Question

Per the textbook, some investors (e.g., Warren Buffet) have contended that the U.S. GAAP treatment undervalued the parent’s investment carrying value for post-control step acquisitions. Construct one (1) argument in which you provide at least two (2) reasons for the U.S. GAAP treatment of reporting additional investments in subsidiaries when the parent previously established control. Provide support for your rationale. Determine the main characteristics of a variable interest entity (VIE). Evaluate the usefulness to investors of the inclusion of VIEs in the company’s consolidated financial statements. Provide support for your rationale.

Answer 1

ASC810 of US GAAP provides that there are two consolidation models. First, entities are subjected to the variable interest entity (VIE) model. If the VIE model is not applicable, then entities are subjected to the voting interest model.

Under the VIE model, a reporting entity has a
controlling financial interest in a VIE if it has:

(a) the power to direct the activities of the VIE
that most significantly affect the VIE’s economic
performance and (b) the obligation to absorb
losses or the rights to receive benefits that could
be significant to the VIE.
Under the voting interest model, a controlling
financial interest generally exists if a reporting
entity has a majority voting interest in another
entity. In certain circumstances, the power to
control may exist when one entity holds less
than a majority voting interest (e.g., because of
contractual provisions or agreements with other
shareholders).

A variable interest entity (VIE) is a legal entity in which an investor holds a controlling interest, despite not having a majority of its share ownership. A VIE has the following characteristics:

• The entity's equity is not sufficient to support its operations
• Residual equity holders do not control the VIE
• Residual equity holders are shielded from the gains and losses normally associated with ownership

If an investor is the primary beneficiary of such an entity, the investor must consolidate its financial statements with those of the VIE. The primary beneficiary is the one that can direct the most significant economic activities of the VIE.

Variable interest entities are used as special purpose vehicles to finance certain investments without putting the parent entity at risk of loss.

Benefits-

GAAP guidelines help businesses maintain consistency in their presentation of financial information, reduce the risk of misrepresentation and avoid fraud. GAAP was created to safeguard the rights of stakeholders, including investors. It holds companies responsible for their financial reporting activities, thus providing greater assurance to all interested parties. Through the use of GAAP guidelines, companies provide true and fair presentation of financial information.

Consistency

Adhering to GAAP guidelines can help you implement proper controls and safeguards. The fact that the GAAP guidelines suggest using a consistent basis that professionals can apply to accounting transactions illustrates this fact. Consistency leads to a more fair presentation and helps in comparing financial statements across multiple periods. This helps you determine your company’s overall performance, identify areas that need improvement and judge the benefits of changes that you implement.

Stakeholder's Trust

Presenting your information using GAAP also helps to instill trust in those with an interest in your company. There are many possible ways to manipulate the financial information of a company, and many times, a simple modification to the way things are presented changes the face of financial statements. These changes can cause the reader to interpret the statements differently than if the modifications were not applied. Complying with GAAP guidelines gives assurance to anyone interested in your company that your financial statements were prepared using standard guidelines.

Comparable Statements

Investors and other interested parties can compare financial information of across different companies because GAAP provides standardized guidelines that accounting, auditing and financial professionals follow. This means that you can draw realistic conclusions about your company’s performance, as the accounting principles that you use are consistent with those of your competitors. If GAAP guidelines were not applied, a high profit shown by one company might not be comparable to a company showing lesser returns because of a difference in the revenue-recognition method. One company might have higher profits than another in true terms; however, the lack of standardization makes comparing the two results difficult.