After studying this chapter, you should be able to do the following:

1. Identify when a special-purpose entity should be consolidated, and prepare consolidated statements for a sponsor and its controlled special-purpose entities.
2. Describe and apply the current accounting standards that govern the reporting of interests in joint arrangements.
3. Understand the deferred tax implications of the accounting for a business combination.
4. Describe the requirements for segment disclosures and apply the quantitative thresholds to determine reportable segments.
5. Analyze and interpret financial statements involving other consolidation reporting issues.
6. Identify some of the differences between IFRSs and ASPE involving other consolidation reporting issues.

Special-Purpose Entities (SPE) and Variable Interest Entities (VIE)
In this chapter, we have examined four different topics, which almost wind up our study of business combinations and the preparation of consolidated financial statements. In the previous chapters, the parent controlled the subsidiary through voting rights. However, there are other means of controlling the operating and financial policies of the subsidiary. Consolidation is required for a variable-interest entity (VIE), which is controlled by a primary beneficiary on a basis of control other than through ownership of a voting interest.

Some points to remember for special-purpose entities (SPEs):

• Control of an SPE is usually based on who directs the key activities of the SPE. Control of an SPE is generally achieved by contracts and operating agreements, and the SPE must be consolidated in a fashion similar to what we used in previous chapters.



• An SPE is an entity created to accomplish a very specific business activity.



• SPEs are often able to obtain debt financing at very favourable interest rates. The SPE purchases and finances the asset acquisition, then leases the asset to the sponsor.



• Before GAAP was changed, many companies used SPEs as a vehicle for “off-balance sheet financing.” The sponsoring entity did not have to own a majority of the voting shares to maintain control. In fact, a sponsoring enterprise usually owned very little, if any, of the voting shares of the SPE. Therefore, the sponsoring enterprise did not control the SPE through a voting interest and did not, until the late 1990s, have to consolidate the SPE.



• The risks and rewards (i.e., profit and loss) may not be distributed in accordance with equity ownership but rather with some other variable interest attaching to a sponsoring firm as a result of contractual arrangements.



• The equity investors of an SPE typically receive a guaranteed rate of return as a reward for ceding control to the SPE’s sponsor.



• In 1998, the IASB issued SIC 12 Consolidation — Special Purpose Entities. It required that an SPE should be consolidated when the substance of the relationship between an entity and the SPE indicates that the SPE is controlled by that entity. Canada and the United States did not adopt any special rules related to an SPE until 2003.



• A variable interest entity (VIE) is a special-purpose entity that is not subject to control through voting ownership interests, but is nonetheless controlled by another enterprise. In order to determine if consolidation is required, it is first necessary to determine if there is a primary beneficiary of the VIE. Each enterprise involved with a VIE must determine whether the financial support provided by that enterprise makes it the primary beneficiary of the VIE’s activities. The primary beneficiary of the VIE is then required to include the assets, liabilities, and results of the VIE in its consolidated financial statements. The primary beneficiary bears most of the risks and receives the residual returns.



• The financial reporting principles for consolidating VIEs require assets, liabilities, and non-controlling interests (NCIs) to be initially recorded at fair values, with two notable exceptions. First, if any of the SPE’s assets have been transferred from the primary beneficiary, these assets will be measured at the carrying value before the transfer. Second, the asset valuation procedures in IAS 27 also rely on the allocation principles described in IFRS 3, which identifies some instances where assets and liabilities are not reported at fair value at the date of acquisition.



• In a VIE, control is not obtained by incurring a cost but through governance agreements and contractual arrangements. Therefore, an implied value substitutes for the acquisition cost in determining the valuation of a VIE.



• Initial Consolidation Measurement Issues – The amounts of the implied value and the consideration received are compared to determine the amount of any goodwill or negative goodwill. If the implied value is less than the value of consideration received (which we will refer to as the assessed value), then there is negative goodwill. The excess of the assessed value (i.e., consideration received) over the implied value (i.e., consideration given) is reported as a gain on purchase. If the implied value is greater than the assessed value, the difference is reported as goodwill when the SPE is a business or as a reduction in the amounts assigned to the assets acquired when the SPE is not a business.



• Consolidation Issues Subsequent to Initial Measurement – After the initial measurement, consolidations of VIEs with their primary beneficiary should follow the same process as if the entity were consolidated based on voting interests. The implied acquisition differential must be amortized. All intercompany transactions must be eliminated. The income of the VIE must be allocated among the parties involved (i.e., equity-holders and the primary beneficiary). For a VIE, contractual arrangements, as opposed to ownership percentages, typically specify the distribution of its income.



• The disclosure requirements for a SPE are very extensive.

Joint Arrangements A joint arrangement is a contractual arrangement whereby two or more parties undertake an activity together and jointly control that activity. Accounting guidance is provided in IFRS 10: Joint Arrangements. Joint arrangements are typically classified into two types — joint operations and joint ventures. In many joint operations, the venturers contribute the use of assets but retain title to the assets. In most joint ventures, the venturers contribute assets to a separate legal entity, which has title to the assets. For an interest in a joint operation, the venturer should recognize the assets it controls and the liabilities it incurs, the expenses it incurs, and its share of the revenue and expenses from the sale of goods or services by the joint arrangement.

