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What’s all the Fuss About – Special Purpose Entities
From [http://www.nasd.com] NASD is the National Association of Securities Dealers (I think, they never say what the
acronym stands for! Accessed 3/27/03)
Consolidating Special Purpose Entities (SPEs) or Variable Interest Entities (VIEs)
Enron used off-the-books partnerships to disguise debt and inflate profits, supposedly acting
within existing rules. Some people argue that this shows detailed rules for Special Purpose Entities
(SPEs), like those used in US GAAP, have an Achilles heel, in that a firm can abide by the letter
of the rule but violate its spirit. FASB in late January 2003 issued a new Interpretation creating
what it calls Variable Interest Entities (VIEs). FASB renamed the special entities to identify more
precisely the activity that generates concern.
IAS launched a project on consolidation, including SPEs, in June 2002. Its goal is to reconfirm the
basis on which an entity should consolidate its investments and add rigor to guidance about what
constitutes control. While most standards look to control, the definition varies across countries.
Consolidation of special entities under IAS
IASB describes SPEs in a general way in SIC-12: Consolidation - Special Purpose Entities
(effective June 1999). An SPE is an entity established to accomplish a narrow and well-defined
objective (e.g. to effect a lease, research and development activities or a securitization of financial
assets).
IAS applies a general test for control to decide whether a reporting firm should consolidate
another (see IAS 27, Consolidated Financial Statements and Accounting for Subsidiaries). For
SPEs, the SIC-12 interpretation calls for consolidation when in substance the firm controls the
SPE. That is, the firm is able to direct or dominate decision-making and intends to benefit from the
SPE’s activities. SIC-12 gives examples, such as activities by the SPE on behalf of the reporting
entity, decision-making power over the SPE, rights to the majority of benefits, and exposure to
significant risks of the SPE. So the IAS tests both control and, sometimes, looks to risk and
reward, though it does not define these words.
Consolidation of special entities under FAS
Before January 2003, US GAAP applied different rules to determine when to consolidate different
types of SPEs: (a) control in certain cases and (b) risks and rewards in others. Firms were (and still
are) required to consolidate SPEs when they have substantive control (decisionmaking power)
over the activities of an SPE. A non-majority owner was required to consolidate an SPE if the
majority owner made only a nominal capital investment (generally less than 3% of assets) and
lacked substantive control (decision-making power) over the SPE’s activities, and if the nonmajority owner received virtually all the benefits from those activities, the substantive risks and
rewards of the assets, or the debt of the SPE. An exception was made (and continues to exist) for
certain qualifying special-purpose vehicles holding securitized financial assets and meeting other
stringent criteria.
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FASB’s January interpretation creates a new term, Variable Interest Entity (VIE), because it found
SPE insufficiently precise. An entity is a VIE if (i) its total equity investment is not large enough
for the entity to finance its activities without additional subordinated financial support (equity less
than 10% of assets suggests financial dependence) or (ii) the holders of its ownership interests do
not have (a) the ability to make decisions about the VIE’s activities through voting or similar
rights, (b) the obligation to absorb the expected losses of the entity if they occur, or (c) the right to
receive the expected residual returns of the entity if they occur. FASB defined variable interests as
pecuniary interests arising through contract or ownership, for example, that change with the VIE’s
net asset value. The interests do not need to include voting rights.
FASB’s January interpretation modified its existing tests to consolidate. A VIE will be
consolidated with its primary beneficiary, which is the firm, if any, with beneficial interests that
give it a majority of the expected losses or a majority of the expected residual returns of the VIE.
This elaborates and defines the notion that the primary beneficiary bears a majority of the risk,
reaps a majority of the reward, or controls decisions.
Nice description from KPMG available at [http://www.fei.org/download/January03_3.pdf] –
includes an example. Accessed 3/28/03
An internal educational document from Deloitte & Touche is available at
[http://www.deloitte.com/dtt/cda/doc/content/Heads%20Up%20Vol%2010%20Issue%201(1).pdf]
. Accessed 3/28/03
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Note that there is a new file with the DEC 2003 Revisions
FASB Up-Date – FIN 46
FIN No. 46 – Consolidation of Variable Interest Entities (January 2003)
Special purpose entities (SPEs) typically are partnerships or joint ventures that are often used by
companies to move debt off their balance sheet. Many have legitimate uses, but others are structured
specifically with the intent of concealing debt from investors. They came into the spotlight after the collapse
of energy trader Enron, which used sophisticated partnerships it controlled to move debt off its balance
sheet. The murky deals were instrumental in Enron's demise and the company is accused of using them to
fool investors about the true state of its finances. [From Tougher Rules on Enron-type Deals Approved,
By Deepa Babington, 01/15/2003, Reuters English News Service, accessed 3/28/03 at
http://www.stern.nyu.edu/News/news/2003/january/0115reuters.html
VARIABLE INTEREST ENTITIES
Variable interest entity refers to an entity subject to consolidation according to the provisions of
Interpretation No. 46. There are two conditions, either one of which, if met, would cause a
particular entity to be consolidated within the financial statements of the primary beneficiary.
The term includes “special purpose entities” but FASB decided that SPE was too narrow a term and these
rules should apply to a broader group of entities.
Variable interest entities are subject to consolidation if, by design, either of the following
conditions apply:
a.
The total equity investment at risk is not sufficient to permit the entity to finance its
activities without additional subordinated financial support from other parties. That is, the
equity investment at risk is not greater than the expected losses of the entity.
b.
As a group the holders of the equity investment at risk lack any one of the following three
characteristics of a controlling financial interest:
(1)
The direct or indirect ability to make decisions about an entity’s activities through
voting rights or similar rights.
(2)
The obligation to absorb the expected losses of the entity if they occur.
The investor or investors do not have that obligation if they are directly or indirectly protected from
the expected losses or are guaranteed a return by the entity itself or by other parties involved with
the entity.
(3)
The right to receive the expected residual returns of the entity if they occur.
The investors do not have that right if their return is capped by the entity’s governing documents or
arrangements with other variable interest holders or with the entity. The equity investors as a group
also are considered to lack characteristic (b)(1) if (i) the voting rights of some investors are not
proportional to their obligations to absorb the expected losses of the entity, to receive the expected
residual returns of the entity, or both and (ii) substantially all of the entity’s activities (for example,
providing financing or buying assets) either involve or are conducted on behalf of an investor that
has disproportionately few voting rights.
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Determination of status
The initial determination of whether an entity is a variable interest entity is made on the date at
which an enterprise becomes involved with the entity.
Involvement with an entity is defined to be ownership, contractual, or other pecuniary interests that may be
determined to be variable interests.
Status as a variable interest entity is reconsidered only if one or more of the following occur:
a.
The entity’s governing documents or the contractual arrangements among the parties involved
change.
b.
The equity investment or some part thereof is returned to the investors, and other parties become
exposed to expected losses.
c.
The entity undertakes additional activities or acquires additional assets that increase the entity’s
expected losses.
NOT CLASSIFIED AS VIE:
The following are exceptions to the scope of FIN46:
1.
