Other Consolidation Reporting Issues

1. Chapter 10 1 Chapter 10 Other Consolidation Reporting Issues

2. Chapter 10 2 Learning Objectives What are variable interest entities (VIE)? Rules for consolidation of VIE Joint ventures

3. Chapter 10 3 Variable Interest Entities An SPE = Special Purpose Entity SPE is a proprietorship, partnership, corporation, or trust set up to accomplish a very specific and limited business activity

4. Chapter 10 4 Variable Interest Entities Why establish VIE? Low cost financing of asset purchases is often a major benefits of establishing an SPE Instead of buying an asset directly, a company can get a lower financing cost by setting up a SPE whose sole purpose is to buy the asset and lease it to the parent. Why is financing cost lower? SPE has just one asset therefore risk is isolated from the rest of the business Prior to 2003, to avoid the consolidation of the SPE with the sponsoring enterprise and thereby avoid having to show additional debt on the consolidated balance sheet (off-balance sheet financing) because Handbook stated control was required through voting shares

5. Chapter 10 5 Variable Interest Entities BUT: Control was achieved not through share ownership but by contractual agreements EG. Parent guarantees debt and has veto power over all decisions Since equity owners had little risk, they got a small return. In effect, Parent controls the VIE even if it doesn�t own shares

6. Chapter 10 6 Exhibit 10.1

7. Chapter 10 7 Consolidation of Variable Interest Entities Accounting Guidline 15 (June 2003) � Enron Standards: An entity qualifies as a VIE if either of the following conditions exists: The total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any parties. In most cases, if equity at risk is less than 10 percent of total assets, the risk is deemed insufficient

8. Chapter 10 8 Consolidation of Variable Interest Entities The equity investors in the VIE lack any of the following three characteristics of a controlling financial interest The direct or indirect ability to make decisions about an entity�s activities through voting or similar rights The obligation to absorb the expected losses of the entity if they occur (e.g. another firm may guarantee a return to the equity investors) The right to receive the expected residual returns of the entity (e.g. the investors� returns may be capped by the entity�s governing documents)

9. Chapter 10 9 Consolidation of Variable Interest Entities The following characteristics are indicative of an enterprise qualifying as a primary beneficiary with a controlling financial interest in a VIE: The direct or indirect ability to make decisions about the entity�s activities The obligation to absorb the expected losses of the entity if they occur The right to receive the expected residual returns of the entity if they occur

10. Chapter 10 10 Consolidation of Variable Interest Entities Initial measurement issues � the financial report principles for consolidating VIEs require assets, liabilities, and noncontrolling interests (NCI) to be initially recorded at fair values with two notable exceptions: First, if any of the SPE�s assets have been transferred from the primary beneficiary, these assets will be measured at the carrying value before the transfer Second, the asset valuation procedures in AcG-15 also rely in part on the allocation principles described in Handbook sec. 1581 (Business Combinations) � use fair values

11. Chapter 10 11 Initial measurement Compare implied value to consideration: Implied value of VIE�s assets Fair value of amount invested by parent Fair value of Non-controlling interest shares Fair market value of assets Difference is loss on investment (since VIE is not a business according to the Handbook definition)

12. Chapter 10 12 Initial measurement Handbook definition of �Business� A self-sustaining, integrated set of activities and assets conducted and managed for the purpose of providing a return to investors. A business consists of inputs, processes applied to those inputs, and resulting outputs that are used to generate revenues. Needs to sustain a revenue stream by providing output to customers If it is a business, then difference is assigned to goodwill

13. Chapter 10 13 Consolidation of Variable Interest Entities Consolidation issues subsequent to initial measurement � after the initial measurement, consolidation of VIEs with their primary beneficiary should follow the same process as if the entity were consolidated based on voting interests All intercompany transactions must be eliminated The implied purchase price discrepancy must be amortized The income of the VIE must be allocated among the parties involved (parent and NCI)

14. Chapter 10 14 Consolidation of Variable Interest Entities Disclosure requirements � a primary beneficiary of a VIE should disclose the following in its consolidated financial statements: The carrying amount and classification of consolidated assets that are collateral for the VIE�s obligations Lack of recourse if creditors (or beneficial interest holders) of a consolidated VIE have no recourse to the general credit of a primary beneficiary

15. Chapter 10 15 Consolidation of Variable Interest Entities An enterprise the holds significant variable interest in a VIE but is not the primary beneficiary should disclose the following: The nature of its involvement with the VIE and when that involvement began The nature, purpose, size, and activities of the VIE The enterprise�s maximum exposure to loss as a result of its involvement with the VIE

16. Chapter 10 16 Joint Ventures

17. Chapter 10 17 Joint Ventures Joint Ventures are a common mechanism where two or more companies with common interests Generally, a separate business entity is formed, which may or may not be incorporated The venturers continue in their own businesses; the venture tends to carry on a �new� business under the control of the venturers, such as entering a new market or developing a new oil well

