Balance Sheet Classification and Equity Investment Assessment

TOPIC REVIEW 6.1 Balance Sheet Classification and Equity at Risk Assume a legal entity’s capital structure consists of reported equity at risk of $50 and subordinated debt, loaned by the equity holder, of $30. Thus, the total capital is $80, and all comes from the same party. a. Assume the expected losses are predicted to be $50 or less. Is the equity investment at risk suf- ficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders? b. Assume the expected losses are greater than $50. Is the equity investment at risk sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders?

TOPIC REVIEW 6.2 Evaluating Equity Investment Provided by Parties Involved with the Entity Shamco forms a limited partnership with Moneyco, a third-party company. The purpose of the partner- ship is to acquire and lease construction equipment. Shamco contributes $8 million to the partnership in exchange for a 10% general partnership interest. Moneyco contributes $72 million in exchange for a 90% limited partnership interest. At its inception, the partnership acquires construction equipment for $72 million. Additionally, as compensation for identification and acquisition of the construction equipment, and structuring of the partnership, Moneyco pays an $8 million fee to Shamco. What is the amount of equity investment at risk for Shamco?

TOPIC REVIEW 6.3 At-Risk Equity: Test for Equity Sufficiency Versus Test for Power to Direct A biotechnology company forms a limited partnership for the development of a new molecule for the treatment of Alzheimer’s disease. A group of independent investors contributes at-risk equity equal to 93% of the entity’s capitalization in exchange for limited partnership interests. The biotechnology company contributes equity equal to 7% of the entity’s capitalization in exchange for the general partnership interest. Thus, the limited partnership has no liabilities. At formation of the limited partnership, the biotechnology company is paid a management fee equal to 8% of the entity’s total capitalization. The biotechnology company, as general partner, makes all substantive decisions for the partnership. As we describe in our discussion of Step ❹ , part (a), because the fee is not “arm’s length” (i.e., it is provided by other parties involved with the legal entity), the fee is netted against the biotechnology company’s equity investment, reducing it to zero for purposes of determining the equity investment at risk. Accordingly, the biotechnol- ogy company does not have an equity investment at risk. However, the expected losses for the limited partnership are only expected to be 20 percent of the total capitalization of the limited partnership. Given that the 93 percent of total capitalization contributed by the group of independent investors is considered to be at risk, the limited partnership has more than enough equity at risk to permit the legal entity to finance its activities without additional subordinated financial support. Thus, the limited partnership is not a VIE on the basis of the equity sufficiency test in Part (a) of Step ❹ . Turning now to the test in Step ❹, Part (b) (1), do the holders of the equity investment at risk lack the power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance?

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TOPIC REVIEW 6.4 Obligation to Absorb the Expected Losses of the Legal Entity Investor A owns 100 percent of the equity issued by Legal Entity X. All of Legal Entity X’s equity is considered equity at risk. Company Y (an unrelated company) enters into a contract to purchase finished goods from the Legal Entity X at a price equal to the actual costs of production (including raw materi- als, labor, overhead, etc.) plus a 1.5 percent fixed margin. The purchase agreement is structured so that Company Y absorbs all variability associated with the production of the finished product. This contract represents a variable interest in Entity X. There are no other variable interest holders in the entity. What is the effect of this contract on Investor A’s obligation to absorb the expected losses of Legal Entity X?

TOPIC REVIEW 6.5 Constructive Retirement of Intercompany Debt—Equity Method Assume that a parent company acquires a 90% interest in its subsidiary on January 1, 2018. On the date of acquisition, the fair value of the 90 percent controlling interest was $594,000 and the fair value of the 10 percent noncontrolling interest was $66,000. On January 1, 2018, the book value of net assets equaled $660,000 and the fair value of the identifiable net assets equaled the book value of identifiable net assets (i.e., there was no AAP or Goodwill). On December 31, 2019, the parent company issued $1,200,000 (face) 6 percent, five-year bonds to an unaffiliated company for $1,251,954 (i.e., the bonds had an effective yield of 5 percent). The bonds pay interest annually on December 31, and the bond premium is amortized using the straight-line method. This results in annual bond-payable premium amortization equal to $10,391 per year. On December 31, 2021, the subsidiary paid $1,138,150 to purchase all of the outstanding parent company bonds (i.e., the bonds had an effective yield of 8 percent). The bond discount is amortized using the straight-line method, which results in annual bond-investment discount amortization equal to $20,617 per year. The parent uses the equity method of pre-consolidation investment bookkeeping. The parent and the subsidiary report the following financial statements for the year ended December 31, 2022: Provide the consolidation entries and prepare a consolidation worksheet for the year ended December 31, 2022.

Parent Subsidiary Sales 12,000,000 1,200,000 Cost of goods sold (8,640,000) (720,000) Gross profit 3,360,000 480,000 Depr & amort expense - - Operating & other expense (1,800,000) (312,000) Bond interest income - 92,617 Bond interest expense (61,609) - Income from subsidiary 203,547 - Net income 1,701,938 260,617 Beginning retained earnings 6,889,800 270,000 Net income 1,701,938 260,617 Dividends declared (340,800) (24,000) Ending retained earnings 8,250,938 506,617 Cash 1,110,310 387,900 Accounts receivable 2,100,000 546,000 Inventories 3,120,000 660,000 PPE, net 12,072,000 1,236,000 Investment in subsidiary 846,289 - Investment in bond, net - 1,158,767 19,248,599 3,988,667 Accounts payable 1,013,280 573,600 Other current liabilities 1,428,000 600,000 Bond payable, net 1,220,781 - Other long-term liabilities 1,800,000 1,913,650 Common stock 663,600 178,800 APIC 4,872,000 186,000 Retained earnings 8,250,938 506,617 19,248,599 3,958,667

