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CHAPTER 3

CHAPTER 3. PARTIALLY OWNED CREATED SUBSIDIARIES. FOCUS OF CHAPTER 3. Partially Owned Created Subsidiaries Preparing Consolidated Statements: The Cost Method The Equity Method Unconsolidated Subsidiaries — Ways to Value the Parent’s Investment Variable Interest Entities

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CHAPTER 3

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  1. CHAPTER 3 PARTIALLY OWNED CREATED SUBSIDIARIES

  2. FOCUS OF CHAPTER 3 • Partially Owned Created Subsidiaries • Preparing Consolidated Statements: • The Cost Method • The Equity Method • Unconsolidated Subsidiaries—Ways to Value the Parent’s Investment • Variable Interest Entities • Taxation of domestic subsidiaries.

  3. Proportional vs. Full Consolidation: At Opposite Ends of the Spectrum

  4. Parent Company Concept vs. Economic Unit Concept: Not Much Difference for “Created” Subsidiaries

  5. Parent Company Concept (PCC) vs. Economic Unit Concept (EUC): Definition & Classification Differences 1. Pumco ownership % of Sumco: 80%.2. Sumco’s net income for 2006: $100,0003. Pumco’s net income for 2006 from its own separate operations: $400,000. PCCEUCConsol. net income . . $480,000 $500,000NCI in Net Income . . $20,000 $20,000Classification of NCI in Net Assets . . O/S Equity Equity

  6. Unconsolidated Subsidiaries: 100% Ownership Situations • Permissible Valuation Methods(for when control has been lost): • Equity Method—but ONLY IF significant influence exists. • Cost Method—makes sense to use when realization of sub’s expected future earnings is doubtful. • The default method if NOsignificant influence exists.

  7. Unconsolidated Subsidiaries:PartialOwnerships—NCI Shares Are NOT Publicly Traded • Permissible Valuation Methods(for when control has been lost): • Equity Method—but ONLYIFsignificant influence exists. • Cost Method. • The default method if NOsignificant influence exists.

  8. Unconsolidated Subsidiaries:Partial Ownerships—NCI SharesAREPublicly Traded • Permissible Valuation Methods(for when control has been lost): • Equity Method—but ONLY IF significant influence exists. • Fair Value Method (the new kid)—must use if significant influence does NOT exist. Look for a new kid on the block. WSJ--12/31/06....”33 7/8”

  9. Variable Interest Entities (VIEs): Defined • VIE: A less than majority-owned entity that is subject to consolidation under the provisions of FASB Interpretation 46. • If certain conditions exist, the entity must be consolidated. • An entity that has a variable interest in a VIE—an interest that changes with changes in the VIE’s net assets—must determine if it must consolidate the VIE.

  10. Variable Interest Entities (VIEs):“Variable Interest Relationships” • Variable Interest Relationships: • Situations in which an entity:Receivesbenefits and/or is exposed toriskssimilar to those received from having amajority ownership interest. • Result fromcontractual arrangements.

  11. Variable Interest Entities (VIEs): “Contractual Arrangements” • Contractual Arrangement Types: • Options • Leases • Guarantees of asset recovery values • Guarantees of debt repayment • Contractual arrangements may exist simultaneously with a less than majority ownership in a VIE.

  12. Variable Interest Entities (VIEs):Most are “SPEs” • Special Purpose Entities: • Legally structured entities to serve a specific, predetermined, limited purpose. • May be a corporation, partnership, trust, or some other legal entity. • Creator is called the “sponsor.” • Usually thinly capitalized. • Most commonly used for securitizations (of receivables).

  13. Variable Interest Entities (VIEs):“SPEs” • Special Purpose Entities: • Not subject to consolidation provisions of FIN 46 if sales recognition criteria of FAS 140 is met for transfer of assets to SPE. • If met, SPE is called a “Qualifying SPE.” (If not met, the proceeds from the transfer are treated as a loan.) • FAS 140 prohibits transferors from consolidating QSPEs (because risk exposure is considered insignificant).

  14. Variable Interest Entities (VIEs):Potential Variable Interests • Potential Variable Interests: • Subordinated loans to a VIE. • Equity interests in a VIE (50% or less). • Guarantees to a VIE’s lenders or equity holders (that reduce the true risk of these parties). • Written put options on a VIE’s assets held by a VIE or its lenders or equity holders. • Forward contracts on purchases and sales.

