Question 7

Evergreen Brothers is a large producer of bedding plants and shrubs that are sold to various retail nurseries and home improvement stores located across the western coast of the United States with approximately $85 million in annual sales. Evergreen grows its products at two facilities, one in Northern California and the other in the Southern part of the state. Each production facility currently distributes its products within an approximate 150 mile radius of its location. All aspects of the shipping and delivery of products have historically been provided by an independent, third-party distribution company.

Because of impressive growth in the company’s sales over the past several years, management has decided to pursue plans to bring “in-house” the distribution of the company’s products. They believe that the projected decreased freight costs as well as the increased efficiencies in more actively managing the distribution of their production should immediately yield increased profit margins. As an initial step, Evergreen has negotiated the price for ten delivery trucks, which could provide all distribution capacity needed for the company’s Northern production facility for the upcoming season. Current plans are to continue the use of the independent distribution company for the needs of the firm’s Southern facility for at least the next several years.

Under advice from the company’s CFO, Evergreen has created a new special purpose entity (SPE), QuickTime, Inc., which will serve as the entity that will purchase the trucks from the dealer. The purchase will be financed through a combination of debt and equity, with the dealer lending 75% of the total cost. The loan is collateralized by both the trucks and Evergreen’s guarantee of the debt, as required by the dealer.

Evergreen has arranged for an outside investor to provide the remaining 25% of the upfront costs of the equipment in exchange for 100% of QuickTime’s nonvoting stock. In addition, the outside investor is guaranteed an 8% annual return for the life of the financing term. At the end of seven years, QuickTime will be liquidated and Evergreen will have the option of purchasing the equipment for its fair value at that time. The proceeds of the liquidation will be used to repurchase the outside investor’s stock at par value. In the event that the liquidation value is insufficient to buy back the outside investor’s stock, Evergreen has committed to fund the shortfall.

Management has given its tentative approval of the project and the proposed structure. Questions remain, however, as to the effect of the creation of QuickTime on Evergreen’s financial statements. With the relatively recent issuance of FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (FIN 46(R)), the management of Evergreen has not had prior experience with the new consolidation requirements for SPEs.

Part 1)

Which of the following statements regarding special purpose entities (SPEs) is least accurate?

A)   In general, the equity investors in an SPE can expect to receive a limited rate of return on their investment in exchange for limited risk exposure.

B)   An SPE can be formed to isolate specific assets from the sponsor, thus lowering the cost of capital by protecting the assets of the SPE in the event the sponsor experiences financial distress.

C)   The entity that absorbs the majority of the risk or receives the majority of the rewards of an SPE is known as the primary beneficiary.

D)   An SPE can be established as one of several legal forms, such as corporations, partnerships, or trusts, but must establish separate management from that of the sponsor.

Part 2)

In exchange for providing lower-cost financing to an SPE, lenders typically require additional financial support from a sponsor, which may be in the form of additional collateral or guarantees. In return, the sponsor will typically receive which of the following risk and return profiles?

A)   Pro-rata share of the actual risk and a pre-determined fixed rate of return on the project.

B)   Pro-rata share of the actual risks and returns on the project.

C)   Pro-rata share of the actual returns on the project and a pre-determined fixed level of risk on the project.

D)   Pre-determined fixed levels of both the risks and returns on the project.

Part 3)

According to FIN 46(R), if an SPE is to be considered a variable interest entity (VIE), it must meet which of the following conditions?

A)   The equity investors in the VIE must bear all of the SPE’s risk up to a pre-determined level as outlined in the governing documents.

B)   The SPE must be consolidated by the primary beneficiary, whose status as primary beneficiary is defined by the level of the firm’s percentage of voting control.

C)   The total at-risk equity of the SPE is not sufficient to finance the entity’s activities without additional subordinated financial support.

D)   The equity investors must maintain decision-making rights, which include, but are not limited to, majority voting rights.

Part 4)

In order to be considered a VIE under FIN 46(R), an entity must meet certain conditions. Which of the following statements about QuickTime is most accurate? Under FIN 46(R), QuickTime is:

A)   considered a VIE because outside investors share the residual gains and losses at liquidation with Evergreen.