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TOPIC REVIEW 6.6 Comprehensive Review (This comprehensive review problem includes business combinations and consolidations concepts discussed in Chapters 1 through 5 and the intercompany bond material from the current chapter.) A parent company acquired 90 percent of the stock of a subsidiary company on January 1, 2018, for $459,000. On this date, the balances of the subsidiary's stockholders' equity accounts were Common Stock, $72,000; Additional Paid-in Capital, $120,000; and Retained Earnings, $138,000. On January 1, 2018, the fair value of the 10% of shares not purchased by the parent was $51,000. On January 1, 2018, the subsidiary's recorded book values were equal to fair values for all items except one: a previously unrecorded patent asset had a book value of $0 and a fair value of $120,000. Both companies use the FIFO inventory method and sell all of their inventories at least once per year. On the acquisition date, the patent had a remaining economic useful life of 10 years. On January 1, 2021, the parent sold a building to the subsidiary for $90,000. On this date, the building was carried on the parent's books (net of accumulated depreciation) at $57,600. Both companies estimated that the building has a remaining life of 10 years on the intercompany sale date, with no salvage value. Each company routinely sells merchandise to the other company, with a profit margin of 40 percent of selling price (regardless of the direction of the sale). During 2022, intercompany sales amount to $36,000, of which $15,000 of merchandise remains in the ending inventory of the parent. On December 31, 2022, $12,000 of these intercompany sales remained unpaid. Additionally, the parent's December 31, 2021 inventory includes $9,000 of merchandise purchased in the preceding year from the subsidiary. During 2021, intercompany sales amount to $30,000, and on December 31, 2021, $6,000 of these intercompany sales remained unpaid. On December 31, 2019, the subsidiary company issued a $300,000 (face) 5 percent, five-year bond to an unaffiliated company for $313,355 (i.e., the bond had an effective yield of 4 percent). The bond pays interest annually on December 31, and the bond premium is amortized using the straightline method. This results in annual bond-payable premium amortization equal to approximately $2,671 per year. On December 31, 2021, the parent paid $291,981 to purchase the outstanding subsidiary company bond (i.e., the bond had an effective yield of 6 percent). The bond discount is amortized using the straight-line method, which results in annual bond-investment discount amortization equal to $2,673 per year. The parent accounts for its investment in the subsidiary using the equity method. Unconfirmed profits are allocated pro rata, except for intercompany bond profits, which are allocated 100 percent to the parent company. The parent and subsidiary report the following pre-consolidation financial statements for the year ended December 31, 2022: Complete the consolidating entries according to the C-E-A-D-I sequence and complete the consolidation worksheet.

Parent Subsidiary Sales $ 4,800,000 $ 480,000 Cost of goods sold (3,456,000) (288,000) Gross profit $ 1,344,000 $ 192,000 Depreciation & amort expense (420,000) (34,800) Operating & other expenses (300,000) (90,000) Bond interest income 17,673 - Bond interest expense - (12,329) Investment income from sub 34,320 Net income $ 675,993 $ 54,871 Beginning retained earnings $ 973,221 $ 237,387 Net income 675,993 54,871 Dividends declared (120,000) (9,600) Ending retained earnings $ 1,529,214 $ 282,658 Cash $ 300,000 $ 180,000 Accounts receivable 420,000 240,000 Inventories 540,000 360,000 PPE, net 1,800,000 480,000 Investment in subidiary 514,560 - Investment in bond (net) 294,654 - Total assets $ 3,869,214 $ 1,260,000 Accounts payable $ 420,000 $ 60,000 Other current liabilities 540,000 180,000 Bond payable (net) - 305,342 Other long-term liabilities 600,000 240,000 Common stock 300,000 72,000 APIC 480,000 120,000 Retained earnings 1,529,214 282,658 Total liabilites and equity $ 3,869,214 $ 1,260,000

TOPIC REVIW 6.7 Exercise 6.46 Determination of whether a legal entity is a variable interest entity Assume a Legal Entity’s capital structure consists of the following accounts: Short-term note payable 28,750 Bond payable 172,500 Common stock 46,000 Additional paid in capital 115,000 Retained earnings - Total liabilites and equity 362,250 Reporting Company A contributed $112,700 for a 70 percent interest in the Legal Entity and Report- ing Company B contributed $48,300 for a 30 percent interest in the Legal Entity. Unless otherwise indicated, each of the following parts of this question is independent: a. Assume that Reporting Company B borrowed from an unaffiliated bank $41,400 of its $48,300 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? b. Assume that the chair of the Board of Directors of Reporting Entity A paid $39,100 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?

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TOPIC REVIEW 6.8 Exercise 6.48 Determination of whether a legal entity is a variable interest entity Assume that a limited partnership is formed to perform research and development. The general part- ner acquires a 1% interest in the limited partnership, and its investment is considered an equity investment at risk. The 99% limited partner interests are also considered substantive at-risk equity. As is customary in a limited partnership, the general partner makes day-to-day decisions about the activities of the limited partnership that most significantly impact the entity’s economic performance. The limited partners have only protective rights and do not have the ability to make decisions about the activities of an entity that most significantly impact the entity’s economic performance. There are no other variable interest holders in the partnership (e.g., a lender) that have participating rights. As- sume that the equity at risk is sufficient to absorb all expected future losses. Is the limited partnership a variable interest entity (VIE) on the basis of the power test? Explain your answer.

TOPIC REVIEW 6.9 Exercise 6.49 Determination of whether a legal entity is a variable interest entity Assume that a Legal Entity owns and operates a real estate development and property management company. The decisions that significantly impact the performance of the Legal Entity include mak- ing capital investments, such as incurring capital expenditures for new developments to continue to attract tenants. The Legal Entity typically funds its capital investments via a mix of equity and debt financing. However, all capital investment decisions involving new property developments need the lender’s approval (one party). There are no other variable interest holders in the Legal Entity (e.g., a lender) that have participating rights. Assume that the equity at risk is sufficient to absorb all ex- pected future losses of the partnership. Is the limited partnership a variable interest entity (VIE) on the basis of the power test? Explain your answer.

