of acquisition, net cash outflow (cash paid less subsidiary cash acquired) to acquire the subsidiary is reported. Any amounts acquired are not included in the increase or decrease of balance sheet accounts. In all years, add back noncontrolling interest’s share of the sub’s net income. Deduct dividends paid to outside owners as cash outflow. 6 -14

Consolidated Earnings Per Share Learning Objective 6 -5: Compute basic and diluted earnings per share for a business combination. Computing 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 -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. ‣ Compute the sub’s own diluted EPS. ‣Earnings used in the computation are used to determine consolidated EPS. ‣ Portion assigned to the computation is based on the percent of the subsidiary owned by the parent. 6 -16

Subsidiary Stock Transactions Learning Objective 6 -6: Demonstrate the accounting effects of subsidiary stock transactions on parent’s financial records and consolidated financial statements. 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). ØThe effects on the consolidated entity are recorded by the parent as an adjustment to APIC and the investment account. ØNot reported as a gain or loss of the consolidated entity. 6 -17