Other

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Chapter 10

• Other
• Consolidation Reporting
• Issues

2
Learning Objectives

• What are variable interest entities (VIE)?
• Rules for consolidation of VIE
• Joint ventures

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
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
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
  doesnt own shares

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Exhibit 10.1
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

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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 entitys 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 entitys governing
  documents)

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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 entitys 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

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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 SPEs 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

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Initial measurement

• Compare implied value to consideration
• Implied value of VIEs 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)

a
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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
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)

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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
  VIEs 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

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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 enterprises maximum exposure to loss as a
  result of its involvement with the VIE

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Joint Ventures
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

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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

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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 dont use traditional
  consolidation.
• Accounting method is PROPORTIONATE CONSOLIDATION

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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

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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

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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

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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

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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

b
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Examples

• Notes on blackboard

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Future Income Taxes and Business Combinations
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

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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
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

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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)

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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

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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

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Segmented Disclosures
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
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

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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

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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

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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

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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

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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 segments 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

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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 companys country of
  domicile and those from all foreign countries

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 companys 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
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

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Exhibit 10.2
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Exhibit 10.3
46
International Perspective

• The Canadian standard on consolidation of
  variable interest entities is substantially
  similar to the current FASB and IASB standards
• The IASBs 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
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