TOPIC REVIEW 6.10 Exercise 6.50 Determination of whether a legal entity is a variable interest entity Assume that a limited partnership is formed to perform research and development. None of the partnership interests have voting rights, but one partner, a pharmaceutical company, makes all significant decisions for the partnership under the terms of a service agreement entered into at inception of the entity. The phar- maceutical company is not required to have a substantive equity investment at risk as long as it provides services pursuant to the service agreement. Assume the service agreement is a variable interest. There are no other variable interest holders in the partnership (e.g., a lender) that have participating rights. Assume that the equity at risk is sufficient to absorb all expected future losses of the partnership. Is the limited partnership a variable interest entity (VIE) on the basis of the power test? Explain your answer.

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TOPIC REVIEW 6.11 Problem 6.63 Consolidation worksheet for gain on constructive retirement of parent’s debt with no AAP Assume that a Parent company acquires a 70 percent interest in its Subsidiary on January 1, 2018. On the date of acquisition, the fair value of the 70 percent controlling interest was $291,200 and the fair value of the 30 percent noncontrolling interest was $124,800. On January 1, 2018, the book value of net assets equaled $416,000 and the fair value of the identifiable net assets equaled the book value of identifiable net assets (i.e., there was no AAP or Goodwill). On December 31, 2019, the Parent company issued $400,000 (face) 6 percent, five-year bonds to an unaffiliated company for $416,000. The bonds pay interest annually on December 31, and the bond premium is amortized using the straight-line method. This results in annual bond-payable pre- mium amortization equal to $3,200 per year. On December 31, 2021, the Subsidiary paid $388,000 to purchase all of the outstanding Parent company bonds. The bond discount is amortized using the straight-line method, which results in an- nual bond-investment discount amortization equal to $4,000 per year. The Parent and the Subsidiary report the following financial statements for the year ended De- cember 31, 2022: The parent uses the equity method of pre-consolidation investment bookkeeping. Provide the consoli- dation entries and prepare a consolidation worksheet for the year ended December 31, 2022. 12/31/19 Parent Issues Bonds to Unaffiliated party parent Cash 416,000 Premium on Bonds 16,000 Bonds Payable 400,000 12/31/2022 Sub buy them sub bond investment 388,000 cash 388,000 Ibond Entry bonds payable 400,000 interest income 28,000 premium on bonds payable 6,400 interest expense 20,800 bond investment 400,000 gain on sale 13,600 Parent Subsidiary Consolidated Income Statement Sales $ 2,240,000 $ 720,000 2,960,000 Cost of Goods Sold (1,200,000) (424,000) (1,624,000) Gross Profit 1,040,000 296,000 1,336,000 Income (loss) from Subsidiary 52,720 - c 52,720 - Operating & other expenses (880,000) (238,400) (1,118,400) Bond interest income 28,000 ibond 28,000 - Bond interest expense (20,800) 20,800 ibond - Gain on sale of bond purchase Net Income $ 191,920 $ 85,600 217,600 Income attributable to NCI c 25,680 (25,680) Income attributable to Controlling Int 191,920 ask professor when this number won't equal the parents net income potential: would it not equal in the year of the sale? But equals in subsequent years? Retained Earnings Statement Beg. Ret. Earn. - Parent $ 1,421,680 $ 346,400 e 346,400 1,421,680 Net Income 191,920 85,600 191,920 Dividends Declared (120,000) (40,000) 40,000 c (120,000) Ending Retained Earnings $ 1,493,600 $ 392,000 1,493,600 Balance Sheet Cash $ 640,000 $ 240,000 880,000 Accounts receivable 720,000 320,000 1,040,000 Inventories 800,000 400,000 1,200,000 Property, Plant & Equipment, net 1,792,000 720,000 2,512,000 Investment in Subsidiary 468,000 421,680 e - 24,720 c 21,600 ibond Investment in Bond (net) 392,000 392,000 ibond - Total Assets $ 4,420,000 $ 2,072,000 5,632,000 Accounts Payable $ 480,000 $ 384,000 864,000 Other current liabilities 640,000 400,000 1,040,000 Bond Payable (net) 406,400 ibond 406,400 - Other long-term liabilites 640,000 640,000 1,280,000 Common Stock 360,000 120,000 e 120,000 360,000 APIC 400,000 136,000 e 136,000 400,000 Retained Earnings 1,493,600 392,000 1,493,600 Noncontrolling Interest 180,720 e 194,400 13,680 c Total Liabilities and Equity $ 4,420,000 $ 2,072,000 1,115,200 1,115,200 5,632,000 -