Not-for-profit organizations unless they are used by business enterprises in an attempt to circumvent the
provisions of this Interpretation.
2.
Employee benefit plans subject to specific accounting requirements in existing FASB Statements
3.
Registered investment companies are not required to consolidate a variable interest entity unless the
variable interest entity is a registered investment company.
4.
Separate accounts of life insurance enterprises as described in AICPA Auditing and Accounting Guide,
Life and Health Insurance Entities.
5.
Transferors to qualifying special-purpose entities and "grandfathered" qualifying special-purpose
entities subject to the reporting requirements of FASB Statement No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities: Do not consolidate those entities.
6.
No other enterprise consolidates a qualifying special-purpose entity or a "grandfathered" qualifying
special-purpose entity unless the enterprise has the unilateral ability to cause the entity to liquidate or to
change the entity in such a way that it no longer meets the requirements to be a qualifying specialpurpose entity or "grandfathered" qualifying special-purpose entity.
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DEFINITONS OF TERMS
By design. This phrase refers to entities that meet the conditions for treatment as a variable
interest entity because of the way they are structured. For example, an enterprise under the
control of its equity investors that originally was not a variable interest entity does not
become one because of operating losses.
Entity refers to 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. Portions of entities or aggregations of assets within an entity shall not be
treated as separate entities for purposes of applying this Interpretation unless the entire
entity is a variable interest entity. Some examples are divisions, departments, branches,
and pools of assets subject to liabilities that give the creditor no recourse to other assets of
the entity. Majority-owned subsidiaries are entities separate from their parents that are
subject to this Interpretation and may be variable interest entities.
Equity investments in an entity are interests that are required to be reported as equity in that
entity’s financial statements.
Expected losses and expected residual returns refer to amounts derived from discounted expected
cash flows using a credit-adjusted risk-free rate. Expected variability is the sum of the
absolute values of the expected residual return and the expected loss. All three concepts are
illustrated in Appendix A.
Primary beneficiary refers to an enterprise that consolidates a variable interest entity under the
provisions of this Interpretation.
Subordinated financial support refers to variable interests that will absorb some or all of an
entity’s expected losses if they occur.
Total equity investment at risk (for the purpose of applying FIN 46)
(1) Includes only equity investments in the entity that participate significantly in profits and losses
even if those investments do not carry voting rights
(2) Does not include equity interests that the entity issued in exchange for subordinated interests in
other variable interest entities
(3) Does not include amounts provided to the equity investor directly or indirectly by the entity or
by other parties involved with the entity (for example, by fees, charitable contributions, or other
payments), unless the provider is a parent, subsidiary, or affiliate of the investor that is required to
be included in the same set of consolidated financial statements as the investor
(4) Does not include amounts financed for the equity investor (for example, by loans or guarantees
of loans) directly by the entity or by other parties involved with the entity, unless that party is a
parent, subsidiary, or affiliate of the investor that is required to be included in the same set of
consolidated financial statements as the investor.
Variable interests 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. Equity
interests with or without voting rights are considered variable interests if the entity is a
variable interest entity.
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FIN 46, Paragraph 12 explains how to determine whether a variable interest in specified assets of an entity is
a variable interest in the entity. Appendix B in FIN 46 describes various types of variable interests and
explains in general how they affect the determination of the primary beneficiary of a variable interest entity.
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Death Knell for Synthetic Leases?
From [http://www.globest.com/csuite.html] accessed 3/28/03
The silence punctuating the real estate community is the reaction to FASB finalizing its revision of
rules impacting special purpose entities and synthetic leases. After a year of development and
review, the final regulations, entitled FASB Interpretation #46, Consolidation of Variable Interest
Entities Interpretation of ARB #51, are out, bringing to a close the saga of special purpose entities
synthetic leases and the disaster created by the Enron scandal.
The regulators' intent was not aimed at restricting the use of SPEs (and by default, synthetic
leases), but rather to clarify the reporting requirements surrounding their use. Major changes in the
new regulations include:
* Changing the name "special purpose entity" to "variable purpose entity" (whew!);
* Requiring the consolidation (off-the-book treatment of synthetic leases to become on-the-book
treatment) for those entities receiving a majority of their risk or benefits from variable purpose
entities;
* Disclosure of any variable-purpose entities, even if the risk or benefit is not accrued to the
holding company; and
* In the future, ownership participation, previously pegged at 3%, will be increased to 10%.
From a timing perspective, new entities created in 2003 will be subject to reporting requirements
effective immediately. For existing entities, e.g., the majority of previously issued synthetic leases,
companies have until June 15, 2003 to consolidate or report existing SPEs and by default, their
existing synthetic leases.
So, what is the impact on existing synthetic leases--now and in the future? Companies with
existing synthetic leases or other VPEs will need to consolidate; convert to another structure (most
likely sale-leaseback); or disclose.
Many companies who utilized synthetic leases, e.g., high-tech companies bent on growth without
balance sheet encumbrances, have already had to deal with these assets due to deteriorating
business conditions. Many of the remaining companies with synthetic leases will simply
consolidate, move them onto the balance sheet and be done with it. Company explanations will
cite recent accounting-treatment revisions to lessen negative reactions. Other companies will
convert to a sale-leaseback structure--a more costly alternative. Despite early predictions of severe
negative impacts, in fact, the worst may be past. Disclosures have already been made by most
companies with existing synthetic leases in the period since Enron erupted. As a result, there will
probably be little impact from disclosures of consolidation in the future resulting from the new
regulations.
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The Future of Synthetic Leases
From a real estate perspective, synthetic leases were financial vehicles built for high growth
companies looking to leverage their capital position and manage balance-sheet treatment. But in
the current economic climate, there is no or very little growth activity in the marketplace. The 10%
participation requirement, coupled with low interest rates, further erodes the financial benefits that
synthetic leases once offered.
Today, most corporate real estate professionals are interested in optimizing their portfolios,
nudging growth forward and controlling costs. They are not likely to be interested in creative
financing through balance-sheet management.
The result, in short, is that synthetic leases are largely dead--the wrong product for today's
economic conditions. FASB's goal to preserve SPEs while increasing their reporting requirements
has been met. SPEs' name has been changed to protect the innocent. In the next few months, those
companies with existing synthetic leases will continue to take a hard look at whether certain assets
should remain a part of their portfolio, be disposed of, be consolidated and moved onto the
balance sheet or simply be converted into a traditional sale-leaseback.
I'm betting that when the marketplace does return and growth becomes of paramount concern,
synthetic leases will rise from the ashes, re-branded and re-launched under some new name, all
thanks to some bright structured finance professional. "Phoenix Leases" anyone?
Ed Lubieniecki is national director of Grubb & Ellis Consulting Services Co.
