Objectives and Techniques to consolidate Special Purpose Entities in International Financial Reporting Standards and US Accepted Accounting Principles
Term Paper 2003 35 Pages
I. SPEs: characteristics, formation, structure, usage
1.1 Common features of SPEs
1.2 Typical structures of SPEs
II. The objectives of SPE consolidation
2.1 The objectives of financial accounting and reporting
2.2 The legal advantages of SPE consolidation
2.3 Separate accounting purposes of SPEs
III. Consolidation of special entities under US GAAP
3.1 Existing accounting guidance
3.2 Qualifying and nonqualifying SPEs
3.3 SPE consolidation based on voting and variable interests
3.4 Consolidation procedures, techniques and initial measurement
IV. Consolidation of SPEs under IFRS
4.1 Accounting guidance under IFRS
4.2 Main conclusions on SPE consolidation under SIC 12
4.3 SPE consolidation under IAS 27
4.4 Consolidation techniques in acquisition accounting
Summary and conclusions
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Special [i] Purpose Entity - is an entity created by an asset transferor or sponsor to carry out a specific purpose, activity or series of transactions directly related to its specific purpose.
Variable interests[ii] - in a variable interest entity are contractual, ownership, or other pecuniary interests in an entity that change with changes in the entity’s net asset value.
Variable Interest Entity - in general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities.
Entity - any legal structure used to conduct activities or to hold assets. Some examples of such structures are corporations, partnerships, limited liability companies, grantor trusts, and other trusts.
Subsidiary - an entity that is controlled by another entity.
Primary beneficiary of the entity - a company that consolidates a VIE.
Control - the ability of an entity to direct the policies and management that guide the
ongoing activities of another entity so as to increase its benefits and limit its losses from that other entity’s activities.
Autopilot – limited or decision-making ability of SPE by its charter to certain permitted activities.
Qualifying SPE - a purpose entity to which the initiator transfers financial assets and cumulatively comply with 4 conditions of FSAS 140[iii].
Nonqualifying SPE - a purpose entity to which the initiator transfers non-financial assets.
Parent - an entity that controls one or more subsidiaries.
Affiliate - an entity that, directly or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with another entity. A parent and its subsidiary are affiliates, and subsidiaries of a common parent are affiliates.
Majority-owned subsidiaries - are entities separate from their parents and may be VIEs.
Derivative[iv] - is a financial instrument, whose value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index; requires little or no initial net investment, and is settled at a future date. Examples of derivatives are forwards, options, futures, caps& floors, swaps.
Minority interests - those equity investors not part of the holding company.
Financial reporting - presenting financial data, on a company's position, operating performance, and funds flow for an accounting period.
GAAP - conventions, rules and procedures governing accepted accounting practices. In a particular country, GAAP are determined by the Financial Accounting Standard-Setter. The IASC determines worldwide GAAP.
IFRS (IAS) - a series of pronouncements published by IASB, which are observed in the preparation of financial statements. The standards aim to facilitate improvement and global harmonization of procedures relating to the presentation of financial statements. IFRS is the new name for IAS.
Until recently, many people in the accounting profession, never heard of SPEs. Some who heard of these esoteric financing vehicles knew little about how they operated or the accounting standards that guide the accounting and financial reporting by companies who sponsor SPEs. Reports in the popular press that preceded Enron's case in December 2001 introduced many accountants for the first time to the topic of SPEs. Even though SPE financing vehicles have been around for about two decades, they failed to capture the attention of many participants in the mainstream of accounting discourse.
The origin of SPEs can be traced to the way large international projects were financed. Let’s say a company wants to build a gas pipeline in Kazakhstan and needs to raise $1 billion. It may find that potential investors of the pipeline would want their risk and reward exposure limited to the pipeline, and not be subjected to the overall risks and rewards associated with the sponsoring company. In addition, the investors would want the pipeline to be a self- supported, independent entity with no fear that the sponsoring company would take it over or sell it. The investors are able to achieve these objectives by putting the pipeline into a special purpose entity that is limited by its charter to those permitted activities only[v]. Thus a common historical use of SPE was to design it as a joint venture between a sponsoring company and a group of outside investors. The SPE would be limited by charter to certain permitted activities only – hence the name. Such an SPE is often described as brain-dead or at least on auto-pilot. Cash flows from the SPE’s operations of the project are to be used to pay its investors.
Also called special purpose vehicles, SPEs typically are defined as entities created for a limited purpose, with a limited life and limited activities, and designed to benefit a single company. They may take the legal form of a partnership, corporation, trust, or joint venture. SPEs began appearing in the portfolio of financing vehicles that investment banks and financial institutions offered their business customers in the late 1970s to early 1980s, primarily to help banks and other companies monetize, through off-balance-sheet securitizations, the substantial amounts of consumer receivables on their balance sheets. Current accounting standards require an enterprise to include subsidiaries in which it has a controlling financial interest in its consolidated financial statements.