CHAPTER 6 MULTIPLE CHOICE 6.1 Special-purpose entities a. Are usually only used to obtain "off balance sheet" treatment of risky assets b. Are usually used in fraudulent business transactions c. Usually have most of their operations financed by equity investors d. Are usually "robot-like" entities that have no distinct physical location, have no independent management or employees, and make no strategic business decisions 6.2 Which of the following characteristics does not usually exist for a special purpose entity (SPE) that is used in a securitization transaction? a. The SPE is expected to seek strategic business opportunities that maximize returns to the SPE's equity investors. b. The SPE is usually legally distinct from the sponsoring company that forms the SPE and is bankruptcy remote. c. If the SPE is formed to securitize accounts receivable, then the SPE's security holders are only repaid if the securitized accounts receivable are collected. d. All of the above 6.3 Which of the following is not a variable interest? a. Guarantee of indebtedness b. Corporate bond rated BBB- by Standard & Poors c. U.S. treasury bond d. Common stock 6.4 Which of the following is not automatically exempt from the consolidation guidance included in FASB ASC 810 ("Consolidations") a. Legal entities that qualify as investments accounted for at fair value in accordance with the specialized guidance in FASB ASC 946 ("Financial Services - Investment Companies") b. Legal entities that administer employee benefit plans subject to FASB ASC 712 ("Compensation- Nonretirement Postemployment Benefits") c. Legal entities that meet the definition of "businesses" as defined by FASB ASC 805 ("Business Combinations") d. Legal entities that are not-for-profit 6.5 If a legal entity is within the scope of FASB ASC 810 ("Consolidations"), when can a reporting company completely skip an evaluation of whether the legal entity is a variable interest entity (i.e., the "variable interest entity model") and solely determine consolidation based on whether the reporting company owns a majority of the voting common stock of a legal entity (i.e., the "voting interest entity model")? a. The reporting company does not have the obligation to absorb the losses of the legal entity that could potentially be significant to the legal entity. b. The legal entity satisfies none of the four conditions for the business-related scope exception. c. The reporting company does not have the power to direct the activities that most significantly impact the legal entity's business activities. d. The legal entity is only capitalized with a bank loan and voting common stock. 6.6 FASB ASC 810 ("Consolidations") states that a Primary Beneficiary is the company that consolidates a variable interest entity (VIE). Which of the following is not a triggering condition for a reporting entity to be deemed the Primary Beneficiary of a VIE in which the reporting entity has a variable interest? a. The reporting entity owns a majority of the voting common stock of the VIE. b. The reporting entity has the power to direct the activities of a VIE that most significantly impact the VIE's economic performance. c. The reporting entity has the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. d. Both b and c, above, are not triggering conditions. 6.7 When a Primary Beneficiary initially consolidates a variable interest entity (VIE), the primary beneficiary must determine whether the VIE is a "business" as defined by FASB ASC 805 ("Business Combinations") because: a. The initial consolidation-date fair value of the VIE's identifiable net assets will depend on whether the VIE is a "business" b. FASB ASC 805 only applies to acquisitions of "businesses," so the Primary Beneficiary can avoid consolidation if the VIE is not a business. c. If the VIE is not a "business," then a gain or loss is always recognized upon initial consolidation by a Primary Beneficiary. d. Goodwill is only recognized by the Primary Beneficiary when a consolidated VIE is a "business." 6.8 On January 1, 2022, a Parent company has a debt outstanding that was originally issued at a discount and was purchased, on issuance, by an unaffiliated party. On January 1, 2022, a Subsidiary of the Parent purchased the debt from the unaffiliated party. The debt was purchased by the Subsidiary at a slight premium. The Parent is a calendar year company. Which one of the following statements is true? a. The consolidated balance sheet at December 31, 2022 will report none of the debt, and the consolidated income statement for the year ended December 31, 2022 will report a gain or loss from constructive retirement of the debt and will not report any interest expense from the debt. b. The consolidated balance sheet at December 31, 2022 will report none of the debt, and the consolidated income statement for the year ended December 31, 2022 will report a gain or loss from constructive retirement of the debt and will report interest expense from the debt. c. The consolidated balance sheet at December 31, 2022 will report the debt, and the consolidated income statement for the year ended December 31, 2022 will not report any interest expense from the debt. d. The consolidated balance sheet at December 31, 2022 will report the debt, and the consolidated income statement for the year ended December 31, 2022 will report a gain or loss from constructive retirement of the debt and will not report any interest expense from the debt.

6.9 On January 1, 2022, a Parent company has a debt outstanding that was originally issued at a discount and was purchased, on issuance, by an unaffiliated party. On July 1, 2022, a Subsidiary of the Parent purchased the debt from the unaffiliated party. The debt was purchased by the subsidiary at a slight premium. The Parent is a calendar year company. Which one of the following statements is true? a. The consolidated balance sheet at December 31, 2022 will report none of the debt, and the consolidated income statement for the year ended December 31, 2022 will report a gain or loss from constructive retirement of the debt and will not report any interest expense from the debt. b. The consolidated balance sheet at December 31, 2022 will report the debt, and the consolidated income statement for the year ended December 31, 2022 will report a gain or loss from constructive retirement of the debt and will not report any interest expense from the debt. c. The consolidated balance sheet at December 31, 2022 will report none of the debt, and the consolidated income statement for the year ended December 31, 2022 will report a gain or loss from constructive retirement of the debt and will report some interest expense from the debt. d. The consolidated balance sheet at December 31, 2022 will report none of the debt, and the consolidated income statement for the year ended December 31, 2022 will not report any interest expense from the debt. Use the following information for 6.10 and 6.11 A Parent Company owns 100 percent of its Subsidiary. During 2021, the Parent company reports net income (by itself, without any investment income from its Subsidiary) of $450,000 and the subsidiary reports net income of $180,000. The parent had a bond payable outstanding on January 1, 2021, with a carrying value equal to $378,000. The Subsidiary acquired the bond on January 1, 2021, for $355,500. During 2021, the Parent reported interest expense (related to the bond) of $28,800 while the Subsidiary reported interest income parent sub (related to the bond) of $31,500. sale of bond equity income 28,800 equity investment 28,800 6.10 What is consolidated net income for the year ended December 31, 2021? DR CR equity investment 31,500 a. $652,500 Equity Income interest income 31,500 b. $632,700 180,000 c. $630,000 22,500 accelerated gain on constructive retirement d. $655,200 2,700 why a debit? 450,000 649,800 e. $649,800 potentially, the net effect is a loss from the parents perspective, because the subs interest income is really at the expense of the parent Answer: the excess interest income of the sub means you debit the Equity income account because that excess income is going to be recognized through the interest revenue 6.11 What is consolidated net income for the year ended December 31, 2022? (assume the same standalone parent income, sub income, interest expense, and interest income as 2021) Equity Income a. $632,700 DR Cr b. $630,000 180,000 c. $655,200 d. $652,500 2,700 450,000 627,300 e. $627,300 You need to debit/credit to equity income whatever makes the parents balance interest/expense equal to the subs interest/expense 6.12 A Parent Company owns 100 percent of its Subsidiary. During 2021, the Parent company reports net income (by itself, without any investment income from its Subsidiary) of $1,150,000 and the subsidiary reports net income of $460,000. The parent had a bond payable outstanding on December 31, 2021, with a carrying value equal to $966,000. The Subsidiary acquired the bond on December 31, 2021, for $908,500. During 2021, the Parent reported interest expense (related to the bond) of $80,500 while the Subsidiary reported no interest income (related to the bond). What is consolidated net income for the year ended December 31, 2021? a. $1,690,500 b. $1,667,500 c. $1,748,000 d. $1,610,000 Use the information below for 6.13 and 6.14 A Parent Company owns 70 percent of its Subsidiary. During 2022, the Parent company reports net income (by itself, without any investment income from its Subsidiary) of $975,000 and the subsidiary reports net income of $455,000 The Subsidiary had a bond payable outstanding on January 1 2022, with a carrying value equal to $715,000 The face amount of this bond is $650,000 The Parent acquired the bond on January 1, 2022, for $734,500 During 2022, the Parent reported interest income (related to the bond) of $67,600 while the Subsidiary reported interest expense (related to the bond) of $71,500. 6.13 What is consolidated net income attributable to the controlling interest for the year ended December Sub has this bond 31, 2022? Equity Income Cash 715,000 DR CR Bonds Pay 650,000 a. $1,270,100 318,500 Premium 65,000 b. $1,293,500 19,500 c. $1,291,550 3,900 why is this a credit? selling bond to parent parent buys d. $1,430,000 975,000 1,277,900 bonds pay 650,000 bond investment 734,500 e. $1,277,900 premium 65,000 cash 734,500 6.14 What is consolidated net income attributable to the noncontrolling interest for the year ended December 31, 2022? 136,500 a. $156,780 b. $130,650 c. $136,500 d. $115,050

