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Chapter Six

Variable Interest Entities,

Consolidated Cash Flows, and Other
Issues

Advanced Accounting, 15e

Hoyle | Schaefer | Doupnik
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Learning Objective 6-1

Describe a variable interest entity, a

primary beneficiary, and the factors used
to decide when a variable interest entity
is subject to consolidation.

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Variable Interest Entities (VIEs)

 Commonly known as special purpose entities (SPEs).
 Most VIEs are established for valid business purposes.
 Established as a separate business structure:
– Trust
– Joint venture
– Partnership
– Corporation
 VIEs sometimes have no independent management or
employees.

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Variable Interest Entities (VIEs)

(continued)
 Common examples of VIE activities:
– Transfers of financial assets
– Leasing
– Hedging financial instruments
– Research and development
 Benefits of VIE:
– Often eligible for a lower interest rate
– Low-cost financing of assets
 Governing agreements limit activities and decision
making.
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Variable Interest Entities (VIEs)—

Primary Beneficiary
 Enterprise that created VIE may not own any of its
voting stock.
 Prior to current consolidation requirements, enterprises
left VIEs unconsolidated in their financial reports.
 Primary beneficiary typically exercises its financial
control through governance documents or contractual
agreements giving it decision-making authority over the
VIE.
 Primary beneficiary must consolidate in its financial
statements the VIE’s assets, liabilities, revenues,
expenses, and noncontrolling interest.

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Characteristics of VIEs
 VIEs generally have assets, liabilities, and investors with
equity interests.
 Activities are strictly limited.
 Role of equity investors can be minor; they may serve
simply to allow the VIE to function as a legal entity.
 Because they bear relatively low economic risk, investors
may be provided only a small rate of return.
 Another party, e.g., the primary beneficiary, contributes
substantial resources—loans and/or guarantees—to enable
the VIE to secure additional financing to accomplish its
purpose.

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Characteristics of VIEs (continued)

 Primary beneficiary may guarantee the VIE’s debt,
assuming the risk of default.
 Contractual arrangements may limit returns to equity
holders, yet participation rights provide increased profit
potential and risks to the primary beneficiary.
 Beneficiary’s economic interests vary depending on the
VIE’s success—hence the term variable interest entity.
 Risks and rewards are not distributed according to
stock ownership but according to other variable
interests.

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Variable Interest Entities—Risk and

Ownership
 Variable interests increase a firm’s risk as the resources it
provides (or guarantees) to the VIE increase.
 With increased risks come incentives to restrict the VIE’s
decision making.
 A firm with variable interests will regularly limit the
equity investors’ power through the VIE’s governance
documents.
 Investors are the owners of the VIE, but they may retain
little responsibility of ownership risk and benefits.
 Investors may cede financial control of a VIE to the
variable interests in exchange for a guaranteed rate of
return.
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Prior Consolidation of VIEs

 In the past, assets, liabilities, and results of operations
for VIEs and other entities frequently were not
consolidated with those of the firm that controlled the
entity.
 These firms invoked a reliance on voting interests, as
opposed to variable interests, to indicate a lack of a
controlling financial interest.
 As noted by GAAP literature, legacy FASB standard
FIN 46R requires the primary beneficiary (regardless
of their ownership) to consolidate the VIE.

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Examples of VIEs
EXHIBIT 6.1 Examples of Variable Interests

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Identification of a VIE
An entity qualifies as a VIE if either of the following conditions
exists:
 Total equity at risk is not sufficient to permit the entity to
finance its activities without additional subordinated financial
support provided by any parties, including equity holders.
 Equity investors in VIE, as a group, lack any one of 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
entity’s economic performance.
2) The obligation to absorb the expected losses of the entity.
3) The right to receive expected residual returns of the entity.

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Identification of the Primary

Beneficiary of the VIE
 Once a firm has a relationship with a VIE, the firm must
determine whether it qualifies as the VIE’s primary
beneficiary.
 An enterprise with a variable interest with a controlling
financial interest in a VIE is the primary beneficiary and
will have both of the following characteristics:
1) The power to direct the activities of a VIE that most
significantly impact the entity’s economic performance.
2) The obligation to absorb losses that could potentially
be significant to the VIE or the right to receive benefits
from it that could be significant to the VIE.