18. Chapter 10 18 Joint Ventures In terms of definitions, the CICA Handbook notes: A joint venture is an �economic activity� resulting from a contractual arrangement whereby two or more venturers jointly control the economic activity This activity is typically a business venture Joint control of an economic activity is the contractually agreed sharing of the continuing power to determine its strategic operating, investing and financing policies The venture tends to be governed by a board of directors appointed by the venturers

19. Chapter 10 19 Joint Ventures The venturers are the parties to the joint venture, have joint control over that venture, have the right and ability to obtain future economic benefits from the resources of the joint venture and are exposed to the related risks No one venturer can control unilaterally the venture so we don�t use traditional consolidation. Accounting method is PROPORTIONATE CONSOLIDATION

20. Chapter 10 20 Joint Ventures The venturers are bound by contractual arrangements which establish that the venturers have joint control over the joint venture, regardless of the difference that may exist in their ownership interest Although they each have �significant influence�, none of the individual venturers is in a position to exercise unilateral control over the joint venture Decisions in all areas essential to the accomplishment of the joint venture require the consent of the venturers in such manner as defined in the terms of the contractual arrangement

21. Chapter 10 21 Joint Ventures Joint ventures are unique: The characteristic of joint control distinguishes interests in joint ventures from investments in other activities where an investor may exercise control or significant influence A contract is generally required, but not in all cases: Activities conducted with no formal contractual arrangements which are jointly controlled in substance are joint ventures The unique aspects of joint ventures require a unique accounting treatment

22. Chapter 10 22 Accounting for an investment in a Joint Venture Section 3055 in the Handbook is concerned only with the financial reporting for an interest in a joint venture by a venturer This section requires the venturer to report an investment in a joint venture by the proportionate consolidation method

23. Chapter 10 23 Accounting for an investment in a Joint Venture Proportionate consolidation is the appropriate accounting treatment in Canada for external financial reporting by venturers of their investments in joint ventures Proportionate consolidation is an application of the proprietary concept of reporting

24. Chapter 10 24 Accounting for an investment in a Joint Venture The proprietary approach incorporates the amounts recorded by the subsidiary into the consolidated financial statements at fair value at the date of acquisition, but only to the extent of the proportion acquired The basis of the inclusion in this manner is that the investor shares in the risks and rewards of ownership in direct proportion to the shareholding percentage With a joint venture, joint control makes this treatment appropriate

25. Chapter 10 25 Examples Notes on blackboard

26. Chapter 10 26 Future Income Taxes and Business Combinations

27. Chapter 10 27 Future Income Taxes and Business Combinations In earlier chapters, we recognized the income tax effects and accounted for future income taxes when we eliminated unrealized profits We did this when we had asset and liability values for tax purposes which differed from values for financial reporting purposes Gains realized for tax purposes were unrealized in the consolidated financial statements There are other intercorporate investment situations where income tax effects, including future income taxes, must be recognized

28. Chapter 10 28 Future Income Taxes and Business Combinations At any point in time, there may be a difference between the tax basis of an asset or liability and its carrying amount This difference can occur when the purchase discrepancy is recognized and allocated in a business combination accounted for as a purchase The difference in carrying value (new book value in consolidation, as compared to tax basis) gives rise to future income taxes which must be recognized in the financial statements

29. Chapter 10 29 Future Income Taxes and Business Combinations Basic principles The premise is that an enterprise should recognize a future income tax liability whenever recovery or settlement of the carrying amount of an asset or liability would result in future income tax outflows Similarly, an enterprise should recognize a future income tax asset whenever recovery or settlement of the carrying amount of an asset or liability would generate future income tax reductions These situations arise whenever the values in consolidation differ from the tax values as recorded by the individual companies

30. Chapter 10 30 Future Income Taxes and Business Combinations There are two essential provisions of the Handbook which apply in the context of business combinations: �Old� future income taxes recorded by the subsidiary company are not carried forward into the consolidated financial statements �New� future income taxes are recognized on any temporary differences arising in consolidation between the reported values (consolidated) and the tax basis of the asset on the books of the individual enterprise (the subsidiary)

31. Chapter 10 31 Future Income Taxes and Business Combinations Example In a business combination, the carrying amount of a particular asset is stated at its fair value of $20,000. In the books of the acquired company, the asset had a book value of $12,000 and a tax basis of $9,000, which does not change. Assume a tax rate of 40% The �old� future tax liability of (12,000 - 9,000) * 40% = $1,200 must be eliminated A �new� future tax liability must be reported in the consolidated financial statements in the amount of (20,000 - 9,000) * 40% = $4,400 Such allocations change the reported goodwill

