How to Consolidate Special Purpose Entity
I lost my first serious job in Arthur Andersen in 2001.
I was devastated, because I really loved that job.
Yes, it was full of hard work and long overtimes, but it was the best accounting and auditing school ever.
How did I lose my job?
Well, Arthur Andersed died after the big accounting scandal of Enron.
I feel it’s very unfair that about 85 000 employees of Arthur Andersen worldwide (including me!) lost their jobs just due to fraudulent actions of few audit managers in Chicago.
On the other hand, if an auditor fails to do her job properly and then she shreds her working papers to hide evidence, then she deserves nothing else than losing her reputation and going out of business – I understand that.
Why am I writing about it?
Well, because Enron’s accounting scandals has something to do with special purpose entities (SPE) and it is a great life example of what happens when you do NOT consolidate them.
In today’s article, I will try to shed some light on special purpose entities and show you how to consolidate them.
What is special purpose entity?
Special purpose entity (SPE), sometimes called “Special purpose vehicle (SPV)”, is a legal entity or company created to fulfil special purpose or objective.
For example, multinational group may created SPE to perform research and development activities.
Or, banks create SPE for the loan securitization purposes, to collect the debts, to avoid certain legal risks in specific countries, to transfer assets and sometimes to avoid high taxes.
Special purpose entities are often designed to attract the source with lower cost of financing.
If you are interested in detailed explanation, you are very welcome to check out my IFRS Kit in which I fully explain the loan securitization schemes, too.
Very important factor is that often the special purpose entity is not formally owned by its creator for various reasons.
There are some other equity investors who don’t behave like true owners – they don’t make any decisions, they often get fixed return on their investment (not dividend based on profits), etc.
A great example is – you guessed it – Enron.
Enron set up lots of these special purpose entities to hide debts and in fact, Enron’s ownerhip in SPE was close to zero.
What happened in Enron?
Enron was an America energy corporation which employed about 20 000 people right before its bankruptcy in 2001.
But, Enron’s leaders played with their financial results and issued confusing and untrue financial statements.
On top of it, Enron generated huge debts and therefore it set up hundreds of special purpose entities to hide the debt.
How was that possible?
To make the long story short, Enron did NOT consolidate these special purpose entities and therefore, no one could see the debts in the Enron’s consolidated financial statements.
Why did not Enron consolidate special purpose entities?
Because, the accounting rules for consolidation were not as strict those days as they are now.
Should you consolidate special purpose entity?
To avoid similar accounting scandals as Enron, the standard IFRS 10 prescribes to assess the need of consolidation based on control, not on legal ownership.
If the parent or creator controls SPE, then yes, SPE must be consolidated even if the parent owns zero percent share.
The standard IFRS 10 gives us extensive guidance on assessing the existence of control, but we will not deal with it in this article.
Here I’d like to focus on the consolidation itself.
How are you going to consolidate if parent owns 0%? How are we going to calculate goodwill and non-controlling interest?
If a parent controls special purpose entity, then SPE is a subsidiary.
And, you should apply the same consolidation principles as for any other subsidiary with “normal” percentual share.
Let me show you.
Example: Consolidation of special purpose entity
Mommy Corp. wishes to take cheap financing from country A and therefore, it makes an agreement with Baby Ltd. Baby is incorporated in country A, fully owned by the third parties, currently not performing any activities.
The banks in country A provide loans with lower interest rates to companies owned by local entrepreneurs. Therefore, Mommy decides not to buy any share in Baby to get the cheaper loan.
Instead, the following agreement is in place:
- Mommy sends CU 10 000 to Baby in order to cover all expenses related to negotiating of the loan;
- Mommy will guarantee all Baby’s debts;
- Mommy’s managers will take over the decision making in Baby including the voting rights.
Mommy’s and Baby’s balance sheets at the reporting date as as follows:
- Baby’s retained earnings at the date of the agreement were CU 1 000.