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Identification of the Primary

Beneficiary of the VIE (continued)
 These characteristics mirror those that the equity investors
often lack in a VIE.
 The primary beneficiary will absorb a significant share of
the VIE’s losses or receive a significant share of the VIE’s
residual returns or both.
 The fact that the primary beneficiary may own no voting
shares whatsoever becomes inconsequential because they
do not effectively give equity investors power to exercise
control.
 Careful examination of the VIE’s governing documents
and who bears risk is necessary to determine whether a
reporting entity possesses control over a VIE.
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Example of a Primary Beneficiary

and Consolidated VIE
 Twin Peaks, a power company, seeks to acquire an
electric generating plant for $400 million to expand its
market share. It expects to sell the electricity
generated by the plant acquisition at a profit to its
owners.
 Twin Peaks’s general credit rating allowed for a 4
percent annual interest rate on a debt issue. It
explored establishing a separate legal entity whose
sole purpose would be to own the electric generating
plant and lease it back to Twin Peaks.

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Example of a Primary Beneficiary

and Consolidated VIE (continued)
 The separate entity will isolate the electric generating
plant from Twin Peaks’s other risky assets and
liabilities and provide specific collateral.
 An interest rate of 3 percent on the debt is available,
producing before-tax savings of $4 million per year.
 To obtain the lower interest rate, however, Twin Peaks
must:
1) Guarantee the separate entity’s debt.
2) Maintain its own predefined financial ratios and
restrict the amount of additional debt it can
assume.
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Power Finance Co. (Part 1)

 Twin Peaks establishes Power Finance Co., designed
solely to own, finance, and lease the electric
generating plant to Twin Peaks.
 The documents governing the new entity specify the
following:
1) The sole purpose of Power Finance is to purchase
the Ace electric generating plant, provide equity
and debt financing, and lease the plant to Twin
Peaks.
2) An outside investor will provide $16 million in
exchange for a 100 percent nonvoting equity
interest in Power Finance.
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Power Finance Co. (Part 2)

3) Power Finance will issue debt in exchange for $384
million. Twin Peaks guarantees the debt because the
$16 million equity investment is insufficient to attract
low-interest debt financing.
4) Twin Peaks will lease the electric generating plant
from Power Finance in exchange for payments of $12
million per year based on a 3 percent fixed interest
rate for the debt and equity investors for an initial
five-year lease term.

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Power Finance Co. (Part 3)

5) At the end of the five-year lease term (or any
extension), Twin Peaks must do one of the following:
• Renew the lease for five years subject to the
approval of the equity investor.
• Purchase the electric generating plant for $400
million.
• Sell the electric generating plant to an independent
third party. If the proceeds of the sale are
insufficient to repay the equity investor, Twin
Peaks must make a payment of $16 million to the
equity investor.
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Power Finance Co. (Part 4)

Exhibit 6.2 Variable Interest Entity to Facilitate Financing

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Conditions for Consolidation of Twin Peaks

Electric Company and Power Finance Company

In evaluating whether Twin Peaks Electric Company

must consolidate Power Finance Company, two
conditions must be met:
1) Power Finance must qualify as a VIE by either:
• An inability to secure financing without additional
subordinated support or
• A lack of either the risk of losses or entitlement to
residual returns (or both).
2) Twin Peaks must qualify as the primary beneficiary of
Power Finance.

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Power Finance Company—VIE Status

In assessing the first condition, several factors point to
VIE status for Power Finance:
1) Its owners’ equity comprises only 4 percent of total
assets, far short of the 10 percent benchmark.
2) Twin Peaks guarantees Power Finance’s debt,
suggesting insufficient equity to finance its operations
without additional support.
3) The equity investor appears to bear almost no risk
with respect to the operations of the Ace electric plant.
These characteristics indicate that Power Finance
qualifies as a VIE.
© McGraw Hill LLC. 6-21