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From [http://www.platts.com/risk_management/sandp/archive/031003analysis.shtml] accessed
3/28/03
FASB Sets New Guidelines Regarding Consolidation of Variable Interest Entities
New York (Standard & Poor's)--10 Mar 2003
The Financial Accounting Standards Board recently issued a new accounting interpretation
(Interpretation No. 46, “ Consolidation of Variable Interest Entities,” or FIN 46) that will likely materially
affect the financial reports of companies in the energy industry. FIN 46 provides an accounting
consolidation model for entities where control is established by means other than voting control. FIN 46
refers to such entities as Variable Interest Entities (VIE). Under the provisions of FIN 46, a VIE is
consolidated by its Primary Beneficiary, which is defined by FIN 46 as the entity with the majority of
risks and/or rewards in the VIE.
Generally, a company must consolidate an entity in which it holds a controlling financial interest. In the
past, a “controlling financial interest” was determined primarily by the level of voting interest. The new
interpretation provides a model where control is established by other means. Specifically, the level of
equity at risk in an enterprise determines whether a company has a controlling financial interest in
certain enterprises.
Implementing the new accounting rule calls for a two-step approach. First, a company must determine
if an entity with which it is associated is considered a VIE under the new accounting guidance. If so, the
company then must determine if it is the Primary Beneficiary, as defined by the FASB. Under the new
rule, a Primary Beneficiary in a VIE must consolidate all such VIEs in its financial statements. Although
the identification of VIEs and their Primary Beneficiaries involves extensive judgments and estimates to
be made by a company’s management and auditors, Standard & Poor’s provides a general outline
below.
Step 1
A VIE is a corporation, partnership, trust, or any other legal structure used for business purposes that:
n Does not have sufficient equity investment at risk to finance its activities; or Has equity investors that
lack one of the following: voting rights; the obligation to absorb expected losses; or the right to receive
expected gains.
Step 2
The Primary Beneficiary is the party that: n Absorbs the majority of the VIE’s expected losses; or n
Receives the majority of the VIE’s expected returns. If a different party would absorb the majority of
expected losses than the party that receives the majority of expected gains, the company that absorbs
the losses is the Primary Beneficiary. The Primary Beneficiary must disclose the terms of its VIE
involvement, including the carrying amount and classification of assets that are used as collateral by
VIEs, as well as any lack of recourse. In addition, companies that have significant interests in VIEs, but
are not Primary Beneficiaries, must similarly disclose the VIE relationships, including estimated loss
exposures.
The Energy Sector Affected
What effect will FIN 46 have on the energy sector? Obviously, a company’s economics are not changed
directly by changes in accounting requirements. However, in some cases changes to reported amounts
could be material to a company’s reported assets, liabilities, cash flow, and results of operations as a
result of consolidation of the VIEs’ accounts. Many energy companies use off-balance-sheet structures,
such as synthetic leases or build-to-suit arrangements to finance individual large projects such as power
plants. The effect on changes in the reported amounts as reflected in public filings is expected to vary,
depending on the extent of the use of such entities and the scope and size of their assets, liabilities, and
operations. Standard & Poor’s typically consolidated such entities in circumstances that it deemed
appropriate even if the accounting rules did not require consolidation. Many companies that use such
off-balance-sheet structures have been dealing with disclosure issues already due to deteriorating
business conditions and demands from the SEC and investors since the demise of Enron Corp. and
recent disclosures by numerous energy companies about their off-balance-sheet arrangements and
exposures. Although accounting changes considered in isolation should not affect credit considerations,
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cases may arise where Standard & Poor’s was not aware of an entity or had an incomplete
understanding of a company’s exposure to such an entity. Furthermore, there could be a real-life effect,
such as cases in which financial covenants become problematic in light of the new consolidation model,
or where market reaction to new disclosures limits a company’s access to capital. In addition, a
company’s regulatory compliance that is based (entirely or partially) on reported GAAP financial
amounts may be adversely affected. It is possible that companies may be required to restructure
transactions in a manner that would not be economically beneficial to the company for it to resolve
regulatory and capital market concerns (e.g., restructuring a lease in a deteriorating credit environment
may result in higher lease cost). Therefore, while there may be no apparent economic implications for
the new accounting rules, there may be credit implications.
Challenges
In some cases, the determination of the Primary Beneficiary will be challenging. For example, consider
the case where a bank made a loan to a lessor for the purpose of building a power plant. The lessor
establishes a separate entity to facilitate the construction and the ultimate lease of the newly built
power plant (without sufficient equity— assumed to be a VIE). An energy company (the ultimate lessee)
guarantees the equity in the separate entity on completion of construction (either directly or via
construction-related guarantees or indemnifications), and a construction company guarantees delay and
performance liquidated damages. Consider a situation where the energy company is having financial
difficulties (not a far-reaching scenario) and the equity contribution is at risk (due to the ineffectiveness
of the guarantee). Who has the majority of the expected downside? Is it the energy company, which is
taking on the long-term risk of the plant? Is it the construction company, which is liable if construction
is not completed on time or if the plant does not perform to specifications? Or is it the bank, which will
own an underfunded power plant if the energy company does not make good on its equity commitment
(via foreclosure proceedings)? FIN 46 requires a probability analysis of expected losses and residual
returns, but it is not clear how to handle a situation where each potential beneficiary believes that
another company is the Primary Beneficiary, nor does it provide specific guidance on how to perform
the underlying calculation.
Disclosures
Companies have recently begun to disclose the potential implications of FIN 46 in their SEC filings. The
disclosures generally provide that an entity that is currently classified off balance sheet, which they
believe could be moved on balance sheet due to the new interpretation. Following are two examples
obtained from recent public filings. The examples are meant to be illustrative, and are not problematic.
The first example was obtained from the September 2002 10-Q of PPL Corp. (BBB/Negative/—). In this
report, PPL disclosed that the then-proposed rule would apply to PPL’s leases for its Sundance,
University Park, and Lower Mt. Bethel generating facilities, and that PPL is currently evaluating the
restructuring of these leases. If PPL elects not to restructure these leases, its consolidated balance
sheet would include these generating facilities as assets and the lease debt as liabilities. In this case,
Standard & Poor’s consolidated the leases for purposes of its analytic considerations, and would not
expect PPL’s future potential consolidation of these entities to affect its evaluation of the company. Also,
it is Standard & Poor’s understanding that the covenant calculations underlying PPL’s credit agreements
also include these entities, so they would not be problematic from a covenant perspective. This is a
fairly simple and relatively straightforward example of the consolidation model. There are two lessee
subsidiaries of PPL in this case, one for Sundance and University Park, and one for Lower Mt. Bethel.
These are typical lease arrangements, where the equity owners of the subsidiaries do not have
operational control. They also do not have the obligation to cover expected losses or the right to receive
residual returns. This results in the entities being considered to be VIEs under FIN 46. When the lease
term ends, the respective lessee has the option to extend the lease term or purchase the facilities (at a
fixed purchase option that effectively provides the upside to the lessee), and if it does not choose either
option, then it will guarantee a residual value (which effectively results in the lessee having the down
side). As such, PPL is likely to be the Primary Beneficiary because it holds the majority of the expected
losses, and therefore would consolidate the leasing entities under FIN 46.
A similar example is presented for a Great Plains Energy subsidiary, Kansas City Power & Light Co.
