Chapter 6:
Variable Interest Entities, IntraEntity Debt, Consolidated Cash
Flows
Prof. Matias A. Sokolowski
1
Variable Interest Entities (VIEs)
•
We have discussed that we consolidate when a company has control
•
This control is generally established when the parent owns more than 50% of another
company
•
However, one entity can control another entity through means other than ownership
•
This type of control can happen with Variable Interest Entities (VIEs), and so the primary
beneficiary must consolidate
Prof. Matias A. Sokolowski
2
Variable Interest Entities (VIEs)
•
VIEs have a well-defined and limited business activity
•
Examples include:
o
o
o
research and development (R&D)
hold an asset and lease the asset back to the enterprise
hold financial assets (stock, bonds, mutual funds, cash)
•
A VIE relies on another entity for financial support (loans, loan guarantees)
•
Equity holders have a limited say in the VIE’s decision-making
o
o
o
The decision-making is governed by an agreement/contract
While equity holders are the legal owners, the variable interest holder is the one that benefits and
takes risks
Equity holders are typically compensated a low amount for holding ownership
Prof. Matias A. Sokolowski
3
Variable Interest Entities (VIEs)
•
•
The primary beneficiary of a VIE
o
has power to direct activities through voting or similar rights
o
has the obligation to absorb losses
o
has the right to receive benefits
The primary beneficiary consolidates the financial statements of the VIE
Prof. Matias A. Sokolowski
4
Variable Interest Entities (VIEs)
•
Why would an enterprise create a VIEs?
•
There are benefits
o
low-cost financing:

The VIE gets financing for the only asset it holds

VIE creditors/lenders are protected (as the VIE only holds one asset)

It can be more difficult to get collateral from the enterprise when there are multiple creditors

Because the lender has lower risk, the borrowing cost is lower
Prof. Matias A. Sokolowski
5
Intra-Entity Debt Transactions
•
In chapter 5, we saw intra-entity asset transactions
o
The takeaway was to remove the gain resulting from the transfer between parent and subsidiary and to
restore the historical cost of the asset
•
We also make adjustments with intra-entity liability transactions
•
We will begin with intercompany loans, but our focus is on bonds
o
For learning purposes bond transactions encompass most accounts also affected by other types of
intra-entity debt transactions
Prof. Matias A. Sokolowski
6
Intra-Entity Debt Transactions
•
Since the parent controls the subsidiary, we view the parent and the subsidiary as one
economic entity
•
Transactions between the parent and subsidiary are transactions within one consolidated
entity and we must eliminate
•
Examples of intra-entity debt transactions include
o
Receivables/Payables AR AP
o
Bonds: most long-term debt for large corporations is in the form of bonds
Prof. Matias A. Sokolowski
7
Intra-Entity Debt Transactions
•
Case of intercompany receivable/payable
o
The parent lent $100,000 to its subsidiary
Parent records:
Accounts Receivable
Subsidiary records:
100,000
Cash
Cash
100,000
100,000
Accounts Payable
100,000
•
Cash cancels on its own (debit and credit cash for $100,000)
•
But the Accounts Receivable and Accounts Payable remain
•
Since this transaction happened within the same consolidated entity (and not with a third party), we must
eliminate the Receivable and Payable for consolidated purposes
•
Worksheet entry:
Accounts Payable
100,000
Accounts Receivable
100,000
•
We have just eliminated the Payable and Receivable
•
In other words, the Payable and Receivable don’t show for consolidated purposes
Prof. Matias A. Sokolowski
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Intra-Entity Debt Transactions
•
Case of bonds
o
o
•
The subsidiary (or parent) issues bonds to the public
The parent (or subsidiary) retires the bonds from the market by purchasing the bonds
Background:
o
o
o
o
o
Why would the parent purchase the bonds?
The parent likely has more cash
Contracts limits the subsidiary from retiring the bonds from the market
Contracts may have set a high price for the subsidiary to retire, and it is cheaper for a related company
to buy at market price
When we retire debt, we evaluate a loss or a gain
Prof. Matias A. Sokolowski
9
Intra-Entity Debt Transactions
•
•
What is the accounting treatment?
o
The subsidiary recognizes a bond liability
o
The parent recognizes an investment in bonds
o
However, on a consolidated entity level, the bonds were purchased and retired from the market. In
other words, on a consolidated level, the consolidated entity does not borrow!
o
So, the account balances related to the bond investment and bond payable must be eliminated to show
one economic unit
Before knowing which accounts to eliminate, we must remind ourselves of how we
account for bonds
Prof. Matias A. Sokolowski
10
Refresher on Bonds
•
Bond: security sold by a corporation to raise money from investors
o
Face value of the bond = amount of principal due at maturity
o
Contractual interest rate (or stated rate or coupon rate) = the rate used to determine the amount of
interest paid by the issuer and received by the investor
o
Hypothetical example: Coca Cola issues bonds with a face value of $1,000, which mature in 10 years
with a contractual rate of 10%. Let’s say you buy two bonds