Power Finance Company—VIE Status

(continued)
For the second condition for consolidation, an assessment is
made to determine whether Twin Peaks qualifies as Power
Finance’s primary beneficiary.
 Twin Peaks has the power to direct Power Finance’s
activities, but to qualify for consolidation, Twin Peaks
must also have the obligation to absorb losses or the right
to receive returns from Power Finance.
 Twin Peaks will pay a fixed fee to lease the electric
generating plant, operate the plant, and sell the electric
power in its markets.
 If the business plan is successful, Twin Peaks will enjoy
residual profits from operating while Power Finance’s
equity investors receive the fixed fee.
© McGraw Hill LLC. 6-22
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Power Finance Company—VIE Status

(concluded)
 If electricity prices fall, revenues generated may be
insufficient to cover Twin Peaks’s lease payments, but the
VIE equity investors are protected from this risk.
 If the plant’s fair value increases significantly, Twin Peaks
can exercise its option to purchase the plant at a fixed
price and either resell it or keep it for its own future use.
 If Twin Peaks sells the plant at a loss, it must pay the
equity investors all of their initial investment, furthering
the loss to Twin Peaks.
These elements point to Twin Peaks as the primary
beneficiary of its VIE, meaning it must consolidate the VIE’s
assets, liabilities, and results of operations with its own.
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Financial Reporting Principles for Consolidating

VIEs—Initial Measurement Issues
 Financial reporting principles for consolidating VIEs
require asset, liability, and noncontrolling interest
valuations.
 These valuations initially, with few exceptions, are
based on fair values.
 If the total business fair value of the VIE exceeds the
collective fair values of its net assets, goodwill is
recognized.

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Initial Measurement Issues—

Collective Fair Values
 If the collective fair values of the net assets exceed the
total business fair value, the primary beneficiary
recognizes a gain on bargain purchase.
 Assuming that the debt and noncontrolling interests
are stated at fair values, Twin Peaks includes in its
consolidated balance sheet:
 Electric Generating Plant at $400 million.
 Long-Term Debt at $384 million.
 Noncontrolling interest of $16 million.

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Consolidation of VIEs Subsequent to

Initial Measurement
 After the initial measurement, all intra-entity
transactions between the primary beneficiary and
the VIE must be eliminated in consolidation.
 VIE’s income must be allocated among the parties
involved (equity holders and the primary
beneficiary).
 The distribution of income is typically specified in
contractual arrangements.

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Learning Objective 6-2

Demonstrate the process to consolidate a

primary beneficiary with a variable
interest entity.

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Consolidation of a Primary
Beneficiary and VIE Illustrated
 Assume that on January 1, 2024, Payton Corporation loans
Vincente, Inc., a business entity $2,200,000 due January 1,
2029.
 Vincente had been unable to secure the financing needed to
continue its operations.
 As part of the loan agreement, Vincente agrees to provide to
Payton during the next five years:
 5 percent annual interest (market rate) on the loan.
 Decision-making power over Vincente’s operating and
financing activities.
 Annual management fee equal to 10% of Vincente’s sales.

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Consolidation of a Primary Beneficiary

and VIE—Agreement Options
At the end of the five-year agreement, Payton has the
option of either:
1) Acquiring ownership of Vincente, Inc., for $500,000 or
2) Extending the original agreement for an additional
five years.
As a result of the agreement, Vincente is a variable
interest entity, and Payton is its primary beneficiary that
requires consolidation.

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Primary Beneficiary and VIE—

Balance Sheets
At January 1, 2024, Payton estimated the fair value of Vicente’s common
stock at $143,000.
The $125,000 difference between the fair value of the common stock and
Vicente’s book value ($143,000 – $18,000) was attributed entirely to the
patented technology with a five-year estimated remaining life.

Payton’s and Vicente’s balance sheets

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Consolidation Worksheet:
Date of Acquisition

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Consolidation Worksheet:
Subsequent to Initial Measurement

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Consolidation Worksheet Process:

Subsequent to Initial Measurement
 Consolidation of a VIE with its primary beneficiary
follows a similar process as if the entity were consolidated
based on voting interests.
 All intra-entity transactions between the primary
beneficiary and the VIE (including fees, expenses, other
sources of income or loss, and intra-entity transfers) must
be eliminated in consolidation.
 Because VIEs typically have noncontrolling interests, an
appropriate allocation of the VIE’s net income requires a
close examination of the underlying contractual
arrangements between the primary beneficiary and other
holders of variable interests.