B)   not considered a VIE because the outside investor does not have any decision making rights.

C)   considered a VIE because the outside investor’s capital contribution is not sufficient to finance QuickTime’s operations.

D)   not considered a VIE because the outside investor receives a pre-determined rate of return.

The correct answer was C) considered a VIE because the outside investor’s capital contribution is not sufficient to finance QuickTime’s operations.

Part 5)

As outlined in FIN 46(R), the primary beneficiary of a VIE is that entity which meets which of the following conditions?

A)   Holds the majority voting control of the VIE and has separate management from the VIE.

B)   Has contributed the majority of the capital involved in the formation of the VIE.

C)   Has exposure to the majority of the loss risks or receives the majority of the residual benefits of the VIE.

D)   Holds the majority voting control of the VIE and shares management with the VIE.

Part 6)

Assuming that QuickTime is considered a VIE in accordance with FIN 46(R), which of the following statements regarding the consolidation of QuickTime on Evergreen’s financial statements is most accurate?

A)   Because the outside investor holds only nonvoting stock, Evergreen holds the majority controlling financial interest in QuickTime and must consolidate QuickTime on its financial statements.

B)   An outside investor is a participant in QuickTime’s risks and rewards, so Evergreen may not consolidate QuickTime on its financial statements.

C)   Evergreen is exposed to the majority of QuickTime’s risks and rewards, so Evergreen must consolidate QuickTime on its financial statements.

Part 1)

Which of the following statements regarding special purpose entities (SPEs) is least accurate?

A)   In general, the equity investors in an SPE can expect to receive a limited rate of return on their investment in exchange for limited risk exposure.

B)   An SPE can be formed to isolate specific assets from the sponsor, thus lowering the cost of capital by protecting the assets of the SPE in the event the sponsor experiences financial distress.

C)   The entity that absorbs the majority of the risk or receives the majority of the rewards of an SPE is known as the primary beneficiary.

D)   An SPE can be established as one of several legal forms, such as corporations, partnerships, or trusts, but must establish separate management from that of the sponsor.

Your answer: D was correct!

An SPE can take on one of many legal forms, but does not necessarily have to have separate management or employees from that of the sponsor.

This question tested from Session 5, Reading 23, LOS a

Part 2)

In exchange for providing lower-cost financing to an SPE, lenders typically require additional financial support from a sponsor, which may be in the form of additional collateral or guarantees. In return, the sponsor will typically receive which of the following risk and return profiles?

A)   Pro-rata share of the actual risk and a pre-determined fixed rate of return on the project.

B)   Pro-rata share of the actual risks and returns on the project.

C)   Pro-rata share of the actual returns on the project and a pre-determined fixed level of risk on the project.

D)   Pre-determined fixed levels of both the risks and returns on the project.

The correct answer was B) Pro-rata share of the actual risks and returns on the project.

By transferring the variability in the risk of a project to a sponsor, a lender can provide a lower cost of financing to the company that creates the SPE. In return, the sponsor will receive pro-rata profits or other residual interests in the project.

This question tested from Session 5, Reading 23, LOS a

Part 3)

According to FIN 46(R), if an SPE is to be considered a variable interest entity (VIE), it must meet which of the following conditions?

A)   The equity investors in the VIE must bear all of the SPE’s risk up to a pre-determined level as outlined in the governing documents.

B)   The SPE must be consolidated by the primary beneficiary, whose status as primary beneficiary is defined by the level of the firm’s percentage of voting control.

C)   The total at-risk equity of the SPE is not sufficient to finance the entity’s activities without additional subordinated financial support.

D)   The equity investors must maintain decision-making rights, which include, but are not limited to, majority voting rights.

The correct answer was C) The total at-risk equity of the SPE is not sufficient to finance the entity’s activities without additional subordinated financial support.

To qualify as a VIE under FIN 46(R), any one of four conditions must be met, one of which is the presence of an insufficient at-risk equity investment.

This question tested from Session 5, Reading 23, LOS a

Part 4)

In order to be considered a VIE under FIN 46(R), an entity must meet certain conditions. Which of the following statements about QuickTime is most accurate? Under FIN 46(R), QuickTime is:

A)   considered a VIE because outside investors share the residual gains and losses at liquidation with Evergreen.

