Do you think there is sufficient evidence in this case to suggest that Deluxe Seating needs to consolidate its financial statements with Eagle, Inc.? Explain your reasoning.
Yes, I think there is sufficient evidence suggesting that Deluxe Seating should consolidate its financial statements with Eagle Inc. Deluxe Seating was in dire need of $500 million for purchase of equipment. The best option at the time was the creation of a variable interest entity called Eagle Inc. This was the initial involvement with Deluxe seating which is a legal entity.
According to VIE GAAP, a recording entity shall consolidate a VIE if it has a variable interest that will absorb a majority of the VIEs expected losses, receive a majority of the VIE's expected residual returns, or both. Deluxe Seating absorbs any operating losses incurred by Eagle Inc. but does not receive expected residual returns whatsoever. However, the principle states that the party absorbing majority of the expected losses has to consolidate the VIE as opposed to the other party which only receives a majority of VIEs expected residual return. After the lease period, theres no guarantee of a residual value and just in case the VIE files for bankruptcy, the residual monies, after paying Central Capital Banks loan, is paid to Eagle Inc.s shareholders. Deluxe Seating top management does not own any shares in Eagle Inc, therefore there is no expected residual return. In this case, Deluxe Seating is the primary beneficiary of Eagle Inc. Furthermore, Deluxe Seating has the power to direct the activities of a VIE that most significantly impact the VIEs economic performance since its employees work part time for Eagle Inc therefore affect the economic performance of Eagle Inc.
Do you think there is sufficient evidence in this case to suggest that Deluxe Seating needs to consolidate its financial statements with VPI, Enterprises? Explain your reasoning and address the impact that the existence of kick-out rights has on your thinking.
A reporting entity is obligated to consolidate its VIE if it is the primary beneficiary of the said VIE. For a company to be a primary beneficiary of the VIE, it has to have a controlling financial interest in the VIE. Consequently, we can deduce that Deluxe Seating does not have a controlling financial interest in VPI Enterprises; the reason being that it owns 30% and is a general partner. Moreover, the limited partners have the ability to exercise kick-out rights. We can therefore conclude that Deluxe Seating is not the primary beneficiary of VPI Enterprises and therefore does not need to consolidate the VIE into its sheets. The kick out rights are quite interesting. In the event that Deluxe Seating is kicked out, they are paid double their capital contribution and they wouldnt have any ownership interests. We know that Deluxe Seating has unlimited liability in this partnership with the other shareholders have limited liability.
Given your recommendation to have Deluxe Seating consolidate or not consolidate its financial statements with its VIEs, discuss how you think Deluxe Seating should account for its contingent obligation for its VIEs debts. Does ASC 450 (formerly FASB 5) concerned with contingent liabilities have any bearing on this case? If so, explain the implications of this standard on the accounting for the two VIEs in this case.
Since I recommended the consolidation of Dekuxe Seating with Eagle Inc and not VOI, special attention would have to be given when footnoting this disclosure. Eagle Inc would no longer be accounted on its own but as part of Deluxe Seating,
4. Compute the impact on Deluxe Seatings debt to assets ratio if: (1) Eagle, Inc. and/or VPI Enterprises need to be consolidated with its sponsoring company and/or (2) ASC 450 requirements dictate that Deluxe Seating needs to book contingent liabilities related to Eagle, Inc. and/or VPI Enterprises on its balance sheet. Assess the risk that Deluxe Seating will not be able to continue as a going concern if either Eagle, Inc. and/or VPI Enterprises defaulted on their loans.
The debts to assets ratio is computed by dividing the total liabilities by the total assets.
For the Eagle Inc, they have a debt of $460 million owed to Central Capital Bank at 5% the borrowing cost. Currently, Deluxe Seating is at a debt to asset ratio of 78.7%.
Assets: 878.3 + 500 = $1378.3M
Liabilities: 460 + 28.4 + 662. 9 = $1151.3M
The new ratio is 83.5%
Likewise for VPI Enterprises, they have a current liability of $2.5 M and non-current liability of $81.2 M making a total of $83.7M
If VPI is consolidated into Deluxe Seating sheets, the new total assets would be
Assets : 878.3 + 93.2 = $971.5M
Current liability : 2.5 + 28.4 = $30.9M
Non current liability: 81.2 + 662.9 = $744.1M
The new ratio is (30.9+744.1)/971.5= 79.77%
5. Assess the likelihood that Deluxe Seating will violate its debt covenants (specifically the covenant concerned with its debt to assets ratio) with its major lender, American Bank. Discuss the implications of any possible future debt covenant violation and potential strategies for trying to get American Bank to renegotiate the debt covenants if default seems likely.
If Deluxe Seating follows my recommendation and consolidates with Eagle Inc., there will be a dramatic shift in the debt to assets ratio. I t will go beyond 80% forcing the bank to pay the loan immediately, risk being foreclosed, renegotiate the contract at another rate or the bank could have some shares in the company. Deluxe Seating board of governors do not want to lose majority shares in their company. The best option would be renegotiating the interest rate.
6. Do you agree with the approach Deluxe Seating has taken in accounting for its intercompany sales to VPI Enterprises? If you think these intercompany sales need to be accounted for differently, compute the impact of your suggested approach on Deluxe Seatings net income for the year ended December 31, 2014. (Ignore tax effects).
Legally, the method is correct. I do not see the need for getting another approach for accounting,
7. Are there any ethical issues in this case? What options are there for you (in your role as Deluxe Seating's newly hired controller) to consider if top management does not agree with your analysis with respect to the issue of consolidating or nonconsolidating the Company's VIEs?
Yes there are. The top management would obviously be against consolidation of Deluxe Seating with any or both of its VIEs so as to maintain the debt asset ratio. Options would be getting another job elsewhere since they are bring unethical. This is against GAAP and as a professional getting caught up in the mess is the last thing Id want to do.
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