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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, sometimes 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 with a primary beneficiary is addressed by FASB ASC
subtopic 810-10 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. If a reporting entity has a controlling financial interest in a variable interest entity, it should
include the assets, liabilities, and results of the activities of the variable interest entity its
consolidated financial statements.

Proposed Accounting Standards Update on Variable Interest Entities


In November 2011 (updated January 2013), the FASB issued a proposed change for
evaluating whether an entity must consolidate a VIE. The proposed accounting standard
update, entitled Principal versus Agent Analysis, would introduce a separate qualitative
analysis to determine whether a reporting entity with the authority to make economic
decisions for a VIE uses its power in a principal or agent capacity. If the decision making
party is a principal (rather than an agent of another party) then it is the controlling party.
Alternatively, if the party that exercises decision-making power acts in the capacity of an
agent, under the proposed guidance that party would not consolidate the VIE. As this
latest FASB proposal demonstrates, the manner in which control is assessed continues to
evolve over time.

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

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.
1. Because the acquisition price will usually differ from the book value of the liability, a
gain or loss has been created by an effective retirement 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. After the year of effective retirement, all intra-entity accounts must be eliminated again in
each subsequent consolidation. However, when the parent uses the equity method, the
parents Investment in Subsidiary account is adjusted in consolidation rather than a gain or
loss account. If the parent employs an accounting method other than the equity method,
then the parents Retained Earnings are adjusted for the prior years income net effects of
the effective gain/loss on retirement.
1. The change in retained earnings is needed because a gain or loss was created in a
prior year by the effective 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. Consolidated net income is the starting point for the cash flow from operating section
including both the parent and noncontrolling interest share.
C. Intra-entity cash transfers are omitted from this statement because they do not occur with
an outside unrelated party.
D. Dividends paid by the subsidiary to the noncontrolling interest are reported as a financing
activity.
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

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.
1. The subsidiary's diluted earnings per share are computed first to arrive at (1) an
earnings figure and (2) a shares figure.
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 net 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 this $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 consolidated net income is allocated across the controlling
interest and the noncontrolling interest does the assignment decision have an impact.
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, an 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 book loss. Therefore,
assigning the $300,000 to the subsidiary directs the impact of their decision to the wrong
party. In effect, the subsidiary had nothing to do with this transaction (as indicated in the case)
so that its share of consolidated net income 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
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

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 agreed to be the acquirer is not justified.
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 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 agreed 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 challenges 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.
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

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.
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 effective retirement as well as later effects on interest caused by amortization
are also included to arrive at an adjustment to the beginning retained earnings (or the
Investment account if the equity method is used) 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 (or the Investment account if the equity method is used). 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 (or the
Investment account if the equity method is used) 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 from the public
market. 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 net 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.

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

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.
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.

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

Answers to Problems
1. C
2. B
3. D
4. A
5. D
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 .......................................
7. C

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

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 .........................

(20,000)
$25,000

($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 Danes income from own operations .......................


Carltons income ......................................................
Eliminate intra-entity interest income ......................
Eliminate intra-entity interest expense ....................
Recognize retirement gain on debt ($209,000 $196,000)
Consolidated net income ....................................

$185,000
105,000
(19,000)
18,000
13,000
$302,000

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

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

12. B Aaron net income .....................................................


Less intra-entity dividends (initial value method) ..
Zeese reported net income ......................................
Gain on extinguishment of debt ($60,200 $56,000)
Eliminate interest expense on "retired" debt
($60,200 10%) ....................................................
Eliminate interest income on "retired" debt
($56,000 12%) ....................................................
Consolidated net income .........................................

$430,000
(8,050) $421,950
164,000
4,200
6,020
(6,720)
$589,450

13. B 30% of $147,000 subsidiary net income; the intra-entity debt effects are
attributed solely to the parent company. 30% x $147,000 = $44,100
14. A For 2014, the adjustment to beginning retained earnings should recognize
the gain on the retirement of the debt, the elimination of the 2013 interest
expense, and the elimination of the 2013 interest income.
Gain on Retirement of Bond:
Original book value .............................................................
20102012 amortization ($600,000 20 yrs. 3 yrs.) .......
Book value, January 1, 2013 ...............................................
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 Debt2013


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 Debt2013


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

$360,000
8,000
$368,000

Adjustment to 1/1/14 Retained Earnings


Recognition of 2013 gain on extinguishment of debt (above) .....
Elimination of 2013 intra-entity interest expense (above)............
Elimination of 2013 intra-entity interest income (above) .............
Increase in retained earnings, 1/1/14
.......................................

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

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

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. B Consideration transferred for preferred stock .............................


Consideration transferred for common stock ..............................
Noncontrolling interest fair value for common ............................
Acquisition-date fair value .............................................................
Acquisition-date book value ..........................................................
Excess fair over book value ...........................................................
to building ..................................................................................
to goodwill ..................................................................................