Transactions involving SPEs have become increasingly common, and the existing accounting literature related to VIEs is fragmented and incomplete. Under US GAAP the accounting guidance established by FASB for consolidation of SPEs will be effective only after March 15, 2003. FIN 46 will apply to any business enterprise—both public and private companies—that has an ownership interest, contractual relationship or other business relationship with an SPE. The Board changed the name of FIN 46 to Consolidation of Variable Interest Entities mainly because the term “special-purpose entities” is not sufficiently defined in current accounting pronouncements and its common use does not match its use FIN 46. Therefore, VIE is now the term now used by the FASB in place of the older term SPE. Also, since the crash of Enron, SPE has a negative connotation. The FASB now prefers the term VIE to depict a special entity in which the developing sponsor may have a varying interest in the financial risk.
This paper reviews the major actions taken by the accounting standard setters- FASB, EITF under the framework of US GAAP, as well as IAS, SIC under the framework of IFRC[vi] - in connection with special purpose entities (SPEs) and traces the evolution of related authoritative guidance. The EITF/SIC guidelines are not standards, but they have a significant impact since auditing firms often insist that these guidelines be followed by their clients. Accounting for SPEs entered public and professional prominence as a result of the Enron Corporation's failure. The primary accounting issues regarding these entities are (1) whether they should be consolidated into the sponsor's[vii] (or primary beneficiary's) financial statements or left "off-balance sheet," and (2) whether the sponsor should be able to treat gains and losses resulting from transactions with SPEs as independent, arm's-length transactions[viii].
The purpose of my work is to define SPEs and reflect its consolidation under the framework of US GAAP and IFRS. In this paper I will describe the purposes of SPE inclusion in a consolidated financial statement of primary beneficiary as well as according techniques for that.
I. SPEs: characteristics, formation, structure, usage
1.1 Common features of SPEs
SPEs (further VIEs, SPVs) appear in many different forms: common are limited companies, trusts or limited partnerships. Such entities are always very complex to analyse and understand. Thus it is important to identify all the features of control[ix] (including through autopilot arrangements) as well as the related risks and rewards of a SPE:
- Thin capitalization - a common feature of most SPEs is that they are thinly capitalized – the proportion represented by equity is too small to support the overall activities of the entity. However, the presence of substantial capital does not of itself mean that an entity is not an SPE.
- Absence of “profit” - another common feature of most SPEs is that the contractual arrangements at the outset mean that the equity holders will never obtain a significant distribution of profit or capital gain. However, this also is not always the case and the parties to an SPE may derive some of their returns through equity participation.
- Country of “incorporation” - SPEs are sometimes based in low tax locations to take advantage of low tax rates and less formal regulation. However, this is not always the case as double tax treaties and specific tax legislation may make an “onshore” structure attractive.
- Professional directors, trustees and partners - a typical feature of a SPE is that it is unable to make substantive decisions of its own (autopilot).
- Effective decision-making - a key question in any analysis of a SPE is whether it is able to pursue its own independent business interests and in practice does so.
The following are some of the ways in which variable interests can arise[x]:
(a) ownership interests;
(b) loans, especially subordinated debt;
(d) management contracts or other service contracts;
(e) referral agreements;
(f) options to acquire assets;
(g) purchase contracts;
(h) credit enhancements, such as over-collateralisation provided by a transferor or seller of assets to an SPE;
(i) residual interests in transferred assets;
(j) guarantees of debt or asset values, or related cash flows;
(k) derivative instruments.
Typical structures of SPE
Structured Financing/Transaction - the isolation of assets and obligations in a "structure" apart from the main operations of sponsors[xi]. The explicit focus of the current, fast- track rulemaking is the situation marked by "entities that lack sufficient independent substance"[xii]. In practice, such SPEs are elaborately structured entities. The structure is typically called a SPE or SPV. The following types of structures are most common in practice:
- Cash flow structure (sponsors receive cash for asset sales to the SPE)
Each sponsor factors (sells) ownership of actual assets (e.g., receivables "factoring") to the structure. Assets are deleted from the sponsor's balance sheet. Multiple sponsors may use the same SPE such as when banks sell mortgage investments to a "mortgage pool" SPE. Initially, SPE cash used to purchase the assets generally comes from the 3% (now 10%) invested by the SPE's independent, up-front investor who is totally independent of the SPE sponsors/originators. Cash used to purchase more assets later on from a sponsor may come from cash flows (e.g., interest income) generated from the SPE's assets, sales of its assets, or borrowing by the SPE. Contractual limits may be placed upon SPE asset sales, borrowing, and securitization. A drawback of cash flow structures is that gains reported on asset sales are taxable.