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Subsidiary issues to unaffiliated party Issue on 12/31/19 sub Cash $ 1,913,410.00 Amortizing at Discount on BP $ 86,590.00 Bonds Payable $ 2,000,000.00 Parent purchases on 12/31/2021 parent bond investment $ 1,893,080.00 at the purchase date, cash $ 1,893,080.00 relative discount stra equity investment $ 54,966.00 accelerated gain due equity income $ 54,966.00 12/31/21 Consolidation Ibond bonds payable $ 2,000,000.00 Discount on BP $ 51,954.00 bond investment $ 1,893,080.00 gain on retirement $ 54,966.00 12/31/2022 sub interest expense $ 97,318.00 discount on bp $ 17,318.00 cash $ 80,000.00 parent cash $ 80,000.00 equity inco bond investment $ 35,640.00 equity in interest income $ 115,640.00 consolidated bonds payable $ 2,000,000.00 interest income $ 115,640.00 interest expense $ 97,318.00 discount on BP $ 34,636.00 2 years of the subs re bond investment $ 1,928,720.00 BOY equity inv $ 54,966.00 $ 2,115,640.00 $ 2,115,640.00 E6-60 Preferred Stock Problem, what I missed Computing consolidated net income for noncontrolling and controllin interests Facts 75% ownership of sub 30% ownership of preferred stock

parent net income $ 270,000.00 sub net income $ 112,500.00 c entry equity income controlling consolidated net income NI attrib to NCI net income $ 112,500.00 noncontrolling int pref dividends $ 37,800.00 100% of the dividends dividends remaining inc for CS $ 74,700.00 noncontrolling int 75% claim on that inc $ 56,025.00 parent net income $ 270,000.00 controlling net income $ 326,025.00 noncontrolling consolidated net income net income $ 112,500.00 pref dividends paid $ 37,800.00 inc for CS $ 74,700.00 claim on that inc 25% $ 18,675.00

$ 17,318.00 , the parent now elects to amortize their aightline Amortizing at $ 35,640.00 e to constructive retirement ome $ 18,322.00 nvestment $ 18,322.00 emaining unamortized discount

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$ 56,025.00 $ 18,675.00 $ (7,785.00) $ 37,800.00 $ 44,685.00

TOPIC REVIEW 6.1 Balance Sheet Classification and Equity at Risk Assume a legal entity’s capital structure consists of reported equity at risk of $50 and subordinated debt, loaned by the equity holder, of $30. Thus, the total capital is $80, and all comes from the same party. a. Assume the expected losses are predicted to be $50 or less. Is the equity investment at risk suf- ficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders? b. Assume the expected losses are greater than $50. Is the equity investment at risk sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders? a. Yes b. No

TOPIC REVIEW 6.2 Evaluating Equity Investment Provided by Parties Involved with the Entity Shamco forms a limited partnership with Moneyco, a third-party company. The purpose of the partner- ship is to acquire and lease construction equipment. Shamco contributes $8 million to the partnership in exchange for a 10% general partnership interest. Moneyco contributes $72 million in exchange for a 90% limited partnership interest. At its inception, the partnership acquires construction equipment for $72 million. Additionally, as compensation for identification and acquisition of the construction equipment, and structuring of the partnership, Moneyco pays an $8 million fee to Shamco. What is the amount of equity investment at risk for Shamco? Equity at risk for Shamco - million Equity at risk for Shamco & Moneyco 72 million

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TOPIC REVIEW 6.3 At-Risk Equity: Test for Equity Sufficiency Versus Test for Power to Direct A biotechnology company forms a limited partnership for the development of a new molecule for the treatment of Alzheimer’s disease. A group of independent investors contributes at-risk equity equal to 93% of the entity’s capitalization in exchange for limited partnership interests. The biotechnology company contributes equity equal to 7% of the entity’s capitalization in exchange for the general partnership interest. Thus, the limited partnership has no liabilities. At formation of the limited partnership, the biotechnology company is paid a management fee equal to 8% of the entity’s total capitalization. The biotechnology company, as general partner, makes all substantive decisions for the partnership. As we describe in our discussion of Step ❹ , part (a), because the fee is not “arm’s length” (i.e., it is provided by other parties involved with the legal entity), the fee is netted against the biotechnology company’s equity investment, reducing it to zero for purposes of determining the equity investment at risk. Accordingly, the biotechnol- ogy company does not have an equity investment at risk. However, the expected losses for the limited partnership are only expected to be 20 percent of the total capitalization of the limited partnership. Given that the 93 percent of total capitalization contributed by the group of independent investors is considered to be at risk, the limited partnership has more than enough equity at risk to permit the legal entity to finance its activities without additional subordinated financial support. Thus, the limited partnership is not a VIE on the basis of the equity sufficiency test in Part (a) of Step ❹ . Turning now to the test in Step ❹, Part (b) (1), do the holders of the equity investment at risk lack the power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance? Yes the 93% equity holders lack power to direct activities, so this is a VIE based on the power test.