$214,000
1,253,280
835,520
$2,302,800
(2,174,000)
$ 128,800
63,600
$ 65,200

17. B Parents reported sales ............................................


Subsidiary's reported sales .....................................
Less: intra-entity transfers ......................................
Sales to outsiders ...............................................
Less: increase in receivables ...................................
Cash generated by sales ....................................

$480,000
264,000
(57,600)
$686,400
(37,300)
$649,100

18. B Subsidiarys unamortized fair value of prior to new share issue


(12,000 $49) .......................................................
Parent's ownership ...................................................
Unamortized subsidiary fair value .........................

$588,000
100%
$588,000

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

$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 proportional
ownership remains the same. Because the amount the parent pays will
necessarily equal 80 percent of the increase in the subsidiary's book value,
no separate adjustment by the parent is required.

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

20. C Adjusted acquisition-date sub. fair value at 1/1/14


Consideration transferred ........................................................
Noncontrolling interest acquisition-date fair value ................
Increase in Stamford book value ..............................................
Stock issue proceeds ................................................................
Subsidiary valuation basis 1/1/14 ..................................................
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

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.

(30 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.
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

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).

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

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

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
Consideration transferred by Pantech
Total business fair value
Fair value of VIE net assets
Excess net asset value fair value

$ 60,000
20,000
80,000
100,000
$20,000

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 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 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)
-0-

6-12
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

25. (40 minutes) (Acquisition-date consolidated worksheet for a parent and a


variable interest entity)

Cash
Investment in NetConnect
Capitalized software
Computer equipment
Communications
equipment
Research and
development asset
Patent
Goodwill
Total assets
Long-term debt
Common stock-Access IT
Common stockNetConnect
Retained earnings
Noncontrolling interest
Total liabilities and equity

Access
IT
61,000
1,000,000

Net
Connect
41,000

981,000
1,066,000

156,000
56,000

1,137,000
1,122,000

916,000

336,000

1,252,000

Adjust. & Elim.

NCI

S 65,600
A 934,400

A1,960,000

1,960,000
191,000
376,000
6,140,000

191,000
A 376,000
4,024,000

780,000

(941,000)
(2,660,000)

(616,000)

(423,000)
(4,024,000)

Consideration transferred
Noncontrolling interest fair value
Acquisition-date fair value
Book value
Excess fair over book value
Research and development asset
Goodwill

Consolidated
Balances
102,000

(41,000)
(123,000)
(780,000)

(1,557,000)
(2,660,000)
S
S

16,400
49,200

2,401,600

A 1,401,600
2,401,600

(24,600)
(73,800)
(1,401,600)

(423,000)
(1,500,000)
(6,140,000)

$1,000,000
1,500,000
$2,500,000
(164,000)
$2,336,000
1,960,000
$ 376,000

6-13
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

26. (25 Minutes) (Consolidation entry for three consecutive years to report effects
of intra-entity bond acquisition. Straight-line method used. Parent uses equity
method)
a. Book Value of Bonds Payable, January 1, 2013
Book value, January 1, 2011 .................................................
Amortization20112012 ($5,000 per year
[$50,000 premium 10 years] for two years) ..................
Book value of bonds payable, January 1, 2013 ....................
Book value of 40% of bonds payable
(intra-entity portion), January 1, 2013 .............................
Gain on Retirement of Bonds, January 1, 2013
Purchase price ($400,000 96%) ..........................................
Book value of liability (computed above) .............................
Gain on retirement of bonds .................................................
Book Value of Bonds Payable, December 31, 2013
Book value, January 1, 2013 (computed above) ..................
Amortization for 2013..............................................................
Book value of bonds payable, December 31, 2013 ..............
Book value of 40% of bonds payable (intra-entity portion),
December 31, 2013 ............................................................
Book Value of Investment, December 31, 2013
Book value of investment, January 1, 2013 (purchase price)
Amortization for 2013 ($16,000 discount 8-yr. rem. life) ..
Book value of investment, December 31, 2013 ....................
Intra-entity Interest Balances for 2013
Interest expense:
Cash payment ($400,000 9%) ........................................
Amortization of premium for 2013 ($5,000 per year
40% intra-entity portion) ..........................................
Intra-entity interest expense ............................................
Interest income:
Cash collection ($400,000 9%) ......................................
Amortization of discount for 2013 (above) .....................
Intra-entity interest income ..............................................

