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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

CHAPTER 6
VARIABLE INTEREST ENTITIES, INTRA-ENTITY DEBT,
CONSOLIDATED CASH FLOWS, AND OTHER ISSUES
Chapter Outline
I.

Variable interest entities (VIEs)


A. VIEs typically take the form of a trust, partnership, joint venture, or corporation. In most
cases a sponsoring firm creates these entities to engage in a limited and well-defined set
of business activities. For example, a business may create a VIE to finance the
acquisition of a large asset. The VIE purchases the asset using debt and equity
financing, and then leases the asset back to the sponsoring firm. If their activities are
strictly limited and the asset is pledged as collateral, VIEs are often viewed by lenders as
less risky than their sponsoring firms. As a result, such arrangements can allow financing
at lower interest rates than would otherwise be available to the sponsor.
B. Control of VIEs, by design, often does not rest with its equity holders. Instead, control is
exercised through contractual arrangements with the sponsoring firm who becomes the
"primary beneficiary" of the entity. These contracts can take the form of leases,
participation rights, guarantees, or other residual interests. Through contracting, the
primary beneficiary bears a majority of the risks and receives a majority of the rewards of
the entity, often without owning any voting shares.
C. An entity whose control rests a primary beneficiary is addressed by FASB ASC subtopic
Variable Interest Entities. The following characteristics indicate a controlling financial
interest in a variable interest entity.
1. The power, through voting rights or similar rights, to direct the activities of an entity
that most significantly impact the entitys economic performance.
2. The obligation to absorb the expected losses of the entity if they occur,
or
3. The right to receive the expected residual returns of the entity if they occur
The primary beneficiary bears the risks and receives the rewards of a variable interest
entity and is considered to have a controlling financial interest.
D. The FASB reasons that if a "business enterprise has a controlling financial interest in a
variable interest entity, assets, liabilities, and results of the activities of the variable
interest entity should be included with those of the business enterprise." Therefore,
primary beneficiaries must include their variable interest entities in their consolidated
financial statements.

II. Intra-entity debt transactions


A. No special difficulty is created when one member of a business
combination loans money to another. The resulting receivable/payable accounts
as well as the interest income expense balances are identical and can be
directly offset in the consolidation process.
B. The acquisition of an affiliate's debt instrument from an outside party does
require special handling so that consolidated financial statements can be
produced.

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

1. Because the acquisition price will usually differ from the book value of
the liability, a gain or loss has been created which is not recorded within
the individual records of either company.
2. Because of the amortization of any associated discounts and/or
premiums, the interest income reported by the buyer will not equal the
interest expense of the debtor.
C. In the year of acquisition, the consolidation process eliminates intra-entity
accounts (the liability, the receivable, interest income, and interest expense)
while the gain or loss (which produced all of the discrepancies because of the
initial difference) is recognized.
1. Although several alternatives exist, this textbook assigns all income
effects resulting from the retirement to the parent company, the party
ultimately responsible for the decision to reacquire the debt.
2. Any noncontrolling interest is, therefore, not affected by the adjustments
utilized to consolidate intra-entity debt.
D. Even after the year of retirement, all intra-entity accounts must be
eliminated again in each subsequent consolidation; however, the beginning
retained earnings of the parent company is adjusted rather than a gain or loss
account.
1. The change in retained earnings is needed because a gain or loss was
created in a prior year by the retirement of the debt, but only interest
income and interest expense were recognized by the two parties.
2. The adjustment to retained earnings at any point in time is the original
gain or loss adjusted for the subsequent amortization of discounts or
premiums.
III. Subsidiary preferred stock
A. Subsidiary preferred shares not owned by the parent are a part of
noncontrolling interest.
B. The fair value of any subsidiary preferred shares not acquired by the
parent is added to the consideration transferred along with the fair value
of the noncontrolling interest in common shares to compute the
acquisition-date fair value of the subsidiary.
IV. Consolidated statement of cash flows
A. Statement is produced from consolidated balance sheet and income statement and not from
the separate cash flow statements of the component companies.
B. Intra-entity cash transfers are omitted from this statement because they do not occur with an
outside, unrelated party.
C. The "Noncontrolling Interest's Share of the Subsidiary's Income'' is not included as a cash
flow. Dividends paid to these outside owners are reported as a financing activity.
V. Consolidated earnings per share
A. This computation normally follows the pattern described in intermediate accounting
textbooks. For basic EPS, consolidated net income is divided by the
weighted-average number of parent shares outstanding. If convertibles (such as
bonds or warrants) exist for the parent shares, their weight must be included in
computing diluted EPS but only if earnings per share is reduced.

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

1. The subsidiary's diluted earnings per share are computed first to arrive at (1) an earnings
figure and (2) a shares figure.

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

2.

The portion of the shares figure belonging to the parent is computed. That percentage of the
subsidiary's diluted earnings is then added to the parent's income in order to
complete the earnings per share computation.
VI. Subsidiary stock transactions
A. If the subsidiary issues new shares of stock or reacquires its own shares as treasury stock, a
change is created in the book value underlying the parent's investment account.
The increase or decrease should be reflected by the parent as an adjustment to this
balance.
B. The book value of the subsidiary that corresponds to the parent's ownership is measured
before and after the transaction with any alteration recorded directly to the
investment account. The parent's additional paid-in capital (or retained earnings)
account is normally adjusted although the recognition of a gain or loss is an
alternate accounting treatment.
C. Treasury stock acquired by the subsidiary may also necessitate a similar adjustment to the
parent's investment account. In addition, any subsidiary treasury stock is eliminated
within the consolidation process.

Answer to Discussion Question: Who Lost the $300,000?


This case is designed to give life to a theoretical accounting issue: If a subsidiary's debt is
retired, should the resulting gain or loss be assigned to the parent or to the subsidiary? The case
illustrates that there is no clear-cut solution. This lack of an absolute answer makes financial
accounting both intriguing and frustrating.
The assignment decision is only necessary in the presence of a noncontrolling interest.
Regardless of the ownership level all intra-entity balances are eliminated on the worksheet with
a gain or loss recognized. Not until the time that the noncontrolling interest computations are
made does the identity of the specific party become important.
We assume that financial and operating decisions are made in the best interest of the business
entity as a whole. This debt would not have been retired unless corporate officials believed that
Penston/Swansan would benefit from the decision. Thus, a strong argument can be made
against any assignment to either separate party.
Students should choose and justify one method. Discussion often centers on the following:
Parent company officials made the actual choice that created the loss. Therefore, assigning
the $300,000 to the subsidiary directs the impact of their reasoned decision to the
wrong party. In effect, the subsidiary had nothing to do with this transaction (as
indicated in the case) so that its financial records should not be affected by the
$300,000 loss.
The debt was that of the subsidiary. Because the subsidiary's debt is being retired, all of the
$300,000 should be attributed to that party. Financial records measure the results of
transactions and the retirement simply culminates an earlier transaction made by the
subsidiary. The parent is doing no more than acting as an agent for the subsidiary (as
indicated in the case). If the subsidiary had acquired its own debt, for example, no
question as to the assignment would have existed. Thus, changing that assignment
simply because the parent was forced to be the acquirer is not justified.

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Both parties were involved in the transaction so that some allocation of the loss is required.
If, at the time of repurchase, a discount existed within the subsidiary's accounts, this
figure

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

would have been amortized to interest expense (if the debt had not been retired). Thus, the

$300,000 loss was accepted now in place of the later amortization. This reasoning then
assigns this portion of the loss to the subsidiary. Because the parent was forced to pay
more than face value, that remaining portion is assigned to the buyer.

Answers to Questions
1. A variable interest entity (VIE) is a business structure that is designed to accomplish a
specific purpose. A VIE can take the form of a trust, partnership, joint venture, or
corporation although typically it has neither independent management nor
employees. The entity is frequently sponsored by another firm to achieve favorable
financing rates.
2. Variable interests are contractual, ownership, or other pecuniary interests in an entity that
change with changes in the entity's net asset value. Variable interests will absorb
portions of a variable interest entity's expected losses if they occur or receive
portions of the entity's expected residual returns if they occur. Variable interests
typically are accompanied by contractual arrangements that provide decision making
power to the owner of the variable interests. Examples of variable interests include
debt guarantees, lease residual value guarantees, participation rights, and other
financial interests.
3. The following characteristics are indicative of an enterprise qualifying as a primary
beneficiary with a controlling financial interest in a VIE.

The power, through voting rights or similar rights, to direct the activities of an entity that most
significantly impact the entitys economic performance.
The obligation to absorb the expected losses of the entity if they occur, or
The right to receive the expected residual returns of the entity if they occur
4. Because the bonds were purchased from an outside party, the acquisition price is likely
to differ from the book value of the debt in the subsidiary's records. This difference
creates accounting problems in handling the intra-entity transaction. From a
consolidated perspective, the debt is retired; a gain or loss is reported with no further
interest being recorded. In reality, each company continues to maintain these bonds
on their individual financial records. Also, because discounts and/or premiums are
likely to be present, these account balances as well as the interest income/expense
will change from period to period because of amortization. For reporting purposes,
all individual accounts must be eliminated with the gain or loss being reported so
that the events are shown from the vantage point of the consolidated entity.
5. If the bonds are acquired directly from the affiliate company, all reciprocal accounts will be
equal in amount. The debt and the receivable will be in agreement so that no gain or loss is
created. Interest income and interest expense should also reflect identical amounts.
Therefore, the consolidation process for this type of intra-entity debt requires no more than
the offsetting of the various reciprocal balances.
6. The gain or loss to be reported is the difference between the price paid and the book value
of the debt on the date of acquisition. For consolidation purposes, this gain or loss should be
recognized immediately on the date of acquisition.