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TOPIC REVIEW 6.4 Obligation to Absorb the Expected Losses of the Legal Entity Investor A owns 100 percent of the equity issued by Legal Entity X. All of Legal Entity X’s equity is considered equity at risk. Company Y (an unrelated company) enters into a contract to purchase finished goods from the Legal Entity X at a price equal to the actual costs of production (including raw materi- als, labor, overhead, etc.) plus a 1.5 percent fixed margin. The purchase agreement is structured so that Company Y absorbs all variability associated with the production of the finished product. This contract represents a variable interest in Entity X. There are no other variable interest holders in the entity. What is the effect of this contract on Investor A’s obligation to absorb the expected losses of Legal Entity X? Investor A (100% equity holder) now lacks the obligation to absorb expected losses. Therefore, Legal Entity X is VIE. Note: If the Company Y had entered into a fixed price contract, Investor A would still absorb expected losses. Therefore, Legal Entity X would not be a VIE.

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TOPIC REVIEW 6.5 Constructive Retirement of Intercompany Debt—Equity Method Assume that a parent company acquires a 90% interest in its subsidiary on January 1, 2018. On the date of acquisition, the fair value of the 90 percent controlling interest was $594,000 and the fair value of the 10 percent noncontrolling interest was $66,000. On January 1, 2018, the book value of net assets equaled $660,000 and the fair value of the identifiable net assets equaled the book value of identifiable net assets (i.e., there was no AAP or Goodwill). On December 31, 2019, the parent company issued $1,200,000 (face) 6 percent, five-year bonds to an unaffiliated company for $1,251,954 (i.e., the bonds had an effective yield of 5 percent). The bonds pay interest annually on December 31, and the bond premium is amortized using the straight-line method. This results in annual bond-payable premium amortization equal to $10,391 per year. 12/31/2021 Carrying value 1,231,172 12/31/2021 Reacquisition price 1,138,150 On December 31, 2021, the subsidiary paid $1,138,150 to purchase all of the outstanding parent 1/1/2022 Accelerated gain 93,022 company bonds (i.e., the bonds had an effective yield of 8 percent). The bond discount is amortized using the straight-line method, which results in annual bond-investment discount amortization equal to 2022 excess income over expense 31,007 or 31,008 $20,617 per year. The parent uses the equity method of pre-consolidation investment bookkeeping. The parent and the subsidiary report the following financial statements for the year ended December 31, 2022: Parent Subsidiary Dr. Cr. Consolidated Sales 12,000,000 1,200,000 13,200,000 Cost of goods sold (8,640,000) (720,000) (9,360,000) Gross profit 3,360,000 480,000 3,840,000 Depr & amort expense - - - Operating & other expense (1,800,000) (312,000) (2,112,000) Bond interest income - 92,617 [Ibond] 92,617 - Bond interest expense (61,609) - 61,609 [Ibond] - Income from subsidiary 203,597 - [C] 203,597 0 Net income 1,701,988 260,617 1,728,000 NI attrib to NCI [C] 26,062 (26,062) NI attrib to parent 1,701,938 Beginning retained earnings 6,889,800 270,000 [E] 270,000 6,889,800 Net income 1,701,938 260,617 1,701,938 Dividends declared (340,800) (24,000) 24,000 [C] (340,800) Ending retained earnings 8,250,938 506,617 8,250,938 Cash 1,110,310 387,900 1,498,210 Accounts receivable 2,100,000 546,000 2,646,000 Inventories 3,120,000 660,000 3,780,000 PPE, net 12,072,000 1,236,000 13,308,000 Investment in subsidiary 846,339 - 571,320 [E] 0 181,997 [C] 93,022 [Ibond] Investment in bond, net - 1,158,767 1,158,767 [Ibond] - 19,248,649 3,988,667 21,232,210 Accounts payable 1,013,280 573,600 1,586,880 Other current liabilities 1,428,000 600,000 2,028,000 Bond payable, net 1,220,781 - [Ibond] 1,220,781 - Other long-term liabilities 1,800,000 1,913,650 3,713,650 Common stock 663,600 178,800 [E] 178,800 663,600 APIC 4,872,000 186,000 [E] 186,000 4,872,000 Retained earnings 8,250,938 506,617 8,250,938 Noncontrolling interest 63,480 [E] 87,142 23,662 [C] 19,248,599 3,958,667 21,202,210 Provide the consolidation entries and prepare a consolidation worksheet for the year ended December 31, 2022.

