ACCT 402 Week 7 Group Discussion Board Forum 4 Example

Group Discussion Board Forum 4: Variable Interest Entities and Intra-Entity Transactions

ACCT 402 Consolidations and Advanced Accounting Topics, Group Discussion Board Forum 4

Thread by [Student Name]

The companies, their figures and the classmate are composites; the textbook and the scholarly source cited are real.

Ridgeway Manufacturing needs a $40 million distribution center but does not want the debt on its balance sheet. A separate entity is formed to buy the building and lease it to Ridgeway. Outside investors contribute $1.2 million of equity, 3% of the cost, and the entity borrows the rest from a bank. Ridgeway guarantees the loan, agrees to a residual value guarantee on the building and decides how the facility is operated and maintained. Ridgeway owns no shares, so a voting interest test would leave the entity and its $38.8 million of debt off Ridgeway's statements.

Hoyle et al. (2018) explain that an entity is a variable interest entity when its owners' equity at risk cannot carry its operations without further subordinated backing, or when those owners lack the power or economic exposure ownership normally brings. Ridgeway's guarantees are variable interests, because their value changes with the entity's performance. Consolidation falls to the primary beneficiary, the party with power over the decisions that most shape the entity's results together with significant exposure to its losses or benefits. Ridgeway meets both conditions, so it consolidates the entity, bringing the building and the debt onto its balance sheet. Consolidation follows the party that bears the risk and makes the decisions, whoever holds the shares.

The rule responds to a real pattern. Feng et al. (2009) found that the share of firms using at least one special purpose vehicle rose about two and a half times from 1997 to 2004, that use increased with financial reporting incentives as well as tax and economic motives, and that vehicles arranged for financial reporting purposes were associated with earnings management. Strong corporate governance tended to reduce their use. The variable interest model removes much of the reporting benefit by looking through legal form to who actually controls and bears the risk. For Ridgeway, consolidation means its debt ratios now include the warehouse loan, which is exactly the information a lender evaluating Ridgeway would want.

Reply to Ethan

Ethan, your thread explained that consolidated statements must remove profits on sales between a parent and subsidiary until the goods are sold to outsiders, and a short example shows how the deferral works. Suppose Ridgeway sells inventory that cost $300,000 to its subsidiary for $400,000, a markup of 25% on the selling price, and the subsidiary still holds $80,000 of that inventory at year-end. The unrealized profit is 25% of $80,000, or $20,000. On the worksheet, the entire $400,000 of intra-entity sales and purchases is eliminated, and the $20,000 is removed from ending inventory and added to cost of goods sold. Hoyle et al. (2018) explain that in a downstream sale like this one, the full deferral reduces the parent's income, while in an upstream sale it is shared with any noncontrolling interest. The profit is recognized the following year, when the subsidiary sells the goods to an outside customer. Until then, the consolidated entity has simply moved goods from one warehouse to another.

References

Feng, M., Gramlich, J. D., & Gupta, S. (2009). Special purpose vehicles: Empirical evidence on determinants and earnings management. The Accounting Review, 84(6), 1833-1876. https://doi.org/10.2308/accr.2009.84.6.1833

Hoyle, J. B., Schaefer, T. F., & Doupnik, T. S. (2018). Advanced accounting (13th ed.). McGraw-Hill Education.