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

7. Because the bonds are still legally outstanding, they will continue to be found on both sets of
financial records. Thus, each account (Bonds Payable, Investment in Bonds, Interest
Expense, and Interest Income) must be eliminated within the consolidation process. Any gain
or loss on the retirement as well as later effects on interest caused by amortization are also
included to arrive at an adjustment to the beginning retained earnings of the parent
company.
8. The original gain is never recognized within the financial records of either company. Thus,
within the consolidation process for the year of acquisition, the gain is directly recorded
whereas (for each subsequent year) it is entered as an adjustment to beginning retained
earnings. In addition, because the book value of the debt and the investment are not in
agreement, the interest expense and interest income balances being recorded by the two
companies will differ each year because of the amortization process. This amortization
effectively reduces the difference between the individual retained earnings balances and the
total that is appropriate for the consolidated entity. Consequently, a smaller change is
needed each period to arrive at the balance to be reported. For this reason, the annual
adjustment to beginning retained earnings gradually decreases over the life of the bond.
9. No set rule exists for assigning the income effects from intra-entity debt transactions
although several different theories exist and include: (1) assignment of the entire amount to
the debtor, (2) assignment of the entire amount to the buyer, and (3) allocation of the gain or
loss between the two parties in some manner. This textbook attributes the entire income
effect (the $45,000 gain in this case) to the parent company. Assignment to the parent is
justified because that party is ultimately responsible for the decision to retire the debt. The
answer to the discussion question included in this chapter analyzes this question in more
detail.
10. Subsidiary outstanding preferred shares are part of the noncontrolling interest and are
included in the consolidated financial statements at acquisition-date fair value and
subsequently adjusted for their share of subsidiary income and dividends.
11. The consolidated cash flow statement is developed from consolidated balance sheet and
income statement figures. Thus, the cash flows generated by operating, investing, and
financing activities are identified only after the consolidation of these other statements.
12. The noncontrolling interest share of the subsidiarys income is a component of consolidated
net income. Consolidated net income then is adjusted for noncash and other items to arrive
at consolidated cash flows from operations. Any dividends paid by the subsidiary to these
outside owners are listed as a financing activity because an actual cash outflow occurs.
13. An alternative to the normal diluted earnings per share calculation is required whenever the
subsidiary has dilutive convertible securities such as bonds or warrants. In this case, the
potential impact of the conversion of subsidiary shares must be factored into the overall
diluted earnings per share computation.
14. Basic Earnings per Share. The existence of subsidiary convertible securities does not affect
basic EPS. The parents basic earnings per share is computed by dividing the parents share
of consolidated net income by the weighted average number of parent shares outstanding.

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Diluted Earnings per Share. The subsidiary's diluted earnings per share is computed by
including both convertible items. The portion of the parent's controlled shares to the total
shares used in this calculation is then determined. Only this percentage (of the income figure
used in the subsidiary's computation) is added to the parent's income in arriving at the parent
companys diluted earnings per share.
15. Several reasons could exist for a subsidiary to issue new shares of stock to outside parties.
First, additional financing is brought into the company by any such sale. Also, stock issuance
may be used to entice new individuals to join the organization. Additional management
personnel, as an example, might be attracted to the company in this manner. The company
could also be forced to sell shares because of government regulation. Many countries
require some degree of local ownership as a prerequisite for operating within that country.
16. Because the new stock was issued at a price above the subsidiarys assigned consolidation
value, the overall valuation for Metcalf's stock has been increased. Consequently, the
Washburn's investment is increased to reflect this change. To measure the effect, the value
of Washburn's investment is calculated both before and after the new issue. Because the
increment is the result of a stock transaction, an increase is made to additional paid-in
capital. Although the subsidiary's shares (both new and old) are eliminated in the
consolidation process, the increase in the parent's APIC (or gain or loss) carries into the
consolidated figures. Also, the noncontrolling interest percentage of the subsidiary increases.
17. A stock dividend does not alter the assigned consolidated subsidiary value and, thus, creates
no effect on Washburn's investment account or on the consolidated figures. Hence, no entry
is recorded by the parent company in connection with the subsidiary's stock dividend.

Answers to Problems
1. C
2. D
3. A
4. D
5. A
6. D Cash flow from operations:
Net income...................................................................
Depreciation.................................................................
Trademark amortization.............................................
Increase in accounts receivable................................
Increase in inventory..................................................
Increase in accounts payable....................................
Cash flow from operations.........................................

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$45,000
10,000
15,000
(17,000)
(40,000)
12,000

(20,000)
$25,000

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

7. C

Cash flow from financing activities:


Dividends to parents interest...................................
Dividends to noncontrolling interest (20% $5,000)
Reduction in long-term notes payable.....................
Cash flow from financing activities..........................

($12,000)
(1,000)
(25,000)
($38,000)

8. C
9. C Post-issue subsidiary valuation ($800,000 + $250,000)
Arcolas new ownership percentage (40,000 50,000)
Arcolas share of post-issue subsidiary valuation
Arcolas pre-issue equity balance
Increase to Arcolas investment account

$1,050,000
80%
$ 840,000
800,000
$ 40,000

10. C Jordans income from own operations....................


Fey's income ...............................................................
Eliminate intra-entity interest income......................
Eliminate intra-entity interest expense.....................
Recognize retirement gain on debt ($212,000 $199,000)
Consolidated net income .....................................

$200,000
80,000
21,000
(22,000)
13,000
$292,000

11. B Mattoons share of consolidated net income..........


Number of Mattoon common shares outstanding. .

$465,000
100,000

Mattoons EPS = ($465,000 100,000 shares).........

$4.65

12. B Ace net income ...........................................................


Less intra-entity dividends (initial value method). .
Byrd reported income ................................................
Gain on extinguishment of debt ($48,300 $46,600)
Eliminate interest expense on "retired" debt
($48,300 10%) .....................................................
Eliminate interest income on "retired" debt
($46,600 12%) .....................................................
Consolidated net income ..........................................

$400,000
(7,000) $393,000
100,000
1,700
4,830
(5,592)
$493,938

13. D 30% of Byrd's net income of $100,000; the intra-entity debt transaction is
attributed solely to the parent company.
14. A For 2011, the adjustment to beginning retained earnings should recognize
the gain on the retirement of the debt, the elimination of the 2010 interest
expense, and the elimination of the 2010 interest income.
Gain on Retirement of Bond:

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Original book value ...............................................................


20072009 amortization ($600,000 20 yrs. 3 yrs.) ........
Book value, January 1, 2010 ................................................
Percentage of bonds retired ......................................
Book value of retired bonds ................................................
Cash received ($4,000,000 96.6%) ....................................
Gain on retirement of bonds .....................................

$10,600,000
(90,000)
$10,510,000
40%
$4,204,000
3,864,000
$ 340,000

Interest Expense on Intra-entity Debt2010


Cash interest expense (9% $4,000,000) ...........................
Premium amortization ($30,000 per year total 40%
retired portion of bonds) ................................................
Interest expense on intra-entity debt .................................

$360,000
(12,000)
$348,000

Interest Income on Intra-entity Debt2010


Cash interest income (9% $4,000,000) ............................
Discount amortization (.034 $4,000,0000 17 years).....
Interest income on intra-entity debt ...................................

$360,000
8,000
$368,000

Adjustment to 1/1/11 Retained Earnings


Recognition of 2010 gain on extinguishment of debt (above)....
Elimination of 2010 intra-entity interest expense (above)...........
Elimination of 2010 intra-entity interest income (above).............
Increase in retained earnings, 1/1/11........................................

$340,000
348,000
(368,000)
$320,000

15. D Consideration transferred for preferred stock .............................


Consideration transferred for common stock ..............................
Noncontrolling interest fair value for preferred ..........................
Noncontrolling interest fair value for common ............................
Acquisition-date fair value ..............................................................
Acquisition-date identified net asset fair value ...........................
Goodwill ............................................................................................

$ 424,000
3,960,000
1,696,000
440,000
6,520,000
(6,000,000)
$ 520,000

16. D Consideration transferred for preferred stock ............................. $106,000


Consideration transferred for common stock ..............................
870,000
Noncontrolling interest fair value for common ............................
580,000
Acquisition-date fair value .............................................................. $1,556,000
Acquisition-date book value ........................................................... (1,460,000)
Excess fair over book value............................................................ $ 96,000
to building .......................................................................................
50,000
to goodwill....................................................................................... $ 46,000
17. A Parents reported sales .............................................
Subsidiary's reported sales ......................................

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$300,000
200,000

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Less: intra-entity transfers ........................................


Sales to outsiders .................................................
Eliminate increase in receivables (less cash collected)
Cash generated by sales .....................................
18. B Subsidiarys unamortized fair value of prior to new share issue
(12,000 $49) ........................................................
Parent's ownership ....................................................
Unamortized subsidiary fair value ..........................
Subsidiary unamortized fair value after issuing new
shares (above value plus 3,000 shares at $50 each)
Parent's ownership 12,000 15,000 shares) ...........
Unamortized subsidiary fair value after stock issue

(40,000)
$460,000
(30,000)
$430,000
$588,000
100%
$588,000
$738,000
80%
$590,400

Investment in Veritable increases by $2,400 ($590,400 less $588,000).


19. A Because the parent acquired 80 percent of the new shares, its proportion of
ownership has remained the same. Because the purchase price will
necessarily equal 80 percent of the increase in the subsidiary's book value,
no separate adjustment by the parent is required.
20. C Adjusted acquisition-date sub. fair value at 1/1/11
Consideration transferred .........................................................
Noncontrolling interest acquisition-date fair value ...............
Increase in Stamford book value...............................................
Stock issue proceeds.................................................................
Subsidiary valuation basis 1/1/11...................................................
New parent ownership (32,000 shs. 50,000 shs.) ......................
Parents post-stock issue ownership balance..............................
Parent's investment account ($592,000 + [80% 80,000]) ..........
Required adjustment decrease .............................................

$592,000
148,000
80,000
150,000
970,000
64%
$620,800
656,000
$(35,200)

21. D Adjusted acquisition-date fair value ($820,000 $192,000) .......


New parent ownership (32,000 shs. 32,000 shs.) ......................
Fair value equivalency of parent's ownership ........................
Parent's investment account ($592,000 + [80% 80,000]) ..........
Required adjustmentdecrease...............................................

$628,000
100%
$628,000
656,000
$(28,000)

22. (10 minutes) (Qualification of Primary Beneficiary of a VIE)


Consolidation of a variable interest entity is required if a firm has a variable
interest that gives the firm

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

The power, through voting rights or similar rights, to direct the


activities of an entity that most significantly impact the entitys
economic performance.

The obligation to absorb a majority of the entity's expected losses if


they occur and/or the right to receive a majority of the entity's expected
residual returns if they occur

Because (1) HCO Medias losses are limited by contract, and (2)
Hillsborough has the right to receive the residual benefits of the sales
generated on the HCO Media internet site above $500,000, Hillsborough
should consolidate HCO Media.
23.

(40 minutes) (VIE Qualifications for Consolidation)


a. The purpose of consolidated financial statements is to present the financial
position and results of operations of a group of businesses as if they were a
single entity. They are designed to provide information useful for making
business and economic decisionsespecially assessing amounts, timing,
and uncertainty of prospective cash flows. Consolidated statements also
provide more complete information about the resources, obligations, risks,
and opportunities of an enterprise than separate statements.
b. An entity qualifies as a VIE and is subject to consolidation if either of the
following conditions exist.
(23. continued)

The total equity at risk is not sufficient to permit the entity to finance its
activities without additional subordinated financial support from other
parties. In most cases, if equity at risk is less than 10% of total assets,
the risk is deemed insufficient.

The equity investors in the VIE lack any one of the following three
characteristics 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 entitys
economic performance.
2. 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)
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).

