Hank - Chapter 6 Final (PDF)

Chapter Six Variable Interest Entities, Intra- Entity Debt, Consolidated Cash Flows, and Other Issues Advanced Accounting, 15e Hoyle | Schaefer | Doupnik © McGraw Hill LLC. All rights reserved. No reproduction or distribution without th...

Chapter Six Variable Interest Entities, Intra- Entity Debt, Consolidated Cash Flows, and Other Issues Advanced Accounting, 15e Hoyle | Schaefer | Doupnik © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 6-1  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. This is the result of ENRON ---- bth creative CPAs and bad guys CONSPIRACY OF FOOLS 6-2  Variable Interest Entities (VIEs)  Commonly known as special purpose entities (SPEs).  Most VIEs are established for valid business purposes.  Established as a separate business structure: – Trust – Joint venture – Partnership – Corporation  VIEs sometimes have no independent management or employees. – What did Enron do? 6-3  Variable Interest Entities (VIEs) (continued)  Common examples of VIE activities: – Transfers of financial assets – Leasing – Hedging financial instruments – Research and development  Benefits of VIE: – Often eligible for a lower interest rate – Low-cost financing of assets  Governing agreements limit activities and decision making. 6-4  Variable Interest Entities (VIEs)— Primary Beneficiary  Enterprise that created VIE may not own any of its voting stock.  Prior to current consolidation requirements, enterprises left VIEs unconsolidated in their financial reports.  Primary beneficiary typically exercises its financial control through governance documents or contractual agreements giving it decision-making authority over the VIE.  Primary beneficiary must consolidate in its financial statements the VIE’s assets, liabilities, revenues, expenses, and noncontrolling interest. 6-5  Characteristics of VIEs  VIEs generally have assets, liabilities, and investors with equity interests.  Activities are strictly limited.  Role of equity investors can be minor; they may serve simply to allow the VIE to function as a legal entity.  Because they bear relatively low economic risk, investors may be provided only a small rate of return.  Another party, e.g., the primary beneficiary, contributes substantial resources—loans and/or guarantees—to enable the VIE to secure additional financing to accomplish its purpose. 6-6  Characteristics of VIEs (continued)  Primary beneficiary may guarantee the VIE’s debt, assuming the risk of default.  Contractual arrangements may limit returns to equity holders, yet participation rights provide increased profit potential and risks to the primary beneficiary.  Beneficiary’s economic interests vary depending on the VIE’s success—hence the term variable interest entity.  Risks and rewards are not distributed according to stock ownership but according to other variable interests. 6-7 Variable Interest Entities—Risk and Ownership  Variable interests increase a firm’s risk as the resources it provides (or guarantees) to the VIE increase.  With increased risks come incentives to restrict the VIE’s decision making.  A firm with variable interests will regularly limit the equity investors’ power through the VIE’s governance documents.  Investors are the owners of the VIE, but they may retain little responsibility of ownership risk and benefits.  Investors may cede financial control of a VIE to the variable interests in exchange for a guaranteed rate of return. 6-8  Prior Consolidation of VIEs  In the past, assets, liabilities, and results of operations for VIEs and other entities frequently were not consolidated with those of the firm that controlled the entity.  These firms invoked a reliance on voting interests, as opposed to variable interests, to indicate a lack of a controlling financial interest.  As noted by GAAP literature, legacy FASB standard FIN 46R requires the primary beneficiary (regardless of their ownership) to consolidate the VIE. 6-9  Examples of VIEs EXHIBIT 6.1 Examples of Variable Interests 6-10  Identification of a VIE An entity qualifies as a VIE if either of the following conditions exists:  Total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders.  Equity investors in VIE, as a group, lack any one of three characteristics of a controlling financial interest: 1) The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance. 2) The obligation to absorb the expected losses of the entity. 3) The right to receive expected residual returns of the entity. 6-11  Identification of the Primary Beneficiary of the VIE  Once a firm has a relationship with a VIE, the firm must determine whether it qualifies as the VIE’s primary beneficiary.  An enterprise with a variable interest with a controlling financial interest in a VIE is the primary beneficiary and will have both of the following characteristics: 1) The power to direct the activities of a VIE that most significantly impact the entity’s economic performance. 