B)   not considered a VIE because the outside investor does not have any decision making rights.

C)   considered a VIE because the outside investor’s capital contribution is not sufficient to finance QuickTime’s operations.

D)   not considered a VIE because the outside investor receives a pre-determined rate of return.

The correct answer was C) considered a VIE because the outside investor’s capital contribution is not sufficient to finance QuickTime’s operations.

The outside investor contributed 25% of the necessary capital, but this was not sufficient because the dealer additionally required Evergreen’s guarantee in order to close the deal. This condition satisfies the requirements established by FIN 46(R) in order to be classified as a VIE.

This question tested from Session 5, Reading 23, LOS a

Part 5)

As outlined in FIN 46(R), the primary beneficiary of a VIE is that entity which meets which of the following conditions?

A)   Holds the majority voting control of the VIE and has separate management from the VIE.

B)   Has contributed the majority of the capital involved in the formation of the VIE.

C)   Has exposure to the majority of the loss risks or receives the majority of the residual benefits of the VIE.

D)   Holds the majority voting control of the VIE and shares management with the VIE.

Your answer: C was correct!

Unlike past accounting treatments of VIEs where consolidation was based upon voting control, FIN 46(R) recognizes the primary beneficiary of a VIE as that entity that absorbs the majority of the risks and enjoys the majority of the benefits of the VIE. The primary beneficiary is required to consolidate the VIE on their financial statements.

This question tested from Session 5, Reading 23, LOS a

Part 6)

Assuming that QuickTime is considered a VIE in accordance with FIN 46(R), which of the following statements regarding the consolidation of QuickTime on Evergreen’s financial statements is most accurate?

A)   Because the outside investor holds only nonvoting stock, Evergreen holds the majority controlling financial interest in QuickTime and must consolidate QuickTime on its financial statements.

B)   An outside investor is a participant in QuickTime’s risks and rewards, so Evergreen may not consolidate QuickTime on its financial statements.

C)   Evergreen is exposed to the majority of QuickTime’s risks and rewards, so Evergreen must consolidate QuickTime on its financial statements.

D)   The truck dealer is supplying the financing for the majority (75%) of QuickTime’s debt, so Evergreen may not consolidate QuickTime on its financial statements.

The correct answer was C) Evergreen is exposed to the majority of QuickTime’s risks and rewards, so Evergreen must consolidate QuickTime on its financial statements.

Before the issuance of FIN 46(R), consolidation was based upon possession of voting control of an entity. FIN 46(R) uses a risk/reward approach when determining which firm must consolidate the VIE on its financial statements. Since Evergreen is the sole entity exposed to variability in QuickTime’s net income and as well asset value, QuickTime should be consolidated on their financial statements.

This question tested from Session 5, Reading 23, LOS a

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Question 7

Evergreen Brothers is a large producer of bedding plants and shrubs that are sold to various retail nurseries and home improvement stores located across the western coast of the United States with approximately $85 million in annual sales. Evergreen grows its products at two facilities, one in Northern California and the other in the Southern part of the state. Each production facility currently distributes its products within an approximate 150 mile radius of its location. All aspects of the shipping and delivery of products have historically been provided by an independent, third-party distribution company.

Because of impressive growth in the company’s sales over the past several years, management has decided to pursue plans to bring “in-house” the distribution of the company’s products. They believe that the projected decreased freight costs as well as the increased efficiencies in more actively managing the distribution of their production should immediately yield increased profit margins. As an initial step, Evergreen has negotiated the price for ten delivery trucks, which could provide all distribution capacity needed for the company’s Northern production facility for the upcoming season. Current plans are to continue the use of the independent distribution company for the needs of the firm’s Southern facility for at least the next several years.

Under advice from the company’s CFO, Evergreen has created a new special purpose entity (SPE), QuickTime, Inc., which will serve as the entity that will purchase the trucks from the dealer. The purchase will be financed through a combination of debt and equity, with the dealer lending 75% of the total cost. The loan is collateralized by both the trucks and Evergreen’s guarantee of the debt, as required by the dealer.