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Consolidation of a variable interest entity is required if a firm has a variable


interest that gives the firm

The power, through voting rights or similar rights, to direct the


activities of an entity that most significantly impact the entitys
economic performance.

The obligation to absorb a majority of the entity's expected losses if


they occur and/or the right to receive a majority of the entity's expected
residual returns if they occur

c. Risks of the construction project that has TecPC has effectively shifted to
the owners of the VIE:
At the end of the 1st five-year lease term, if the parent opts to sell the
facility, and the proceeds are insufficient to repay the VIE investors, TecPC
may be required to pay up to 85% of the project's cost. Thus, a potential
15% risk.
Risks that remain with TecPC

Guarantees of return to VIE investors at market rate, if facility does not


perform as expected TecPC is still obligated to pay market rates.

If lease is not renewed, TecPC must either purchase the facility or sell it
on behalf of the VIE with a guarantee of Investors' (debt and equity)
balances representing a risk of decline in market value of asset

Debt guarantees

(23. continued)
d. TecPC possesses the following characteristics of a primary beneficiary:
Direct decision-making ability (end of five-year lease term).

Absorb a majority of the entity's expected losses if they occur (via debt
guarantees and guaranteed lease payments and residual value).

Receive a majority of the entity's expected residual returns if they occur


(via use of the facility and potential increase in its market value).

24. (10 minutes) (Consolidation of variable interest entity.)


a. Implied valuation and excess allocation for Softplus.
Noncontrolling interest fair value
$ 60,000
Consideration transferred by Pantech
20,000
Total business fair value
80,000
Fair value of VIE net assets
100,000
Excess net asset value fair value
$20,000

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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

PanTech recognizes the $20,000 excess net asset fair value as a bargain purchase
and records all of SoftPlus assets and liabilities at their individual fair values.
Cash
$20,000
Marketing software
160,000
Computer equipment
40,000
Long-term debt
(120,000)
Noncontrolling interest
(60,000)
Pantech equity interest
(20,000)
Gain on bargain purchase
(20,000)
-0b. Implied valuation and excess valuation for Softplus.
Noncontrolling interest fair value
60,000
Consideration transferred by Pantech
20,000
Total business fair value
80,000
Fair value of VIE net identifiable assets
60,000
Goodwill
$20,000
When the fair value of a VIE (that is a business) is greater than assessed
asset values, all identifiable assets and liabilities are reported at fair values
(unless a previously held interest) and the difference is treated as goodwill.
Cash
Marketing software
Computer equipment
Goodwill (excess business fair value)
Long-term debt
Noncontrolling interest
Pantech equity interest

$20,000
120,000
40,000
20,000
(120,000)
(60,000)
(20,000)
-025. (25 Minutes) (Consolidation entry for three consecutive years to report effects
of intra-entity bond acquisition. Straight-line method used.)
a. Book Value of Bonds Payable, January 1, 2010
Book value, January 1, 2008 ................................................... $1,050,000
Amortization20082009 ($5,000 per year
[$50,000 premium 10 years] for two years) ..................
10,000
Book value of bonds payable, January 1, 2010.................... $1,040,000
Book value of 40% of bonds payable
(intra-entity portion), January 1, 2010 ..............................
$416,000
Gain on Retirement of Bonds, January 1, 2010
Purchase price ($400,000 96%) ...........................................
Book value of liability (computed above) .............................
Gain on retirement of bonds ..................................................

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$384,000
416,000
$ 32,000

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Book Value of Bonds Payable, December 31, 2010


Book value, January 1, 2010 (computed above) .................. $1,040,000
Amortization for 2010...............................................................
5,000
Book value of bonds payable, December 31, 2010............... $1,035,000
Book value of 40% of bonds payable (intra-entity portion),
December 31, 2010..............................................................
$414,000
Book Value of Investment, December 31, 2010
Book value of investment, January 1, 2010 (purchase price)
$384,000
Amortization for 2010 ($16,000 discount 8-yr. rem. life)
Book value of investment, December 31, 2010 ....................
Intra-entity Interest Balances for 2010
Interest expense:
Cash payment ($400,000 9%) .........................................
Amortization of premium for 2010 ($5,000 per year
multiplied by 40% intra-entity portion) .......................
Intra-entity interest expense .............................................
Interest income:
Cash collection ($400,000 9%) .......................................
Amortization of discount for 2010 (above) ......................
Intra-entity interest income ...............................................

2,000
$386,000

$36,000
2,000
$34,000
$36,000
2,000
$38,000

25. (continued)
CONSOLIDATION ENTRY B (2010)
Bonds Payable ............................................................ 400,000
Premium on Bonds Payable ...................................... 14,000
Interest Income ........................................................... 38,000
Investment in Bonds ..............................................
386,000
Interest Expense ....................................................
34,000
Extraordinary Gain on Retirement of Bonds ......
32,000
(To eliminate accounts stemming from intra-entity bonds [balances
computed above] and to recognize gain on the retirement of this debt.)
b. In 2011, because straight-line amortization is used, the interest accounts
remain unchanged at $38,000 and $34,000. However, the premium
associated with the bond payable as well as the discount on the
investment are affected by the $2,000 per year amortization. In addition,
the gain now has to be included as a component of beginning retained
earnings. Concurrently, the two interest balances recorded by the

6-15

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

individual companies in 2010 are removed from retained earnings because


they resulted after the intra-entity retirement. Gain of $32,000 plus
$34,000 expense removal less $38,000 income elimination gives $28,000
increase in retained earnings.
CONSOLIDATION ENTRY *B (2011)
Bonds Payable .....................................................
400,000
Premium on Bonds Payable ($2,000 amortization)
12,000
Interest Income ....................................................
38,000
Investment in Bonds ($2,000 amortization) .
388,000
Interest Expense ..............................................
34,000
Retained Earnings, 1/1/11 (Darges) ...............
28,000
(To remove intra-entity bond accounts that remain on the individual
records of both companies. Both debt and investment balances have
been adjusted for 201011 amortization. Entry to retained earnings
brings the totals reported by the individual companies [interest income
and expense] to the balance of the original gain.)
c. As with part b, new premium and discount balances must be determined
and then removed. The adjustment made to retained earnings takes into
account that another year of interest expense ($34,000) and income
($38,000) have been closed into this equity account by the separate
companies.
25. (continued)
CONSOLIDATION ENTRY *B (2012)
Bonds Payable ......................................................
Premium on Bonds Payable ................................
Interest Income .....................................................
Investment in Bonds .......................................
Interest Expense ..............................................
Retained Earnings, 1/1/12 (Darges) ...............

400,000
10,000
38,000
390,000
34,000
24,000

(To remove intra-entity bond accounts that remain on the individual


records of both companies. Both debt and investment balances have
been adjusted for 20102012 amortization. Entry to retained earnings
brings the totals reported by the individual companies to the balance of
the original gain.)
26.

(12 Minutes) (Determine consolidated income statement accounts after


acquisition of intra-entity bonds.)

6-16

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Interest Expense To Be Eliminated = $84,000 11% = $9,240

Interest Income To Be Eliminated = $108,000 8% = $8,640

Loss To Be Recognized = $108,000 $84,000 = $24,000


CONSOLIDATED TOTALS

Revenues and Interest Income = $1,051,360 (add the two book values and
eliminate interest income on intra-entity bond)

Operating and Interest Expense = $751,760 (add the two book values and
eliminate interest expense on intra-entity bond)

Other Gains and Losses = $152,000 (add the two book values)

Loss on Retirement of Debt = $24,000 (computed above)

Net Income = $427,600 (consolidated revenues, interest income, and gains


less consolidated operating and interest expense and losses)

27.

(30 Minutes) (Consolidation entry for two years to report effects of intraentity bond acquisition. Effective rate method applied.)
a. Loss on Repurchase of Bond
Cost of acquisition ..........................................
Book value ($668,778 1/8) ...........................
Loss on repurchase ........................................

$121,655
83,597
$ 38,058

Interest Balances for 2010


Interest income:
$121,655 6% .............................................

$7,299

Interest expense:
$83,597 (book value [above]) 10% ........

$8,360

Investment Balance, December 31, 2010


Original cost, 1/1/10.........................................
Amortization of premium:
Cash interest ($100,000 8%) ..................
Effective interest income (above) ............
Investment, 12/31/10.............................
Bonds Payable Balance, December 31, 2010
Book value, 1/1/10 (above) .............................
Amortization of discount:
Cash interest ($100,000 8%) ..................

6-17

$121,655
$8,000
7,299

701
$120,954
$83,597

$8,000

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Effective interest expense (above) ..........


Bonds payable, 12/31/10.......................

8,360

360
$83,957

Entry B12/31/10
Bonds Payable .................................................
83,957
Interest Income ................................................
7,299
Loss on Retirement of Debt ...........................
38,058
Investment in Bonds .................................
120,954
Interest Expense ........................................
8,360
(To eliminate intra-entity debt holdings and recognize loss on
retirement.)
b. Interest Balances for 2011
Interest income: $120,954 (investment
balance for the year) 6% .........................................

$7,257

Interest expense: $83,957 (liability balance


for the year) 10% .....................................................

$8,396

27. (continued)
Investment Balance, December 31, 2011
Book value, January 1, 2011 (part a) .......................
Amortization of premium:
Cash interest ($100,000 8%) .............................
Effective interest income (above) .......................
Investment balance, December 31, 2011.......
Bonds Payable Balance, December 31, 2011
Book value, January 1, 2011 (part a) .......................
Amortization of discount:
Cash interest ($100,000 8%) .............................
Effective interest expense (above) .....................
Bonds payable balance,
December 31, 2011 ..........................................
Interest Balances for 2012
Interest income: $120,211 (investment.....................
balance for the year [above]) 6%
Interest expense: $84,353 (liability balance
for the year [above]) 10% ..................................
Investment Balance, December 31, 2012

6-18

$120,954
$8,000
7,257

743
$120,211
$83,957

$8,000
8,396

396
$84,353
$7,213

$8,435

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Book value, January 1, 2012 (above) .......................


Amortization of premium:
Cash interest ($100,000 8%) .............................
Effective interest income (above) .......................
Investment balance, December 31, 2012.......
Bonds Payable Balance, December 31, 2012
Book value, January 1, 2012 (above) .......................
Amortization of discount:
Cash interest ($100,000 8%) .............................
Effective interest expense (above) .....................
Bonds payable balance,
December 31, 2012 .....................................

$120,211
$8,000
7,213

787
$119,424
$84,353

$8,000
8,435

435
$84,788

27. (continued)
Adjustment Needed to Retained Earnings, January 1, 2012
Loss on retirement of debt (part a) ..........................
Balances currently in retained earnings:
Interest income:
2010
($7,299)
2011
(7,257)
($14,556)
Interest expense: 2010
$8,360
2011
8,396
16,756
Reduction needed to beginning retained
earnings to arrive at consolidated total ..........................

