Consolidating a VIE

According to #48 of 2012 AM Mock (my words):

If a VIE has $30m of Net Income, and you choose to consolidate, then parent Net Income and Total Equity are reduced by 30m.

My opinion:

If you are consolidating, shouldn’t Net Income and Equity Increase? This makes no intuitive sense.

This must be an error, I cannot see how the mock answer is correct

I believe it was because the asset was sold for 200mn and the fair value was 170mn. The company sold the plant, or whatever it was for 200mn (FV was 170)mn so you have to add the 200 back and subtract out 30.

hmm…that makes sense

That’s true. When u sold SPE u book 30 gain in IS. Whenu consolidate u no longer have that gain therefore equity n NI both reduced by 30

So when you consolidate a VIE, you have to reverse gains?

Apparently so. The answer did not go on to say how the balance sheet balances. What does the VIE’s balance sheet look like?

The way I reason it is this. Remember that Consoldiation Method for the Income Statement, assuming NO minority interest is just cominbing ALL the REVENUES and EXPENSES. Prior to this VIE consoldation, assume the 2 firms only did that 1 transaction with each other.

Firm A

$30 Revenue

$0 cost

$30 NI

Firm B

$0 Revenue

$ 30 Cost

  • $30 NI

Prior to consolidation, the Income Statement for Firm A is what’s shown by the analyst. Now if you decided to now consolodate the 2 companies, you would see

$30 Revenues

$ 30 Cost

$0 NI

Reason being, A’s profit = B’s cost. Combine the 2 and you should not have any excess net income. Thus you reduce whatever net income by the amount of this transaction. And if you’re going to reduce your NI, then you must trace it to the Balance Sheet and reduce it there as well =)

This problem has nothing to do with the net income provided by the VIE. Given the other posters, it looks like the VIE paid > book value for the receivables. Since you didn’t sell the assets if you reverse the transaction, you need to remove the “gain” provided to the sponsor.

You won’t always have a “gain” when you sell receivables to a VIE, only if the VIE and the sponser agree that the receivables are worth more than book value. But, if you are being told to remove the effects of the sale, then you have to remove the effect of the gain.

I would think that in a very basic scenario, the VIE would issue debt for 200 and pay the sponsor 200 for something they had on their books for 170. The extra 30 is income to the sponsor. Cash goes up by 200, Receivables down by 170, and Net Income up by 30. OR, the VIE could issue debt for 190 and the sponsor would have 10mm in an equity investment. Follow the cash transactions, and try not to make it too complicated.

If you reverse it, Cash goes down by 200, receivable up by 170, equity down by 30