  15. Variable Interest Entities (VIEs):The Primary Beneficiary • PRIMARY BENEFICIARY of a VIE must consolidate the VIE. • PRIMARY BENEFICIARY is the entity that: • Will absorb a majority (more than 50%) of the VIE’s expected losses and/or • Will receive a majority (more than 50%) of the VIE’s expected residual returns. • Expected losses are given more weight than expected residual returns in certain situations.

  16. Variable Interest Entities (VIEs):The Primary Beneficiary • Only one PRIMARY BENEFICIARY can exist for a VIE (by definition). • Potential for Erroneously Determined Multiple Primary Beneficiaries Does Exist: • When one or more variable interest holders(VIH) has incomplete information about the VIE’s other VIH. • Different VIH make different judgments about their variable interests.

  17. Variable Interest Entities (VIEs):Determining if an Entity is a VIE • IN GENERAL, an entity is subject to consolidation if, by design, any of three conditions exists. These conditions focus on: 1. Sufficiency of equity investment at risk. 2. Characteristics of the holders of equity investment at risk. 3. Whether certain disproportionalities exist among the equity investors.

  18. Variable Interest Entities (VIEs):Determining if an Entity is a VIE • Condition #1: Equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support (SFS). • SFS is defined as variable interests that will absorb some or all of an entity’s expected losses (example: a debt guarantee or an equity guarantee). • In general, the equity at risk is deemed sufficient if it is at least 10% of total assets. (May need more than 10%.)

  19. Variable Interest Entities (VIEs):Determining if an Entity is a VIE (cont.) • Condition #2: The holders of the equity investment at risk (as a group) lack any of the following characteristics: • The ability to make decisions about an entity’s activities. • The obligation to absorb the entity’s expected losses. • The right to receive the entities expected residual returns.

  20. Variable Interest Entities (VIEs):Determining if an Entity is a VIE (cont.) • Condition #3: Certain disproportionalities exist among the equity investors. • Example: Certain equity holders possess voting rights that are not proportional to their obligation to share the VIE’s losses.

  21. Variable Interest Entities (VIEs):Consolidation Procedures • Major Points in Consolidating: • #1 Eliminate primary beneficiary’s interest in the VIE. • #2 Report VIE’s assets & liabilities at fairvalues—not their book values. • #3 Report goodwill if it exists. • #4 Extinguish “negative goodwill”/ BPE if it exists. • #5 Report noncontrolling interest at FV. • #6 Eliminate intercompany transactions.

  22. Variable Interest Entities (VIEs):Disclosures Required When Involved • Disclosures for Primary Beneficiaries (that do not hold a majority voting interest): • #1 VIE’s nature, purpose, size, activities. • #2 Carrying value and classification of consolidated assets that are collateral for the VIE’s obligations. • #3 Lack of recourse if creditors (or beneficial interest holders) of a consolidated VIE have no recourse to the general credit of the primary beneficiary.

  23. Variable Interest Entities (VIEs):Disclosures Required When Involved • Disclosures for Nonprimary Beneficiaries: • #1 Nature of involvement with VIE and when involvement began. • #2 VIE’s nature, purpose, size, activities. • #3 The entity’s maximum exposure to loss as a result of its involvement with the VIE.

  24. Review Question #1 Which of the following is NOT permitted under GAAP?A. The economic unitconcept.B. The parent companyconcept.C. Full consolidation.D. Proportional consolidation.E. None of the above.

  25. Review Question #1With Answer Which of the following is NOT permitted under GAAP?A. The economic unitconcept.B. The parent companyconcept.C. Full consolidation.D. Proportional consolidation.E. None of the above.

  26. Review Question #2 The noncontrolling interest (NCI) is reported OUTSIDE consolidated stockholders’ equity under:A. The economic unitconcept.B. The parent companyconcept.C. Full consolidation.D. Proportional consolidation.E. None of the above.

  27. Review Question #2With Answer The noncontrolling interest (NCI) is reported OUTSIDE consolidated stockholders’ equity under:A. The economic unit concept.B. The parent companyconcept.C. Full consolidation.D. Proportional consolidation.E. None of the above.

  28. Review Question #3 The noncontrolling interest (NCI) is reported AS PART OF consolidated stockholders’ equity under:A. The economic unitconcept.B. The parent companyconcept.C. Full consolidation.D. Proportionalconsolidation.E. None of the above.

  29. Review Question #3With Answer The noncontrolling interest (NCI) is reported AS PART OF consolidated stockholders’ equity under:A. The economic unit concept.B. The parent companyconcept.C. Full consolidation.D. Proportional consolidation.E. None of the above.