$38,058

2,200
$35,858

Entry *B12/31/12
Bonds Payable ............................................................
Interest Income ...........................................................
Retained earnings, 1/1/12 (Parent) ...........................
Investment in Bonds ............................................
Interest Expense ...................................................

84,788
7,213
35,858
119,424
8,435

(To eliminate intra-entity bond holdings and adjust beginning retained


earnings balance of the parent to amount representing loss on retirement.
Amounts computed above.)
28. (35 Minutes) (Consolidation procedures and balances related to intra-entity
bonds. Both straight-line and effective interest rate methods are used.)
a. Acquisition price of bonds ................................................................
Book value of bonds payable (see Schedule 1)

6-19

$283,550

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

($443,497 50%) ............................................................................


Loss on retirement .............................................................................

(221,749)
$61,801

SCHEDULE 1Book Value of Bonds Payable

Date
2008
2009
2010

Book
Value
$435,763
$438,055
$440,622

Effective
Interest
(12% Rate)
$52,292
$52,567
$52,875

Cash
Interest
$50,000
$50,000
$50,000

Amortization
$2,292
$2,567
$2,875

b. Investment in Bloom Bonds


Purchase price12/31/10...........................................
Cash interest ($250,000 10%) ................................
Effective interest income ($283,550 8%) ..............
Amortization ..........................................................
Investment in Bloom bonds, 12/31/11 .....................
Bonds Payable
Book value12/31/10 (computed above) ................
Cash interest ($500,000 10%) ................................
Effective interest expense ($443,497 12%) ..........
Amortization ..........................................................
Bonds payable, 12/31/11 ...........................................

Year- End
Book Value
$438,055
$440,622
$443,497
$283,550

$25,000
22,684
2,316
$281,234
$443,497
$50,000
53,220
3,220
$446,717

Although not required, the consolidation entry as of 12/31/11 is as follows. The


reduction in retained earnings represents the loss only; no intra-entity interest
was recognized in the previous year because the purchase was made on
December 31.
Entry *B (2011)
Bonds Payable ($446,717 50%) .............................
Interest Income ...........................................................
Retained Earnings, 1/1/11 .........................................
Interest Expense ($53,220 50%) .......................
Investment in Bloom Bonds ................................

223,359
22,684
61,801
26,610
281,234

28. continued
c. Loss on Retirement of Bond
Because Bloom uses the straight-line method of amortization, the loss on
retirement must be computed again.
Original issue price1/1/08 .........................................................

6-20

$435,763

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Discount amortization (20082010) ([$64,237 11] 3 years).


Book value 12/31/10 ......................................................................

17,519
$453,282

Intra-entity portion of bonds payable (50%) ..............................


Purchase price ...............................................................................
Loss on retirement ........................................................................

$226,641
283,550
$ 56,909

Investment in Bloom Bonds


Purchase price12/31/10 .............................................................
Premium amortization (2011) ($33,550 8) ................................
Book value 12/31/11 .................................................................

$283,550
(4,194)
$279,356

Interest Income
Cash interest ($250,000 10%) ...................................................
Premium amortization (above) ....................................................
Intra-entity interest income2011 .........................................

$25,000
(4,194)
$20,806

Bonds Payable
Original issue price 1/1/08.............................................................
Discount amortization (20082011) [($64,237 11) 4 years] .
Book value 12/31/11 .................................................................
Opus ownership .......................................................................
Intra-entity portion12/31/11 ...........................................

$435,763
23,359
$459,122
50%
$229,561

Interest Expense
Cash interest ($250,000 10%) ...................................................
Discount amortization ([$64,237 11] 1/2) ..............................
Intra-entity interest expense2011 .......................................

$25,000
2,920
$27,920

The reduction in retained earnings represents the loss only; no intra-entity


interest was recognized in the previous year because the purchase was made
on December 31.
Entry *B (2011)
Bonds Payable ............................................................
Interest Income ...........................................................
Retained Earnings, 1/1/11 ........................................
Interest Expense ..................................................
Investment in Bloom Bonds ................................

229,561
20,806
56,909
27,920
279,356

29. (8 Minutes) (Determine goodwill for a purchase in which subsidiary has both
common stock and preferred stock)
Consideration transferred for common stock
Consideration transferred for preferred stock

6-21

$1,600,000
630,000

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Noncontrolling interest in common stock


Noncontrolling interest in preferred stock
Hepners acquisition-date fair value
Book value of Hepner
Goodwill

400,000
270,000
$2,900,000
2,500,000
$400,000

30. (30 Minutes) (Consolidation entries with subsidiary cumulative preferred


stock.)
a. The preferred shares are entitled to the specified cumulative dividend. Thus,
the noncontrolling interest's share of the subsidiary's income equals $160,000 or
8 percent of the preferred stock's par value.
b. Acquisition-Date Fair Value Allocation and Amortization
Consideration transferred ............................................................
Noncontrolling interest fair value (preferred shares)................
Acquisition-date fair value of Smith............................................
Book value .....................................................................................
Franchises ......................................................................................
Period of amortization ..................................................................
Annual amortization ......................................................................

$14,040,000
2,000,000
16,040,000
(16,000,000)
$ 40,000
40 years
$1,000

Investment in Smith Account, December 31, 2011


Consideration transferred, January 1, 2011 ............................... $14,040,000
Equity accrual (income remaining for common stock
after preferred stock dividend) ..............................................
290,000
Dividends collected ($360,000 total less $160,000
paid to preferred shareholders) .............................................
(200,000)
Amortization for 2011 (above) .....................................................
(1,000)
Investment in Smith account, December 31, 2011..................... $14,129,000
c. Consolidation Entries
Entry S and A combined
Preferred Stock (Smith) ............................................. 2,000,000
Common Stock (Smith) ............................................. 4,000,000
Retained Earnings, 1/1/11 (Smith) ............................ 10,000,000
Franchises ..................................................................
40,000
Investment in Smith.........................................
14,040,000
Noncontrolling Interest in Smith, Inc.............
2,000,000
(To eliminate subsidiary stockholders equity, record excess fair values, and
record outside ownership of subsidiary's preferred stock at fair value)
30. c. (continued)
Entry I

Equity Income of Subsidiary ...............................

6-22

289,000

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Investment in Smith ........................................


289,000
(To eliminate equity accrual made in connection with common stock
[$290,000] along with excess amortization recorded by parent.)
Entry D Investment in Smith ..............................................
200,000
Dividends Paid .................................................
200,000
(To remove intra-entity dividend payments made on common stock [see
computation above].)
Entry E Amortization Expense ..........................................
1,000
Franchises ........................................................
1,000
(To recognize amortization of franchises for current year [see computation
above].)
31. (30 Minutes) (Prepare consolidation entries for a purchase where subsidiary
has outstanding preferred stock)
Consideration transferred for common stock
$ 7,368,000
Consideration transferred for preferred stock
3,100,000
Noncontrolling interest in common stock
4,912,000
Acquisition-date fair value for Young
$15,380,000
Youngs book value
15,000,000
Excess fair over book value
380,000
to building (5-year life)
$200,000
to equipment (10-year life)
(100,000)
100,000
to brand name (20-year life)
$280,000
CONSOLIDATION ENTRIES
Entries S and A combined
Preferred Stock (Young) ............................................ 1,000,000
Common Stock (Young) ............................................ 4,000,000
Retained Earnings (Young) ....................................... 10,000,000
Brand name..................................................................
280,000
Building ......................................................................
200,000
Equipment .............................................................
Investment in Young's Preferred Stock (100%)
Investment in Young's Common Stock (60%) ...
Noncontrolling interest ........................................

100,000
3,100,000
7,368,000
4,912,000

(To eliminate subsidiary stockholders equity, record excess acquisitiondate fair values, and record outside ownership of subsidiary's preferred
stock at acquisition-date fair value)
31. (continued)

6-23

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Entry I1
Dividend Income ........................................................
80,000
Dividends Paid ......................................................
80,000
(To offset intra-entity preferred stock dividend payments recognized as
income by parent$1,000,000 par value 8% dividend rate.)
Entry I2
Dividend Income ........................................................
192,000
Dividends Paid ......................................................
192,000
(To eliminate intra-entity dividend payments [60% of $320,000] on common
stock. Because the $320,000 in dividends remaining after Entry I1 equals
exactly 8 percent of the common stock par value, the participation factor
does not affect the distribution.)
Entry E
Amortization Expense ...............................................
44,000
Equipment ...................................................................
10,000
Building ..................................................................
Brand name ...........................................................
(To record 2011 amortization of specific accounts
recognized within acquisition price of preferred stock.)

40,000
14,000

32. (15 Minutes) (The effect that various events have on a consolidated statement
of cash flows.)

Sale of building. The $44,000 in cash received from the sale is listed as a
cash inflow within the company's investing activities. If the company
is using the direct approach in presenting cash flows from
operations, the $12,000 gain is merely omitted. However, if the
indirect approach is in use, the gain (a positive) must be eliminated
from net income by a subtraction.

Intra-entity inventory transfers. Because these transactions do not occur


with any parties outside of the business combination, they are not
reflected in the consolidated statement of cash flows.

Dividend paid by the subsidiary. The $27,000 payment to the parent is


eliminated in consolidated statements and is not a cash outflow from
the consolidated entity. The remaining $3,000 payment to the
noncontrolling interest is reported as a cash outflow from a
financing activity.

Amortization of intangible asset. This $16,000 noncash expense appears in


the consolidated income statement. If the combined companies are
using the direct approach to present cash flows from operations, this
expense is omitted. If the indirect approach is used, the expense
must be removed from consolidated net income by an addition.

6-24

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

32. continued

Decrease in accounts payable. Cash payments have been used to reduce


this liability balance during the period. If the direct approach is used to
present cash flows from operations, the change is added to cost of
goods sold as one step in deriving the cash paid during the period for
inventory (an outflow). If the indirect approach is applied, the decrease
is subtracted from net income in arriving at the net cash generated
from operations during the period.

33. (20 Minutes) (Determine cash flows from operations for a consolidated entity.)
DIRECT APPROACH
Cash revenues (add book values, eliminate intra-entity transfers,
and add decrease in accounts receivable) ...................................
$648,000
Cash inventory purchases (add book values, eliminate
intra-entity transfers, eliminate unrealized gains, add increase in
inventory, and add decrease in accounts payable)......................
(370,000)
Depreciation and amortization (omit as noncash expenses)...........
-0Other expenses (add book values) .....................................................
(40,000)
Gain on sale of equipment (omit because this is an investing activity)
-0Equity in earnings of Knight (intra-entity so not included) .............
-0Cash generated from operations ..............................................
$238,000
INDIRECT APPROACH
Consolidated net income (computed below) .....................................
Adjustments:
Depreciation and amortization ..................................................
Gain on sale of equipment ........................................................
Increase in inventory .................................................................
Decrease in accounts receivable ..............................................
Decrease in accounts payable ..................................................
Cash generated from operations ........................................