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Variable Interest Entity Disclosure

Requirements
Enhanced disclosures are required for any enterprise that
holds a variable interest in a VIE, including:
 VIE’s nature, purpose, size, and activities.
 Significant judgments and assumptions an enterprise
makes in determining whether it must consolidate a
VIE and/or disclose information about its involvement
in a VIE.
 Nature of restrictions on a consolidated VIE’s assets
and on the settlement of its liabilities reported by an
enterprise in its statement of financial position,
including the carrying amounts of such assets and
liabilities.
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Variable Interest Entity Disclosure

Requirements (continued)
 Nature of, and changes in, the risks associated with an
enterprise’s involvement with the VIE.
 How an enterprise’s involvement with the VIE affects
the enterprise’s financial position, financial
performance, and cash flows.

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Comparisons with International

Accounting Standards
Under U.S. Generally Accepted Accounting Principles (GAAP)
and International Financial Reporting Standards (IFRS):
 Controlling financial interest is the critical concept in
assessing consolidation by a reporting enterprise and VIEs.
 Current reporting standards differ across these
jurisdictions.
 IFRS has one model for all entities regardless of whether
control is evidenced by voting interests or variable
interests.
 U.S. GAAP has separate models for assessing control for
variable interest entities and voting interest entities.

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Comparisons with International

Accounting Standards (continued)
 Financial Accounting Standard Board (FASB)
continues to deliberate its consolidation policies and
procedures.
 International Accounting Standards Board (IASB)
has issued updated standards IFRS 10, “Consolidated
Financial Statements,” and IFRS 12, “Disclosure of
Interests in Other Entities,” that cover and define
control to encompass all possible ways (voting power,
contractual power, decision-making rights, etc.) in
which one entity can exercise power over another.

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Learning Objective 6-5

Prepare a consolidated statement of cash

flows.

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Consolidated Statement of Cash Flows

 Current accounting standards require that companies
include a statement of cash flows among the
consolidated financial reports.
 Main purpose of the statement of cash flows is to
provide information about the entity’s cash receipts
and cash payments during a period.
 It is also designed to show why an entity’s net income
is different from its operating cash flows.
 A consolidated statement of cash flows is based on the
consolidated balance sheet and consolidated income
statement.
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Acquisition Period Statement

of Cash Flow
 If a business combination occurs during a particular
reporting period, the consolidated cash flow statement
must reflect several considerations.
 Cash purchases of businesses are an investing activity.
The net cash outflow is reported as the amount paid at
acquisition.
 Adjustment to accrual-based income must reflect only
postacquisition amounts for the subsidiary.
 Changes in operating balance sheet accounts (accounts
receivable, inventory, accounts payable, etc.) must be
computed net of the amounts acquired in the
combination.
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Consolidated Statement
of Cash Flows—Adjustments
 Adjustments arising from subsidiary’s revenues or
expenses (e.g., depreciation, amortization) must
reflect only postacquisition amounts.
 Proper presentation of cash flows requires no
special adjustments for intra-entity transfers.
 Subsidiary dividends paid to a noncontrolling
interest are a component of cash outflows from
financing activities.

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Consolidated Statement of Cash Flows—Example (Part 1)

On July 1, 2023, Pinto Company acquires 90 percent of Salida Company’s

outstanding stock for $774,000 in cash. At the acquisition date, the 10 percent
noncontrolling interest has a fair value of $86,000. Information about the
acquisition is presented below:

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Consolidated Statement of Cash Flows—Example (Part 2)

At the end of 2023, the following information is available:

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Consolidated Statement of Cash Flows—Example (Part 3)

Additional Information for 2023

 The consolidated income statement totals include Salida’s
postacquisition revenues and expenses.
 During the year, Pinto paid $50,000 in dividends. On August 1, Salida
paid a $25,000 dividend.
 During the year, Pinto issued $504,000 in long-term debt at par value.
 No asset purchases or dispositions occurred during the year other than
Pinto’s acquisition of Salida.

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Consolidated Statement of Cash Flows—Example (Part 4)

Based on the consolidated totals from the consolidated income statement,

comparative balance sheets and additional information, the following
consolidated statement of cash flows is prepared:

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