Each year Coca Cola will pay you $200 ($1,000 * 2 * 10%)

At maturity (after 10 years), Coca will pay you $2,000 when the bonds mature.
Prof. Matias A. Sokolowski
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Refresher on Bonds
•
A company sets an interest rate with the help of an investment bank (and other
specialists)
•
While the company states an interest, the interest rate that investors demand may be
different
That is, stated rate may not equal market rate
So, we have three scenarios
•
•
Prof. Matias A. Sokolowski
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Refresher on Bonds
•
Journal entries on bond issuance date:
o
Face value
Dr.
Cr.
Cash
Bonds Payable
o
Discount
Cash
Discount
Bonds Payable
o
Premium
Cash
Premium
Bonds Payable
Prof. Matias A. Sokolowski
13
Refresher on Bonds
•
Carrying amount (or book value) of the bond is
o
•
Face Value – Discount (or + Premium)
The discount or premium (whichever you have) is amortized during the life of the bond
Bond issued at a discount:
•
Bond issued at a premium:
Therefore, the carrying amount approaches the face value over time
Prof. Matias A. Sokolowski
14
Refresher on Bonds
•
Example: On January 1, 2022, Company ABC issues a $100,000, five-year, 10% bond at 98.
•
Bond issuance (1/1/22)
Cash
Discount on Bonds Payable
98,000
2,000
Bonds Payable
•
100,000
Adjusting journal entry (12/31/22)
Interest Expense
10,400
Discount on Bonds Payable
Cash
o
•
Face value of the bond after this entry is $98,400 (which is 100,000-1,600)
Same AJE at the end of 2023, 2024, 2025, and 2026
o
•
400
10,000
Face value is $98,800 after 2023 AJE; $99,200 after 2024 AJE; $99,600 after 2025 AJE; and $100,000
after 2026 AJE
Payoff:
Bonds Payable
100,000
Cash
Prof. Matias A. Sokolowski
100,000
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Intra-Entity Debt Transactions
• Now, let’s go back to our goal:
• Remove the accounts associated with the bond payable and bond
investment
Prof. Matias A. Sokolowski
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Example
•
Alpha controls Omega.
•
On January 1, 2018, Omega issued $1,000,000 in 10-year bonds paying interest of 9%. Due to market
conditions, the bonds sold at $938,555 to yield a market rate of 10%.
•
On January 1, 2020, Alpha purchased all these bonds in the open market for $1,057,466 (when the carrying
value of the bonds was $946,651). This price was based on a market rate of 8%.
Prof. Matias A. Sokolowski
17
Example
•
Alpha controls Omega.
•
On January 1, 2018, Omega issued $1,000,000 in 10-year bonds paying interest of 9%. Due to market
conditions, the bonds sold at $938,555 to yield a market rate of 10%.
•
On January 1, 2020, Alpha purchased all these bonds in the open market for $1,057,466 (when the carrying
value of the bonds was $946,651). This price was based on a market rate of 8%.
Alpha records:
Omega records:
1/1/2018
Cash
Discount
938,555
61,445
Bonds Payable
1/1/2020
12/31/2020
Investment in Bonds
Cash
Cash
Prof. Matias A. Sokolowski
1,057,466
1,057,466
90,000
Interest Income
Investment in Bonds
1,000,000
Interest Expense
84,597
5,403
94,665
Discount
Cash
4,665
90,000
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Example
•
The above information tells you that the balances as of 12/31/2020 for both companies associated with the
bond are
Omega
Interest Expense
Interest Income
Bonds Payable
Discount on Bonds Payable
Investment in Bonds
Alpha
94,665
84,597
1,000,000
48,684
1,052,063
•
Omega paid $1,057,466 for bonds with a carrying value of $946,651. Therefore there is a loss of $110,815
•
Our worksheet entry to remove the balances associated with the intra-entity liability
Dr.
Bonds Payable
Interest Income
Loss
1,000,000
84,597
110,815
Investment in Bonds
Discount on Bonds Payable
Interest Income
Prof. Matias A. Sokolowski
Cr.
1,052,063
48,684
84,597
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Example
• While this topic is complex, the main take away from the prior example is –
o Remove Interest Expense and Interest Revenue
o Remove Bonds Payable and related account (either Discount or Premium)
o Remove Investment
o Record Gain or Loss associated with the retirement of bonds
Prof. Matias A. Sokolowski
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Good News…
•
I will provide the numbers
•
You have already calculated the present value of future cash flows, the amortization of
discounts (and premiums), and the investment amount using the effective interest rate in
Intermediate Accounting
•
Some of these computations and concepts are also covered in Principles of Accounting
•
Our focus is on eliminating these account balances
Prof. Matias A. Sokolowski
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Intra-Entity Debt Transactions
•
Let’s recap
•
When a company within the consolidated entity acquires the bonds, these bonds must be
treated as repurchases by the issuer
o
o
•
Bonds are not actually retired but for accounting purposes we treat them as retired for consolidation
purposes
Separately, the issuer and the buyer of the bonds will continue to account for the bond
How do we consolidate?
o
o
o
o
The retirement leads to a gain or loss
𝐺𝑎𝑖𝑛 = 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐴𝑚𝑜𝑢𝑛𝑡 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒
Example: Company B has bonds with a carrying amount of $900,000, and Company A pays $1,000,000
900,000 – 1,000,000 = a loss of $100,000
Prof. Matias A. Sokolowski
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Example
•
Company A has had bonds payable of $15,000 outstanding for several years.
•
On January 1, 2021, when there was an unamortized discount of $3,000 and a remaining
life of 4 years, its 80% owned subsidiary, Company B, purchased the bonds in the open
market for $13,000.
The bonds pay 5% interest annually on December 31.
Compute the consolidated gain or loss on a consolidated income statement for 2021.
•
•
Prof. Matias A. Sokolowski
23
Example
•
Company A has had bonds payable of $15,000 outstanding for several years.
•
On January 1, 2021, when there was an unamortized discount of $3,000 and a remaining
life of 4 years, its 80% owned subsidiary, Company B, purchased the bonds in the open
market for $11,000.
The bonds pay 5% interest annually on December 31.
Compute the consolidated gain or loss on a consolidated income statement for 2021.
•
•
Prof. Matias A. Sokolowski
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Example
•
Company A owns Company B.
•
Company A reported net income (without consideration of its investment in Company B) of $420,000 while
the subsidiary reported $180,000 for 2021
•
The subsidiary had bonds payable outstanding on January 1, 2021, with a book value (or carrying amount)
of $320,000.
•
The parent acquired the bonds on that date for $305,000.
•
During 2021, Company A reported interest income of $30,000 while Company B reported interest expense
of $25,000.
•
What is consolidated net income for 2021?
Prof. Matias A. Sokolowski
25
Example
•
Company A owns 90% of Company B
•
Company A reports net income for 2022 (without consideration of its investment in Company B) of
$1,200,000.
•
For the same year, Company B reports net income of $800,000.
•
Company A had bonds payable outstanding on January 1, 2022 with a carrying value of $1,300,000.
•
Company B acquired the bonds on the open market on January 1, 2022 for $1,110,000.
•
For the year 2022, Company A reported interest expense on the bonds in the amount of $102,000, while
Company B reported interest income of $100,000 for the same bonds.
•
What is Company A’s share of consolidated net income?
Prof. Matias A. Sokolowski
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Consolidated Cash Flows
•
We have been consolidating the income statement, statement of retained earnings and
the balance sheet
•
What about the statement of cash flows?
Prof. Matias A. Sokolowski
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Refresher
•
The statement of cash flows shows cash generated from operating, investing, and
financing activities
o
Cash provided or used by operations is a critical number because it indicates whether the firm can
survive and expand
•
The goal is to find out “net cash provided/used by operating activities”
•
We begin with net income and make some adjustments
Prof. Matias A. Sokolowski
28
Refresher
•
Add noncash expenses: these expenses reduce net income but do not involve cash
o
•
Examples: depreciation, amortization, bad debt expense
Remove gains and losses: these do not belong in the operating section
o
Examples: loss/gain on disposal of assets
Prof. Matias A. Sokolowski
29
Refresher
•
Analyze changes in noncash current assets and current liabilities:
o
Subtract increase in current asset: an increase in noncash current assets means that we have less cash
and therefore we subtract from net income