$216,000
61,000
(30,000)
(11,000)
8,000
(6,000)
$238,000

Consolidated Net Income = $206,200 + 9,800 = $216,000 or computation below:


Revenues (add book values and subtract intra-entity transfers)
$640,000
Cost of goods sold (add book values, less intra-entity
transfers and beginning unrealized gain, plus ending
unrealized gain) ..........................................................................
(353,000)
Depreciation and amortization (add book values plus
amortization from excess fair value allocations) ....................
(61,000)
Other expenses (add book value) ..................................................
(40,000)
Gain on sale of equipment ..............................................................
30,000
Consolidated net income ..........................................................
$216,000

6-25

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

34. (30 Minutes) (Compute basic and diluted earnings per share for a parent and its
100 percent owned subsidiary, both with convertible bonds.)
Basic EPSPorter Company:
Porter's reported income ..........................................
Street's reported income ...........................................
Amortization expense ................................................
Consolidated net income (all to Porter)..............
Porter shares outstanding ...................................
Basic earnings per share ($270,000 60,000) ........
Diluted EPSStreet Company
Street earnings after amortization............................
Shares outstanding ....................................................
Basic earnings per share (120,000 30,000) ..........
Street's earnings assuming conversion of its bonds
($120,000 + $24,000 interest saved net of tax) . .
Street's shares assuming conversion of its bonds
(30,000 + 10,000) ...................................................
Diluted earnings per share (144,000 40,000) ........

$150,000
130,000
(10,000)
$270,000
60,000
$4.50

$120,000
30,000
$4.00
$144,000
40,000
$3.60

Because diluted earnings per share is less than basic earnings per share, the
convertible bonds are dilutive and should be included.
Porters share of Streets diluted earnings:
Total shares assuming Street bond conversion ....
Shares owned by Porter.............................................
Porter's ownership percentage (30,000 40,000) . .
Street's earnings for diluted EPS (above) ...............
Porter's ownership percentage.................................
Earnings attributed to Porter company ...................
Porters earnings and shares for diluted EPS:
Porter's separate income ..........................................
Streets income applicable to Porter (above)..........
Interest saved (net of tax) on assumed
conversion of Porter's bonds ..............................
Diluted earnings to Porter..........................................
Porter shares outstanding ........................................
Additional shares from assumed bond conversion
Diluted shares .............................................................

40,000
30,000
75%
$144,000
75%
$108,000
$150,000
108,000
32,000
$290,000
60,000
8,000
68,000

Consolidated income statement EPS amounts for Porter Company:


Basic earnings per share (above).............................
$4.50

6-26

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Diluted earnings per share ($290,000 68,000) ......


$4.26
35. (15 Minutes) (Compute diluted EPS. Subsidiary has stock warrants
outstanding)
Figures For Sonston's Basic EPS
Net Income ......................................................................
Shares outstanding .........................................................
Assumed conversion of stock warrants .......................
Repurchase of treasury stock with proceeds of stock
Warrants (10,000 $10 = $100,000 $20) .....................
Shares for basic earnings per share computation.......

$200,000
40,000
10,000
(5,000)

5,000
45,000

Shares controlled by Primus: 40,000 + (20% of 5,000) =


41,000
Percentage of total held by Primus: 41,000 45,000 =
91%
(rounded)
Income to be included in parents diluted EPS = $200,000 91% = $182,000
Parents Diluted Earnings Per Share:
Net income Primus .......................................................
Net income included from Sonston ...............................
Earnings for diluted EPS ...........................................
Outstanding shares of Primus .................................

$600,000
182,000
$782,000
100,000

PARENTS DILUTED EARNINGS PER SHARE = $782,000 100,000 = $7.82


36. (15 Minutes) (Compute diluted EPS. Subsidiary has convertible bonds.)
Figures for Simon's diluted EPS:
Net income ..........................................................................................
Interest (net of tax) saved from assumed conversion ...................
Earnings for diluted earnings per share ..........................................

$290,000
56,000
$346,000

Shares outstanding ............................................................................


Assumed conversion of bonds .........................................................
Subsidiary shares for parents share of diluted earnings..............

80,000
30,000
110,000

Shares controlled by Garfun = 80,000 110,000 = 73% (rounded)


Income to be included in parents diluted EPS = $346,000 73% = $252,580
Earnings for parents diluted earnings per share:
Net incomeGarfun
Dividends to Garfun's preferred stock
Net Income included from Simon (above)
Earnings for diluted EPS

6-27

$480,000
(15,000)
252,580
$717,580

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

PARENTS DILUTED EARNINGS PER SHARE = $717,580 80,000 = $8.97 (rounded)


37. (35 Minutes) (Compute basic and diluted earnings per share for parent
company. Subsidiary has stock warrants and convertible bonds.)
Basic EPSParent Company (Mason):
Reported income (separate)Mason ......................
Income of Dixon (80% [$90,000 25,000)) ............
Preferred stock dividends (5,000 $4) ....................
Masons earnings applicable to basic EPS .............
Mason's outstanding shares ....................................
Basic earnings per share ($142,000 50,000) ........

$110,000
52,000
(20,000)
$142,000
50,000
$2.84

Diluted EPSParent Company (Mason)


Subsidiary income for Masons EPS:
Net income after amortization ($90,000 25,000). . .
$65,000
Interest (net of tax) saved assuming bond conversion 30,000
Income applicable to diluted EPS .......................
$95,000
Shares outstanding ....................................................
Assumed conversion of warrants ............................
Assumed acquisition of treasury stock with
proceeds of conversion [(10,000 $20) $25] .
Assumed conversion of bonds ................................
Shares applicable to diluted EPS .......................
Shares controlled by parent:
(30,000 80% plus 15% 20,000) .......................
Income used in diluted EPS computation ...............
Portion owned by parent (27,000 52,000) .............
Subsidiary income applicable to parentdiluted EPS
Earnings applicable to Masons diluted EPS:
Reported income (separate)Mason.......................
Less: intra-entity interest revenue (net of tax)........
Masons income for diluted EPS...............................
Income of Dixon (above) ...........................................
Because of assumed conversion, preferred stock
dividends would not be paid ...............................
Earnings applicable to diluted EPS .........................
Mason's outstanding shares ....................................
Assumed conversion of preferred stock (5,000 4)
Shares applicable to diluted EPS .............................

6-28

30,000
10,000
(8,000)
20,000
52,000
27,000
$95,000
52%
$49,400
$110,000
(4,500)
$105,500
$ 49,400
-0$154,900
50,000
20,000
70,000

(rounded)

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Diluted earnings per share ($154,900 70,000) .....

$2.21

(rounded)

37. (continued)
Alternative derivation of Masons diluted EPS:
Consolidated net income
Consolidated interest saved (net of intra-entity interest)
Consolidated net income assuming bond conversion
Subsidiary net income
$(90,000)
Excess fair value amortization
25,000
Subsidiary interest saved
(30,000)
Income applicable to diluted EPS
$(95,000)
Noncontrolling interest share
0.48
Parent's net income applicable to diluted EPS

$(175,000)
(25,500)
(200,500)

(45,600)
$(154,900)

Shares for diluted EPS

70,000

Diluted EPS ($154,900 70,000 shares)

$2.21

38. (8 Minutes) (Effect of subsidiary stock issuance to public at a price above


reported value per share)
Equity method investment prior to share issue by Ricardo
Parent's ownership percentage......................................
Fair value ownership equivalency..................................
Adjusted subsidiary fair value after new share issue
(above value plus 10,000 shares at $15.75 each) ...
Parent's Ownership (40,000 50,000 shares) ..............
New ownership adjusted fair value................................

$490,000
100%
$490,000
$647,500
80%
$518,000

Investment in Ricardo should be increased by $28,000 ($518,000 less $490,000)


39. (20 Minutes) (Effects of two different stock issuances by subsidiary.)
a. Prior to the issuance of the new shares, Albuquerque owns an 80% interest in
Marmon (16,000 shares out of 20,000 shares). The adjusted acquisition-date fair
value is $840,000 ($600,000 + $150,000 + $90,000). After the stock issue, the
adjusted acquisition-date fair value of the subsidiary will increase by $235,000
(the price of the stock) to $1,075,000. Albuquerque' ownership, however, will
only be 64% (16,000 25,000). The investments equity method balance before
stock issue is $672,000 (600,000 + [$90,000 80%]). The book value underlying

6-29

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Albuquerque' investment is now $688,000 (64% of $1,075,000) so that a $16,000


increase is recorded by the parent.
Investment in Marmon ...............................................
Additional Paid-in Capital ....................................

16,000
16,000

39. continued
b. Albuquerque's adjusted acquisition-date fair value is $840,000 (see above) prior
to the issuance of the new shares. The 4,000 additional shares increase
subsidiary's total value by $132,000 (the price of the stock) to $972,000.
Albuquerque' ownership decreases to 2/3 (16,000 shares out of a total of
24,000) for a fair value equivalency of $648,000. Reducing the $672,000 (see a.)
to $648,000 requires a $24,000 decrease to the parents APIC.
Additional Paid-in Capital .........................................
Investment in Marmon .........................................

24,000
24,000

40. (55 Minutes) (Prepare consolidation entries following a subsidiary stock issue
to outside parties.)
Initially, Aronsen owns 18,000 shares (or 90%) of Siedel's outstanding
shares (the total number of shares can be determined by dividing the
subsidiary's Common Stock account by the $10 per share par value). After
issuing 4,000 additional shares, the parent must prepare an adjustment to
reflect the change in its share of the subsidiarys unamortized acquisitiondate fair value. Because that entry has not been recorded, it is included on
the consolidation worksheet as Entry C1 (labeled in this manner as a
correction). Other consolidation procedures follow as described in previous
chapters.
Excess Acquisition-Date Fair Value Allocation and Amortization
Fair value (consideration transferred plus NCI fair value) .......... $649,000
Acquisition-date book value............................................................
(480,000)
Fair value in excess of book value ................................................ $169,000
Allocated to land based on fair value.............................................
89,000
Allocated to copyrights based on fair value..................................
$80,000
Life of copyrights .............................................................................
16 yrs
Annual amortization ........................................................................
$ 5,000
Adjustment for Stock Transaction
Adjusted acquisition-date fair value of subsidiary
on new issue date ($649,000 + $90,000 + $152,000) ...............
Adjusted parent ownership (18,000 shares 24,000 shares) .....
Parents post-issue equity method value at 1/1/11 ................
Equity method balance before new subsidiary stock issue

6-30

$891,000
75%
$668,250

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Consideration transferred........................................... 584,100


Increase in book value (90% $100,000)................... 90,000
Copyright amortization ($5,000 2 years 90%).....
(9,000)
Required increase (Entry C1) .........................................................
40. (continued)
Consolidation worksheet entries:
Entry *C
Investment in Siedel ..................................................
Retained earnings, 1/1/11 (Aronsen) ..................