(KCP&L; BBB/Stable/A-2). According to KCP&L’s September 2002 10- Q, it entered into a synthetic
lease arrangement with a trust (lessor) to finance the purchase, installation, assembly, and construction
of five combustion turbines. The trust is a special purpose entity and has an aggregate financing
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commitment from third-party equity and debt participants. The project and related lease obligations are
not currently included in KCP&L’s consolidated balance sheet. Under the terms of the arrangement, the
third-party equity participants do not have operational control or share in the expected losses or
residual value, and consequently, the entity is a VIE. At the end of the lease term, KCP&L may choose
to sell the project for the lessor, guaranteeing to the lessor a residual value for the project in an amount
that may be up to 83.21% of the project cost. If KCP&L does not elect the sale option, it must either
extend the lease, if it can obtain the consent of the lessor, or purchase the project for the thenoutstanding project cost. As illustrated in the previous example, KCP&L holds the majority of the
expected losses and is likely to be the Primary Beneficiary. As with PPL, Standard & Poor’s had
consolidated this entity in its analytics, so the accounting change would not be expected to affect our
view of the financial profile.
The two cases above are not unusual for the energy sector. Overall, Standard & Poor’s expects that
most cases that arise will be similar to these (i.e., lease obligations that had been consolidated by
Standard & Poor’s are now consolidated for reporting purposes). Financial reports may be very different
in these cases, but the company economics and underlying Standard & Poor’s analytics will likely be
unaffected. However, there will also likely be cases where past disclosures were insufficient, and
Standard & Poor’s either was not aware of an entity or did not fully capture the extent of a company’s
exposure to it. Upon gaining a better understanding, Standard & Poor’s will reevaluate its analytic
considerations and take whatever rating action is necessary. There is also the possibility of the
consolidation model ultimately pressuring covenants, causing negative capital markets reactions, or
leading to problems with regulatory requirements that are based on GAAP reporting. Such results could
indirectly pressure a rating as well.
Scott Taylor
New York (1) 212-438-2057
Neri Bukspan
New York (1) 212-438-1792
Daniel Volpi
New York (1) 212-438-7688
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Accessed 3/28/03
fromhttps://www.cpa2biz.com/News/Viewpoint/Prognosis+for+OffBalance+Sheet+Financing.htm
VIEWPOINT
Jan. 13, 2003
Prognosis for Off-Balance Sheet Financing
Regulatory uncertainty and recent corporate scandals cloud the future of this once-popular
corporate finance strategy.
by Marie Leone
What's the prognosis for off-balance sheet financing? These transactions, that lighten balance
sheets by removing debt, received a big black eye from Enron and other corporate scandals that
underscored the misuse of the accounting maneuver. Meanwhile, the SEC and FASB are about to
release final rules that will likely force senior financial managers and auditors to modify the
structures, or simply abandon off-balance sheet financing completely.
Reader Note: Thursday's (January 16) two-hour live Webcast, co-presented by AICPA and
CFO.com, will take a closer look at the future of off-balance sheet financing. The 1:00 p.m.(EST)
Webcast, entitled "Will Off-Balance Sheet Financing Survive?" features expert panelists:
Teresa Iannoconi, partner at KPMG LLP; Herbert Birman, vice president of finance and
operations at software maker MIS AG North America; and Leonard Hyman, senior associate at
R.J. Rudden Associates Inc., the economic and financial analysis firm.
Some professional advisers have observed that the number of new off-balance sheet transactions
has probably declined over the last six month because of the uncertainty surrounding the new
guidance. Essentially, executives didn't want to chance that they were structuring transactions that
would come undone after the guidance was promulgated. Once the guidance is finalized, it is
expected that companies will, for example, continue use of certain special structures. Why?
Because if done correctly, special purpose entities can deliver significant tax and cost efficiencies.
Although there has been a lot of press about the misuse of variable interest entities (formerly
called special purpose entities), there are legitimate uses of these and other off-balance sheet
financing techniques. It is expected that the principles based approach of the new guidance, which
focuses on consolidation based on variable interest exposures to risks and rewards rather than an
artificial bright line equity investment test, will result in financial statements that more clearly
reflect the exposures of entities exposed to those risks.
MIS AG's Herbert Birman believes that off-balance sheet financing will remain a viable tool,
especially because securitizations, synthetic leases, and project finance structures are useful. In
fact, MIS AG North America is technically a large special purpose entity, which does not have to
be consolidated on its parent company's balance sheet. The key to any off-balance sheet
transactions is transparent reporting, notes Birman. "You have to let the chips fall where they may.
The market forgives a screw up, but not deceit."
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Former Merrill Lynch equity analyst and Salomon Brothers advisor Hyman agrees with Birman.
He looks at off-balance sheet financing from an investor's point of view, and insists that all
material liabilities must be front and center. His enduring question is whether off-balance sheet
financing really delivers the desired results when managers use the structure only to boost the
earnings per share ratio. As a strategy to "goose up the stock price," off-balance sheet financing is
often dishonest, and this application of it won't last.
The next few months promise to be a bumpy ride in the world of aggressive corporate finance.
Marie Leone, senior editor of CFO.com, moderates the quarterly CFO/Controller Quarterly
Roundtable Series co-presented by AICPA and CFO.com
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FROM CGA Magazine, accessed 3/28/03 at http://www.cgacanada.org/eng/magazine/jan-feb03/standards_e.htm
Standards
Enron...and After
In the wake of Enron, a new accounting guideline provides special purpose entities with guidance
on consolidation principles.
By Stephen Spector
Accounting has traditionally been perceived as a staid, respectable profession — as witnessed by
the portrayals of accountants in Monty Python films and others. All that changed last year, and the
tidal wave of change can be heralded by a single word — Enron. With Enron, accounting suddenly
became sexy — full of intrigue and deception. Although the reasons for the energy trader's
collapse are many and varied, one salient fact has emerged. The firm played fast and loose with
the way it accounted for its investments in what are called special purpose entities (SPEs).
Responding to demands for more control, the U.S. Financial Accounting Standards Board (FASB)
has proposed a number of restrictions to force firms to better report the real relationship between a
parent company and its SPEs. Sensitive to the close ties between U.S. and Canadian GAAP, the
Accounting Standards Board has also moved to ensure North American enterprises face a level
playing field. It issued an exposure draft last year with comments due September 30, 2002. The
accounting guideline, Consolidation of Special-Purpose Entities, was intended to provide
appropriate guidance for SPEs with respect to the application of the consolidation principles in
section 1590 of the Handbook.
What is an SPE?
An SPE is an entity created by an asset transferor or sponsor to carry out a specific purpose,
activity or series of transactions. It is established as a limited partnership, limited liability
company, trust or corporation, and, thus, may have a limited life. Many companies use SPEs and
similar structured financing vehicles to access capital and/or manage risk. The specified purpose
of these instruments dictates the level of equity accessed and the degree of risk reduction achieved.
Examples of transactions that involve SPEs include the following:



Leasing arrangements, i.e., sales with leasebacks;
Financing arrangements with third-party financial institutions to fund acquisitions of assets
or businesses; or
Project development activities.