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TOPIC REVIEW 6.6 Comprehensive Review (This comprehensive review problem includes business combinations and consolidations concepts discussed in Chapters 1 through 5 and the intercompany bond material from the current chapter.) A parent company acquired 90 percent of the stock of a subsidiary company on January 1, 2018, At 1/1/18 for $459,000. On this date, the balances of the subsidiary's stockholders' equity accounts were Common E C/S 72,000 Stock, $72,000; Additional Paid-in Capital, $120,000; and Retained Earnings, $138,000. On January 1, APIC 120,000 2018, the fair value of the 10% of shares not purchased by the parent was $51,000. RE 138,000 Equity investment 297,000 On January 1, 2018, the subsidiary's recorded book values were equal to fair values for all items Noncontrolling interest 33,000 except one: a previously unrecorded patent asset had a book value of $0 and a fair value of $120,000. Both companies use the FIFO inventory method and sell all of their inventories at least once per year. A Patent 120,000 On the acquisition date, the patent had a remaining economic useful life of 10 years. Goodwill 60,000 Equity investment 162,000 On January 1, 2021, the parent sold a building to the subsidiary for $90,000. On this date, the Noncontrolling interest 18,000 building was carried on the parent's books (net of accumulated depreciation) at $57,600. Both companies estimated that the building has a remaining life of 10 years on the intercompany sale date, with no salvage value. Initial gain deferred on 1/1/21= 32,400 Unconfirmed gain on 1/1/22= 29,160 Each company routinely sells merchandise to the other company, with a profit margin of 40 percent of selling price (regardless of the direction of the sale). During 2022, intercompany sales amount to $36,000, of which $15,000 of merchandise remains in the ending inventory of the parent. On December 31, 2022, $12,000 of these intercompany sales remained unpaid. Additionally, the parent's December 31, 2021 inventory includes $9,000 of merchandise purchased in the preceding year from the subsidiary. During 2021, intercompany sales amount to $30,000, and on December 31, 2021, $6,000 of these intercompany sales remained unpaid. On December 31, 2019, the subsidiary company issued a $300,000 (face) 5 percent, five-year bond to an unaffiliated company for $313,355 (i.e., the bond had an effective yield of 4 percent). The bond pays interest annually on December 31, and the bond premium is amortized using the straightline method. This results in annual bond-payable premium amortization equal to approximately $2,671 per year. On December 31, 2021, the parent paid $291,981 to purchase the outstanding subsidiary company 12/31/21 carrying value 308,013 bond (i.e., the bond had an effective yield of 6 percent). The bond discount is amortized using 12/31/21 reacquisition price 291,981 the straight-line method, which results in annual bond-investment discount amortization equal to 1/1/22 accelerated gain 16,032 $2,673 per year. The parent accounts for its investment in the subsidiary using the equity method. Unconfirmed profits are allocated pro rata, except for intercompany bond profits, which are allocated 100 percent to the parent company. The parent and subsidiary report the following pre-consolidation financial statements for the year ended December 31, 2022: Complete the consolidating entries according to the C-E-A-D-I sequence and complete the consolidation worksheet. Consolidation entries Parent Subsidiary Dr Cr Consolidated Sales $ 4,800,000 $ 480,000 [Isales] 36,000 5,244,000 Cost of goods sold (3,456,000) (288,000) [Icogs] 6,000 36,000 [Isales] (3,710,400) 3,600 [Icogs] Gross profit $ 1,344,000 $ 192,000 1,533,600 Depreciation & amort expense (420,000) (34,800) [D] 12,000 3,240 [Idep] (463,560) Operating & other expenses (300,000) (90,000) (390,000) Bond interest income 17,673 - [Ibond] 17,673 - Bond interest expense - (12,329) 12,329 [Ibond] - Investment income from sub 34,320 [C] 34,320 0 Net income attrib to NCI [C] 4,047 (4,047) Net income attrib to parent $ 675,993 $ 54,871 675,993 Beginning retained earnings $ 973,221 $ 237,387 [E] 237,387 973,221 Net income 675,993 54,871 675,993 Dividends declared (120,000) (9,600) 9,600 [C] (120,000) Ending retained earnings $ 1,529,214 $ 282,658 1,529,214 Cash $ 300,000 $ 180,000 480,000 Accounts receivable 420,000 240,000 12,000 [Ipay] 648,000 Inventories 540,000 360,000 6,000 [Icogs] 894,000 PPE, net 1,800,000 480,000 [Idep] 3,240 29,160 [Igain] 2,254,080 Investment in subidiary 514,560 - [Icogs] 3,240 25,680 [C] (0) [Igain] 29,160 386,448 [E] 118,800 [A] 16,032 [Ibond] Investment in bond (net) 294,654 - 294,654 [Ibond] - Patent [A] 72,000 12,000 [D] 60,000 Goodwill [A] 60,000 60,000 Total assets $ 3,869,214 $ 1,260,000 4,396,080 Accounts payable $ 420,000 $ 60,000 [Ipay] 12,000 468,000

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Other current liabilities 540,000 180,000 720,000 Bond payable (net) - 305,342 [Ibond] 305,342 - Other long-term liabilities 600,000 240,000 840,000 Common stock 300,000 72,000 [E] 72,000 300,000 APIC 480,000 120,000 [E] 120,000 480,000 Retained earnings 1,529,214 282,658 1,529,214 Noncontrolling interest [Icogs] 360 3,087 [C] 58,866 42,939 [E] 13,200 [A] Total liabilites and equity $ 3,869,214 $ 1,260,000 4,396,080

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TOPIC REVIW 6.7 Exercise 6.46 Determination of whether a legal entity is a variable interest entity Assume a Legal Entity’s capital structure consists of the following accounts: Short-term note payable 28,750 Bond payable 172,500 Common stock 46,000 Additional paid in capital 115,000 Retained earnings - Total liabilites and equity 362,250 Reporting Company A contributed $112,700 for a 70 percent interest in the Legal Entity and Report- ing Company B contributed $48,300 for a 30 percent interest in the Legal Entity. Unless otherwise indicated, each of the following parts of this question is independent: a. Assume that Reporting Company B borrowed from an unaffiliated bank $41,400 of its $48,300 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? b. Assume that the chair of the Board of Directors of Reporting Entity A paid $39,100 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? a. 161,000 b/c equity at risk = GAAP reported stockholders equity obtained at arm's length. Reporting company B obtained financing from an unaffiliated bank so still arm's length. b. 121,900 b/c equity at risk = GAAP reported stockholders equity obtained at arm's length Reporting company B obtained $39,100 from a another investor in the entity so not arm's length.

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TOPIC REVIEW 6.8 Exercise 6.48 Determination of whether a legal entity is a variable interest entity Assume that a limited partnership is formed to perform research and development. The general part- ner acquires a 1% interest in the limited partnership, and its investment is considered an equity investment at risk. The 99% limited partner interests are also considered substantive at-risk equity. As is customary in a limited partnership, the general partner makes day-to-day decisions about the activities of the limited partnership that most significantly impact the entity’s economic performance. The limited partners have only protective rights and do not have the ability to make decisions about the activities of an entity that most significantly impact the entity’s economic performance. There are no other variable interest holders in the partnership (e.g., a lender) that have participating rights. As- sume that the equity at risk is sufficient to absorb all expected future losses. Is the limited partnership a variable interest entity (VIE) on the basis of the power test? Explain your answer. VIE because equity holders as a group have power to control activities, but the 1% shareholder has more control than proportional to his/her ownership (anti-abuse provision).

