Borrowing by Variable Interest Entities
Hydro Corporation needed to build a new production facility. Because it already had a relatively high debt ratio, the company decided to establish a joint venture with Rich Corner Bank. This arrangement permitted the joint venture to borrow $30,000,000 for 20 years on a fixed-interest-rate basis at a rate nearly 2 percent less than Hydro would have paid if it had borrowed the money. Rich Corner Bank purchased 100 percent of the joint venture’s equity for $200,000, and Hydro provided a guarantee of the debt to the bondholders and a guarantee to Rich Corner Bank that it would earn a 20 percent annual return on its investment.
On completion of the production facility, Hydro entered into a 10-year lease with the joint venture for use of the new facility. Due to the lease agreement terms, Hydro has reported the lease as an operating lease. Hydro does not report an investment in the joint venture because it holds no equity interest.
Required
As a senior member of Hydro’s accounting staff, you have been asked to investigate the financial reporting standards associated with accounting for variable interest entities and determine whether Hydro’s reporting is appropriate. Prepare a memo to Hydro’s president stating your findings and conclusions and analyzing the impact on Hydro’s financial statements if the current reporting procedures are inappropriate. Include citations to or quotations from the authoritative accounting literature in support of your findings and conclusions.
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