Special-Purpose Entities Explained: A Short Analysis of Consolidation Avoidance and SPEs in Accounting

According to Schroeder, Clark, and Cathey, "the primary motive for most SPEs is off-balance sheet accounting, often to avoid reporting capital leases under SFAS No. 13" (2005). Thus companies can avoid reporting long-term liabilities, improving their financial appearance by transferring these liabilities to SPEs à la Enron. I hasten to add that such arrangements are not necessarily nefarious by nature; they often have a quite legitimate purpose.

For those involved in small business transactions, writing-in inflation indices into lease contracts is rare because most small enterprises do not sign long-term leases; instead, a fixed percentage is usually used. This is a good opportunity to explore where an exception occurs for specialized operations, such as a manufacturer or a hospital looking for a home. If the organization in question finds it better to enter into a lease arrangement than to finance construction on its own, you can bet your sweet bippy that the lessor isn't going to be the tiniest bit happy with a short-term lease - such buildings offer the lessor little in the way of options if the lessee moves out. This is not a big issue for an operation (such as a hospital or a manufacturing firm) that doesn't up and move stakes in the normal course of business anyway, so long-term leases are the norm in these situations. Satellite operations are, of course, a different matter, so many of these enterprises will have a variety of arrangements for their various operating segments; here I examine a sole operation or primary operating segment for purposes of discussion.

So let's say I finance my own building for a hospital. Eventually I need to raise cash to expand operations elsewhere or catch up with some expensive technology on an operation-wide scale. One way to obtain capital is to sell off my building and make the sale contingent on a lease agreement with the buyer. Now I've got cash, and as a bonus, my financial statements look better to potential creditors and IPO investors - it is suddenly easier and cheaper for me to raise even more capital if I need it.

I might not be terribly comfortable with relinquishing 100 percent control of a building I have to have for my enterprise, and that's where consolidation kicks in. If I want to keep the SPE off of my books, I cannot retain a majority voting interest, and at least 10 percent of the capital for the investment in the SPE must come from a third-party investor. If I meet these minimum guidelines, my portion of the SPE that was created to lease my building back to me appears only as an investment on my books; SFAS No. 140 has been satisfied for purposes of the sale and the housekeeping I have to do to eliminate the liability on my books, and SFAS No. 94 has been satisfied with respect to my lack of control over the SPE (Shroeder et al., 2005).

But come on now - I only have to give up ten percent? Ten percent sounds awfully small to me, and the FASB has been sufficiently troubled by majority financial control even in the absence of majority voting rights to explore the issue in an exposure draft entitled "Consolidation of Certain Special Purpose Entities," released in 2002 (Schroeder et al., 2005). Some six years later, this issue shows no signs of resolution; the EITF has identified sixteen areas that will be impacted by changes to the reporting requirements under consolidation theory, yet still there is no sign of an official SFAS proclamation that directly mentions special purpose entities (FASB, 2008). I'm genuinely surprised that the Enron debacle did not inspire the urgency to push through finalization of the draft on this issue. (Note that SFAS No. 160, issued antecedent to the publication of our textbook, amends SFAS No. 94, paragraph 4, as well as significantly changing ARB 51 - but SFAS No. 160 does not explicitly address SPEs. However, it does speak to consolidation and deconsolidation issues, as well as "financial controlling interests," so I am left thinking that its provisions should apply where the divesting parent has an incestuous relationship with the SPE due to a majority financial interest. After retrieving and reading Comment Letter No. 3 (Draft Abstract) for [EITF] Issue 08-10, "Selected Statement 160 Implementation Questions," from FARS, I am no clearer on the subject; but it does appear that I am in good company in this regard.)

References

FASB. (2008, November 13). Emerging issues task force (EITF): Issues grouped by type. Retrieved January 27, 2009, from http://www.fasb.org/eitf/1108STATS.pdf.

Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2005). Financial accounting theory and analysis: Text readings and cases (8th ed.). Hoboken, NJ: John Wiley & Sons, Inc.