2) The obligation to absorb losses that could potentially be significant to the VIE or the right to receive benefits from it that could be significant to the VIE. 6-12  Identification of the Primary Beneficiary of the VIE (continued)  These characteristics mirror those that the equity investors often lack in a VIE.  The primary beneficiary will absorb a significant share of the VIE’s losses or receive a significant share of the VIE’s residual returns or both. This is the real key  The fact that the primary beneficiary may own no voting shares whatsoever becomes inconsequential because they do not effectively give equity investors power to exercise control.  Careful examination of the VIE’s governing documents and who bears risk is necessary to determine whether a reporting entity possesses control over a VIE. 6-13  Example of a Primary Beneficiary and Consolidated VIE  Twin Peaks, a power company, seeks to acquire an electric generating plant for $400 million to expand its market share. It expects to sell the electricity generated by the plant acquisition at a profit to its owners.  Twin Peaks’s general credit rating allowed for a 4 percent annual interest rate on a debt issue. It explored establishing a separate legal entity whose sole purpose would be to own the electric generating plant and lease it back to Twin Peaks. 6-14  Example of a Primary Beneficiary and Consolidated VIE (continued)  The separate entity will isolate the electric generating plant from Twin Peaks’s other risky assets and liabilities and provide specific collateral.  An interest rate of 3 percent on the debt is available, producing before-tax savings of $4 million per year.  To obtain the lower interest rate, however, Twin Peaks must: 1) Guarantee the separate entity’s debt. 2) Maintain its own predefined financial ratios and restrict the amount of additional debt it can assume. 6-15  Power Finance Co. (Part 1)  Twin Peaks establishes Power Finance Co., designed solely to own, finance, and lease the electric generating plant to Twin Peaks.  The documents governing the new entity specify the following: 1) The sole purpose of Power Finance is to purchase the Ace electric generating plant, provide equity and debt financing, and lease the plant to Twin Peaks. 2) An outside investor will provide $16 million in exchange for a 100 percent nonvoting equity interest in Power Finance. 6-16  Power Finance Co. (Part 2) 3) Power Finance will issue debt in exchange for $384 million. Twin Peaks guarantees the debt because the $16 million equity investment is insufficient to attract low-interest debt financing. 4) Twin Peaks will lease the electric generating plant from Power Finance in exchange for payments of $12 million per year based on a 3 percent fixed interest rate for the debt and equity investors for an initial five-year lease term. © McGraw Hill LLC. 6-17  Power Finance Co. (Part 3) 5) At the end of the five-year lease term (or any extension), Twin Peaks must do one of the following: Renew the lease for five years subject to the approval of the equity investor. Purchase the electric generating plant for $400 million. Sell the electric generating plant to an independent third party. If the proceeds of the sale are insufficient to repay the equity investor, Twin Peaks must make a payment of $16 million to the equity investor. 6-18  Power Finance Co. (Part 4) Exhibit 6.2 Variable Interest Entity to Facilitate Financing 6-19  Conditions for Consolidation of Twin Peaks Electric Company and Power Finance Company In evaluating whether Twin Peaks Electric Company must consolidate Power Finance Company, two conditions must be met: 1) Power Finance must qualify as a VIE by either: An inability to secure financing without additional subordinated support or A lack of either the risk of losses or entitlement to residual returns (or both). 2) Twin Peaks must qualify as the primary beneficiary of Power Finance. © McGraw Hill LLC. 6-20  Power Finance Company—VIE Status In assessing the first condition, several factors point to VIE status for Power Finance: 1) Its owners’ equity comprises only 4 percent of total assets, far short of the 10 percent benchmark. 2) Twin Peaks guarantees Power Finance’s debt, suggesting insufficient equity to finance its operations without additional support. 3) The equity investor appears to bear almost no risk with respect to the operations of the Ace electric plant. These characteristics indicate that Power Finance qualifies as a VIE. © McGraw Hill LLC. 6-21  Power Finance Company—VIE Status (continued) For the second condition for consolidation, an assessment is made to determine whether Twin Peaks qualifies as Power Finance’s primary beneficiary.  Twin Peaks has the power to direct Power Finance’s activities, but to qualify for consolidation, Twin Peaks must also have the obligation to absorb losses or the right to receive returns from Power Finance.  Twin Peaks will pay a fixed fee to lease the electric generating plant, operate the plant, and sell the electric power in its markets.  