$1,050,000
10,000
$1,040,000
$416,000

$384,000
416,000
$ 32,000

$1,040,000
5,000
$1,035,000
$414,000

$384,000
2,000
$386,000

$36,000
2,000
$34,000

$36,000
2,000
$38,000

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

26. (continued)
CONSOLIDATION ENTRY B (2013)
Bonds Payable .......................................................... 400,000
Premium on Bonds Payable ..................................... 14,000
Interest Income .......................................................... 38,000
Investment in Bonds..............................................
386,000
Interest Expense ...................................................
34,000
Gain on Retirement of Bonds ..............................
32,000
(To eliminate accounts stemming from intra-entity bonds [balances
computed above] and to recognize gain on the effective retirement of this
debt.)
b. In 2014, 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 removed from the Investment in Hamilton account.
Concurrently, the two interest balances recorded by the individual
companies in 2013 are removed from the Investment in Hamilton because
they occurred after the intra-entity retirement. Gain of $32,000 plus
$34,000 expense removal less $38,000 income elimination yields a
$28,000 credit to the investment account.
CONSOLIDATION ENTRY *B (2014)
Bonds Payable .............................................................. 400,000
Premium on Bonds Payable (net of $2,000 amort.) ........
12,000
Interest Income ..............................................................
38,000
Investment in Bonds (net of $2,000 amorti.) ...............
388,000
Interest Expense .......................................................
34,000
Investment in Hamilton .............................................
28,000
(To remove intra-entity bond accounts that remain on the individual
records of both companies. Both debt and bond investment balances
have been adjusted for 201313 amortization. Entry to Investment in
Hamilton 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 the Investment in Hamilton
takes into account that another year of interest expense ($34,000) and
income ($38,000) have been incorporated into the investment account
through application of the equity method.

6-15
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

26. (continued)
CONSOLIDATION ENTRY *B (2015)
Bonds Payable ....................................................
Premium on Bonds Payable ...............................
Interest Income ....................................................
Investment in Bonds ......................................
Interest Expense ............................................
Investment in Hamilton ..................................

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 bond investment balances
have been adjusted for 20132015 amortization. Credit to Investment in
Hamilton brings the totals reported by the individual companies to the
balance of the original gain.)
27.

(12 Minutes) (Determine consolidated income statement accounts after


acquisition of intra-entity bonds.)

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)

6-16
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

28.

(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 ($760,000 1/5) ..........................
Loss on repurchase .......................................

$201,000
152,000
$ 49,000

Interest Balances for 2013


Interest income:
$201,000 7% ...........................................

$14,070

Interest expense:
$152,000 (book value [above]) 12% .....

$18,240

Investment in Bonds Balance, December 31, 2013


Original cost, 1/1/13 ........................................
Amortization of premium:
Cash interest ($180,000 9%) .................
$16,200
Effective interest income (above) ...........
14,070
Investment in Bonds, 12/31/13 .......................
Bonds Payable Balance, December 31, 2013
Book value, 1/1/13 (above) ............................
Amortization of discount:
Cash interest ($180,000 9%) .................
Effective interest expense (above) ..........
Bonds payable, 12/31/13 ................................

$201,000

2,130
$198,870

$152,000
$16,200
18,240

2,040
$154,040

Entry B12/31/13
Bonds Payable ...............................................
154,040
Interest Income ..............................................
14,070
Loss on Retirement of Debt ..........................
49,000
Investment in Bonds ................................
198,870
Interest Expense .......................................
18,240
(To eliminate intra-entity debt holdings and recognize loss on
retirement.)
b. Interest Balances for 2014 followed by 2015
Interest income: $198,870 (Investment in Bonds
balance for the year) 7% (rounded).......................

$13,921

Interest expense: $154,040 (liability balance


for the year) 12% (rounded) ...................................

$18,485

6-17
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

28. (continued)
Investment in Bonds Balance, December 31, 2014
Book value, January 1, 2014 (part a) .......................
Amortization of premium:
Cash interest ($180,000 9%) ............................
Effective interest income (above) ......................
Investment in Bonds balance, December 31, 2014 .
Bonds Payable Balance, December 31, 2014
Book value, January 1, 2014 (part a) .......................
Amortization of discount:
Cash interest ($180,000 9%) ............................
Effective interest expense (above) ....................
Bonds payable balance, December 31, 2014 ..........

$198,870
$16,200
13,921

$154,040
$16,200
18,485

Interest Balances for 2015


Interest income: $196,591 (Investment in Bonds....
balance for the year [above]) 7% (rounded)

Bonds Payable Balance, December 31, 2015


Book value, January 1, 2015 (above) ......................
Amortization of discount:
Cash interest ($180,000 9%) ............................
Effective interest expense (above) ....................
Bonds payable balance, December 31, 2015 ..........

2,285
$156,325

$13,761

Interest expense: $156,325 (liability balance


for the year [above]) 12% ................................
Investment in Bonds Balance, December 31, 2015
Book value, January 1, 2015 (above) ......................
Amortization of premium:
Cash interest ($180,000 9%) ............................
Effective interest income (above) ......................
Investment in Bonds balance, December 31, 2015 .

2,279
$196,591

$18,759

$196,591
$16,200
13,761

2,439
$194,152

$156,325
$16,200
18,759

2,559
$158,884

6-18
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

28. (continued)
Adjustment Needed to Investment in Zack for Bond Retirement Loss:
Loss on retirement of debt (part a) ............................................
Amounts recognized in previous years:
Interest income:
2013 $(14,070)
2014
(13,921)
$(27,991)
2013
$18,240
2014
18,485
36,725
Adjustment needed to Investment
in Zack to arrive at consolidated total ..................................

