Exercise B4-1: Variable Interest Entities

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Note: Prior to completing these exercises, it might be worthwhile for you to consult the Glossary in FASB ASC 810-10-20 and provide definitions (in your own words) for the following “terms of art:” Terminology is important in this area…

1. Variable Interests

2. Variable Interest Entity

3. Primary Beneficiary

4. Expected Losses

5. Expected Residual Returns

6. Expected Variability

7. Subordinated Financial Support

Exercise B4-1: Variable Interest Entities – A few scenarios…  

In each of the following scenarios, assume Company A has the described involvements in Entity X and assume that Entity X is a variable interest entity (VIE). Also assume that the involvement identified is the only involvement Company A has with Entity X. Does Company A have a variable interest in Entity X? Please explain your answer.  

1. Company A holds debt that was issued by Entity X.

2. Entity X owns 30 percent of the common stock of Company A

3. Company A is a 40 percent partner in Entity X, a partnership. This entitles Company A to 40 percent of the distributable profits of Entity X.  

4. Company A has provided Entity X a guarantee that Entity X’s sole asset will be worth at least $1 million at the end of five years.

Exercise B4-2: Accounting for Business Ventures

Harold Corp. (“Harold”), a manufacturer of gardening equipment, formed a business venture with Kumar, Inc. (“Kumar”) on January 1, 2018. Kumar is a large agricultural company that is seeking to enter into the gardening equipment business. The venture, Grow-It, a newly formed business with no existing operations, plans to lease large-scale gardening equipment (e.g., large hydroponic systems) to U.S. medicinal herb farmers. Grow-It plans to purchase the equipment from a manufacturer unrelated to either Harold or Kumar (collectively, the venturers) and then lease the equipment to the farmers. The venturers have no relationship with each other aside from this venture. At formation, Grow-It is in the process of collecting regulatory permits and licenses to enter the gardening equipment leasing business and, thus, is a development stage entity.

The board of directors (the Board) has six members: three representatives for Harold and three representatives for Kumar. Board approval is required for ongoing business activities (e.g., selecting, terminating, and setting the compensation of management) and approval of all new contracts in excess of $50,000, including those with new vendors and customers. All Board decisions require a majority vote. Neither venturer has any additional involvement with Grow-It (i.e., no management contracts, service contracts, leases).

Grow-It is formed with initial cash contributions of $55,000 from Harold and $45,000 from Kumar. Ownership, as well as profits and losses, are divided accordingly (55:45).

Required:

1. According to FASB ASC 323-10-20, what kind of entity is Grow-It?

2. How are these entities typically accounted for?  Why?  (For this question, ignore the VIE guidance in FASB ASC 810.)

3. Can either venturer qualify for the business scope exception, which would exempt that investor from the remaining provisions of the VIE subsections of ASC 810-10?

Exercise B4-3, Part A: Determination of VIE

Assume a Legal Entity’s capital structure consists of the following accounts:

Reporting Company A contributed $119,000 for a 70 percent interest in the Legal Entity and Reporting Company B contributed $51,000 for a 30 percent interest in the Legal Entity.  Note that balance sheet classification of mandatorily redeemable preferred stock is covered in FASB ASC 480-10-25-4. Unless otherwise indicated, each of the following parts of this question is independent:     

Required:

1. Assume that Reporting Company B borrowed from an unaffiliated bank $40,000 of its $51,000 capital contribution.  What is the maximum amount of expected losses that the Legal Entity can expect to sustain without being considered a variable interest entity (VIE)? Why?

2. Assume that the Chairman of the Board of Directors of Reporting Entity A paid $35,000 to Reporting Company B for consulting services.  What is the maximum amount of expected losses that the Legal Entity can expect to sustain without being considered a variable interest entity (VIE)? Why?

Exercise B4-3, Part B: Determination of VIE

Assume the same base facts in Part A, but ignore the scenarios in questions (1) and (2). Assume that the legal entity is an oil and gas exploration company and that the bank loans were provided by a single lender, Bank Wonderful. The decisions that significantly impact the performance of the Legal Entity include making capital investments, such as incurring capital expenditure for new oil and gas properties. The Legal Entity typically funds its new oil-and-gas-property acquisitions via a mix of equity and debt financing. However, all capital investment decisions involving new oil-and-gas-property development need the approval of one party, Bank Wonderful. (That is, Bank Wonderful has absolute veto power.) There are no other variable interest holders in the Legal Entity that have participating rights.

Required:

Assume that the equity at risk is sufficient to absorb all expected future losses of the partnership. Is the Legal Entity a variable interest entity (VIE) on the basis of the power test? Explain your answer.

Exercise B4-3, Part C: Primary Beneficiary Status

Assume the same base facts in Parts A & B.  Also assume that your analysis of the facts and circumstances in Parts A & B caused you to decide that the Legal Entity is a variable interest entity, as that term is defined in FASB ASC 810.  

Required:

Which party (i.e., Company A, Company B or Bank Wonderful) must consolidate the Legal Entity?  How did you arrive at your answer? 

Exercise B4-4: Consolidation of VIEs

Assume that prior to January 1, 2019, a Reporting Company owned a 15 percent interest in a Legal Entity. The Reporting Company acquired its 15 percent ownership interest in the Legal Entity on July 1, 1995 for $30,000, and correctly accounted for this investment under the cost method (i.e., it was a passive investment and it was not marketable).  On January 1, 2019, the Reporting Company purchased an additional 30 percent interest in the Legal Entity for $153,000. As a result of an evaluation of the facts and circumstances on January 1, 2019, the Reporting Entity determined that the Legal Entity is a variable interest entity (VIE) and that the Reporting Company is the primary beneficiary of the VIE. The Reporting Company also determined that, on January 1, 2019, the fair value of the previously held 15 percent interest is $76,500. In addition, independent appraisals revealed that the fair value of the noncontrolling interest (i.e., the 55 percent not owned by the Reporting Company) is $280,500. On January 1, 2019, the Legal Entity has reported book values for its identifiable net assets equal to $365,000 and fair values for its identifiable net assets equal to $440,000.

Required:

Use the base facts to answer the following two independent questions.

1. Assume that the Legal Entity is not a “business,” as that term is defined in FASB ASC 805 (“Business Combinations”).   Related to the initial consolidation of the Legal Entity on January 1, 2019, determine the amount of (a) Goodwill and (b) Gain or Loss on initial consolidation of the Legal Entity

2. Assume that the Legal Entity is a “business,” as that term is defined in FASB ASC 805 (“Business Combinations”).   Related to the initial consolidation of the Legal Entity on January 1, 2019, determine the amount of (a) Goodwill and (b) Gain or Loss on initial consolidation of the Legal Entity