Unlikely Alliance Memo free essay sample

Florabama is an energy venture classified as a variable interest entity (VIE) of its two investors – Meyer Inc. and Saban Company. Meyer and Saban own 60 percent and 40 percent of Florabama respectively and the profit and losses are split according to ownership percentage. According to the terms of the venture arrangement, Saban is permitted, but not required, to purchase up to 20 percent of the power produced by Florabama at cost plus. The cost-plus arrangement between Saban and Florabama represents a variable interest in that Saban absorbs variability in Florabama through the cost-plus pricing terms. The questions facing us are the following: Because Florabama is a variable interest entity, what are the business activities of Florabama that most significantly impact the entity’s economic performance? And should the cost-plus arrangement between Saban and Florabama be considered in the determination of the consolidating entity? In this memo I will first discuss the issue of consolidation common to all alternatives, and then explain how Meyer Inc. We will write a custom essay sample on Unlikely Alliance Memo or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page r Saban Company could consolidate Florabama according to US GAAP. Finally, I will recommend which entity is the controlling interest, and in effect, should consolidate Florabama to its financial statements. Discussion of Alternatives In either alternative, there is no question that since Florabama is classified as a variable interest entity, it needs to be assessed whether Meyer or Saban is the VIE’s primary beneficiary according to ASC 810-10-25-38A. As defined in ASC 810-10-15, the primary beneficiary is an entity that consolidates the variable interest entity. In the past, the determination of the controlling financial interest was done by simply establishing which entity owned the majority of the subsidiary in question. Now according to ASC 810-10-25-38A, an entity is deemed to have a controlling financial interest in a VIE if it has both of the following characteristics: (a) the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance and (b) the obligation to absorb losses or the right to receive benefits from the VIE that could both potentially be significant to the VIE. In the following two alternatives, Meyer and Saban will be analyzed for evidence of meeting the two characteristics to be appointed the primary beneficiary and consolidator of Florabama. US GAAP Alternative A: Meyer Inc. meets both of the characteristics of the primary beneficiary requirements as stated in ASC 810-10-25-38A and thus Florabama’s financials are consolidated up to Meyer Inc’s financial statements. In determining the power to direct the activities of a VIE that most significantly impacts the entity’s economic performance, the purpose and design of a legal entity must be evaluated (ASC 810-10-25-25). Through analysis of the business risks incurred in ASC 810-10-25-24, the most significant risk is the operations risk, commodity price risk, and also environmental risk. These risks are directly related to the strategic decisions regarding the operations of Florabama, such as operating and capital budgets, pricing of the power produced. These are the most significant activities regarding the economic performance of Florabama. According to the case information, these decisions are presented to the board and implemented by a simple majority vote among the ten members of the board of directors. Because Meyer has six board members out of the total ten board members, Meyer has â€Å"the power to direct the activities †¦ that most significantly impact [Florabama]’s performance† through the majority on the board of directors. The second characteristic of losses and benefits that could be potentially be significant to Florabama is simply the fact that Meyer receives 60 percent of the profits and incurs 60 percent of the losses. ASC 810-10-25-38 states that the characteristic is based off absorbing a majority of the losses and receive a majority of the expected residual returns. The important change from majority (paragraph 38) to significant (paragraph 38A) does not change the fact that the characteristic is met because of this 60 percent incurred benefits and losses from Florabama. US GAAP Alternative B: Saban Company meets both of the characteristics of the primary beneficiary requirements as stated in ASC 810-10-25-38A and thus Florabama’s financials are consolidated up to Saban Company’s financial statements. The activities that most significantly impact the economic performance of Florabama can be determined to be the day-to-day operations of the business (revenues, expenses, etc). These decisions are defined as the CEO’s right and responsibility in the terms of governance. The CEO of Florabama continues to be an employee of Saban and as such, Saban is appointed the entity that holds the power to direct the activities that affect the economic performance of Florabama the most. The losses incurred and future expected benefits that could be significant to Florabama are attributable to Saban through a combination of 40 percent variable interest through ownership percentage and the cost-plus arrangement between Saban and Florabama. According to ASC 810-10-25-20, the cost-plus arrangement is a variable interest and as such, expected benefits and losses significant to Florabama are attributed directly to Saban. Recommendations US GAAP: We recommend Alternative A to account for the consolidation of Florabama. Both Meyer and Saban incur future significant losses and receive expected significant returns, so the main issue is the determination of which entity holds the power to direct the activities that most significantly impact the economic performance of Florabama. These activities, as indicated in Alternative A through risk analysis, are the strategic decisions regarding the operations of Florabama, such as capital and operating budgets and the pricing of power produced. These activities are all implemented by the majority vote by the board of directors, so Meyer Inc. holds the power to direct these activities with six board members out of the ten total members. I recommend that Meyer Inc. is the primary beneficiary and controlling interest, and as such, has the obligation according to ASC 810-10 to consolidate its financial statements to include Florabama’s financials.