- At the reporting date, Mommy’s financing via Baby was CU 150 000.
It seems that Mommy takes control of Baby despite having 0% share.
Let’s consolidate. We will use the proportional share method for valuing non-controlling interest.
3 Steps in Consolidation Procedures
It’s not going to be any different with consolidating SPE.
We will take all three steps:
- Eliminate parent’s investment and parent’s share in subsidiary (+ goodwill)
- Eliminate intragroup transactions.
Step 1: Combine
Just like with any other consolidation, let’s add up all like-items, line by line.
The combined amounts are here:
Step 2: Eliminate
We can now eliminate:
- The carrying amount of the parent’s investment in the special purpose entity, and
- The parent’s portion of equity in the special purpose entity;
and recognize any non-controlling interest and goodwill.
This time, it will be a little bit different, because the parent did not make any direct investment in the subsidiary’s shares.
Instead, Mommy just paid CU 10 000 to Baby to cover the expenses related to the financing. This transfer is Mommy’s investment in special purpose entity.
Also, here’s one very interesting point about the non-controlling interest.
How much is it in this case?
Well, 100% – you guessed it.
It’s because Mommy does not own any share and everything is owned by non-controlling interest.
This is possible, because Mommy gained control over Baby by the contractual arrangement, and NOT by ownership of shares.
The goodwill calculation is as follows:
- Fair value of Mommy’s investment: CU 10 000
- Add non-controlling interest at acquisition (Baby’s share capital of CU 20 000 plus Baby’s pre-acquisition retained earnings of CU 1 000, all multiplied with NCI’s share of 100%): CU 21 000*100% = CU 21 000
- Less Baby’s net assets at acquisition (see above): CU 21 000
- Goodwill= CU 10 000
It should not surprise you that the goodwill is equal exactly to parent’s investment in SPE.
No wonder – parent paid CU 10 000 for acquiring zero share!
We also need to recognize non-controlling interest at the reporting date, which is 100% of Baby’s net assets at the reporting date – CU 22 000.
Here’s the journal entry to make:
|Remove Mommy’s investment in Baby||-10 000||FP – Investment in Baby|
|Remove Baby’s share capital in full||+20 000||FP – Baby’s share capital|
|Remove 100% (NCI) of Baby’s post-acquisition retained earnings||+2 000||FP – Retained earnings|
|Recognize non-controlling interest at the rep. date||-22 000||FP – Non-controlling interest|
|Recognize goodwill acquired in a business combination||+10 000||FP – Intangible assets (goodwill)|
Our step 2 is shown in the following table:
Eliminate intragroup transactions
The last step is to eliminate intragroup transactions.
This is very often omitted with special purpose entities, since they are not typical subsidiaries – however, once you apply the full consolidation method, you need to eliminate in full.
In this case, Mommy has a long-term payable of CU 150 000 to Baby and vice-versa, Baby has a receivable to Mommy in the same amount.
These amounts represent a loan transfer from Baby to Mommy.
Elimination entry is shown here:
Add it up
Now, we can add up the combined numbers with all the adjustments and thus get the consolidated statement of financial position:
The interesting fact is that there’s huge non-controlling interest and the consolidated retained earnings show only those of Mommy, because there’s no share in Baby at all.
Well, there are many ways how parents transfer the profits from special purpose entities outside dividends, such as charging various license or service fees, etc.
Why is it important to consolidate SPE?
Indeed, why is it so important to show huge non-controlling interest and the same retained earnings as in the separate financial statements of a parent?
The meaning of consolidating SPE lies in showing combined assets and liabilities.
If some parent wants to hide huge debts in SPE, consolidation makes it impossible because debts of SPE are shown within consolidated liabilities.
If Enron would have had consolidated its SPEs and shown huge debts, then probably it could prevent its catastrophic bankruptcy and the management would not be able to be so greedy and continue in dirty practices ruining the company.
And, I would have not lost my job.
Any comments? Please share them below. Thank you!
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