665,100
$ 3,150

81,000
81,000

(To convert 1/1/11 balance to full accrual [$100,000 less


two years amortization expense $5,000 2] 90%)
Entry C1
Investment in Siedel ..................................................
Additional paid-in capital (Aronsen) ..................

3,150
3,150

(To record adjustment for subsidiary stock


transaction; computation shown above.)
Entry S
Common stock (Siedel) .............................................
Additional paid-in capital (Siedel) ............................
Retained earnings, 1/1/11 (Siedel) ............................
Investment in Siedel (75%) ..................................
Noncontrolling interest in Siedel, 1/1/11 (25%). .

240,000
112,000
380,000
549,000
183,000

(To eliminate subsidiary stockholders' equity accounts


against Investment accountand to recognize noncontrolling
interest. Stockholdersequity balances have been adjusted
for increase in book value during 20092010 and the issuance
by the subsidiary of 4,000 shares of stock on 1/1/11.)
Entry A
Land ............................................................................
Copyrights ..................................................................
Investment in Siedel (75%)...................................
Noncontrolling interest (25%) .............................

89,000
70,000
119,250
39,750

(To recognize acquisition price allocated to land and


copyrights. Copyrights balance has been reduced for
20092010 amortization to arrive at 1/1/11 balance.
NCI now reflects 25% of the unamortized 1/1/11 balance.)
Entry I
Dividend income ........................................................
Dividends paid ......................................................

6-31

15,000
15,000

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

(To eliminate intra-entity dividends recorded by


parent as income [75% $20,000].)
Entry E
Amortization expense ................................................
Copyrights..............................................................

5,000
5,000

(To recognize current year amortization.)


41. (50 Minutes) (Prepare consolidation worksheet for business combination. Intraentity bond acquisition is made during the current year.)
Acquisition-date fair-value allocation and amortization:
Equipment
Trademarks

$30,000
$40,000

10-year life
20-year life

$3,000 annual amortization


$2,000 annual amortization

As indicated in the problem, the parent is applying the partial equity method.
Hence an Entry *C must be recorded on the worksheet to convert the recorded
figures (amortization is needed for the three years prior to 2012) to equity
balances:
Amortization expense ($5,000 3 years) = .............
$15,000 (Entry *C)
Unrealized gain in ending inventory (downstream):
Ending balance ...........................................................
Markup ($20,000 $100,000) .....................................
Unrealized gain to be eliminated ..............................

$10,000
20%
$ 2,000

(Entry G)

Loss on extinguishment of bonds:


Book value at date of repurchase ..................................
Percentage repurchased .................................................
Equivalent book value ....................................................
Amount paid .................................................................
Loss on extinguishment of bonds ................................

$282,000
50%
$141,000
145,500
$ 4,500

(Entry B)

Amortization during 2012 changed the carrying value of the bond payable from
$282,000 to $288,000 (found in the balance sheet) and the investment from
$145,500 to $147,000. This amortization also affects interest income and
expense accounts.
Entry A reflects remaining values after three years of amortizations.

6-32

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
41. continued

Pavin and Stabler


Consolidation Worksheet
Year Ending December 31, 2012

Accounts
Revenues...............................................
Cost of goods sold...............................
Expenses...............................................
Interest expensebonds ....................
Interest incomebond investment.....
Loss on extinguishment of bonds......
Equity in income of Stabler.................
Net income.........................................

Pavin
(740,000)
455,000
125,000
36,000
-0-0(123,000)
(247,000)

Retained earnings, 1/1/12.....................


Retained earnings, 1/1/12.....................
Net income (above)...............................
Dividends paid......................................
Retained earnings, 12/31/12.................

(345,000)
(247,000)
155,000
(437,000)

(361,000)
(123,000)
61,000
(423,000)

Cash and receivables...........................


Inventory................................................
Investment in Stabler...........................

217,000
175,000
613,000

35,000
87,000
-0-

Investment in Pavin bonds..................


Land, buildings, and equipment (net)
Trademarks............................................
Total assets........................................
Accounts payable.................................
Bonds payable......................................
Discount on bonds...............................
Common stock......................................
Retained earnings (above)...................
Total liabilities and stockholders equity

Stabler
(505,000)
240,000
158,500
-0(16,500)
-0-0(123,000)

-0245,000
-01,250,000

147,000
541,000
-0810,000

(225,000)
(300,000)
12,000
(300,000)
(437,000)
(1,250,000)

(167,000)
(100,000)
-0(120,000)
(423,000)
(810,000)

6-33

Consolidation Entries
Debit
Credit
(TI)100,000
(G) 2,000
(TI) 100,000
(E) 5,000
(B)
18,000
(B) 16,500
(B) 4,500
(I) 123,000
(*C) 15,000
(S) 361,000
(D)

(D) 61,000

(A) 21,000
(A) 34,000

61,000

(P)
33,000
(G)
2,000
(*C) 15,000
(S) 481,000
(A)
55,000
(I)
123,000
(B) 147,000
(E)
3,000
(E)
2,000

(P) 33,000
(B) 150,000
(B)

6,000

(S) 120,000
1,046,000

1,046,000

Consolidated
Totals
(1,145,000)
597,000
288,500
18,000
-04,500
-0(237,000)
(330,000)
-0(237,000)
155,000
(412,000)
219,000
260,000
-0-0804,000
32,000
1,315,000
(359,000)
(250,000)
6,000
(300,000)
(412,000)
(1,315,000)

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

42. (40 Minutes) (Prepare consolidation entries after intra-entity bond acquisition.)
a. Allocation of Acquisition-date Excess Fair Value
Consideration transferred
$312,000
Noncontrolling interest fair value
208,000
Acquisition-date fair value
$520,000
Book value acquired
300,000
Fair value in excess of book value $220,000
Annual Excess
Excess allocated to patents based
Life Amortizations
on fair value
90,000 12 years
$7,500
Customer list
$130,000 10 years
13,000
Total
$20,500
CONSOLIDATION ENTRIES
Entry *TL
Investment in Herman ................................................
7,000
Land ......................................................................
7,000
(To eliminate unrealized gain created by previous intra-entity transfer.
Investment is adjusted here because transfer was downstream and equity
method has been applied by parent. Thus, retained earnings have already
been corrected.)
Entry *G
Retained Earnings 1/1/11 (Herman) .........................
8,000
Cost of Goods Sold ..............................................
8,000
(To remove unrealized inventory gain from prior year so that it can be
properly realized in current year. Amount is computed as shown below.)
Intra-entity profit2010 .............................................
Transfer price2010 ..................................................
Markup ($25,000 $125,000) .....................................
Unrealized gain in 1/1/11 inventory
($40,000 20%) .....................................................

$25,000
$125,000
20%
$8,000

Entry S
Common Stock (Herman) ..........................................
100,000
Retained Earnings, 1/1/11 (Herman)
(adjusted for Entry *G) .........................................
292,000
Investment in Herman (60%) ..........................
235,200
Noncontrolling Interest in Herman (40%) .....
156,800
(To eliminate Herman's stockholders' equity accounts and to record
beginning of year balance for noncontrolling interest.)
42. a. (continued)

6-34

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Entry A
Patents ......................................................................
75,000
Customer list...............................................................
104,000
Investment in Herman ..........................................
107,400
Noncontrolling interest ........................................
71,600
(To recognize unamortized balances as of 1/1/11 of amounts allocated within
original acquisition price. Allocations have been reduced by two years of
amortizations.)
Entry I
Equity Income of Herman...........................................
3,000
Investment in Herman......................................
(To eliminate intra-entity equity income accrual)
Hermans income.............................................................. $25,000
Excess amortizations....................................................... (20,500)
2010 intra-entity inventory gross profit.........................
8,000
2011 intra-entity inventory gross profit.........................
(7,500)
Accrual-based income..................................................... $5,000
Freds ownership percentage.........................................
60%
Equity in earnings of Herman......................................... $3,000
Entry D
Investment in Herman ................................................
Dividends paid ......................................................
(To eliminate intra-entity dividend payments.)
Entry E
Amortization expense ................................................
Patents....................................................................
Customer list..........................................................
(To recognize current year amortization expense.)

3,000

2,400
2,400

20,500
7,500
13,000

Entry P
Accounts payable ......................................................
60,000
Accounts receivable .............................................
(To remove intra-entity debt created by inventory transfers.)

60,000

42. a. (continued)
Entry B
Bonds payable ............................................................
Premium on bonds payable ......................................
Interest income ...........................................................
Investment in parent bonds ................................

6-35

20,000
1,069
1,873
19,005

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Interest expense ...................................................


1,283
Gain on retirement of bond..................................
2,654
(To eliminate effect created by bond acquisition and recognize the related
retirement gain [$21,386 $18,732]. Amounts are calculated below.)

Investment
Liability

Book
Value
(given)

Effective
Interest

$18,732
21,386

$1,873 (10%)
1,283 (6%)

Cash
Interest
(8%)

$1,600
1,600

Excess
Amortizations

$273
317

Entry Tl
Sales ............................................................................
120,000
Cost of goods sold (or Purchases) ....................
(To eliminate intra-entity transfers made during current year.)

Year- End
Book
Value

$19,005
21,069

120,000

Entry G
Cost of goods sold ....................................................
7,500
Inventory.................................................................
7,500
(To defer recognition of inventory transfer gains until subsequent year.
Amount calculated as follows.)
Intra-entity profit ...................................................
$30,000
Transfer price 2011 ...............................................
$120,000
Markup ($30,000 $120,000) ...............................
25%
Unrealized gain in ending inventory
($30,000 25%) ...................................................
$7,500
b. Herman's reported income for 2011 .........................................
Excess fair value amortization ..................................................
2010 unrealized gain recognized in 2011 (Entry *G) ..............
2011 unrealized gain (Entry G) ..................................................
Herman's realized income for 2011...........................................
Noncontrolling interest ownership ..........................................
Noncontrolling interest's share of the subsidiary's income. .
Noncontrolling interest, 1/1/11 (Entries S and A) ...................
Noncontrolling interest's share of Herman's income (above)
Noncontrolling interest's share of Herman's dividends
($4,000 40%) ........................................................................
Noncontrolling interest, 12/31/11..............................................