32. Chapter 10 32 Future Income Taxes and Business Combinations A business combination may increase the likelihood that loss carry forwards or other tax deductible amounts may be claimed Other previously unrecognized future income tax assets (of either parent or subsidiary) may be recognized at the time of a business combination, providing that it is more likely than not that the benefits will be realized These future income tax assets are identifiable assets in the allocation of the purchase price

33. Chapter 10 33 Segmented Disclosures

34. Chapter 10 34 Segmented Disclosures When consolidated financial statements are prepared, a significant amount of detail is lost This lost detail could be very useful for analysts and other users of the financial statements Yet, individual financial statements of subsidiaries may provide so much information as to overload Managers do not wish competitors to have confidential or sensitive data An efficient method of communicating just enough pertinent detail is necessary The mechanism of segmented reporting provides this vehicle

35. Chapter 10 35 Segmented Disclosures Segments may be defined in various ways; there are fundamental issues associated with segment definition: The CICA Handbook recommends a management approach, based on the way segments are organized within the enterprise for making operating decisions and assessing performance As a result: Segments are based on defined organizational structure in a transparent manner Preparers can provide the required information in a cost-effective and timely manner

36. Chapter 10 36 Segmented Disclosures To employ the management approach, an operating segment is defined as a component of an enterprise: that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise) whose operating results are regularly reviewed by the enterprise's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available

37. Chapter 10 37 Segmented Disclosures Separate disclosure is required for segments when one or more of these thresholds is met: Reported revenue, both external and intersegment, is 10 percent or more of the combined revenue, internal and external, of all segments The absolute amount of reported profit or loss is 10 percent or more of the greater, in absolute amount, of: the combined reported profit of all operating segments that did not report a loss, or the combined reported loss of all operating segments that did report a loss Its assets are 10 percent or more of the combined assets of all operating segments

38. Chapter 10 38 Segmented Disclosures General information is required: Factors used to identify the enterprise's reportable segments, including the basis of organization whether management has chosen to organize the enterprise around differences in products and services, geographic areas, regulatory environments, or a combination of factors and whether operating segments have been aggregated Types of products and services from which each reportable segment derives its revenues Note that the prior approach of geographic and industrial segmentation has been superceded

39. Chapter 10 39 Segmented Disclosures A measure of profit (loss) Each of the following if the specific amount are included in the measure of profit (loss) above Revenues from external customers Intersegment revenues Interest revenue and expense Amortization of capital assets Unusual revenues, expenses, and gains (losses) Equity income from significant influence investment Income taxes Extraordinary items Significant noncash items other that the amortization above

40. Chapter 10 40 Segmented Disclosures Total assets The amount of significant influence investments, if such investments are included in segment assets Total expenditures for additions to capital assets and goodwill An explanation of how a segment�s profit (loss) and assets have been measured, and how common costs and jointly used assets have been allocated, and of the accounting policies that have been used Reconciliation of the following Total segment revenue to consolidated revenues Total segment profit (loss) to consolidated net income (loss) Total segment assets to consolidated assets

41. Chapter 10 41 Segmented Disclosures The following information must also be disclosed, unless such an information has already been clearly provided as part of segment disclosures This additional information is also required when the company has only a single reportable segment The revenue from external customers for each product or service, or for each group of similar products and services, whenever practical The revenue from external customers broken down between those from the company�s country of domicile and those from all foreign countries

42. Chapter 10 42 Segmented Disclosures Where revenue from an individual country is material, it must be separately disclosed Goodwill and capital assets broken down between those located in Canada and those located in foreign countries Where assets located in an individual country is material, it must be separately disclosed When a company�s sales to a single external customer are 10 percent or more of total revenues, the company must disclose this fact, as well as the total amount of revenues from each customer and which operating segment reported such revenues. The identity of the customer does not have to be disclosed

43. Chapter 10 43 Segmented Disclosures As with all financial reporting, comparative amounts for at least the last fiscal year must also be presented The disclosures required be the new Section 1701 are a radical departure from those of the old Section 1700 and the approach seems to be a better one because it provides external users with the information that top management uses to assess performance Exhibit 10.2 shows the segment disclosure for the ATCO Group

44. Chapter 10 44 Exhibit 10.2

45. Chapter 10 45 Exhibit 10.3

46. Chapter 10 46 International Perspective The Canadian standard on consolidation of variable interest entities is substantially similar to the current FASB and IASB standards The IASB�s standard of SPEs applies a general test for control and is being applied more broadly than the previous FASB rules on SPEs and does require consolidation of VIEs controlled by primary beneficiaries

47. Chapter 10 47 International Perspective Canada, Australia, and New Zealand seem to be the only countries in the world requiring or allowing proportionate consolidation for an investment in a joint venture In the United States, some companies are allowed to follow industry practice and proportionately consolidate; but aside from these exceptions most companies with joint venture investments are required to use the equity method