Starting in the late 1970s, many firms began establishing separate business structures to help finance their operations at favorable rates. These struc- tures became commonly known as special purpose entities(SPEs), special purpose vehicles,or off-balance sheet structures.In this text, we refer to all such entities collectively as variable interest entitiesor VIEs. Many firms have routinely included their VIEs in their consolidated financial reports.
However, others sought to avoid consolidation. 241
chapter
6
Variable Interest
Entities, Intra-Entity Debt, Consolidated Cash Flows, and
Other Issues
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
LO1 Describe a variable interest entity, a primary beneficiary, and the fac- tors used to decide when a variable interest entity is subject to consolidation.
LO2 Understand the consolida- tion procedures to elimi- nate all intra-entity debt accounts and recognize any associated gain or loss created whenever one company acquires an affili- ate’s debt instrument from an outside party.
LO3 Understand that subsidiary preferred stocks not owned by the parent are a component of the noncontrolling interest and are initially valued at acquisition-date fair value.
LO4 Prepare a consolidated statement of cash flows.
LO5 Compute basic and diluted earnings per share for a business combination.
LO6 Understand the accounting for subsidiary stock trans- actions that impact the underlying value recorded within the parent’s Invest- ment account and the consolidated financial statements.
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242 Chapter 6
VIEs can help accomplish legitimate business purposes. Nonetheless, their use was widely criticized in the aftermath of Enron Corporation’s 2001 collapse. Because many firms avoided consolidation and used VIEs for off-balance sheet financing, such entities were often charac- terized as vehicles to hide debt and mislead investors. Other critics observed that firms with variable interests recorded questionable profits on sales to their VIEs that were not arm’s- length transactions.1The FASB ASC Variable Interest Entities sections within the Consolida- tions Topic were issued in response to such financial reporting abuses.
Accounting standards for consolidating VIEs continue to evolve over time. In 2009, the FASB expanded consolidation requirements for entities previously known as qualifying special purpose entities (QSPEs). Such QSPEs are often established to transform financial assets such as trade receivables, loans, or mortgages into securities that are offered in equity markets. Additionally in 2009 the FASB adopted a new qualitative assessment for deciding whether a firm must consoli- date a VIE. Consolidation criteria now focus on the power to direct the activities of the entity as well as the obligation to absorb losses and the right to receive benefits from the VIE.
What Is a VIE?
A VIE can take the form of a trust, partnership, joint venture, or corporation although sometimes it has neither independent management nor employees. Most are established for valid business purposes, and transactions involving VIEs have become widespread. Common examples of VIE activities include transfers of financial assets, leasing, hedging financial instruments, research and development, and other transactions. An enterprise often sponsors a VIE to accomplish a well-defined and limited business activity and to provide low-cost financing.
Low-cost financing of asset purchases is frequently a main benefit available through VIEs.
Rather than engaging in the transaction directly, the business may sponsor a VIE to purchase and finance an asset acquisition. The VIE then leases the asset to the sponsor. This strategy saves the business money because the VIE is often eligible for a lower interest rate. This advantage is achieved for several reasons. First, the VIE typically operates with a very limited set of assets––in many cases just one asset. By isolating an asset in a VIE, the asset’s risk is iso- lated from the sponsoring firm’s overall risk. Thus the VIE creditors remain protected by the specific collateral in the asset. Second, the governing documents can strictly limit the business activities of a VIE. These limits further protect lenders by preventing the VIE from engaging in any activities not specified in its agreements. As a major public accounting firm noted,
[t]he borrower/transferor gains access to a source of funds less expensive than would otherwise be available. This advantage derives from isolating the assets in an entity prohibited from under- taking any other business activity or taking on any additional debt, thereby creating a better security interest in the assets for the lender/investor.2
Because governing agreements limit activities and decision making in most VIEs, there is often little need for voting stock. In fact, a sponsoring enterprise may own very little, if any, of its VIE’s voting stock. Prior to current consolidation requirements for VIEs, many businesses left such entities unconsolidated in their financial reports because technically they did not own a majority of the entity’s voting stock. In utilizing the VIE as a conduit to provide financing, the related assets and debt were effectively removed from the enterprise’s balance sheet.