- Derivatives financial instrument structure in lieu of an asset transfer
As an example, suppose that a sponsor enters into forward sales contracts for product from a plant such as Enron's forward energy sales contracts in India for an enormous new power plant built by Enron. Suppose the plant is originally financed with floating rate, short-term debt until the plant begins to generate electricity. This is an example of a case where there is economic benefit (because of achieving fixed rate debt at a lower rate than would otherwise be available without the SPE) and the cosmetic benefit (of not having the long-term, fixed rate debt ever be booked as a liability on the sponsor's balance sheet).
- Diamond structure
A diamond structure arises when three or more sponsors form an SPE where no one sponsor has control over the SPE. This type of SPE is common when the sponsors can provide securitization with long-term throughput or take--or-pay contracts. Diamond structures may be separate corporations that not even meet the definition of a SPE and yet function exactly like an SPE.
- Defeasance (in substance defeasance)
Defeasance OBSF was invented over 20 years ago in order to report gain in bond debt. An SPE was formed in a bank's trust department (although the term SPE was not used in those days). The bond debt was transferred to the SPE and the trustee purchased risk-free government bonds that, at the future maturity date of the bonds, would exactly pay off the balance due on the bonds as well as pay the periodic interest payments over the life of the bonds.
- Synthetic lease structure (sponsors sell the asset to SPE, then lease it back)
A common approach is for the sponsor to sell the asset to the SPE and then lease it back from the SPE via what is known as synthetic leasing. A synthetic lease is structured under FAS 140 rules such that a sale/leaseback transaction takes place where the fair value of the assets "sold" can be reported by the sponsor as "revenue" for financial reporting. In a synthetic lease, this "revenue" does not have to be reported up-front for tax purposes even though it is reported up-front for financial reporting purposes.
Hence, the examples of transactions that involve SPEs include[xiii]:
- Leasing arrangements, i.e., sales with leasebacks
- Sale/transfer of assets to an SPE that issues debt obligations and/or equity certificates supported by the transferred assets
- Issuing equity in the form of preferred, tracking or common stock in exchange for cash from an SPE that is capitalized by debt and stock
- Financing arrangements with third-party financial institutions to fund acquisitions of assets or businesses
- Project development activities[xiv]
In practice the following two SPE models are spread[xv]:
The first SPE model is established by initiator and another investor, where the initiator produce a primary share on capital stock, and the investor shares only a part of equity. The investor has the majority of voting rights and the decision-making ability.
In second model, SPE is established by investor for the purposes of initiator, where the initiator processes only a limited part on SPE’s equity or nothing at all. Again, the investor has the majority of voting rights and the decision-making ability.
II. The objectives of SPE consolidation
2.1 The objectives of financial accounting and reporting
The need for information on which to base investment, credit, and similar decisions underlies the objectives of U.S. financial accounting and reporting. The mission of the Financial Accounting Standards Board (FASB) is to develop high-quality accounting standards that serve the public interest by providing information that is useful to present and potential investors and creditors and other users in making investment, credit, and other similar decisions. The primary qualities of decision-useful information are relevance and reliability[xvi]. Comparability, including consistency, is a secondary quality that interacts with relevance and reliability to contribute to the usefulness of information.
On August 17, 2001 the FASB issued a proposal on Reporting Information about the Financial Performance of Business Enterprises [xvii]. The primary objectives of the proposed project is to improve the quality of information displayed in financial statements. Including variable interest entities in consolidated financial statements with the primary beneficiary will help achieve that objective by providing information that helps in assessing the amounts, timing, and uncertainty of prospective net cash flows of the consolidated entity. The overview of CFS will provide potential investors information useful in decision making and give them a chance to monitor management (historically referred to as ‘stewardship’)[xviii].
Transparency[xix] in financial reporting - that is, the extent to which financial information about a company is visible and understandable to investors and other market participants- plays a fundamental role in making our markets the most efficient, liquid, and resilient in the world.
Completeness is identified in FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, as an essential element of representational faithfulness and relevance. The traditional reason for including two or more enterprises in consolidated financial statements, as described in ARB 51, is that consolidated financial statements are “usually necessary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in the other companies.”
The objective of FASB Interpretation No. 46 on consolidation of VIEs is not to restrict the use of VIEs but to improve financial reporting by enterprises involved with VIEs.
2 .2 The legal advantages of SPE consolidation
Accounting guidance on SPE consolidation is intended to achieve more consistent application of consolidation policies to variable interest entities and, thus, to improve comparability between enterprises engaged in similar activities even if some of those activities are conducted through variable interest entities. Including the assets, liabilities, and results of activities of variable interest entities in the consolidated financial statements of their primary beneficiaries will provide more complete information about the resources, obligations, risks, and opportunities of the consolidated enterprise. Disclosures about variable interest entities in which an enterprise has a significant variable interest but does not consolidate will help financial statement users assess the enterprise’s risks.