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At the time of the Enron debacle, the U.S. GAAP required a minimum three per cent investment
from an independent third-party investor to be contributed in order to represent a legal equity
ownership interest in an SPE. The three per cent is based on the fair value of the financial assets to
be sold. In exchange for its investment, the third-party equity investor controls the SPE activities
and retains the substantial risks and rewards of its ownership in the SPE assets.
For an SPE to be an arm's-length entity and not consolidated into the sponsor's financial
statements, the third-party investor must bear the risk of its investment. For example, if an investor
contributes equity as a note payable to the SPE or secures the investment by a letter of credit,
insurance or guarantee, the investment would not be considered at risk. Once the three per cent is
established, the SPE then finances the remaining funds to acquire the financial assets from the
sponsoring company by issuing debt and/or additional equity to institutional investors or public
shareholders. As long as the specific qualifications are met, the assets and the corresponding debt
and equity of the SPE achieve off-balance sheet treatment with respect to the sponsor's financial
statements.
However, many SPEs may be independent in appearance, but not in fact. They actually rely on
the financial support of the entity that is the primary beneficiary of the SPE's activities. Although
control over the SPE realistically rests with the primary beneficiary rather than with the nominal
owner, it has been accounted for as if it were the other way around.
Enron executives used this accounting approach to structure the firm's SPEs so that they were able
to keep significant amounts of debt off Enron's balance sheet. The changes implemented by the
FASB and the CICA are intended to limit an enterprise's ability to mask its true financial situation
in this way.
Intent of the Guideline
The new guideline addresses a weakness in Handbook section 1590; the general principles for
determining whether one enterprise consolidates another cannot be applied using the guidance
provided.
When the nominal owners of an SPE have not provided sufficient financial support, another party
or parties almost always provide that support. The other parties usually protect their interests by
placing limits on the SPE's activities or wielding decision-making authority in some form other
than a voting interest. In these circumstances, the nominal owners do not in fact control the SPE.
Guidance applicable to these circumstances has been set out in the new guideline.
When the nominal owners do not control an SPE, the existence of control is determined by the
variable interests in the SPE. Variable interests, which arise from certain contractual rights and
obligations or ownership interests, are the means through which an enterprise provides financial
support to an SPE and by which it gains or loses from activities and events that affect the SPE's
assets and liabilities.
An enterprise (the primary beneficiary) controls an SPE by holding a majority of the variable
interests in it or by holding variable interests that are both a significant portion of the total variable
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interests and significantly larger than any other party's variable interests. And an enterprise that
does control an SPE by means of variable interests must consolidate it in its financial statements.
In order to comply with the new guideline, an enterprise that is the primary beneficiary of, or has a
significant ownership interest in, an SPE must disclose general information about its relationship
with the SPE and the SPE's nature and purpose. An enterprise that is not the primary beneficiary
of an SPE, but provides significant administrative services to it, must disclose the SPE's assets and
liabilities and its purpose.
At the time of writing, the guideline had yet to be finalized. The guideline will be effective for
annual and interim fiscal periods beginning on or after April 1, 2003 — although certain
(unstated) requirements would be effective on the issue date. The effect of initially applying the
guideline should be reported in the same manner as a change in accounting policy, except that
prior years' financial statements are not retroactively restated. Instead, enterprises should provide
pro forma disclosure of the effects the guideline would have had on comparative financial
statements for prior years.
Remaining Gap in GAAP
The FASB was taken to task for its three per cent threshold and the fact that what was an arbitrary
threshold became the rule in practice. Its response was to raise the threshold to 10 per cent. The
Handbook guideline does not include a threshold since the notion of a "bright line" test is
inconsistent with the underlying requirement that the amount of equity investment be greater than
or equal to expected future losses. Further, a benchmark might result in the possibly unwarranted
conclusion that the equity investment in an SPE is sufficient to finance the SPE's operations
unassisted. Accordingly, the primary beneficiary who controls an SPE by means of variable
interests must consolidate it. Full financial disclosure has never been so sexy.
Stephen Spector, MA, FCGA, is the proprietor of Spector and Associates and is currently
teaching Managerial Accounting at Simon Fraser University. He has also taught courses at the
University of British Columbia and CGA-B.C., and has led seminars on accounting and auditing
standards. In addition, he is currently on CGA-B.C.'s board of governors. He is chair of the CGAB.C. ethics committee and is one of Canada's technical advisers to the IFAC ethics committee. Email shspector@shaw.ca.
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From Bob Jensen’s web page, accessed 3/28/03
http://www.trinity.edu/rjensen/theory/00overview/speOverview.htm#FIN46
WHAT ARE SPECIAL PURPOSE ENTITIES?
Until recently, many people in the accounting profession, including accounting
educators, 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 Chapter 11 filing in December 2001
introduced many accountants for the first time to the topic of SPEs and sent many
CPAs scrambling to understand the generally accepted accounting principles
(GAAP) dealing with these entities. 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. A search for references to
SPEs in financial accounting textbooks yields virtually no results, and a search of
the academic and professional accounting literature provides, at best, a limited
explanation of this area of accounting.
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. A newly created SPE
would acquire capital by issuing equity and debt securities, and use the proceeds to
purchase receivables from the sponsoring company, which often guaranteed the
debt issued by the SPE. Because the receivables have limited and reliably
measured risk of nonrepayment, a relatively small amount of equity usually was
sufficient to absorb all expected losses, thus making it unlikely that the sponsoring
company would have to fulfill its guarantee. In this way the sponsoring company
could convert receivables into cash while paying a lower rate of interest than the
alternative of debt or factoring, as the debt holder could be repaid from the
collection of the receivables or the sponsor. SPEs also allow the sponsors to
remove receivables from their balance sheets, and avoid recognizing debt incurred
in the securitization.
Other Uses of SPEs
Another major application in the early years of SPEs related to transactions
involving the acquisition of plant and equipment under long-term lease contracts.
Companies could sponsor an SPE to acquire long-term assets with newly acquired
debt and/or equity and enter into a contract to lease the assets from the SPE. This
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often enabled companies to treat the contract as an operating lease for accounting
purposes, thereby placing the asset and related debt on the SPE's balance sheet
instead of that of the sponsoring company.
Other SPEs, typically organized as limited partnerships, also have been employed
for more than 20 years to fund research and development (R&D) activities. The
sponsor often has only a contractual interest in the SPE, not an equity interest. The
crucial accounting issue for these SPEs, addressed in FASB Statement No. 68
(FASB 1982), is whether the sponsor has directly or indirectly agreed to repay the
funds provided by the outside parties. If such an obligation exists, then the sponsor
recognizes it as a liability, and the sponsor records the R&D costs incurred by the
SPE as an expense. To avoid recognizing the liability and expense, the sponsor
must demonstrate that the financial risks involved with the R&D activities are
transferred from the sponsor to the outside parties.