Characteristics of Variable Interest Entities
Similar to most business entities, VIEs generally have assets, liabilities, and investors with eq- uity interests. Unlike most businesses, because a VIE’s activities can be strictly limited, the role of the equity investors can be fairly minor. The VIE may have been created specifically to benefit its sponsoring firm with low-cost financing. Thus, the equity investors may serve sim- ply as a technical requirement to allow the VIE to function as a legal entity. Because they bear relatively low economic risk, equity investors are typically provided only a small rate of return.
LO1
Describe a variable interest en- tity, a primary beneficiary, and the factors used to decide when a variable interest entity is subject to consolidation.
1 In its 2001 fourth quarter 10-Q, Enron recorded earnings restatements of more than $400 million related to its failure to properly consolidate several of its SPEs (e.g., Chewco and LMJ1). Enron also admitted an improper omission of $700 million of its SPE’s debt. Within a month of the restatements, Enron filed for bankruptcy.
2 KPMG, “Defining Issues: New Accounting for SPEs,” March 1, 2002.
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Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 243
The small equity investments normally are insufficient to induce lenders to provide a low-risk interest rate for the VIE. As a result, another party (often the sponsoring firm that benefits from the VIE’s activities) must contribute substantial resources––often loans and/or guarantees––to enable the VIE to secure additional financing needed to accomplish its purpose. For example, the sponsoring firm may guarantee the VIE’s debt, thus assuming the risk of default. Other contrac- tual arrangements may limit returns to equity holders while participation rights provide increased profit potential and risks to the sponsoring firm. Risks and rewards such as these cause the sponsor’s economic interest to vary depending on the created entity’s success––hence the term variable interest entity. In contrast to a traditional entity, a VIE’s risks and rewards are distributed not according to stock ownership but according to other variable interests. Exhibit 6.1 describes variable interests further and provides several examples.
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. In fact, a firm with variable interests will regularly limit the equity investors’ power through the VIE’s governance documents. As noted by GAAP literature,
[i]f the total equity investment at risk is not sufficient to permit the legal entity to finance its activities, the parties providing the necessary additional subordinated financial support most likely will not permit an equity investor to make decisions that may be counter to their interests.
[FASB ASC (para. 810-10-05-13)]
Although the equity investors are technically the owners of the VIE, in reality they may retain little of the traditional responsibilities, risks, and benefits of ownership. In fact, the equity investors often cede financial control of the VIE to those with variable interest in exchange for a guaranteed rate of return.
Consolidation of Variable Interest Entities
Prior to current financial reporting standards, 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 legacy FASB standard FIN 46R3observed,
. . . an enterprise’s consolidated financial statements include subsidiaries in which the enterprise has a controlling financial interest. That requirement usually has been applied to subsidiaries in which an enterprise has a majority voting interest, but in many circumstances, the enterprise’s consolidated financial statements do not include variable interest entities with which it has similar relationships. The voting interest approach is not effective in identifying controlling financial interests in entities that are not controllable through voting interests or in which the equity investors do not bear residual economic risk. (Summary, page 2)
3FASB Interpretation No. 46R (FIN 46R),“Consolidation of Variable Interest Entities,” December 2003.
EXHIBIT 6.1 Examples of Variable Interests
Variable interests in a variable interest entity are contractual, ownership, or other pecuniary interests in an entity that change with changes in the entity’s net asset value. Variable inter- ests absorb portions of a variable interest entity’s expected losses if they occur or receive por- tions of the entity’s expected residual returns if they occur.
