Special Purpose Entities
What you'll learn
- LOS 7.cAnalyze how different methods used to account for intercorporate investments affect financial statements and ratios.
Special Purpose and Variable Interest Entities
A special purpose entity (SPE) is a legal structure created to isolate certain assets and liabilities of the sponsor. An SPE can take the form of a corporation, partnership, joint venture, or trust. The typical motivation is to reduce risk and thereby lower the cost of financing.
SPEs are often structured such that the sponsor company has control over the SPE’s finances or operating activities while third parties have controlling interest in the SPE’s equity.
In the past, SPEs were often maintained off balance sheet, thereby enhancing the sponsor’s financial statements and ratios.
The FASB uses the term variable interest entity (VIE) to describe a special purpose entity that meets certain conditions. According to FASB ASC Topic 810, Consolidation, a VIE is an entity that has one or both of the following characteristics:
1. At risk equity that is insufficient to finance the entity’s activities without additional financial support.
2. Equity investors that lack any one of the following: − Decision making rights.
- The obligation to absorb expected losses.
- The right to receive expected residual returns.
If an SPE is considered a VIE, it must be consolidated by the primary beneficiary. The primary beneficiary is the entity that absorbs the majority of the risks or receives the majority of the rewards.
The IASB continues to use the term special purpose entity. According to IFRS 10, Consolidated Financial Statements, the sponsoring entity must consolidate if it controls the SPE.
Company P, a textile manufacturer, wants to borrow $100 million. It has two options:
Option A: Borrow $100 million from Bank B.
Option B: Sell $100 million worth of accounts receivable to Company S, an SPE created for this purpose. The SPE will fund the purchase by borrowing the money from Bank B.
Company P’s balance sheet before the borrowing is provided in the following:
Prepare Company P’s balance sheet under both options assuming that the SPE in Option B meets the requirements for consolidation.
Solution
Option A: Company P’s cash and debt will both increase by the new borrowing of $100 million.
Company P’s balance sheet after the borrowing:
Option B: Company P’s (nonconsolidated) balance sheet will reflect a reduction in accounts receivable of $100 million and an increase in cash by the same amount.
Company P’s balance sheet after the sale of accounts receivable to the SPE:
SPE’s balance sheet after purchase of accounts receivable and bank loan:
| Assets | $ millions | Liabilities and Equity | $ millions |
|---|---|---|---|
| Accounts receivable | $100 | Debt | $100 |
| Total | $100 | Total | $100 |
After consolidation, the SPE’s debt gets included with Company P’s debt, and accounts receivable for Company P increase by the same amount.
Company P’s balance sheet after consolidation:
The balance sheet of Company P under either option is the same. Company P cannot hide the borrowing “off the books.”
Other Issues in Business Combinations that Weaken Comparability
Contingent Assets and Liabilities
Under IFRS, only contingent liabilities whose fair value can be measured reliably are recognized at the time of acquisition. (Contingent assets are never recognized.) In subsequent periods, contingent liabilities are measured at the higher of the value initially recognized, or the best estimate of the amount needed to settle the liabilities.
U.S. GAAP divides contingent assets and liabilities into contractual and noncontractual. Contractual contingent assets and liabilities are recorded at their fair values on the acquisition date. Noncontractual contingent assets and liabilities are also recorded if, “more likely than not” they meet the definition of an asset or liability.
Subsequently, measurement of contingent liabilities is similar under IFRS, while contingent assets are recognized at the lower of the initial value and the best estimate of the future settlement amount.
Contingent Consideration
If the terms of the acquisition involve a contingent consideration (e.g., a specific extra amount is payable to the former shareholders of the subsidiary if certain earnings or revenue targets are met), such consideration is recognized at fair value under both IFRS and U.S. GAAP as an asset, liability, or equity. Subsequent changes in value are recognized in the income statement, unless the value was originally classified in equity (any changes then settle within equity and not via the income statement).
In Process R&D
In process R&D is capitalized as an intangible asset and included as an asset under both U.S. GAAP and IFRS. In process R&D is subsequently amortized (if successful) or impaired (if unsuccessful).
Restructuring Costs
Restructuring costs are expensed when incurred, and not capitalized as part of the acquisition cost, under both IFRS and U.S. GAAP.
The effects of the choice of accounting methods on reported financial results have been covered earlier in this topic review, so we won’t repeat the discussion here. Instead, we’ll compare the effects of the equity method, the proportionate consolidation method, and the acquisition method.
There are four important effects on the balance sheet and income statement items that result from the choice of accounting method (in most situations):
1. All three methods report the same net income.
2. Equity method and proportionate consolidation report the same equity. Acquisition method equity will be higher by the amount of minority interest.
3. Assets and liabilities are highest under the acquisition method and lowest under the equity method; proportionate consolidation is in between.
4. Revenues and expenses are highest under the acquisition method and lowest under the equity method; proportionate consolidation is in between.
Figure 7.9: Reported Financial Results from Different Accounting Methods