$49,000

Interest expense:

8,734
$40,266

Entry *B12/31/15
Bonds Payable ..........................................................
Interest Income .........................................................
Investment in Zack ...................................................
Investment in Bonds ...........................................
Interest Expense .................................................

158,884
13,761
40,266
194,152
18,759

(To eliminate intra-entity bond holdings and adjust the Investment in Zack
for the unrecognized loss on retirement. Amounts computed above.)
Many of the above amounts can also be determined using amortization tables as
shown below.
Investment in Bonds Amortization Table:

Cash
2013
2014
2015

16,200
16,200
16,200

Interest
Revenue Amortization
14,070
13,921
13,761

2,130
2,279
2,439

Carrying
Value
201,000
198,870
196,591
194,152

Intra-Entity Portion of Bonds Payable Amortization Table:

Cash
2013
2014
2015

16,200
16,200
16,200

Interest
Expense
18,240
18,485
18,759

Amortization
(2,040)
(2,285)
(2,559)

Carrying
Value
152,000
154,040
156,325
158,884

6-19
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

29. (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)
($443,497 50%) ..........................................................................
Loss on retirement ............................................................................

$283,550
(221,749)
$61,801

SCHEDULE 1Book Value of Bonds Payable

Date
2011
2012
2013

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 price12/31/13 .........................................
Cash interest ($250,000 10%) ...............................
Effective interest income ($283,550 8%) ..............
Amortization ........................................................
Investment in Bloom bonds, 12/31/14 .....................
Bonds Payable
Book value12/31/13 (computed above) ...............
Cash interest ($500,000 10%) ...............................
Effective interest expense ($443,497 12%) ..........
Amortization ........................................................
Bonds payable, 12/31/14 ..........................................

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 12/31/14 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 (2014)
Bonds Payable ($446,717 50%) ............................
Interest Income .........................................................
Retained Earnings, 1/1/14 ........................................
Interest Expense ($53,220 50%) ......................
Investment in Bloom Bonds ...............................

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

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

29.(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 price1/1/11 .........................................................
Discount amortization (20112013) ([$64,237 11] 3 years) ..
Book value 12/31/13 ....................................................................

$435,763
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 price12/31/13 ...........................................................
Premium amortization (2014) ($33,550 8) ...............................
Book value 12/31/14 ...............................................................

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

Interest Income
Cash interest ($250,000 10%) ..................................................
Premium amortization (above) ...................................................
Intra-entity interest income2014 ........................................

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

Bonds Payable
Original issue price 1/1/11 ...........................................................
Discount amortization (20112014) [($64,237 11) 4 years] .
Book value 12/31/14 ...............................................................
Opus ownership .....................................................................
Intra-entity portion12/31/14 ..........................................

$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 expense2014 ......................................

$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 (2014)
Bonds Payable ..........................................................
Interest Income .........................................................
Retained Earnings, 1/1/14 .......................................
Interest Expense ................................................
Investment in Bloom Bonds ...............................

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

6-21
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

30. (8 Minutes) (Determine goodwill for an acquisition in which subsidiary has both
common stock and preferred stock)
Consideration transferred for common stock
Consideration transferred for preferred stock
Noncontrolling interest in common stock
Noncontrolling interest in preferred stock
Hepners acquisition-date fair value
Book value of Hepner
Goodwill

$1,600,000
630,000
400,000
270,000
$2,900,000
2,500,000
$400,000

31. (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 ........................................................... $14,040,000
Noncontrolling interest fair value (preferred shares) ................
2,000,000
Acquisition-date fair value of Smith ........................................... 16,040,000
Book value ................................................................................... (16,000,000)
Franchises .................................................................................... $ 40,000
Period of amortization .................................................................
40 years
Annual amortization ....................................................................
$1,000
Investment in Smith Account, December 31, 2014
Consideration transferred, January 1, 2014 .............................. $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 2014 (above) ....................................................
(1,000)
Investment in Smith account, December 31, 2014..................... $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, 1/1/14 (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)

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

31. c. (continued)
Entry I

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


289,000
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 Declared ........................................
200,000
(To remove intra-entity dividend declarations 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].)

32. (30 Minutes) (Prepare consolidation entries for an acquisition 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 acquisition-date


fair values, and record outside ownership of subsidiary's preferred stock at
acquisition-date fair value)
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

32. (continued)
Entry I1
Dividend Income .......................................................
80,000
Dividends Declared .............................................
80,000
(To offset intra-entity preferred stock dividends recognized as income by
parent $1,000,000 par value 8% dividend rate.)
Entry I2
Dividend Income .......................................................
192,000
Dividends Declared .............................................
192,000
(To eliminate intra-entity dividends [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 2014 amortization of specific accounts
recognized within acquisition price of preferred stock.)

40,000
14,000

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

33. (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 method in presenting cash flows from operating activities, the
$12,000 gain is not presented. However, if the indirect method is used, 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 method to present cash flows from operating activities, this expense
not presented. If the indirect method is used, the expense must be removed
by adding it back to consolidated net income.