  30. Review Question #4 On 1/1/06, Parco invested $900,000 in Sarco (90%-owned). For 2006, Sarco: (1) earned $60,000, (2) declared dividends of $50,000, and (3) paid dividends of $40,000. What amounts does Parco report? CostEquityInvestment income for 2006.... Investment in Sarco at Y/E......Retained earnings increase....

  31. Review Question #4With Answer On 1/1/06, Parco invested $900,000 in Sarco (90%-owned). For 2006, Sarco: (1) earned $60,000, (2) declared dividends of $50,000, and (3) paid dividends of $40,000. What amounts does Parco report? CostEquityInvestment income for 2006..... Investment in Sarco at Y/E......Retained earnings increase....... $45,000 $54,000 $900,000 $909,000 $45,000 $54,000

  32. Review Question #5 On 1/1/06, Parco invested $900,000 in Sarco (90%-owned) and NCI shareholders invested $100,000. For 2006, Sarco: (1) earned $60,000, (2) declared dividends of $50,000, and (3) paid dividends of $40,000. What amounts does Parco report for the items below? NCI in net income for 2006..…….. _________ NCI in net assets at 12/31/06….... _________Con. retained earnings increase.. _________

  33. Review Question #5With Answer On 1/1/06, Parco invested $900,000 in Sarco (90%-owned) and NCI shareholders invested $100,000. For 2006, Sarco: (1) earned $60,000, (2) declared dividends of $50,000, and (3) paid dividends of $40,000. What amounts does Parco report for the items below? NCI in net income for 2006..……. $ 6,000 NCI in net assets at 12/31/06…… $ 101,000 Con. retained earnings increase.. $ 54,000

  34. Review Question #6 A 100%-owned subsidiary is NOT consolidated. The parent could definitely NOT use:A. The cost methodB. The equity method.C. The lower of cost or marketmethod.D. The fair market valuemethod.E. None of the above.

  35. Review Question #6With Answer A 100%-owned subsidiary is NOT consolidated. The parent could definitely NOT use:A. The cost methodB. The equitymethod.C. The lower of cost or marketmethod.D. The fair market valuemethod.E. None of the above.

  36. Review Question #7 A LESS THAN 100%-owned subsidiary is NOT consolidated—the NCI shares ARE publicly traded. The parent definitely could NOT use:A. The costmethodB. The equity method.C. The fair market valuemethod.D. None of the above.

  37. Review Question #7With Answer A LESS THAN 100%-owned subsidiary is NOT consolidated—the NCI shares ARE publicly traded. The parent definitely could NOT use:A. The costmethod.B. The equity method.C. The fair market valuemethod.D. None of the above.

  38. End of Chapter 3(Appendix 3B follows) • Time to Clear Things Up—Any Questions?

  39. Domestic Subs: Recording Taxes at Parent Level on Sub’s Income • Double vs. Triple Taxation—Ways to Easily Avoid the THIRD Tax: • Own 80% or More of Sub’s Stock: • Can file a consolidated tax return or • File separate tax returns—parent uses a dividend received deduction of 100%. Appendix 3B Sub files its own IRS Form 1120

  40. Consolidated Tax Returns—Advantages Vs. Disadvantages • MajorAdvantages: • Can offset X’s LOSS against Y’s INCOME. • Can offset X’s CAPITALLOSS against Y’s CAPITALGAIN. • Avoids Sec. 482 transfer pricing problems. • MajorDisadvantages: • X’s loss on intercompany sale is deferred. • Complexity. Appendix 3B

  41. Domestic Subs:Less Than 80% Ownership Situations Triple Taxation CANNOTbe Entirely Avoided: • Dividend received deduction is only 80%. • FASB: Parent must record any triple tax inthe year in which sub earns its income—NO EXCEPTIONS ARE ALLOWED FOR DOMESTIC SUBSIDIARIES. Appendix 3B Sub must file its own IRS Form 1120

  42. Review Question #3B-1 Pemco owns 60% of Semco. For 2006, Semco: (1) earned $100,000, (2) declared dividends of $75,000, and (3) paid dividends of $55,000. What additional income taxes must Pemco record on its books because of this investment (income tax rate is 40%)?A. $ -0-.B. $4,800.C. $15,000.D. $18,000.E. $24,000. Appendix 3B

  43. Review Question #3B-1With Answer Pemco owns 60% of Semco. For 2006, Semco: (1) earned $100,000, (2) declared dividends of $75,000, and (3) paid dividends of $55,000. What additional income taxes must Pemco record on its books because of this investment (income tax rate is 40%)?A. $ -0-.B. $4,800 ($60,000 - $48,000 DRD) x 40%).C. $15,000.D. $18,000.E. $24,000. Appendix 3B

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