Chapter 03

1. Chapter 03 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential

2. Learning Objective 1 Understand and explain the usefulness and limitations of consolidated financial statements.

3. Consolidation: The Concept • Parent creates or gains control of the subsidiary. • The result: a single legal entity. P S

4. Review How do we report the results of subsidiaries? Parent Company 80% 51% 21% Sub A Sub B Sub C Consolidation (plus the Equity Method) Equity Method

5. Consolidated Financial Statements Consolidated financial statements present the financial position and results of operations for: • a parent (controlling entity) and • one or more subsidiaries (controlled entities) • as if the individual entities actually were a single company or entity.

6. Benefits of Consolidated Financial Statements • Presented primarily for those parties having a long-run interest in the parent company: • shareholders, • long-term creditors, or • other resource providers. • Provide a means of obtaining a clear picture of the total resources of the combined entity that are under the parent's control.

7. Limitations of Consolidated Financial Statements • Results of individual companies not disclosed (hides poor performance). • Financial ratios are not necessarily representative of any single company in the consolidation. • Similar accounts of different companies may not be entirely comparable. • Information is lost any time data sets are aggregated.

8. Subsidiary Financial Statements • Creditors, preferred stockholders, and noncontrolling common stockholders of subsidiaries are most interested in the separate financial statements of the subsidiaries in which they have an interest. • Because subsidiaries are legally separate from their parents, • the creditors and stockholders of a subsidiary generally have no claim on the parent, and • the stockholders of the subsidiary do not share in the profits of the parent.

9. Practice Quiz Question #1 A primary benefit of consolidated financial statements is that they: a. provide information directly applicable to the needs of regulators. b. obscure data of individual companies. c. present data of two or more entities that clearly reports their individual performance. d. give a picture of the use of resources under the parent’s control. e. none of the above.

10. Learning Objective 2 Understand and explain how direct and indirect control influence the consolidation of a subsidiary.

11. Concepts and Standards • Traditional view of control includes: • Direct control that occurs when one company owns a majority of another company’s common stock. • Indirect control or pyramiding that occurs when a company’s common stock is owned by one or more other companies that are all under common control.

12. Concepts and Standards • Ability to Exercise Control • Sometimes, majority stockholders may not be able to exercise control even though they hold more than 50 percent of outstanding voting stock. • Subsidiary is in legal reorganization or bankruptcy • Foreign country restricts remittance of subsidiary profits to domestic parent company • The unconsolidated subsidiary is reported as an intercorporate investment.

13. Concepts and Standards • Differences in Fiscal Periods • Difference in the fiscal periods of a parent and subsidiary should not preclude consolidation. • Often the fiscal period of the subsidiary is changed to coincide with that of the parent. • Another alternative is to adjust the financial statement data of the subsidiary each period to place the data on a basis consistent with the fiscal period of the parent.

14. Concepts and Standards • Changing Concept of the Reporting Entity • FASB 94, requiring consolidation of all majority-owned subsidiaries, was issued to eliminate the inconsistencies found in practice until a more comprehensive standard could be issued. • Completion of the FASB’s consolidation project has been hampered by, among other things, issues related to: • Control • Reporting entity

15. Concepts and Standards • The FASB has been attempting to move toward a consolidation requirement for entities under effective control. • Ability to direct the policies of another entity even though majority ownership is lacking. • Even though FASB 141R indicates that control can be achieved without majority ownership, a comprehensive consolidation policy has yet to be achieved.

16. Concepts and Standards • Defining the accounting entity would help resolve the issue of when to prepare consolidated financial statements and what entities should be included. • FASB 160 deals only with selected issues related to consolidated financial statements, leaving a comprehensive consolidation policy until a later time.

17. Practice Quiz Question #2 P owns 60% of X and 75% of Y. If X and Y jointly own 100% of Z, under what circumstance would P not be deemed to control Z? a. Z is a bank. b. Z’s products are largely sold overseas. c. Z is currently in Chapter 11 bankruptcy. d. Z has a CEO known to have a bad temper and a serious gambling habit. e. none of the above.