SPE's and Off-Balance-Sheet Financing
Before discussing the evolution of authoritative guidance for SPEs, we examine the
broader issue of off-balance-sheet financing, the context within which the guidance
has been developed. SPEs are just one of the vehicles that companies use to
structure financing that avoids recognizing assets and liabilities on their financial
statements. Other vehicles include operating leases, take-or-pay contracts, and
throughput arrangements2 that enable a company to use something in its future
operations in exchange for agreed upon payments. In these situations the
accounting problem is to determine whether an asset or liability exists, and when to
report such items on the balance sheet. GAAP already requires arrangements such
as capital leases and certain SPEs to be included on the balance sheet of the
primary beneficiary of the contracts. For some specified arrangements where assets
and liabilities are not reported on the balance sheet, particularly operating leases,
information about future obligations under the contracts must be disclosed in the
notes to the financial statements.
Consider unconsolidated equity investments in which an investor owns less than 50
percent, SPEs created for the primary benefit of a company, or other off-balancesheet entities. Here the challenge to the accounting profession is to focus on
whether consolidation of such entities actually improves users' understanding of a
company's financial position and results of operations. For most equity method
investments, consolidation does not change net income or net assets, causing only
offsetting changes in the components of those measures. Consolidating equity
method investments currently not consolidated could reduce disclosures about
those investments in the notes to the financial statements. As a broad objective, the
FASB and the SEC should guide the profession in requiring on-balance-sheet
treatment where it enhances the financial statements, but allowing off-balance-sheet
treatment where it provides better information to investors.
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2
Typical take-or-pay contracts obligate the purchaser to take and pay for any product that is
offered to it or pay a specified amount if it refuses to take the product. A throughput arrangement
involves an agreement to put a specified amount of product per period through a particular facility;
for example, an agreement to ship a specified amount of crude oil per period through a particular
pipeline (New York Times 2002).
SPE = Special Purpose Entity that allows "sponsor/originator" companies bearing as much as
90% of the SPE's debt risk to keep that debt off the consolidated balance sheet under U.S.
Generally Accepted Accounting Principles. Enron's double dealing former CFO Andy Fastow and
former CEO Jeff Skilling changed the definition of SPE to S _ _ t Piled Everywhere! But the
majority of SPEs in the world are perfectly legitimate. Special SPE accounting arose largely due
to pressures from banks and leasing companies to provide a way to avoid capitalization (booking)
of special types of leases following the FAS 13 change in leasing rules that stiffened the
requirements for booking of "capital" leases. There are some financing and tax benefits of SPEs,
although the primary motivation is often to achieve off-balance sheet financing (OBSF). Not all
SPEs involve lease financing, but the motivation usually is to achieve some form of OBSF
accounting.
SPV = Special Purpose Vehicle that will be viewed as a synonym for SPE in this document.
VIE = Variable Interest Entity. VIE is now the term now used by the FASB in place of the older
term SPE. Since the crash of Enron, SPE has had 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.
QSPE = Qualified Special Purpose Entity under the FAS 140 Standard. QSPEs enjoy special
privileges under FAS 140, but must meet a number of qualification criteria. One of these is that
QSPEs may not exercise an impermissible degree of discretion in managing the assets which they
hold, which are the principal source of cash flows supporting payments on the related
securities. Aside from OBSF motivations, there are real economic incentives that may arise due to
the following possibilities that make SPEs and SPVs "special"::

The financial risk of the sponsor of may be limited to its investment or explicit recourse
obligation in the SPE or SPV. In many instances, creditors of a bankrupt SPE or SPV
cannot seek additional assets from the sponsor beyond what was invested or contracted for
by that sponsor. In other words, the sponsor may not become the deep pockets for
damages exceeding the assets of the SPE or SPV. The verb "may be" is not as strong as
"cannot be." The reason is that the contracts between the sponsor and the SPE or SPV
may be quite complex and obtain conditional clauses that obligate the sponsor to provide
additional assets or its own stock when certain "trigger events" take place that require early
liquidation or other actions to protect creditors of the SPE or SPV.
The net assets of the SPE or SPV may be protected from creditors of its sponsors
such that the SPE or SPV is not the deep pockets in the event that any sponsor goes
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bankrupt. This protection sometimes allows the SPE or SPV to obtain financing at
a lower cost than the sponsor can obtain financing.
Sources of Authoritative Guidance for Accounting for SPEs
When the idea of SPEs was first conceived in the minds of some bright financial
engineers, no definitive accounting guidance existed. Although specific accounting
guidance for innovative business methods of necessity must lag actual practice, the
conceptual framework and other general guidelines should help accountants treat
innovative practices. When SPEs began to appear, corporate accountants, auditors,
and the SEC could look only to general principles in the authoritative accounting
literature regarding the recognition and de-recognition of assets and liabilities,
criteria for recognizing asset sales, consolidation of related entities, and more
generally to the "entity concept" literature.
From the early 1980s until the mid-1990s, SPEs proliferated in business practice
without any specific official guidance from the Financial Accounting Standards
Board (FASB). Until 1996, all specific guidance regarding SPEs came from the
FASB's surrogate body, the Emerging Issues Task Force (EITF), formed by the
FASB in 1984 to provide timely financial-reporting guidance on matters that the
Board may not have addressed or issued authoritative guidance. As stated on the
FASB's web site (FASB 2002a), the composition of the EITF is designed to include
persons in a position to be aware of emerging issues before they become
widespread and before divergent practices regarding them become entrenched.
Therefore, when the EITF reaches a consensus on an issue, signified by the support
of 11 of the 13 voting members, the FASB usually takes that as an indication that
no Board action is needed. Consensus positions of the EITF are considered part of
GAAP. However, lack of consensus is often viewed as an indication that action by
the FASB is necessary.
Nine of the 13 voting members of the EITF are affiliated with public accounting
firms, with one member from each of the Big 5 firms, and four members from large
companies.3 The Chief Accountant of the Securities and Exchange Commission
attends EITF meetings regularly as an observer with the right to participate in
discussions and present the SEC's views on topics of discussion. Although the
FASB's Director of Research and Technical Activities is the non-voting Chairman
of the EITF, there is no overlap between the members of the FASB and the EITF.
Note that the influence of the public accounting sector of the accounting profession
is much greater on the EITF (nine of 13 members are currently public accounting
practitioners) than it is on the FASB (three of seven full-time members were public
accounting practitioners prior to joining the Board). One might conclude that
authoritative guidance provided by the EITF is likely to have more of a public
accounting tilt than if it is provided by the FASB.
The first FASB statement that included any direct reference to SPE's was Statement
No. 125 (FASB 1996), later replaced by Statement No. 140 (FASB 2000b). Both
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of these Statements focus narrowly on issues involving the transfer (sale) of
financial assets, primarily securitization and servicing of receivables. Authoritative
guidance for other SPEs has been developed in a rather piecemeal fashion by the
EITF. Exhibit 1 lists in chronological order the major FASB and EITF
pronouncements addressing consolidations and SPEs. The next section of the
paper discusses this authoritative guidance.
AUTHORITATIVE GUIDANCE ON CONSOLIDATIONS
Accounting Research Bulletin No. 51
Over the past 40 to 50 years, the accounting profession gradually developed general
policies governing the consolidation of financial statements of companies and their
controlled subsidiaries and affiliates. Accounting Research Bulletin (ARB) No. 51
(AICPA 1959) established broad requirements for companies to fully consolidate
majority-owned subsidiaries into their financial statements and show the equity of
minority-interest shareholders in the consolidated financial statements. ARB No.
