Page 27 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

Special Purpose and Variable
Interest Entities READING 14: INTERCORPORATE INVESTMENTS

Legal structure isolates some sponsor’s assets and liabilities, reducing risk and MODULE 14.10: SPECIAL PURPOSE ENTITIES
cost of financing. Sponsor has control over SPE’s finances or operating activities
while 3rd 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 SPE that meets certain conditions.
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: (1) Decision making rights; (2) Obligation to absorb expected losses; (3) right to receive expected residual returns.

For an SPE to be VIE, it must be consolidated by the primary beneficiary –the absorber of majority of the risks or receives the majority of the rewards.

EXAMPLE: Special purpose entity: Company P, a textile manufacturer, wants to borrow $100 million. It has two options:

Option B: (Nonconsolidated) BS will reflect a reduction in accounts
receivable of $100 million and an increase in cash by the same.

P’s balance sheet before the borrowing is provided below:

SPE’s BS after purchase of accounts receivable and bank loan:

Prepare company P’s balance sheet under both options assuming that
the SPE in option B meets the requirements for consolidation.
After consolidation, the SPE’s debt gets included with company P’s
Option A: Cash and debt increase by the new borrowing of $100 million. debt, and accounts receivable increase by the same amount. 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.”