$25,000
(20,500)
8,000
(7,500)
$5,000
40%
$2,000
$228,400
2,000
(1,600)
$228,800

42. (continued)
c. The balances in the individual records as of December 31, 2012 pertaining to
the Intra-entity bonds are as follows:
Beginning
Book
Value

Effective

6-36

Cash
Interest

Excess

Year- End
Book

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Investment
Liability

(see part a.)

Interest

$19,005
21,069

$1,901 (10%)
1,264 (6%)

(8%)

$1,600
1,600

Amortizations

$301
336

Value

$19,306
20,733

The adjustment to recognize the original gain by the parent can be computed
as follows:
Original gain on retirement (see part a) ........................
Interest income recorded on investment in 2011
(see part a) ..................................................................
Interest expense recorded on liability in 2011
(see part a) .................................................................
Required increase as of January 1, 2012 ......................

$2,654
$1,873
1,283

590
$2,064

Entry *B (as of December 31, 2012)


Bonds payable.............................................................
20,000
Premium on bonds payable ......................................
733
Interest Income ...........................................................
1,901
Investment in Herman ..........................................
2,064
Investment in parent bonds ................................
19,306
Interest expense ...................................................
1,264
(To remove accounts pertaining to intra-entity bonds. "Investment in
Herman" is adjusted here rather than retained earnings because equity
method is being applied and gain is attributed to the parent.)
43. (50 Minutes) (Prepare consolidation entries for intra-entity preferred stock and
bonds. Determine specified account balances. Preferred stock is a debt
instrument.)
a. Consideration transferred for common stock

...............................................$552,800
Consideration transferred for preferred stock..................
Noncontrolling interest in common stock.........................
Noncontrolling interest in preferred stock........................
Lisas acquisition-date fair value........................................
Book value of Lisa................................................................
Excess assigned to franchises...........................................

65,000
138,200
34,000
$790,000
750,000
$ 40,000

CONSOLIDATION ENTRIES 1/1/10


Entry S and A combined
Preferred Stock (Lisa) ................................................
Common Stock (Lisa) ................................................
Retained Earnings, 1/1/10 (Lisa) ...............................
Franchises ..................................................................
Investment in Lisa-common stock.................

6-37

100,000
200,000
450,000
40,000
552,800

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Investment in Lisa-preferred stock................


Noncontrolling Interest in Lisa, Inc................

65,000
172,200

(To eliminate subsidiary stockholders equity, record excess acquisitiondate fair values, and record outside ownership of subsidiary's preferred and
common stock at acquisition-date fair values.)
b. Acquisition price of bonds, 1/2/10 ...........................
Book value of bonds payable ( acquired) ............
Loss on extinguishment of debt .........................
Interest incomeMona ($53,310 8%) ...................
Interest expenseLisa ($44,175 14%) ..................
Investment in Lisabonds (book value)
Book valuedate of acquisition, 1/2/10 ............
Cash interest ($50,000 10%) .............................
Effective interest (above) .....................................
Investment in Lisabonds
(book value as of 12/31/10) ............................

(rounded)
(rounded)

43. b. (continued)
Bonds payable (book value)
Book valuedate of acquisition, 1/2/10 ............
Cash interest ($50,000 10%) .............................
Effective interest (above) .....................................
Bonds payable (book value as of 12/31/10). .
CONSOLIDATION ENTRY BDecember 31, 2010
(all figures computed above)
Bonds Payable ............................................................
Interest Income (or Other Revenues) ......................
Extraordinary Loss on Retirement of Debt .............
Discount on Bonds Payable ($50,000 $45,360)
Interest Expense....................................................
Investment in LisaBonds .................................

$53,310
$5,000
4,265

6-38

735
$52,575

$44,175
$5,000
6,185

1,185
$45,360

50,000
4,265
9,135

c. December 31, 2010 book values based on historical cost figures:


Cost of fixed assets ...................................................
$100,000
Depreciation expense ($40,000 book value over
a 10-year life) .........................................................
4,000
Accumulated depreciation (including current
expense) ................................................................
64,000
December 31, 2010 book values based on transfer price:

$53,310
(44,175)
$9,135
$4,265
$6,185

4,640
6,185
52,575

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Cost of fixed assets ...................................................


Depreciation expense (10-year life) .........................
Accumulated depreciation ........................................
Gain on transfer of fixed assets
($120,000 $40,000) book value .........................

$120,000
12,000
12,000
80,000

CONSOLIDATION ENTRY TADecember 31, 2010


Gain on transfer of fixed assets (to remove) ..........
Accumulated depreciation ($64,000 $12,000).
Depreciation expense ($12,000 $4,000) .........
Fixed assets ($120,000 $100,000) ....................

80,000
52,000
8,000
20,000

43. (continued)
d. Original allocation to franchises (given) ......................
Amortization at $1,000/year (20102011) .................
Consolidated franchises12/31/11 .........................

$40,000
(2,000)
$38,000

Fixed assets (book values):


Mona, Inc. .................................................................... $1,100,000
Lisa Co. ......................................................................
800,000
Reduction necessitated by intra-entity sale
($120,000 transfer price reduced to $100,000
original cost) (see part c) .....................................
(20,000)
Consolidated fixed assets12/31/11 ....................... $1,880,000
Accumulated depreciation (book values):
Mona, Inc......................................................................
Lisa Co. ......................................................................
Increase needed to eliminate intra-entity
sale ($60,000 accumulated depreciation at time
of transfer less excess depreciation expense
[$12,000 - $4,000] for 2010 and 2011) .......................
Consolidated Acc. Depr.12/31/11..........................

$300,000
200,000

44,000
$544,000

Expenses (book values):


Mona, Inc................................................................
$220,000
Lisa Co. ..................................................................
120,000
Recognition of amortization on franchises ............
1,000
Elimination of interest expense on intercompany debt ($45,360 [see part b] 14%) (rounded)
(6,350)
Elimination of excess depreciation from
intra-entity transfer of fixed assets

6-39

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

($12,000 $4,000) ..................................................


Consolidated expenses ...........................................

(8,000)
$326,650

44. (35 Minutes) (Prepare statement of cash flows for a business combination.)
(Note: before working this problem, students may wish to review the statement
of cash flows in an intermediate accounting textbook.)
RODRIGUEZ COMPANY AND CONSOLIDATED SUBSIDIARY MOLINA
Consolidated Statement of Cash Flows
Year Ending December 31, 2011
CASH FROM OPERATIONS
Consolidated net income...........................................
Adjustment from accrual to cash:
Depreciation and amortization ............................
Gain on sale of building .......................................
Decrease in accounts receivable ........................
Increase in inventory ............................................
Decrease in accounts payable ............................
Cash from operations ................................................

$230,000
100,000
(20,000)
10,000
(140,000)
(40,000)
$140,000

CASH FLOWSINVESTING ACTIVITIES


Sale of building ..........................................................
Purchase of equipment .............................................
Cash from investing activities.............................

$50,000
(175,000)

CASH FLOWSFINANCING ACTIVITIES


Dividends paid ............................................................
Issuance of bonds .....................................................
Issuance of common stock .......................................
Cash from financing activities ............................

$(102,000)
100,000
57,000

Net increase in cash during 2011 ..................................


Cash, January 1, 2011 .....................................................
Cash, December 31, 2011 ...............................................

(125,000)

55,000
70,000
80,000
$150,000

The above statement uses the indirect approach for computing cash flows from
operations. Under the direct approach, the following computation is
appropriate.
CASH FROM OPERATIONS
Revenues ....................................................................
Purchases ...................................................................

6-40

$990,000
(820,000)

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Expenses .....................................................................
Cash from operations ..........................................

(30,000)
$140,000

44. (continued)
Development of Cash Flow Balances via Direct Method
OPERATING ACTIVITIES
Revenues (the consolidated balance plus the decrease in
accounts receivable) .......................................................................
Cost of goods sold (cash purchases) (the consolidated
balance plus the increase in inventory plus the
decrease in accounts payable) ......................................................
Depreciation and amortization (not cash expenses) ........................
Gain on sale of building (sales price is shown below as
an investing activity) .......................................................................
Interest expense (the consolidated balance) .....................................
Cash flows from operating activities...................................................
INVESTING ACTIVITIES
Sale of building ($30,000 book value sold at a $20,000 gain)...........
Purchase of equipment (Buildings and Equipment account
increased by $50,000. Building with a $30,000 book value
was sold [a decrease]. Depreciation [without Databases
amortization] was $95,000 [a decrease]. Only a purchase
of $175,000 would turn these two decreases of $125,000 into
an increase of $50,000) ...................................................................
Cash flows from investing activities....................................................
FINANCING ACTIVITIES
Dividends paid by parent (the consolidated balance) ......................
Dividends paid by subsidiary (amount paid to
noncontrolling interest20%) .......................................................
Issuance of bonds .................................................................................
Issuance of common stock by the parent (increase in
common stock and additional paid-in capital) .............................
Cash flows from financing activities....................................................

$990,000
820,000
-0-030,000
$140,000
$50,000

(175,000)
$(125,000)
$(100,000)
(2,000)
100,000
57,000
$55,000

45. (40 Minutes) (Compute basic and diluted earnings per share. Subsidiary has
stock warrants outstanding and convertible debt.)
Basic EPSAustin, Inc.
Consolidated net income to parent................................
Austins preferred dividends ..........................................

6-41

$284,000
(40,000)

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Earnings applicable to Austins basic EPS .............

$244,000

Austin's outstanding common shares ..........................

50,000

Basic earnings per share ($244,000 50,000) ...................

$4.88

Diluted EPSAustin, Inc.


Subsidiary earnings and shares for Austins diluted EPS calculation:
Rio Grande net income after amortization....................
$105,000
Interest saved assuming conversion of bonds
(net of tax) ...................................................................
22,000
Income applicable to diluted EPS ..................................
$127,000
Shares outstanding .........................................................
Assumed conversion of warrants .................................
Assumed treasury stock acquisition using proceeds
from warrant conversion ([5,000 $10] $20) .......
Assumed conversion of bonds ......................................
Subsidiary shares applicable to diluted EPS ...............

30,000
5,000
(2,500)
10,000
42,500

Shares controlled by parent (24,000 plus 50% of increment created by warrants [or 1,250]) .......................

25,250

Portion owned by parent (25,250 42,500) ..................

59.4%

Income applicable to parentdiluted EPS


(59.4% $127,000) ......................................................

$75,438

(rounded)

Austins income and shares for diluted EPS calculation:


Austins separate income................................................
$200,000
Income of Rio Grande to parent (computed above) ....
75,438
Preferred dividends (assumed converted) ...................
-0Earnings applicable to diluted EPS ...............................
$275,438
Austin's outstanding common shares ..........................
Assumed conversion of preferred stock
(10,000 2 shares) .....................................................
Shares applicable to diluted EPS ..................................

50,000

Diluted earnings per share ($280,438 70,000) .................