Decrease in accounts payable. Cash payments have reduced this liability


balance during the period. If the direct method is used to present cash flows
from operating activities, 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 method is applied, the decrease is subtracted from net income in
arriving at the net cash generated from operating activities during the period.

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

34. (20 Minutes) (Determine cash flows from operations for a consolidated entity.)
DIRECT METHOD
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) ..............
-0Net cash flow from operating activities ...................................
$238,000
INDIRECT METHOD
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 .................................................
Net cash flow from operating activities .............................

$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

6-26
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

35. (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 net income ...................................
Street's reported net 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 net 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
Diluted earnings per share ($290,000 68,000) .....

$4.26

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

36. (15 Minutes) (Compute diluted EPS. Subsidiary has stock warrants outstanding)
Figures For Sonston's Diluted 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 diluted 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


37. (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 .........................................
Shares outstanding
80,000
Assumed conversion of bonds
30,000
Subsidiary shares for parents share of diluted earnings

$290,000
56,000
$346,000

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 ............................................................. $480,000
Dividends to Garfun's preferred stock ................................. (15,000)
Net Income included from Simon (above) ........................... 252,580
Earnings for diluted EPS.................................................. $717,580
PARENTS DILUTED EARNINGS PER SHARE = $717,580 80,000 = $8.97 (rounded)

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

38. (35 Minutes) (Compute basic and diluted earnings per share for parent
company. Subsidiary has stock warrants and convertible bonds.)
Basic EPSParent Company (Burks):
Reported net income (separate)Burks ........................
Foreman net income: 80% ($120,000 $40,000 amort.)........
Preferred stock dividends (8,000 $4) .............................
Burks earnings applicable to basic EPS .......................

$150,000
64,000
(32,000)
$182,000

Burks' outstanding shares ..............................................


Basic earnings per share ($182,000 65,000) ...................

65,000
$ 2.80

Diluted EPSParent Company (Burks)


Subsidiary income for Burks EPS:
Net income after amortization ($120,000 40,000) ............
Interest (net of tax) saved assuming bond conversion ..
Income applicable to diluted EPS ..............................

$80,000
45,000
$125,000

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


Assumed conversion of warrants ...................................
Assumed acquisition of treasury stock with
proceeds of conversion [(20,000 $15) $20] ............
Assumed conversion of bonds .......................................
Shares applicable to diluted EPS ..............................

(15,000)
10,000
55,000

Shares controlled by parent:


(40,000 80%) plus (10% 10,000) ............................

33,000

Income used in diluted EPS computation ......................


Portion owned by parent (33,000 55,000) .......................
Subsidiary income applicable to parentdiluted EPS .

$125,000
60%
$ 75,000

Earnings applicable to Burks diluted EPS:


Reported net income (separate) Burks ........................
Less: 10% intra-entity interest revenue (net of tax)........
Burks income for diluted EPS .........................................
Burks share of Foreman income (above) ......................
Because of assumed conversion, preferred stock
dividends would not be paid ......................................
Earnings applicable to diluted EPS ................................

40,000
20,000

$150,000
(4,500)
$145,500
$ 75,000
-0$220,500

Burks' outstanding shares ..............................................


Assumed conversion of preferred stock (8,000 4) .......
Shares applicable to diluted EPS ....................................

65,000
32,000
97,000

Diluted earnings per share ($220,500 97,000)(rounded) =

$ 2.27

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

38. (continued)
Alternative derivation of Burks diluted EPS:
Consolidated net income $150,000 + ($120,000 - $40,000)
$(230,000)
Consolidated interest saved (net of 10% intra-entity interest)
(40,500)
Consolidated net income assuming bond conversion
(270,500)
Subsidiary net income
$(120,000)
Excess fair value amortization
40,000
Subsidiary interest saved (100%)
(45,000)
Income applicable to diluted EPS
$(125,000)
Noncontrolling interest share (22,000 55,000)
40%
(50,000)
Parent's net income applicable to diluted EPS
$(220,500)
Shares for diluted EPS

97,000

Diluted EPS ($220,500 97,000 shares)

$ 2.27

39. (8 Minutes) (Effect of subsidiary stock issuance to public at a price above


reported value per share)
Equity method investment prior to Ricardo share issue
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)

40. (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
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

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

40.(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

41. (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 acquisition-date 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) ..........
Acquisition-date book value ...........................................................
Fair value in excess of book value ................................................
Allocated to land based on fair value ............................................
Allocated to copyrights based on fair value .................................
Life of copyrights ...........................................................................
Annual amortization .......................................................................

