Variable Interest Entities (VIEs)

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 Characteristics of VIEs: Most established for legitimate business purposes Some created to avoid consolidated disclosure Generally have assets, liabilities, and investors with equity interests Role of equity investors can be minor if VIEs activities are strictly limited Equity investors may serve simply to allow the VIE to function as a legal entity

Variable Interest Entities Characteristics continued. . . VIEs bear relatively low economic risk, therefore equity investors are provided a small rate of return. Another party (often the sponsoring firm that benefits from the VIEs activities) contributes substantial resources loans and/or guarantees to enable a VIE to secure financing needed to accomplish its purpose. The sponsoring firm may guarantee the VIEs debt, assuming the risk of default.

Variable Interest Entities Characteristics continued. . . Contractual arrangements limit returns to equity holders yet participation rights provide increased profit potential and risks to sponsor. Risks and rewards are not distributed according to stock ownership but by other variable interests. Sponsors economic interest vary depending on the VIEs success Hence the term variable interest 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 entitys economic performance.

Obligation to absorb significant losses of the entity. Right to receive significant benefits of the entity.

Benefit of VIEs A business sponsors a VIE to purchase and finance asset acquisition. The VIE leases the asset to the sponsor. VIE is often eligible for lower interest rate.

Variable Interest Entity - Example Assume 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. To take advantage of lower interest rates, Twin Peaks creates Power Finance Co., an entity designed solely to purchase the electric generating plant, provide equity and debt financing, and lease the plant to Twin Peaks.

Similar to other combinations, valuation of assets, liabilities, and noncontrolling interest should be based on Fair Value. When a VIEs total business fair value is less than its assessed net asset value, a GAIN is recognized. When a VIEs total business fair value is greater than its assessed net asset value, Goodwill is reported.

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

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.

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.

Assume Alpha owns 80% of Omega. On 1/1/11, Omega issued $1 million in 10-year bonds at 9%. Omega issued the bonds at $938,555, with effective interest at 10%. On 1/1/13, Alpha purchased the bonds for $1,057,466, with effective interest at 8%.

Carrying value of Omega Companys bonds is $946,651 as of December 31, 2012, the date immediately before the day Alpha Company acquired the bonds.

Intra-Entity Debt Transactions Example Omega Companys bonds have been effectively retired. The difference between the $1,057,466 payment and the January 1, 2013, carrying value of the liability must be recognized in the consolidated statements as a gain or loss. Because Alpha paid $110,815 in excess of the recorded liability ($1,057,466 $946,651), the consolidated entity must recognize a loss of this amount. Then, the bond is retired and no further reporting is necessary by the business combination after January 1, 2013.

Omega retains the $1 million debt balance within its separate financial records and amortizes the remaining discount each year. Annual cash interest payments of $90,000 (9 percent) continue to be made. At the same time, Alpha records the investment at the historical cost of $1,057,466, an amount that also requires periodic amortization. Alpha receives the $90,000 interest payments made by Omega. To organize the accountants approach to this consolidation, the subsequent financial recording made by each company is analyzed.

Omega records only two journal entries during 2013 assuming interest is paid each December 31 to record the interest expense cash payment and discount on bonds payable.

In 2013, Alpha records its investment in Omegas bonds and the interest income.

Entry B 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.

Intra-Entity Debt Transactions Example Entry *B (Subsequent Years) Adjust the BVs of the Bonds Payable and the Investment in Bonds to reflect amortization. Also, the loss is now reflected in R/E, which must be adjusted for the difference in interest amounts.

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 subs 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.

The consolidation entry made in the year of acquisition is shown below:

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 entitys 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.

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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.

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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 interests share of the subs net

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income.
Deduct dividends paid to the outside owners as cash outflow.

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 parents stock that can possibly dilute the reported figure must be included in diluted EPS.

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Consolidated Earnings Per Share If potentially dilutive items exist on the subs individual statements, then the portion of the subs net income included in consolidated net income may not be appropriate for the computation of consolidated earnings per share.

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Consolidated Earnings Per Share Compute the subs 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.

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Subsidiary Stock Transactions

A parents ownership percentage may be affected by a subsidiarys 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.

Summary VIEs 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.