$3.93

20,000
70,000
(rounded)

46. (50 Minutes) (Determine consolidated totals. Subsidiary has preferred shares
outstanding that are equity instruments.)
Consideration transferred for common and preferred stock

6-42

$560,000

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Skylers book value


Excess fair value assigned to intangible asset (10-year life)

450,000
$110,000

Annual amortization

$11,000

Ending Unrealized Gain


Ending inventory (at transfer price) ..............................
Markup ($30,000 $90,000) .......................................
Ending unrealized gain (increase made to cost
of goods sold to defer gain) ................................

$18,000
33%
$6,000

Effect of Intra-Entity Equipment Transfer:


Transfer price:
Recorded value.................................................................................
Depreciation expense (20,000 4)..................................................
Accumulated depreciation...............................................................
Gain on sale (20,000 12,000).........................................................

20,000
5,000
5,000
8,000

Historical cost:
Recorded value.................................................................................
Depreciation expense (12,000 4)..................................................
Accumulated depreciation (18,000 + 3,000)...................................

30,000
3,000
21,000

6-43

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

46. (continued)

Accounts
Sales................................................
Cost of goods sold.........................
Expenses.........................................
Gain on sale of equipment.............
Net income...................................

Paisley, Inc. and Skyler Corp.


Consolidation Worksheet
Year Ending December 31, 2011
Consolidation Entries
Paisley, Inc.
Skyler Corp.
Debit
Credit
(800,000)
(400,000)
(TI) 90,000
528,000
260,000
(G)
6,000 (TI) 90,000
180,000
130,000
(E) 11,000
(ED) 2,000
(8,000)
-0(TA)
8,000
(100,000)
(10,000)

Retained earnings, 1/1...................


Net income......................................
Dividends paid................................
Retained earnings, 12/31.............

(400,000)
(100,000)
60,000
(440,000)

(150,000)
(10,000)
-0(160,000)

Cash.................................................
Accounts receivable.......................
Inventory.........................................
Investment in Skyler Corp.............

30,000
300,000
260,000
560,000

40,000
100,000
180,000
-0-

Land, buildings, and equipment....


Accumulated depreciation.............
Intangible Asset..............................
Total assets..................................

680,000
(180,000)
-01,650,000

500,000
(90,000)
-0730,000

Accounts payable...........................
Long-term liabilities........................
Preferred stock...............................
Common stock................................
Additional paid-in capital...............

(140,000)
(240,000)
-0(620,000)
(210,000)

(90,000)
(180,000)
(100,000)
(200,000)
-0-

6-44

(S) 150,000

(400,000)
(87,000)
60,000
(427,000)
(P) 28,000
(G)
6,000
(S) 450,000
(A) 110,000

(TA) 10,000
(ED) 2,000
(A) 110,000
(P)

28,000

(S) 100,000
(S) 200,000

Consolidated
Totals
(1,110,000)
704,000
319,000
-0(87,000)

(TA) 18,000
(E) 11,000

70,000
372,000
434,000
-01,190,000
(286,000)
99,000
1,879,000
(202,000)
(420,000)
-0(620,000)
(210,000)

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Retained earnings, 12/31...............


Total liab. and stockholders equity

(440,000)
(1,650,000)

6-45

(160,000)
(730,000)

(427,000)
(1,879,000)

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

46. (continued)
CONSOLIDATED TOTALS
Sales = 1,110,000 (add book values and eliminate intra-entity transfers)
Cost of Goods Sold = 704,000 (add book values, eliminate intra-entity
transfers, and eliminate ending unrealized gain [computed above])

Expenses = 319,000 (add book values and include amortization of


intangibles and eliminate 2,000 excess equipment depreciation)

Gain on Sale of Equipment = 0 (intra-entity balance is eliminated)

Net Income = 87,000 (consolidated revenues less consolidated expenses)

Retained Earnings, 1/1 = 400,000 (parent company figure only because


subsidiary was not acquired until current year)

Dividends Paid = 60,000 (parent balance only)

Retained Earnings, 12/31 = 427,000 (consolidated beginning retained


earnings plus net income less dividends paid)

Cash = 70,000 (add book values)

Accounts Receivable = 372,000 (add book values after eliminating intercompany balance)

Inventory = 434,000 (add book values after eliminating unrealized gain)

Investment in Skyler Corporation = 0 (intra-entity account is eliminated so


that individual asset and liability accounts of subsidiary can be included)

Land, Buildings, and Equipment = 1,190,000 (add book values and increase
transferred asset from transfer price to historical cost [see above])

Accumulated Depreciation = 286,000 (add book values and adjust balance


for transferred asset from transfer price figure to historical cost (see above])

Intangible Asset = 99,000 (original allocations less one year amortization)

Total Assets = 1,879,000 (summation of consolidated accounts)

Accounts Payable = 202,000 (add book values and remove intra-entity


balance)

Long-Term Liabilities = 420,000 (add book values)

Preferred Stock = 0 (subsidiary outstanding shares are eliminated)

Common Stock = 620,000 (parent balance only)

Additional Paid-in Capital = 210,000 (parent balance only)

Retained Earnings, 12/31 = 427,000 (computed above)

Total Liabilities and Equities = 1,879,000 (summation of consolidated


accounts)

46. continued: Consolidation entries and explanations:


Entry S
Preferred Stock (Skyler)....................................................
Common Stock (Skyler)....................................................
6-46

100,000
200,000

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Retained Earnings, 1/1......................................................

6-47

150,000

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Investment in Skyler Corp..........................................


(To eliminate subsidiary stockholders equity accounts.)

450,000

Entry A
Intangible Asset ................................................................
110,000
Investment in Skyler Corp..........................................
(To recognize excess fair value attributed to intangible asset.)
Entry E
Amortization Expense.......................................................
Intangible Asset...........................................................
(To record current years amortization of intangible asset.)
Entry P
Accounts Payable..............................................................
Accounts Receivable...................................................
(To eliminate intra-entity debt.)

110,000

11,000
11,000

28,000
28,000

Entry TA
Equipment..........................................................................
10,000
Gain on Sale of Equipment...............................................
8,000
Accumulated Depreciation.........................................
18,000
(To eliminate effects as of 1/1 created by intra-entity transfer of equipment.)
Entry TI
Sales .................................................................................
90,000
Cost of Goods Sold.....................................................
(To eliminate intra-entity inventory transfers for the current year.)

90,000

Entry G
Cost of Goods Sold...........................................................
6,000
Inventory.......................................................................
6,000
(To defer unrealized intra-entity gain remaining at the end of the current year.
Markup is 33% [30,000 gross profit 90,000 transfer price] indicating that the
ending inventory of 18,000 contains an unrealized profit of 6,000 [18,000 33%].)
Entry ED
Accumulated Depreciation...............................................
2,000
Depreciation Expense.................................................
2,000
(To eliminate excess depreciation resulting from intra-entity gain of 8,000 on
transfer of equipment [see Entry TA]. Equipment is being depreciated over a
remaining life of four years.)

47. (30 minutes) (Consolidated Cash Flow Statement with current year business
combination)
Plaster Inc. and Subsidiary Stucco Company
Consolidated Statement of Cash Flows

6-48

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

For the year ended 12/31/11


Consolidated net income
Depreciation expense
Amortization expense
Decrease in accounts receivable (net of acquisition)
Increase in inventory (net of acquisition)
Decrease in accounts payable (net of acquisition)
Net cash provided by operations

$274,000
187,500
8,750
3,600
(102,000)
(8,000)

89,850
$363,850

Purchase of Stucco Company assets (net of cash acquired)


Net cash used in investing activities

(856,000)

Issue long-term debt


Dividends
Net cash provided by financing activities

$692,000

800,000
(108,000)

Increase in cash 1/1/11 to 12/31/11

$199,850

Beginning cash, 1/1/11


Ending cash, 12/31/11

43,000
$242,850

Excel CaseIntra-entity Bonds


Bonds with a stated rate of 11% sold to yield 12%
Eff. Yield
12%

2009
2010
2011
2012
2013
2014
2015
2016
2017
2018

1,000,000.00
110,000.00
943,497.77
946,717.50
950,323.60
954,362.43
958,885.93
963,952.24
969,626.51
975,981.69
983,099.49
991,071.43
1,000,000.00

0.32197
5.65022
113,219.73
113,606.10
114,038.83
114,523.49
115,066.31
115,674.27
116,355.18
117,117.80
117,971.94
118,928.57

321,973.24
621,524.53
943,497.77
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00

Consolidated Worksheet Entry 12/31/11

6-49

56,502.23
3,219.73
3,606.10
4,038.83
4,523.49
5,066.31
5,674.27
6,355.18
7,117.80
7,971.94
8,928.57
56,502.23

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Bonds Payable
954,362.43
Interest Revenue
117,523.20
Loss on retirement
0.00
Gain on retirement
Investment in Bonds
Interest Expense
Bonds retired by affiliate on 1/1/11 at
Eff. Yield
13%
1,000,000.00
0.37616
110,000.00
4.79877
2011
2012
2013
2014
2015
2016
2017
2018

904,024.59
911,547.79
920,049.00
929,655.37
940,510.57
952,776.95
966,637.95
982,300.88
1,000,000.00

117,523.20
118,501.21
119,606.37
120,855.20
122,266.37
123,861.00
125,662.93
127,699.12

46,299.01
911,547.79
114,038.83
904,024.59
376,159.86
527,864.73
904,024.59
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00

95,975.41
7,523.20
8,501.21
9,606.37
10,855.20
12,266.37
13,861.00
15,662.93
17,699.12
95,975.41

Financial Reporting Research and Analysis Case


The number of potential solutions is large. Searches in Lexis-Nexis, Edgar, etc. will
produce numerous examples of consolidations of VIEs. For example, Walt Disney
Company prepares a before and after disclosure of its consolidated VIEs Euro
Disney and Hong Kong Disneyland as follows (12-31-08):

Before Euro
Disney and Hong
Kong Disneyland
Consolidation
6-50

Euro Disney, Hong


Kong Disneyland
and Adjustments

Total

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

Cash and cash equivalents


Other current assets
Total current assets
Investments
Fixed assets
Other assets
Total assets
Current portion of borrowings
Other current liabilities
Total current liabilities
Borrowings
Deferred income tax and other liabilities
Minority interests
Shareholders' equity
Total liabilities and shareholders' equity

$2,308
8,346
10,654

$693
319
1,012

$ 3,001
8,665
11,666

2,286
12,793
31,679
$57,412

(723)
4,739
57
$5,085

1,563
17,532
31,736
$62,497

3,030
7,357
10,387

499
705
1,204

3,529
8,062
11,591

7,903
5,945
854
32,323
$57,412

3,207
184
490
-0$5,085

11,110
6,129
1,344
32,323
$62,497

6-51