Examples: increase in accounts receivable, increase in inventory
o
Add decrease in current asset
o
Add increase in current liability
o
Subtract decrease in current liability
Prof. Matias A. Sokolowski
30
Example
•
Comparative consolidated balance sheet data for Company A
and its 80% owned subsidiary follow:
Cash
Accounts receivable (net)
Merchandise inventory
Buildings and equipment (net)
Trademark
Totals
Accounts payable
Notes payable, long-term
Noncontrolling interest
Common stock, $10 par
Retained earnings (deficit)
Totals
•
2021
9,550
49,550
82,750
102,000
118,500
362,350
92,600
0
52,800
200,000
16,950
362,350
2020
10,600
22,750
39,750
116,500
136,500
326,100
71,000
31,700
43,000
200,000
(19,600)
326,100
Change
(1,050)
26,800
43,000
(14,500)
(18,000)
36,250
21,600
(31,700)
9,800
36,550
•
Net cash from operating
activities were:
Consolidated net income
$58,750
Add: depreciation
14,500
Add: amortization
18,000
Less: increase in AR
(26,800)
Less: increase in inventory
(43,000)
Add: increase in AP
21,600
Cash flow from operations
$43,050
36,250
Consolidated net income is $58,750, and there were no
purchases or sales of long-term assets during the year.
Prof. Matias A. Sokolowski
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