Reading 23- LOS b ～ Q1－4

1.Mustang Corporation formed a special purpose entity (SPE) for purposes of providing research and development. An unrelated firm absorbs the expected losses of the SPE and the independent shareholders of the SPE receive the expected residual returns. Is the SPE considered a variable interest entity (VIE) according to FASB Interpretation No. 46(R) and is consolidation required by Mustang?

The correct answer was B)

Since the shareholders do not absorb the expected losses, the SPE is considered a VIE. The unrelated firm (not Mustang) that absorbs the losses is the primary beneficiary and must consolidate the VIE.

2.According to FASB Interpretation No. 46(R), would an entity qualify as a variable interest entity (VIE) if the shareholders have insufficient equity capital at-risk and would an entity qualify as a VIE if the shareholders absorb the expected losses?

The correct answer was C)

An entity is a VIE if there is insufficient equity capital at-risk. If shareholders absorb the expected losses, the entity would not be a VIE unless any of the other conditions apply.

3.Maverick Incorporated formed a special purpose entity (SPE) to purchase and lease a 50,000 acre ranch. The SPE financed 95 percent of the purchase price with debt. The remaining 5 percent was financed with equity capital received from two separate independent investors. The lender would not make the loan without Maverick’s guarantee. How should Maverick treat the SPE in its financial statements if Maverick is the lessee?

A)   Each equity investor must proportionately consolidate the SPE.

B)   No firm must consolidate the SPE.

C)   The lender must consolidate the SPE.

D)   Maverick must consolidate the SPE.

The correct answer was D)

The 5 percent at-risk equity investment is not sufficient to support the activities of the SPE without Maverick’s guarantee. Thus, the SPE is considered a variable interest entity (VIE). Since Maverick is responsible for the guarantee, Maverick is the primary beneficiary and must consolidate the SPE.

4.Pinto Corporation is an automobile manufacturer that recently created two separate special purpose entities, SPE #1 and SPE #2. Pinto’s financial statements are prepared in accordance with U.S. GAAP.

SPE #1 purchases and securitizes notes receivable originated by Pinto. SPE #1’s capital structure consists of a combination of debt and equity. The equity was contributed from investors unrelated to Pinto. No additional financial support from Pinto is necessary to finance SPE #1’s activities.

SPE #2 was created to purchase an automotive parts subsidiary of Pinto. SPE #2’s capital structure consists of 90 percent debt and 10 percent equity. The equity was contributed by investors unrelated to Pinto. Through a series of derivative instruments, the expected losses of the SPE will be absorbed by Pinto. No additional financial support was necessary to obtain the debt financing.

Should Pinto consolidate SPE #1 and SPE #2?

The correct answer was D)

SPE #1 is not a VIE; thus, it is not necessary for Pinto to consolidate. Since shareholders of SPE #2 will not absorb the expected losses, SPE #2 is a VIE. Pinto absorbs the losses; thus, Pinto is the primary beneficiary and must consolidate SPE #2.