If the business plan is successful, Twin Peaks will enjoy residual profits from operating while Power Finance’s equity investors receive the fixed fee. © McGraw Hill LLC. 6-22  Power Finance Company—VIE Status (concluded)  If electricity prices fall, revenues generated may be insufficient to cover Twin Peaks’s lease payments, but the VIE equity investors are protected from this risk.  If the plant’s fair value increases significantly, Twin Peaks can exercise its option to purchase the plant at a fixed price and either resell it or keep it for its own future use.  If Twin Peaks sells the plant at a loss, it must pay the equity investors all of their initial investment, furthering the loss to Twin Peaks. These elements point to Twin Peaks as the primary beneficiary of its VIE, meaning it must consolidate the VIE’s assets, liabilities, and results of operations with its own. © McGraw Hill LLC. 6-23  Financial Reporting Principles for Consolidating VIEs—Initial Measurement Issues  Financial reporting principles for consolidating VIEs require asset, liability, and noncontrolling interest valuations.  These valuations initially, with few exceptions, are based on fair values.  If the total business fair value of the VIE exceeds the collective fair values of its net assets, goodwill is recognized. © McGraw Hill LLC. 6-24 Initial Measurement Issues—Collective Fair Values  If the collective fair values of the net assets exceed the total business fair value, the primary beneficiary recognizes a gain on bargain purchase.  Assuming that the debt and noncontrolling interests are stated at fair values, Twin Peaks includes in its consolidated balance sheet:  Electric Generating Plant at $400 million.  Long-Term Debt at $384 million.  Noncontrolling interest of $16 million. 6-25 Consolidation of VIEs Subsequent to Initial Measurement  After the initial measurement, all intra-entity transactions between the primary beneficiary and the VIE must be eliminated in consolidation.  VIE’s income must be allocated among the parties involved (equity holders and the primary beneficiary).  The distribution of income is typically specified in contractual arrangements. 6-26  Learning Objective 6-2 Demonstrate the process to consolidate a primary beneficiary with a variable interest entity. 6-27 Consolidation of a Primary Beneficiary and VIE Illustrated  Assume that on January 1, 2024, Payton Corporation loans Vincente, Inc., a business entity $2,200,000 due January 1, 2029.  Vincente had been unable to secure the financing needed to continue its operations.  As part of the loan agreement, Vincente agrees to provide to Payton during the next five years:  5 percent annual interest (market rate) on the loan.  Decision-making power over Vincente’s operating and financing activities.  Annual management fee equal to 10% of Vincente’s sales. 6-28 Consolidation of a Primary Beneficiary and VIE—Agreement Options At the end of the five-year agreement, Payton has the option of either: 1) Acquiring ownership of Vincente, Inc., for $500,000 or 2) Extending the original agreement for an additional five years. As a result of the agreement, Vincente is a variable interest entity, and Payton is its primary beneficiary that requires consolidation. 6-29  Primary Beneficiary and VIE— Balance Sheets At January 1, 2024, Payton estimated the fair value of Vicente’s common stock at $143,000. The $125,000 difference between the fair value of the common stock and Vicente’s book value ($143,000 – $18,000) was attributed entirely to the patented technology with a five-year estimated remaining life. Payton’s and Vicente’s balance sheets 6-30 Consolidation Worksheet: Date of Acquisition 6-31  Consolidation Worksheet: Subsequent to Initial Measurement 6-32  Consolidation Worksheet Process: Subsequent to Initial Measurement  Consolidation of a VIE with its primary beneficiary follows a similar process as if the entity were consolidated based on voting interests.  All intra-entity transactions between the primary beneficiary and the VIE (including fees, expenses, other sources of income or loss, and intra-entity transfers) must be eliminated in consolidation.  Because VIEs typically have noncontrolling interests, an appropriate allocation of the VIE’s net income requires a close examination of the underlying contractual arrangements between the primary beneficiary and other holders of variable interests. 6-33  Variable Interest Entity Disclosure Requirements Enhanced disclosures are required for any enterprise that holds a variable interest in a VIE, including:  VIE’s nature, purpose, size, and activities.  Significant judgments and assumptions an enterprise makes in determining whether it must consolidate a VIE and/or disclose information about its involvement in a VIE.  Nature of restrictions on a consolidated VIE’s assets and on the settlement of its liabilities reported by an enterprise in its statement of financial position, including the carrying amounts of such assets and liabilities. 