$649,000
(480,000)
$169,000
89,000
$ 80,000
16 yrs
$ 5,000

Adjustment for Stock Transaction


Adjusted acquisition-date fair value of subsidiary
on new issue date ($649,000 + $90,000 + $152,000) ...............
$891,000
Adjusted parent ownership (18,000 shares 24,000 shares) .....
75%
Parents post-issue equity method value at 1/1/14 ................
$668,250
Equity method balance before new subsidiary stock issue
Consideration transferred .......................................... 584,100
Increase in book value (90% $100,000) ..................
90,000
Copyright amortization ($5,000 2 years 90%) .....
(9,000) 665,100
Required increase (Entry C1) ........................................................
$ 3,150

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

41. (continued)
Consolidation worksheet entries:
Entry *C
Investment in Siedel .................................................
Retained Earnings, 1/1/14 (Aronsen) .................

81,000
81,000

(To convert 1/1/14 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, 1/1/14 (Siedel) ..........................
Investment in Siedel (75%) .................................
Noncontrolling Interest in Siedel, 1/1/14 (25%) ..

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

(To eliminate subsidiary stockholders' equity accounts


against Investment account and to recognize noncontrolling
interest. Stockholdersequity balances have been adjusted
for increase in book value during 20122013 and the issuance
by the subsidiary of 4,000 shares of stock on 1/1/14.)
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
20122013 amortization to arrive at 1/1/14 balance.
NCI now reflects 25% of the unamortized 1/1/14 balance.)
Entry I
Dividend Income .......................................................
Dividends Declared .............................................

15,000
15,000

(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.)


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

42. (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 2015) 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 2015 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.

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

42.(continued)

Pavin and Stabler


Consolidation Worksheet
Year Ending December 31, 2015

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, 1/1/15 .....................


Retained earnings, 1/1/15 .....................
Net income (above) ...............................
Dividends declared ...............................
Retained earnings, 12/31/15 .................

(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 .............................


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)

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)

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

43. (45 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 1/1/14 (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 profit2013 ...........................................
Transfer price2013 ................................................
Markup ($25,000 $125,000) ....................................
Unrealized gain in 1/1/14 inventory
($40,000 20%) ....................................................

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

Entry S
Common Stock (Herman) .........................................
100,000
Retained Earnings, 1/1/14 (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.)

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

43. a. (continued)
Entry A
Patents ....................................................................
75,000
Customer List ............................................................
104,000
Investment in Herman .........................................
107,400
Noncontrolling Interest .......................................
71,600
(To recognize unamortized balances as of 1/1/14 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)
2013 intra-entity inventory gross profit .........................
8,000
2014 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 Declared .............................................
(To eliminate intra-entity dividend declaration.)
Entry E
Amortization Expense ..............................................
Patents ..................................................................
Customer List .......................................................
(To recognize current year amortization expense.)

3,000

2,400
2,400

20,500

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

7,500
13,000

60,000

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

43. a. (continued)
Entry B
Bonds Payable ..........................................................
Premium on Bonds Payable ....................................
Interest Income .........................................................
Investment in Parent Bonds ...............................
Interest Expense .................................................
Gain on Retirement of Bonds ..............................

20,000
1,069
1,873
19,005
1,283
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 intra-entity inventory profits until 2014 as calculated below):
Intra-entity profit .......................................................................
Transfer price 2014 ...................................................................
Markup ($30,000 $120,000) ....................................................
Unrealized gain in ending inventory ($30,000 25%) ............

$30,000
$120,000
25%
$7,500

b. Herman's reported net income for 2014 ..................................


Excess fair value amortization .................................................
2013 unrealized gain recognized in 2014 (Entry *G) ..............
2014 unrealized gain (Entry G) .................................................
Herman's realized net income for 2014 ....................................
NCI ownership ...........................................................................
NCIs share of the subsidiary's net income .............................

$25,000
(20,500)
8,000
(7,500)
$5,000
40%
$2,000

Noncontrolling interest, 1/1/14 (Entries S and A) ...................


NCIs share of Herman's net income (above) .........................
NCIs share of Herman's dividends ($4,000 40%) ................
Noncontrolling interest, 12/31/14 ..............................................

$228,400
2,000
(1,600)
$228,800

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

43. (continued)
c. The balances in the individual records as of December 31, 2015 pertaining to
the Intra-entity bonds are as follows:

Investment
Liability

Beginning
Book
Value
(see part a.)

Effective
Interest

$19,005
21,069

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

Cash
Interest
(8%)

$1,600
1,600

Excess
Amortizations

$301
336

Year-End
Book
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 2014
(see part a) ................................................................
Interest expense recorded on liability in 2014
(see part a) ...............................................................
Required increase as of January 1, 2015 .....................
Entry *B (as of December 31, 2015)
Bonds Payable ...........................................................
Premium on Bonds Payable ....................................
Interest Income .........................................................
Investment in Herman .........................................
Investment in Freds bonds ................................
Interest Expense .................................................

$2,654
$1,873
1,283

590
$2,064

20,000
733
1,901
2,064
19,306
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.)

6-38
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

44. (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 ..................
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 ..........................................