The following are some examples of variable interests and the related potential losses or returns:
Variable interests Potential losses or returns
• Participation rights • Entitles holder to residual profits
• Asset purchase options • Entitles holder to benefit from increases in asset fair values
• Guarantees of debt • If a VIE cannot repay liabilities, honoring a debt guarantee will produce a loss
• Subordinated debt instruments • If a VIE’s cash flow is insufficient to repay all senior debt, subordinated debt may be required to absorb the loss
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Companies must first identify a VIE that is not subject to control through voting ownership interests but is nonetheless subject to their control and therefore subject to consolidation. Each enterprise involved with a VIE must then determine whether the financial support it provides makes it the primary beneficiary of the VIE’s activities. The VIE’s primary beneficiary is then required to include the assets, liabilities, and results of the activities of the VIE in its consoli- dated financial statements.
Identification of a Variable Interest Entity
An entity qualifies as a VIE if either of the following conditions exists:
• The 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 hold- ers. In most cases, if equity at risk is less than 10 percent of total assets, the risk is deemed insufficient.4
• The equity investors in the VIE, as a group, lack any one of the following three character- istics 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 (e.g., the primary beneficiary may guarantee a return to the equity investors).
3. The right to receive the expected residual returns of the entity (e.g., the investors’ return may be capped by the entity’s governing documents or other arrangements with variable interest holders).
Identification of the Primary Beneficiary of the VIE
Once it is established that a firm has a relationship with a VIE, the firm must determine whether it qualifies as the VIE’s primary beneficiary. The primary beneficiary then must con- solidate the VIE’s assets, liabilities, revenues, expenses, and noncontrolling interest. An enter- prise with a variable interest that provides it with a controlling financial interest in a variable interest entity will have both of the following characteristics:
• The power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance.
• The obligation to absorb losses of the entity that could potentially be significant to the vari- able interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.
Note that these characteristics mirror those that the equity investors lack in a VIE. Instead, 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. The fact that the primary beneficiary may own no voting shares whatsoever becomes inconsequential because such shares do not effectively give the equity investors power to exercise control. Thus, a careful examination of the VIE’s gov- erning documents, contractual arrangements among parties involved, and who bears the risk is necessary to determine whether a reporting entity possesses control over a VIE.
The magnitude of the effect of consolidating an enterprise’s VIEs can be large. For exam- ple, Walt Disney Company disclosed that two of its major investments qualified as VIEs and that it now will consolidate them. In its 2008 annual report, Disney stated the following:
The Company has a 51 percent effective ownership interest in the operations of Euro Disney and a 43 percent ownership interest in the operations of Hong Kong Disneyland which are both con- solidated as variable interest entities.
As a result of the 2008 consolidation of these two VIEs, Disney’s total assets increased by
$5.1 billion while its total debt increased by $3.4 billion.
244 Chapter 6
4Alternatively, a 10 percent or higher equity interest may also be insufficient. According to GAAP, “Some entities may require an equity investment greater than 10 percent of their assets to finance their activities, especially if they engage in high-risk activities, hold high-risk assets, or have exposure to risks that are not reflected in the reported amounts of the entities’ assets or liabilities.” [FASB ASC (para. 810-10-25-46)]
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Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 245
Example of a Primary Beneficiary and Consolidated Variable Interest Entity Assume that Twin Peaks Power Company seeks to acquire a generating plant for a negotiated price of $400 million from Ace Electric Company. Twin Peaks wishes to expand its market share and expects to be able to sell the electricity generated by the plant acquisition at a profit to its owners.
In reviewing financing alternatives, Twin Peaks observed that its general credit rating allowed for a 4 percent annual interest rate on a debt issue. Twin Peaks also explored the es- tablishment of a separate legal entity whose sole purpose would be to own the electric gener- ating plant and lease it back to Twin Peaks. Because the separate entity would isolate the electric generating plant from Twin Peaks’s other risky assets and liabilities and provide spe- cific collateral, an interest rate of 3 percent on the debt is available, producing before tax sav- ings of $4 million per year. To obtain the lower interest rate, however, Twin Peaks must guarantee the separate entity’s debt. Twin Peaks must also maintain certain of its own prede- fined financial ratios and restrict the amount of additional debt it can assume.