6-34  Variable Interest Entity Disclosure Requirements (continued)  Nature of, and changes in, the risks associated with an enterprise’s involvement with the VIE.  How an enterprise’s involvement with the VIE affects the enterprise’s financial position, financial performance, and cash flows. 6-35  Comparisons with International Accounting Standards Under U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS):  Controlling financial interest is the critical concept in assessing consolidation by a reporting enterprise and VIEs.  Current reporting standards differ across these jurisdictions.  IFRS has one model for all entities regardless of whether control is evidenced by voting interests or variable interests.  U.S. GAAP has separate models for assessing control for variable interest entities and voting interest entities. © McGraw Hill LLC. 6-36  Comparisons with International Accounting Standards (continued)  Financial Accounting Standard Board (FASB) continues to deliberate its consolidation policies and procedures.  International Accounting Standards Board (IASB) has issued updated standards IFRS 10, “Consolidated Financial Statements,” and IFRS 12, “Disclosure of Interests in Other Entities,” that cover and define control to encompass all possible ways (voting power, contractual power, decision-making rights, etc.) in which one entity can exercise power over another. 6-37  Learning Objective 6-3 Demonstrate the consolidation procedures to eliminate all intra-entity debt accounts and recognize any associated gain or loss created whenever one company acquires an affiliate’s debt instrument from an outside party. © McGraw Hill LLC. 6-38  Intra-Entity Debt Transactions A company CANNOT lend money to itself.  Intra-entity investments in debt securities and related debt accounts must be eliminated in consolidation.  Corresponding receivable and payable and revenue and interest from the consolidated financial statements must be eliminated.  Because no money is owed to or from an outside party, these reciprocal accounts must be eliminated in each subsequent consolidation. 6-39  Acquisition of Affiliate’s Debt from an Outside Party  The purchase of an affiliate’s debt instrument from an outside third party can create difficulties in consolidation.  If the parent purchases all or part of outstanding subsidiary bonds in the open market, from a consolidated view, the combined entity has reacquired its own bonds.  Although the individual companies continue to carry the debt and investment on their individual financial records, from a consolidation viewpoint, this liability is effectively retired as of the debt reacquisition date.  The debt is no longer owed to a party outside the business combination. Subsequent interest payments are simply intra-entity cash transfers. © McGraw Hill LLC. 6-40  Intra-Entity Debt Transactions Example—Bond Retirement  Alpha paid $110,815 in excess of the recorded liability ($1,057,466 – $946,651) due to periodic amortization, and the consolidated entity must recognize a loss of this amount.  The bond is retired, and no further reporting is necessary by the business combination after January 1, 2023.  Neither company separately accounts for the event in this manner. 6-41  Learning Objective 6-4 Understand that subsidiary preferred stock not owned by the parent is a component of the noncontrolling interest and is initially measured at acquisition- date fair value. 6-42  Learning Objective 6-5 Prepare a consolidated statement of cash flows. 6-43  Consolidated Statement of Cash Flows—Example (Part 1) On July 1, 2023, Pinto Company acquires 90 percent of Salida Company’s outstanding stock for $774,000 in cash. At the acquisition date, the 10 percent noncontrolling interest has a fair value of $86,000. Information about the acquisition is presented below: 6-44  Consolidated Statement of Cash Flows—Example (Part 2) At the end of 2023, the following information is available: 6-45 © McGraw Hill LLC.  Consolidated Statement of Cash Flows—Example (Part 3) Additional Information for 2023  The consolidated income statement totals include Salida’s postacquisition revenues and expenses.  During the year, Pinto paid $50,000 in dividends. On August 1, Salida paid a $25,000 dividend.  During the year, Pinto issued $504,000 in long-term debt at par value.  No asset purchases or dispositions occurred during the year other than Pinto’s acquisition of Salida. 6-46  Learning Objective 6-6 Compute basic and diluted earnings per share for a business combination. 6-47  Consolidated Earnings per Share  If the reporting entity has no dilutive options, warrants, or other convertible items, only basic EPS is presented on the face of the income statement.  If any dilutive securities are present, diluted EPS also must be presented.  To compute diluted EPS, combine the effects of any dilutive securities with basic earnings per share. 6-48