18. Learning Objective 3 Understand and explain the rules related to the consolidation of variable interest entities.

19. The Rise and FALL of Enron Press Release Tuesday, October 16, 2001 ENRON REPORTS NON-RECURRING CHARGES OF $1.01 BILLION AFTER-TAX.

20. Special Purpose Entities • Corporations, trusts, or partnerships created for a single specified purpose. • Usually have no substantive operations and are used only for financing purposes. • Used for several decades for asset securitization, risk sharing, and taking advantage of tax statutes.

21. Variable Interest Entities • A legal structure used for business purposes, usually a corporation, trust, or partnership, that either: • does not have equity investors that have voting rights and share in all profits and losses of the entity. • has equity investors that do not provide sufficient financial resources to support the entity’s activities.

22. Enron’s Accounting “Sleight of Hand” Special Purpose Entities (SPEs) • What is normally the business purpose? • Bundle peripheral activities and have them done by an independent, but close, friend. • Examples: • Acquire financing for a project • Package receivables and sell them to third parties • What was Enron’s purpose? • Move liabilities off the balance sheet • Provide favorable terms for some transactions

23. “Raptors” • Established by Enron CFO to provide a quick buyer for Enron assets. • Option 1: Find a bona fide third party. • Can’t find anyone? • Option 2: Establish a SPE to take the other side of the transaction. • Where does the financing come from? • 97% sponsoring institution • 3% third party

24. A diagram of the Chewco transaction is set forth below: Example: The Chewco Raptor

25. Raptor’s Impact on Earnings

26. Variable Interest Entities (VIEs) • As a result of the Enron collapse and other notable scandals related to SPEs, the FASB issued Interpretation No. 46 (FIN46) [the revised version is FIN46R]. • What is a VIE? • An entity that either • does not have equity investors with voting rights and a percentage of profits and losses, OR • has equity investors that do not provide sufficient financial resources to support the entity’s activities. • What is a variable interest? • an interest that changes with changes in the VIE’s net assets.

27. Variable Interest Entities • FIN 46 (an interpretation of ARB 51) uses the term variable interest entities to encompass SPEs and other entities falling within its conditions. • Does not apply to entities that are considered SPEs under FASB 140. • FIN 46R defines a variable interest in a VIE as a contractual, ownership (with or without voting rights), or other money-related interest in an entity that changes with changes in the fair value of the entity’s net assets exclusive of variable interests.

28. Purpose of FIN46R The main effect of Fin46R is to capture those investment relationships in which a controlling financial interest is not indicated by voting rights, but is indicated by residual interests in risks and benefits, which is the conceptual definition of ownership in CON6.

29. Example: Variable Interest Entities Senior Debt ($85k) Junior Debt ($12k) Lease Pmts. $100k ABC Corp. Leasing Corp. Building Owner Use of Building Building Investor ($3k) • How would ABC Corp. typically determine whether to consolidate Leasing Corp.? • What if ABC Corp. were a related party to Investor? • What if ABC Corp. guaranteed the value of the building at the end of the lease? • What if ABC Corp. received any residual value above $100k when building sold?  A controlling financial interest through voting rights.

30. Variable Interest Entities (VIEs) Variable Interest Relationships • Situations in which an entity receives benefits and/or is exposed to risks similar to those received from having a majority ownership interest. • Results from contractual arrangements.

31. 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.

32. 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).

33. 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.

34. VIEs: The Primary Beneficiary • The primary beneficiary of a VIE must consolidate the VIE. • The 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. • Only one primary beneficiary can exist for a VIE (by definition).

35. Group Exercise 1: To Consolidate (or not)? REQUIRED • Is consolidation appropriate? • What would Parch accomplish with this arrangement? • If consolidation were not appropriate, what serious reporting issue exists regarding Parch’s separate financial statements? Parch Inc. and Rees Urch, Parch’s former head of R&D, formed Sede Inc., which will perform research and development. Sede issued 10,000 shares of common stock to Urch, who is now Sede’s president. Parch lent $800,000 to Sede for initial working capital in return for a note receivable that can be converted at will into 100,000 shares of Sede’s common stock. Parch also granted Sede a line of credit of $1,000,000.