To take advantage of the lower interest rate, on January 1, 2011, Twin Peaks establishes Power Finance Co., an entity designed solely to own, finance, and lease the electric generat- ing plant to Twin Peaks.5The documents governing the new entity specify the following:
• 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.
• An outside investor will provide $16 million in exchange for a 100 percent nonvoting equity interest in Power Finance.
• Power Finance will issue debt in exchange for $384 million. Because the $16 million equity investment by itself is insufficient to attract low-interest debt financing, Twin Peaks will guarantee the debt.
• Twin Peaks will lease the electric generating plant from Power Finance in exchange for pay- ments of $12 million per year based on a 3 percent fixed interest rate for both the debt and equity investors for an initial lease term of five years.
• 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.
Once the purchase of the electric generating plant is complete and the equity and debt are issued, Power Finance Company reports the following balance sheet:
5This arrangement is similar to a “synthetic lease” commonly used in utility companies. Synthetic leases also can have tax advantages because the sponsoring firm accounts for them as capital leases for tax purposes.
POWER FINANCE COMPANY Balance Sheet January 1, 2011
Electric Generating Plant . . . $400M Long-Term Debt . . . $384M Owner’s Equity . . . 16M Total Assets . . . $400M Total Liabilities and OE . . . $400M
Exhibit 6.2 shows the relationships between Twin Peaks, Power Finance, the electric generat- ing plant, and the parties financing the asset purchase.
In evaluating whether Twin Peaks Electric Company must consolidate Power Finance Com- pany, two conditions must be met. First, Power Finance must qualify as a VIE by either (1) an inability to secure financing without additional subordinated support or (2) a lack of either the
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risk of losses or entitlement to residual returns (or both). Second, Twin Peaks must qualify as the primary beneficiary of Power Finance.
In assessing the first condition, several factors point to VIE status for Power Finance. Its owner’s equity comprises only 4 percent of total assets, far short of the 10 percent benchmark.
Moreover, Twin Peaks guarantees Power Finance’s debt, suggesting insufficient equity to finance its operations without additional support. Finally, 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.
In evaluating the second condition for consolidation, an assessment is made to determine whether Twin Peaks qualifies as Power Finance’s primary beneficiary. Clearly, 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 the Power Finance—either of which could potentially be significant to Power Finance. But what possible losses or returns would accrue to Twin Peaks? What are Twin Peaks’s variable interests that rise and fall with the fortunes of Power Finance?
As stated in the VIE agreement, Twin Peaks will pay a fixed fee to lease the electric gener- ating plant. It will then operate the plant and sell the electric power in its markets. If the busi- ness plan is successful, Twin Peaks will enjoy residual profits from operating while Power Finance’s equity investors receive the fixed fee. On the other hand, if prices for electricity fall, Twin Peaks may generate revenues insufficient to cover its lease payments while Power Finance’s equity investors are protected from this risk. Moreover, 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. Alternatively, if Twin Peaks were to sell the plant at a loss, it must pay the equity investors all of their initial investment, furthering the loss to Twin Peaks. Each of these elements points to Twin Peaks as the primary beneficiary of its VIE through variable interests. As the primary beneficiary, Twin Peaks must consolidate the assets, liabilities, and results of operations of Power Finance with its own.
Procedures to Consolidate Variable Interest Entities
As Power Finance’s balance sheet exemplifies, VIEs typically possess only a few assets and liabilities. Also, their business activities usually are strictly limited. Thus, the actual proce- dures to consolidate VIEs are relatively uncomplicated.
246 Chapter 6
EXHIBIT 6.2
Variable Interest Entity to Facilitate Financing
Financial
institution Issues
$384 M debt
Issues
$16 M equity
Twin Peaks Electric Co.
Power Finance Co.
(VIE)
Equity investor
Electric Generating Plant
Buys and owns Leases and operates plant for profit Fixed lease
payments guaranteeDebt
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