51 also requires the elimination of intercompany balances and transactions between
the two entities so that the consolidated statements represent the financial position
and results of operations of a single reporting entity. An important exception in
ARB No. 51 that allowed companies to avoid consolidation for "nonhomogeneous"
majority-owned subsidiaries was removed in 1987.
EXHIBIT 1
Chronology of Major Accounting Pronouncements
Related to Consolidations and SPEs
1959 Accounting Research Bulletin (ARB) No. 51, Consolidated Financial Statements
1971
Accounting Principles Board (APB) Opinion No. 18, The Equity Method of
Accounting for Investments in Common Stock
1983 FASB Statement No. 76, Extinguishment of Debt
1983
FASB Statement No. 77, Reporting by Transferors for Transfers of Receivables
with Recourse
1984
Emerging Issues Task Force (EITF) Issue No. 84-30, Sales of Loans to SpecialPurpose Entities
FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries--An
1987 Amendment of ARB No. 51, with Related Amendments of APB Opinion No. 18 and
ARB No. 43, Chapter 12
1989 EITF Topic No. D-14, Transactions Involving Special-Purpose Entities
1990
EITF Issue No. 90-15, Impact of Nonsubstantive Lessors, Residual Value
Guarantees, and Other Provisions in Leasing Transactions
1996
FASB Statement No. 125, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities
1996 EITF Issue No. 96-20, Impact of FASB Statement No. 125 on Consolidations of
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Special-Purpose Entities
1996
EITF Issue No. 96-21, Implementation Issues in Accounting for Leasing
Transactions Involving Special-Purpose Entities
2000
Statement No. 140, Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities--A Replacement of FASB Statement No. 125
SUMMARY AND CONCLUSIONS
After more than 20 years since SPEs appeared on the business scene, there remains
a confusing, if not convoluted, set of guidelines regarding the consolidation of
SPEs. Two streams of reasonably understandable guidance exist for leasing
transactions (EITF Issue No. 90-15) and for transfers of financial assets through
securitizations (FASB Statement No. 140). Until now, the only authoritative
guidance for other types of SPEs, including many of those used by Enron, is the
indication by the EITF and SEC that the guidance outlined in EITF Issue No. 90-15
and Topic D-14, which deals specifically with leasing transactions, is "appropriate"
for other non-lease-related SPEs.
The bankruptcy of the Enron Corporation associated with its use of sponsored unconsolidated SPEs has brought these financial innovations to the attention of the
public and accounting profession. From our review of the slowly evolving
authoritative guidance on the proper GAAP accounting for SPEs, we draw the
following conclusions. Initially, although thinly capitalizated, SPEs designed to
monetize assets such as accounts receivable were properly accounted for by
applying the traditional definitions of assets, liabilities, and unrelated entities.
These SPEs engage in FASB Statement No. 140-type transactions. Cash is usually
received for the receivables sold to the SPEs, so there is no problem with
establishing the value and, hence, the gain or loss on the assets sold. Although the
sponsoring corporation often guarantees the SPEs' debt, the probability of this
becoming a liability is small, because the equity capital provided by unrelated
investors is sufficient to absorb the losses, which could be measured objectively.
Nonconsolidation is generally appropriate.
Then, SPEs were used for the acquisition or sale and leaseback of plant and
equipment. However, the arrangements companies must make with their lessor
SPEs to avoid consolidation under EITF Issue No. 90-15 are not substantially
different from arrangements typically made when leasing properties from
established financial institutions in terms of the risks assumed by the lessee. The
problem at Enron, as it expanded the role of SPEs, was that even though its SPEs
were thinly capitalized and held assets that posed considerable risks, Enron took the
limited authoritative pronouncements literally, allowing them to not consolidate the
SPEs, even in situations where Enron assumed virtually all of the risks. See
Benston and Hartgraves (2002) for a description and analysis of what Enron did
and did not do.
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"Securitization and Structured Finance: Legitimate Business Management Tools," by Barbara T.
Kavanagh, Hosted by the Financial Management Association (FMA) --http://www.fma.org/FMAOnline/Securitization.pdf
Introduction
The events and controversy surrounding the bankruptcy of Enron have led many to
believe that securitization and structured finance serve no other purpose than deceit
and deception. In reality, these are modern business tools that, when properly
deployed, allow corporate treasurers to transfer risk, access alternative funding
sources and capital markets, and maximally leverage a corporation’s own expertise
despite an inevitably limited capital base.
This article explains the basic components of structured finance transactions and
the sound reasons for their undertaking from both an investor and originator
perspective, and will also provide the reader with examples of different common
structures. Section II of this document describes the basic mechanics and players
inherent in nearly all securitizations and structured transactions; the remaining
sections of this document will discuss examples of different types of structures.
Section III discusses asset backed commercial paper (ABCPs) vehicles and the
important reasons for their evolution. Section IV will dissect a project finance
securitization, generally undertaken to specifically fund the project(s) in question.
Section V will discuss catastrophe linked bonds , or “cats”, as an example of a
means of shifting a risk concentration away from the originator and towards
investors in need of portfolio diversification.
Fundamental Components of Securitization and Structured Transactions
Certain structural features are common across all structured transactions. In each
case, a separate entity is created in which a population of assets or cash flows can
be isolated. Commonly called a special purpose vehicle or entity (“SPV or SPE”),
the SPV then issues debt and/or equity instruments to investors representing claims
on the cash flows or assets isolated in the SPV. The SPV is often a trust or
corporation whose establishment is in the best interests of both originator and
investor.
A structure can be a “cash flow” or “synthetic” securitization vehicle. In a cash
flow-based securitization, the ownership of the assets whose cash flows are to be
securitized are actually transferred to the SPV. In a “synthetic” securitization, by
contrast, the cash flows and/or economic exposure is transferred to the SPV
through the use of a total return swap or some other derivatives transaction. The
two are equivalent from a risk and return standpoint, but synthetic SPVs do not
assume actual ownership of any assets.
From the perspective of the originator of a cash flow securitization, isolating the
assets or cash flows in question in an SPV is often a necessary step to achieve sales
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accounting treatment under GAAP and thereby remove the assets in question from
its balance sheet. From the investor perspective, isolating the assets/cash flows
serves to insulate the transaction from the potential bankruptcy of the originator as
well as its overall credit risk profile. In doing so, it allows the investor to take on
the isolated risk in the transaction in question rather than the wider populations of
risk that are probably inherent in direct equity or debt investments of the originator.
In addition, if the obligations of the cash flow-backed SPV are to be more highly
rated than the direct obligations of the originator, complete isolation from the risk
profile of the originator will be requisite.