$552,800
65,000
138,200
34,000
$790,000
750,000
$ 40,000

CONSOLIDATION ENTRIES 1/1/13


Entry S and A combined:
Preferred Stock (Lisa) ..............................................
Common Stock (Lisa) ...............................................
Retained Earnings, 1/1/13 (Lisa) ..............................
Franchises .................................................................
Investment in Lisa-Common Stock ...............
Investment in Lisa-Preferred Stock ...............
Noncontrolling Interest in Lisa, Inc ...............

100,000
200,000
450,000
40,000
552,800
65,000
172,200

(To eliminate subsidiary stockholders equity, record excess acquisition-date


fair values, and record outside ownership of subsidiary's preferred and
common stock at acquisition-date fair values.)
b. Acquisition price of bonds, 1/2/13 ..........................
Book value of bonds payable (one-half acquired) .
Loss on extinguishment of debt ........................
Interest incomeMona ($53,310 8%) ...................
Interest expenseLisa ($44,175 14%) .................
Investment in bonds of Lisa (book value):
Book valuedate of acquisition, 1/2/13 ............
Cash interest ($50,000 10%) ............................
Effective interest (above) ....................................
Investment in Bonds of Lisa
(book value as of 12/31/13) ...........................

(rounded)
(rounded)

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

$5,000
4,265

735
$52,575

6-39
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

44. b. (continued)
Bonds payable (book value)
Book valuedate of acquisition, 1/2/13 ............
Cash interest ($50,000 10%) ............................
Effective interest (above) ....................................
Bonds payable (book value as of 12/31/13) ..
CONSOLIDATION ENTRY BDecember 31, 2013
(all figures computed above)
Bonds Payable ..........................................................
Interest Income (or other revenues) .......................
Loss on Retirement of Bonds ..................................
Discount on Bonds Payable ($50,000 $45,360)
Interest Expense ..................................................
Investment in Bonds of Lisa ..............................

$44,175
$5,000
6,185

1,185
$45,360

50,000
4,265
9,135
4,640
6,185
52,575

c. December 31, 2013 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, 2013 book values based on transfer price:
Cost of fixed assets ..................................................
$120,000
Depreciation expense (10-year life) ........................
12,000
Accumulated depreciation .......................................
12,000
Gain on transfer of fixed assets
($120,000 $40,000) book value ........................
80,000
CONSOLIDATION ENTRY TADecember 31, 2013
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

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

44. (continued)
d. Original allocation to franchises (given) ......................
Amortization at $1,000/year (20132014) ................
Consolidated franchises12/31/14 ........................
Fixed assets (book values):
Mona, Inc. ..................................................................
Lisa Co. ....................................................................
Reduction necessitated by intra-entity sale
($120,000 transfer price reduced to $100,000
original cost) (see part c) ....................................
Consolidated fixed assets12/31/14 ......................
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 2013 and 2014) ......................
Consolidated Acc. Depr.12/31/14..........................
Expenses (book values):
Mona, Inc...............................................................
Lisa Co. ................................................................
Recognition of amortization on franchises ............
Elimination of interest expense on intercompany debt ($45,360 [see part b] 14%) (rounded)
Elimination of excess depreciation from
intra-entity transfer of fixed assets
($12,000 $4,000) .................................................
Consolidated expenses ...........................................

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

$1,100,000
800,000

(20,000)
$1,880,000

$300,000
200,000

44,000
$544,000

$220,000
120,000
1,000
(6,350)

(8,000)
$326,650

6-41
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

45. (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.)
BOLERO COMPANY AND CONSOLIDATED SUBSIDIARY RIVERA
Consolidated Statement of Cash Flows
Year Ending December 31, 2015
CASH FROM OPERATING ACTIVTIES
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 ...........................
Net cash flow from operating activities ..................

$250,000
120,000
(30,000)
20,000
(150,000)
(50,000)
$160,000

CASH FLOWS FROM INVESTING ACTIVITIES


Sale of building .........................................................
Purchase of equipment (given) ................................
Net cash flow from investing activities ..............

$70,000
(205,000)

CASH FLOWS FROM FINANCING ACTIVITIES


Dividends paid ..........................................................
Issuance of bonds ....................................................
Issuance of common stock ......................................
Net cash flow from financing activities .............

$(112,000)
110,000
67,000

Net increase in cash during 2015 .................................


Cash, January 1, 2015 ...................................................
Cash, December 31, 2015 ..............................................

(135,000)

65,000
90,000
90,000
$180,000

The above statement uses the indirect method for computing cash flows from
operations.

