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.
Below is the answer through Kaplan ID: 1208867
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)
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.
B)
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.
C) Correct Via Kaplan
Evergreen is exposed to the majority of QuickTime’s risks and rewards, so Evergreen must consolidate QuickTime on its financial statements.
Explanation
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, as well asset value, QuickTime should be consolidated on their financial statements.
Here is the same question posted on another website, I feel like this si correct and Kaplan is wrong? Anyone have any ideas? I feel like the second website below is correct.
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. 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.
B. 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.
C. 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.
C is correct:
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, as well asset value, QuickTime should be consolidated on their financial statements.