The Enron’s case has demonstrated the negative purposes of SPEs, however, the business purpose of SPEs are not necessarily negative. Before describing negative objectives of SPE consolidation, I want to bring in light positive aspects of SPE consolidation. Thus, the main reasons for consolidating SPEs in a CFS of a parent organization are decision – making ability and ability to increase benefits and limit losses. These abilities derive from control of ability of a parent organization. Other evident benefits are risk sharing among investors and isolation of project risk from company risk.
- Decision-Making Ability
The first essential characteristic of control is that a parent must have the ability by itself to make the decisions that guide the ongoing activities of another entity (subsidiary). That decision-making ability cannot be shared, and it must enable the parent to:
a. Direct the use of and access to another entity’s assets, generally by having the power to set the policies that guide how those assets are used in ongoing activities;
b. Hold the management of that other entity accountable for the conduct of its ongoing activities, including the use of that entity’s assets, generally by having the power to select, terminate, and determine the compensation of the management responsible for carrying out the directives of the parent.
- Ability to Increase Benefits and Limit Losses
The second essential characteristic of control is that a parent must have the ability to increase the benefits that it derives and limit the losses that it suffers from the ongoing activities of its subsidiary[xx]. This Statement, however, does not require that a parent have an exclusive right to those potential increased benefits; rather, non-controlling investors, creditors, and others also often benefit from a parent’s guidance of its subsidiary. A parent usually has the opportunity to increase the benefits that it derives from the activities of a subsidiary by having an interest in its income and residual net assets, but an ownership type of benefit or a minimum level of ownership is not a required characteristic. A parent also can increase its benefits through other means, for example, by initiating actions that result in revenue enhancements or cost savings through synergies between the subsidiary and the parent or its affiliates. Thus, creation of SPEs like corporations, trusts, etc., can be used to increase benefits and benefit the creator-sponsor (see example in Appendix A 4). SPE may also be created to acquire, construct, and use property or to invest in (lease) real estate.
[i] The source of definitions: FIN 46, IAS 27, SFAS 140, etc.
[ii] Paragraph 12 of FASB Interpretation No. 46 explains how to determine whether a variable interest in specified assets of an entity is a variable interest in the entity.
[iii] See chapter 3.1, QSPE
[iv] IAS 39- FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT, January 2001
[vi] The relationship between IFRS and IAS is described in key definitions. Basically IFRS is a successor of IAS
[vii] The term "sponsor" is sometimes used to refer to the organization that legally creates the SPE, which may or may not be the primary beneficiary of the SPE. At other times, and in this paper, it is used to refer to the company for whose primary benefit the SPE has been created.
[viii] "The Evolving Accounting Standards for Special Purpose Entities and Consolidations," by Al L. Hartgraves and George J. Benston, Accounting Horizons, September 2002, pp. 245-258.
[ix] New accounting for SPEs / by E.M. Hancock and D.C. Britt// In: Defining issues (KPMG). March 1. - Vol. 2002. - 6 p.
[x] Consolidation of special-purpose entities; draft guideline / publ. by CICA, AcSB. - Toronto : CICA, 2002
[xi] Special purpose entities: understanding the guidelines / publ. by Financial executives international = FEI// In: Issues alert (FEI). - Vol. January 2002
[xii] Vgl. FASAC, a.a. O. (Fn. 6), S. 4.
[xiii] The evolving accounting standards for special purpose entities and consolidations / by A.L. Hartgraves and G.J. Benston// In: [ T 31 ] Accounting horizons. - Vol. Nr. 3, September 2002
[xiv] for more transaction examples see Appendix A1.
[xv] Schruff/ Rothenburder: Zur Konsolidierung von Special Purpose Entities in Konzernabschluss. 15 Juli, 14/2002, Wirtschaftsprüfung p. 756
[xvi] Enron post-mortem: do we need new accounting standards? / by P. Munter// Journal of corporate accounting & finance. - Vol. Nr. 4, May/June 2002
[xvii] Financial Performance Reporting by Business Enterprises, proposal for a potential agenda project, 17.08.02
[xviii] Financial Reporting Rules, p. 24
[xix] Testimony Concerning Recent Events Relating to Enron Corporation, by Robert K. Herdman, http://www.sec.gov/news/testimony/121201tsrkh.htm
[xx] paragraph 10 of CFS
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- Objectives Techniques Special Purpose Entities Framework International Financial Reporting Standards United States Generally Accepted Accounting Principles