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

45. (continued)
Development of Cash Flow Balances via Direct Method
OPERATING ACTIVITIES
Cash collected from customers (consolidated revenues
plus the decrease in accounts receivable) ................................... $1,050,000
Cash Purchases (consolidated COGS plus
increase in inventory plus
decrease in accounts payable) ...................................................... (850,000)
Interest expense (the consolidated balance) .....................................
(40,000)
Cash flows from operating activities .................................................. $ 160,000
INVESTING ACTIVITIES
Sale of building ($40,000 book value sold at a $30,000 gain)............ $ 70,000
Purchase of equipment (given in problem) ........................................ (205,000)
Cash flows from investing activities ................................................... $(135,000)
FINANCING ACTIVITIES
Dividends paid by parent (the consolidated balance) ...................... $(110,000)
Dividends paid by subsidiary (amount paid to
noncontrolling interest20%) .......................................................
(2,000)
Issuance of bonds ...............................................................................
110,000
Issuance of common stock by the parent (increase in
common stock and additional paid-in capital) .............................
67,000
Cash flows from financing activities ................................................... $ 65,000

6-43
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

46. (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 ........................................
Earnings applicable to Austins basic EPS ............

$284,000
(40,000)
$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
Net 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%

Net income applicable to parentdiluted EPS


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

$75,438

Austins income and shares for diluted EPS calculation:


Austins separate net income ........................................
$200,000
Net income of Rio Grande to parent (computed above)
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 ($275,438 70,000) ................

$3.93

(rounded)

75,438

20,000
70,000
(rounded)

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

47. (50 Minutes) (Determine consolidated totals. Subsidiary has preferred shares
outstanding that are equity instruments.)
Consideration transferred for common and preferred stock
Skylers book value
Excess fair value assigned to intangible asset (10-year life)

$560,000
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

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

47. (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, 2014
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 declared ........................
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

(140,000)
(240,000)
-0(620,000)
(210,000)
(440,000)
(1,650,000)

(90,000)
(180,000)
(100,000)
(200,000)
-0(160,000)
(730,000)

Accounts payable ..........................


Long-term liabilities .......................
Preferred stock...............................
Common stock ...............................
Additional paid-in capital...............
Retained earnings, 12/31 ...............
Total liab. and stockholders equity

(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)

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

28,000

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

715,000

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

715,000

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

6-46
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

47. (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 Declared = $60,000 (parent balance only)
Retained Earnings, 12/31 = $427,000 (consolidated beginning retained
earnings plus net income less dividends declared)
Cash = $70,000 (add book values)
Accounts Receivable = $372,000 (add book values after eliminating intraentity balance)
Inventory = $434,000 (add book values after eliminating unrealized gain)
Investment in Skyler Corporation = 0 (intra-entity account is eliminated
because individual asset and liability accounts of subsidiary are 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)

6-47
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

47. (continued): Consolidation entries and explanations:


Entry S
Preferred Stock (Skyler) ...................................................
Common Stock (Skyler) ...................................................
Retained Earnings, 1/1 .....................................................
Investment in Skyler Corp. .........................................
(To eliminate subsidiary stockholders equity accounts.)

100,000
200,000
150,000
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.)

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

48. (30 minutes) (Consolidated Cash Flow Statement with current year business
combination)
Plaster Inc. and Subsidiary Stucco Company
Consolidated Statement of Cash Flows
For the year ended 12/31/14
CASH FLOW FROM OPERATING ACTIVITIES
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 flow provided by operating activities

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

89,850
$363,850

CASH FLOW FROM INVESTING ACTIVITIES


Purchase of Stucco Company assets (net of cash acquired)
Net cash flow used in investing activities

(856,000)

CASH FLOW FROM FINANCING ACTIVITIES


Issue long-term debt
Dividends
Net cash flow provided by financing activities

$692,000

800,000
(108,000)

Increase in cash 1/1/14 to 12/31/14

$199,850

Beginning cash, 1/1/14


Ending cash, 12/31/14

43,000
$242,850

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

Excel CaseIntra-entity Bonds


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

2012
2013
2014
2015
2016
2017
2018
2019
2020
2021

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

321,973.24
621,524.53
943,497.77

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

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 12/31/14


Bonds Payable
954,362.43
Interest Income
117,523.20
Loss on Retirement
0.00
Gain on Retirement
Investment in Bonds
Interest Expense

46,299.01
911,547.79
114,038.83

Bonds retired by affiliate on 1/1/14 at


Eff. Yield
13%
1,000,000.00
0.37616
110,000.00
4.79877

2014
2015
2016
2017
2018
2019
2020
2021

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

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

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

6-50
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues

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, Hong Kong Disneyland, and Shanghai Disney Resort as follows (9-29-12):

Cash and cash equivalents


Other current assets
Total current assets

Before International International


Theme Parks
Theme Parks
Consolidation
and Adjustments
$2,839
$548
10,066
256
12,905
804

Investments/Advances
Fixed assets
Other assets
Total assets
Current portion of borrowings
Other current liabilities
Total current liabilities
Borrowings
Deferred income tax and other liabilities
Equity
Total liabilities and equity

Total
$ 3,387
10,322
13,709

6,065
17,005
36,949
$72,924

(3,342)
4,507
5
$1,974

2,723
21,512
36,954
$74,898

3,614
8,742
12,356

-0457
457

3,614
9,199
12,813

10,430
9,325
40,813
$72,924

267
105
1,145
$1,974

10,697
9,430
41,958
$74,898

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