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TOPIC REVIEW 6.10 Exercise 6.50 Determination of whether a legal entity is a variable interest entity Assume that a limited partnership is formed to perform research and development. None of the partnership interests have voting rights, but one partner, a pharmaceutical company, makes all significant decisions for the partnership under the terms of a service agreement entered into at inception of the entity. The phar- maceutical company is not required to have a substantive equity investment at risk as long as it provides services pursuant to the service agreement. Assume the service agreement is a variable interest. There are no other variable interest holders in the partnership (e.g., a lender) that have participating rights. Assume that the equity at risk is sufficient to absorb all expected future losses of the partnership. Is the limited partnership a variable interest entity (VIE) on the basis of the power test? Explain your answer. VIE because equity holders lack power to control activities

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TOPIC REVIEW 6.9 Exercise 6.49 Determination of whether a legal entity is a variable interest entity Assume that a Legal Entity owns and operates a real estate development and property management company. The decisions that significantly impact the performance of the Legal Entity include mak- ing capital investments, such as incurring capital expenditures for new developments to continue to attract tenants. The Legal Entity typically funds its capital investments via a mix of equity and debt financing. However, all capital investment decisions involving new property developments need the lender’s approval (one party). There are no other variable interest holders in the Legal Entity (e.g., a lender) that have participating rights. Assume that the equity at risk is sufficient to absorb all ex- pected future losses of the partnership. Is the limited partnership a variable interest entity (VIE) on the basis of the power test? Explain your answer. VIE because equity holders lack power to control activities

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TOPIC REVIEW 6.11 Problem 6.63 Consolidation worksheet for gain on constructive retirement of parent’s debt with no AAP Assume that a Parent company acquires a 70 percent interest in its Subsidiary on January 1, 2018. On the date of acquisition, the fair value of the 70 percent controlling interest was $291,200 and the fair value of the 30 percent noncontrolling interest was $124,800. On January 1, 2018, the book value of net assets equaled $416,000 and the fair value of the identifiable net assets equaled the book value of identifiable net assets (i.e., there was no AAP or Goodwill). On December 31, 2019, the Parent company issued $400,000 (face) 6 percent, five-year bonds to an unaffiliated company for $416,000. The bonds pay interest annually on December 31, and the bond premium is amortized using the straight-line method. This results in annual bond-payable pre- mium amortization equal to $3,200 per year. On December 31, 2021, the Subsidiary paid $388,000 to purchase all of the outstanding Parent company bonds. The bond discount is amortized using the straight-line method, which results in an- nual bond-investment discount amortization equal to $4,000 per year. The Parent and the Subsidiary report the following financial statements for the year ended De- cember 31, 2022: Consolidation Entries Parent Subsidiary Dr Cr Consolidated Income Statement Sales $ 2,240,000 $ 720,000 $ 2,960,000 Cost of Goods Sold (1,200,000) (424,000) (1,624,000) Gross Profit 1,040,000 296,000 1,336,000 Income (loss) from Subsidiary 52,720 - [C] 52,720 - Operating & other expenses (880,000) (238,400) (1,118,400) Bond interest income 28,000 [Ibond] 28,000 - Bond interest expense (20,800) [Ibond] 20,800 - Net Income $ 191,920 $ 85,600 217,600 Income attributable to NCI [C] 25,680 (25,680) Income attributable to Controlling Int $ 191,920 Retained Earnings Statement Beg. Ret. Earn. - Parent $ 1,421,680 $ 346,400 [E] 346,400 $ 1,421,680 Net Income 191,920 85,600 191,920 Dividends Declared (120,000) (40,000) [C] 40,000 (120,000) Ending Retained Earnings $ 1,493,600 $ 392,000 $ 1,493,600 Balance Sheet Cash $ 640,000 $ 240,000 $ 880,000 Accounts receivable 720,000 320,000 1,040,000 Inventories 800,000 400,000 1,200,000 Property, Plant & Equipment, net 1,792,000 720,000 2,512,000 Investment in Subsidiary 468,000 [C] 24,720 - [E] 421,680 [Ibond] 21,600 Investment in Bond (net) 392,000 [Ibond] 392,000 - Total Assets $ 4,420,000 $ 2,072,000 $ 5,632,000 Accounts Payable $ 480,000 $ 384,000 $ 864,000 Other current liabilities 640,000 400,000 1,040,000 Bond Payable (net) 406,400 [Ibond] 406,400 - Other long-term liabilites 640,000 640,000 1,280,000 Common Stock 360,000 120,000 [E] 120,000 360,000

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APIC 400,000 136,000 [E] 136,000 400,000 Retained Earnings 1,493,600 392,000 1,493,600 Noncontrolling Interest [C] 13,680 194,400 [E] 180,720 Total Liabilities and Equity $ 4,420,000 $ 2,072,000 $ 5,632,000 The parent uses the equity method of pre-consolidation investment bookkeeping. Provide the consoli- dation entries and prepare a consolidation worksheet for the year ended December 31, 2022.

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6.1 d 6.2 a 6.3 c 6.4 c 6.5 b 6.6 a 6.7 d 6.8 a 6.9 c Some interest expense b/c retired halfway through the year 6.10 Equity income- 2021 Dr Cr 180,000 Sub NI 22,500 Accelerate gain 2,700 Excess income over expense 199,800 + 450,000 = 649,800 e 6.11 Equity income- 2022 Dr Cr 180,000 Sub NI 2,700 Excess income over expense 177,300 + 450,000 = 627,300 e 6.12 Equity income- 2021 Dr Cr 460,000 Sub NI 57,500 Accelerate gain 517,500 + 1,150,000 = 1,667,500 b 6.13 Equity income- 2022 (70%) ownership 318,500 70 % of Sub NI 19,500 100% of accelerated loss 3,900 100% of excess expense over income 302,900 + 975,000 = 1,277,900 e 6.14 C Equity income 302,900 NI attrib to NCI 136,500 30% of sub NI c Dividends - Equity investment 302,900 Noncontrolling interest 136,500

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Ch 6 TRMC (1)

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