Two additional players are almost always present in each structured transactions,
one to insure strict adherence to the prescribed terms of the deal, the other to
manage funds movement and cash flows. These are the trustee and servicer,
respectively. The trustee is an independent third party paid a fee and retained from
the onset of the transaction to essentially act as an advocate for the SPVs security
holders. The trustee monitors systematic reports by the servicer tracking asset or
pool performance, takes in cash flows collected by the servicer, and acts to monitor
the entire transaction on behalf of the security holder and in relation to underlying
legal indentures. Many structured finance transactions contain prescribed “trigger
events”- specifically identified events or performance measurements that, when
realized, may cause early liquidation or other actions to preserve the interests of the
security holder. It is the obligation of the trustee to track deal performance, based
on data provided monthly from the servicer, and take such actions as legal
covenants in the structure require to preserve the interests of the SPV’s security
holders. Similarly, the trustee will take in cash flows collected and forwarded by
the servicer and pass them through to security holders, also as prescribed by terms
of the underlying structure and supporting legal documents.
The servicer in structured transactions is often the originator of the assets in
question. By way of example, assume a bank bundles a population of residential
mortgages it has originated, conveys them to an SPV, and the SPV then issues
securities representing the beneficial interests in the cash flows eminating from
those mortgages. Most commonly the originator is also the servicer- in this case a
bank. It allows the originator to enjoy fee income over the life of the transaction,
and in this case also keeps the bank customer from realizing some party other than
the bank has met its credit needs. That is, the mortgage obligor continues making
payments to the bank monthly as required; the bank, however, passes them through
to the trustee who, in turn, passes them along to the investor holding a security
interest in the cash flow stemming from that pool of mortgages. Notably, should the
servicer fail to perform as required in the legal documents, the trustee will be
required to substitute another servicer so as to preserve the security holder’s
interests in the deal.
Finally, credit enhancements are often indigenous to structured transactions and
securitizations (and in many cases, liquidity enhancement as well). Enhancements
can be either externally provided by a third party- such as a monoline insurer
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providing a credit default guarantee- or may be “internal” to the deal. In the latter
case, some mechanism(s) is established in the deal design/engineering process to
protect security holders from defaults in excess of anticipated levels.
Continued at http://www.fma.org/FMAOnline/Securitization.pdf
Position of the International Accounting Standards Board --http://www.iasplus.com/interps/sic012.htm
INTERPRETATIONS: SIC 12
Consolidation - Special Purpose Entities
An Interpretation of IAS 27, Consolidated Financial Statements and
Accounting for Investments in Subsidiaries
Effective date: Annual financial periods beginning on or after 1 July 1999
SIC 12 addresses when a special purpose entity should be consolidated by a
reporting enterprise under the consolidation principles in IAS 27. The SIC
agreed that an enterprise should consolidate a special purpose entity ("SPE")
when, in substance, the enterprise controls the SPE.
Examples of SPEs include entities set up to effect a lease, a securitisation of
financial assets, or R&D activities. The concept of control used in IAS 27
requires having the ability to direct or dominate decision making accompanied
by the objective of obtaining benefits from the SPE's activities. The
Interpretation provides example indications of when control may exist in the
context of an SPE. The examples involve activities of the SPE on behalf of the
reporting enterprise, the reporting enterprise having decision-making powers
over the SPE, and the reporting enterprise having rights to the majority of
benefits and exposure to significant risks of the SPE.
Some enterprises may also need to separately evaluate the topic of
derecognition of assets, for example, related to assets transferred to an SPE. In
some circumstances, such a transfer of assets may result in those assets being
derecognised and accounted for as a sale. Even if the transfer qualifies as a
sale, the provisions of IAS 27 and SIC-12 may mean that the enterprise should
consolidate the SPE. SIC-12 does not address the circumstances in which sale
treatment should apply for the reporting enterprise or the elimination of the
consequences of such a sale upon consolidation.
Note especially how companies like to use SPEs in leasing situations.
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"Virtual Ownership: Synthetic real estate leases may be ready to move from Wall Street to
Main,"
by Ian Springsteel, CFO Magazine, Sep 1997
http://www.cfomagazine.com/Pge_mag_detail_archives/1,4583,%7C83% (now
10%)7C09%7C1997%7C1621,00.html
Until recently, off-balance-sheet financing of real estate through so-called synthetic leases
was viewed as an escape vehicle from depreciation burdens useful only in isolated
conditions. The arrangements were contrived, the legal documents thick, the accounting
risky. But several recent developments have conspired to change all that.
Dozens of Silicon Valley companies have penned such deals in the past 36 months, and such
blue-chip companies as General Motors, General Electric, Eastman Kodak, and AlliedSignal
are now said to be testing the waters. And while the Financial Accounting Standards Board
may still redefine the accounting for some lease- holding special-purpose entities as part of
its consolidations project, banks and lessees are now creating legal structures to limit that
risk.
More significant, the $250 million synthetic lease deal signed in December 1996 by Cisco
Systems Inc., which brings its total off- balance-sheet leases to $505 million, is not only one
of the biggest synthetics done so far, but also shows that such leases can be much more than
an accounting sideshow. Indeed, the San Jose, California-based networking- products giant's
latest deal is an integral piece of the company's corporate financing strategy.
Filling a Basic Need Cisco turned to synthetic leases because it needed more space but didn't
like the traditional options. When the company grew to $382 million (in revenues) back in
fiscal 1992, management knew it wouldn't be long before the firm would run out of room.
Sure enough, on completion of its most recent fiscal year, ended July 26, Cisco was a $6.4
billion company with almost 11,000 employees.
How much space and where to get it were Cisco's primary concerns. But David Rogan,
treasurer of Cisco, found both standard types of financing--a traditional lease or ownership- unappealing. The first option, leasing existing property or space built to order, carried a price
tag of 500 to 600 basis points in annual cash outlays above what the company would pay to
own it. Yet ownership--either through a long-term loan or with cash--was also unattractive.
Real estate loans were impossible to secure after the collapse of California's market in the
early 1990s; Cisco needed cash for acquisitions and research; and the company didn't fancy
the hit to reported earnings that would result from depreciation of the property.
Best of Both Worlds Instead, Cisco signed up for three deals in three years for $255 million
in lease financing with Sumitomo Bank Leasing and Finance Inc. for several additions on its
various sites for a total of about 2 million square feet.
First developed on Wall Street in the late 1980s, the structure allows an investment- grade
company like Cisco to obtain 100 percent financing of its property at its corporate borrowing
rate and receive the tax benefits of ownership, while avoiding the depreciation associated
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Lecture Notes for Acct 415/515, Acct 592
Prof. Teresa Gordon
with straight ownership. Now such leases are widely available from specialized leasing
companies.
Synthetic lessees typically reserve the right to buy the property at the end of the lease, extend
the lease, or sell the property and take any gain or loss in its value. Minimum deal size is
approximately $10 million.
"This is a far better mousetrap than corporations have had in the past, and they are now easier
and cheaper to do as the documentation becomes more standardized," says Todd Anson, a
managing partner with Bro-beck, Phleger & Harrison LLP, in San Diego, who helped
structure Cisco's latest deal. Typical legal and accounting bills on a synthetic lease run about
$50,000 to $100,000 now, he adds. That's about half what it was a few years ago.
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