Evergreen has arranged for an outside investor to provide the remaining 25% of the upfront costs of the equipment in exchange for 100% of QuickTime’s nonvoting stock. In addition, the outside investor is guaranteed an 8% annual return for the life of the financing term. At the end of seven years, QuickTime will be liquidated and Evergreen will have the option of purchasing the equipment for its fair value at that time. The proceeds of the liquidation will be used to repurchase the outside investor’s stock at par value. In the event that the liquidation value is insufficient to buy back the outside investor’s stock, Evergreen has committed to fund the shortfall.

Management has given its tentative approval of the project and the proposed structure. Questions remain, however, as to the effect of the creation of QuickTime on Evergreen’s financial statements. With the relatively recent issuance of FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (FIN 46(R)), the management of Evergreen has not had prior experience with the new consolidation requirements for SPEs.

Part 1)

Which of the following statements regarding special purpose entities (SPEs) is least accurate?

A)   In general, the equity investors in an SPE can expect to receive a limited rate of return on their investment in exchange for limited risk exposure.

B)   An SPE can be formed to isolate specific assets from the sponsor, thus lowering the cost of capital by protecting the assets of the SPE in the event the sponsor experiences financial distress.

C)   The entity that absorbs the majority of the risk or receives the majority of the rewards of an SPE is known as the primary beneficiary.

D)   An SPE can be established as one of several legal forms, such as corporations, partnerships, or trusts, but must establish separate management from that of the sponsor.

Part 2)

In exchange for providing lower-cost financing to an SPE, lenders typically require additional financial support from a sponsor, which may be in the form of additional collateral or guarantees. In return, the sponsor will typically receive which of the following risk and return profiles?

A)   Pro-rata share of the actual risk and a pre-determined fixed rate of return on the project.

B)   Pro-rata share of the actual risks and returns on the project.

C)   Pro-rata share of the actual returns on the project and a pre-determined fixed level of risk on the project.

D)   Pre-determined fixed levels of both the risks and returns on the project.

Part 3)

According to FIN 46(R), if an SPE is to be considered a variable interest entity (VIE), it must meet which of the following conditions?

A)   The equity investors in the VIE must bear all of the SPE’s risk up to a pre-determined level as outlined in the governing documents.

B)   The SPE must be consolidated by the primary beneficiary, whose status as primary beneficiary is defined by the level of the firm’s percentage of voting control.

C)   The total at-risk equity of the SPE is not sufficient to finance the entity’s activities without additional subordinated financial support.

D)   The equity investors must maintain decision-making rights, which include, but are not limited to, majority voting rights.

Part 4)

In order to be considered a VIE under FIN 46(R), an entity must meet certain conditions. Which of the following statements about QuickTime is most accurate? Under FIN 46(R), QuickTime is:

A)   considered a VIE because outside investors share the residual gains and losses at liquidation with Evergreen.

B)   not considered a VIE because the outside investor does not have any decision making rights.

C)   considered a VIE because the outside investor’s capital contribution is not sufficient to finance QuickTime’s operations.

D)   not considered a VIE because the outside investor receives a pre-determined rate of return.

The correct answer was C) considered a VIE because the outside investor’s capital contribution is not sufficient to finance QuickTime’s operations.

Part 5)

As outlined in FIN 46(R), the primary beneficiary of a VIE is that entity which meets which of the following conditions?

A)   Holds the majority voting control of the VIE and has separate management from the VIE.

B)   Has contributed the majority of the capital involved in the formation of the VIE.

C)   Has exposure to the majority of the loss risks or receives the majority of the residual benefits of the VIE.

D)   Holds the majority voting control of the VIE and shares management with the VIE.

Part 6)

Assuming that QuickTime is considered a VIE in accordance with FIN 46(R), which of the following statements regarding the consolidation of QuickTime on Evergreen’s financial statements is most accurate?

A)   Because the outside investor holds only nonvoting stock, Evergreen holds the majority controlling financial interest in QuickTime and must consolidate QuickTime on its financial statements.

B)   An outside investor is a participant in QuickTime’s risks and rewards, so Evergreen may not consolidate QuickTime on its financial statements.

C)   Evergreen is exposed to the majority of QuickTime’s risks and rewards, so Evergreen must consolidate QuickTime on its financial statements.