36. Group Exercise 1: To Consolidate (or not)? Parch Inc. and Rees Urch, Parch’s former head of R&D, formed Sede Inc., which will perform research and development. Sede issued 10,000 shares of common stock to Urch, who is now Sede’s president. Parch lent $800,000 to Sede for initial working capital in return for a note receivable that can be converted at will into 100,000 shares of Sede’s common stock. Parch also granted Sede a line of credit of $1,000,000. Rees Urch Former Head of Research 10,000 shares Parch Sede $800,000 loan $1,000,000 Line of credit Option 100,000 shares

37. Practice Quiz Question #3 On 1/1/X2, Pocahontas, Inc. invested $480,000 in Smith (80% owned). For 20X2, Smith: (1) earned $70,000, (2) declared dividends of $60,000, and (3) paid dividends of $50,000. What amounts does Pocahontas report? CostEquity Investment income for 20X2 Investment in Smith at year-end Retained earnings increase

38. Practice Quiz Question #4 On 1/1/X2, Pocahontas, Inc. invested $480,000 in Smith (80% owned) and NCI shareholders invested $120,000. For 20X2, Smith: (1) earned $70,000, (2) declared dividends of $60,000, and (3) paid dividends of $50,000. What amounts does Pocahontas report for the following items? NCI in net income for 20X2 NCI in net assets at 12/31/X2 Parent’s retained earnings increase

39. Learning Objective 4 Understand and explain differences in consolidation rules under U.S. GAAP and IFRS.

40. IFRS Differences Related to VIEs and SPEs • U.S. GAAP and International Financial Reporting Standards (IFRS) are rapidly converging. • The FASB and the IASB are working together to remove differences in existing standards. • They are also working jointly on all new standards so that agreed-upon standards can be adopted. • Despite convergence efforts, there are still some differences related to VIEs and SPEs. • See Fig. 3-1 on p. 117

41. Key Differences between U.S. GAAP and IFRS

42. Key Differences between U.S. GAAP and IFRS

43. Key Differences between U.S. GAAP and IFRS

44. Practice Quiz Question #5 Which of the following differs between U.S. GAAP and IFRS in the determination of control? a. In U.S. GAAP, control is solely based on ownership but IFRS considers other factors. b. U.S. GAAP ignores direct stock ownership, while IFRS considers it. c. In U.S. GAAP, rules related to VIEs must be followed, but IFRS has not specifically addressed VIEs (only SPEs). e. The determination of control is identical under U.S. GAAP and IFRS..

45. Learning Objective 5 Understand and explain differences in the consolidation process when the subsidiary is not wholly owned.

46. NCI <50% Noncontrolling Interest • Only a controlling interest is needed for the parent to consolidate the subsidiary—not 100% interest. • Shareholders of the subsidiary other than the parent are referred to as “noncontrolling” shareholders. • Noncontrolling interest or refers to the claim of these shareholders on the income and net assets of the subsidiary. Parent >50% Sub

47. NCI <50% Noncontrolling Interest (NCI) • What is a noncontrolling interest (NCI)? • Voting shares not owned by the parent company • NCI was formerly called the “Minority Interest” • Two Issues: • Should 100% of the financial statements be consolidated? • (2) Where to report NCI in the financial statements? Parent >50% Sub

48. Issue 1: Should 100% be Consolidated? < 100% 100% No Yes No Yes Easy Hard

49. Issue 1: Should 100% be Consolidated? • Full consolidation required by US GAAP (100%) • This means two special accounts appear in consolidated statements: • NCI in Net Income of Sub • Like an “expense” in the consolidated income statement • “Reported income that doesn’t belong to us.” • NCI in Net Assets of Sub • Equity of unrelated owners • “Net assets on our balance sheet not belonging to us.”

50. Issue 2: Where to report NCI in Net Assets? • Old rules: Could report in in equity, liabilities, or “no man’s land” between liabilities and equity. • New rules: Must report in equity • FASB 160 makes clear that the noncontrolling interest’s claim on net assets is an element of equity, not a liability.