Some points to remember regarding joint arrangements:

• According to GAAP, joint control is the key feature in a joint arrangement, which means no one venturer can unilaterally control the venture regardless of the size of its equity contribution.
• Accounting for Joint Operations – A venturer’s interest in a joint operation is reported in a fashion similar to activities carried out by any entity. It applies relevant IFRSs as it recognizes the following: (a) The assets it controls and the liabilities it incurs; (b) The expenses it incurs; and (c) Its share of the revenue and expenses from the sale of goods or services by the joint arrangement. The venturer reports its proportionate share of the assets, liabilities, revenues, and expenses of the joint operation. When assets are contributed to the joint operation, a portion of the gain can be recognized on the contribution of assets to a joint operation under certain circumstances. A gain can be recognized when the significant risks and rewards have been transferred. A gain can be recognized when the commercial substance test is met. The venturer’s own interest in the gain is recognized over the life of the asset.
• Accounting for an Interest in a Joint Venture – Until the implementation of IFRSs in 2011, Canadian GAAP required that proportional consolidation be used when reporting an interest in a joint venture. Effective 2013, under IFRS 11, the venturer must use the equity method to report its investment in a joint venture. This acquisition differential would be allocated and amortized in the same manner illustrated previously for parent–subsidiary affiliations. For a joint venture, the venturer’s share of any intercompany asset profits are eliminated, regardless of whether the sale was upstream or downstream, however, only the venturer’s share of profits is eliminated. When a venturer contributes non-monetary assets to the joint venture, the investment should be recorded at the fair value of the non-monetary assets transferred to the joint venture, and any unrealized gain is recognized as the asset is used to generate a profit on transactions with outsiders. Disclosure requirements are also extensive for joint arrangements, for instance, the entity must disclose the nature and extent of its operations conducted through joint arrangements.

Deferred Income Taxes and Business Combinations
The consolidated expenses resulting from the allocation of the acquisition differential are not deductible for tax purposes, but under the balance sheet approach the reflection of deferred tax assets and liabilities is required for the differences between the carrying values and the tax bases of subsidiary company’s net assets shown on consolidated balance sheets.

Some key points related to deferred income taxes and business combinations:

• IAS 12: Income Taxes uses the balance sheet (or liability) approach. This approach requires that the differences between the carrying value of an asset or a liability in the balance sheet and its tax base be accounted for. These differences are called temporary differences. Under IAS 12, there are two basic types of temporary differences: deductible and taxable.
• A deductible temporary difference is one that can be deducted in determining taxable income in the future when the asset or liability is recovered or settled for its carrying amount. These differences exist when (a) the carrying amount of an asset is less than its tax base, or (b) an amount related to a liability can be deducted for tax purposes. Accounting for these differences results in deferred income tax assets.
• A taxable temporary difference is one that will result in future taxable amounts when the carrying amount of the asset or the liability is recovered or settled. Such differences, which result in deferred income tax liabilities, occur mainly when the carrying amount of an asset is greater than its tax base. For instance, when the amount of CCA taken exceeds book depreciation, the result is a deferred tax liability.
• When a business combination occurs, the acquirer records the net assets acquired at fair values, and when the tax base of these net assets are a different amount, a deferred tax asset or liability becomes part of the allocation of the acquisition cost.
• In preparing consolidated financial statements in subsequent periods, the values used for each subsidiary’s net assets have to be compared to their tax base in order to determine new values for deferred tax assets and liabilities.
• The tax benefits of operating loss carry-forwards, which were not previously recognizable by either party to the business combination, form part of the allocation of the purchase cost.
• The entity must disclose the amount and reason for changes in deferred tax assets pertaining to a business combination.

Segment Disclosures
Consolidation hides information about the lines of business conducted by multinational conglomerates. Required segment disclosures are designed to provide financial statement users with relevant information that will aid them in assessing company results. Accounting guidance is provided in IFRS 8: Operating Segments.

Some points to remember about segment disclosures:

• Public companies are required to disclose information about their lines of business, products and services, countries where they operate, and major customers.
• Three tests (revenue, profit, and assets) are used to determine whether or not a particular operating segment is reportable. Each test applies a 10% rule. Note that the operating profit test considers the larger of the absolute amount of total profits and total losses.
• Separate disclosure is required if a segment satisfies any one test.
• At least 75% of a company’s total external revenue must be reported in a segment other than the “other” segment.
• IFRS 8 outlines extensive disclosures required for each reportable segment. For instance, reconciliations of the segments’ total revenues, profits, assets, and liabilities to the entity’s overall revenues, profits, assets, and liabilities must be provided. In addition, revenue must be segregated by product or service and by geographical area. Segmented information is provided for revenue, profit (loss), assets, liabilities, capital expenditures, and depreciation. Information by segment should be provided for unusual items and significant non-cash items.

Private enterprises reporting under ASPE:

• may report association with VIEs using full consolidation, the cost method, or the equity method but must be consistent with the method used for reporting subsidiaries;
• may report interest in joint ventures using proportionate consolidation, the cost method, or the equity method;
• may use the taxes payable method or the future income tax payable method, which is similar to the liability method under IFRSs, to account for income tax (deferred income taxes need not be recognized; however, the entity must prepare and disclose reconciliation between the statutory rate and the effective tax rate);
• are not required to disclose any information about operating segments.