for Special Purpose Entities Revised: FASB Interpretation
Jalal Soroosh and Jack T. Ciesielski
purpose entities (SPE), also referred to as off–balance-sheet
arrangements, were used as far back as the 1970s, when many
companies engaged in securitization. Originally, these transactions
served a legitimate business purpose: to isolate financial
risk and provide less-expensive financing. In theory, because
SPEs do not engage in business transactions other than the
ones for which they are created, and their activities are
backed by their sponsors, they are able to raise funds at
lower interest rates than those available to their sponsors.
off–balance-sheet arrangements may be called qualifying
special purpose entities (QSPE) if they meet the requirements
set forth in SFAS 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities.
Or they may be referred to as variable interest entities
(VIE), in accordance with the definition and requirements
established in FASB Interpretation 46 (revised December
2003), “Consolidation of Variable Interest Entities—An
Interpretation of Accounting Research Bulletin (ARB) No.
an off–balance-sheet entity is created by a party
(the transferor or the sponsor) by transferring assets to
another party (the SPE) to carry out a specific purpose,
activity, or series of transactions. Such entities have
no purpose other than the transactions for which they are
created. The legal form for these entities may be a limited
partnership, a limited liability company, a trust, or a
corporation. Regardless of their legal form, off–balance-sheet
entities share the following characteristics:
They are often thinly capitalized.
They typically have no independent management or employees.
Their administrative functions are often performed by
a trustee who receives and distributes cash in accordance
with the terms of contracts and who serves as an intermediary
between the SPE and the parties that created it.
If the SPE holds assets, one of these parties usually
services them under a servicing agreement.
SPEs are formed to accomplish the following objectives:
Financing certain assets or services and keeping the associated
debt off the balance sheet of the sponsors.
Transforming certain financial assets, such as trade receivables,
loans, or mortgages, into liquid securities.
Engaging in tax-free exchanges.
may benefit from these off–balance-sheet entities
in two ways. First, these entities enable the sponsor to
remove debt from its balance sheet so it meets certain ratios
or loan covenants. Second, such arrangements protect the
sponsor from possible financial failure by its SPEs. That
is, if the project for which an SPE was created fails and
the SPE cannot service its debt, the sponsor is at risk
only for what it has put into the SPE. The sponsor pays
a price for these off–balance-sheet arrangements,
however: The sponsor will also have to remove from its balance
sheet the assets related to the debt that has been moved
to the SPE. For example, if a sponsor uses an SPE to finance
a capital project, neither the liability nor the assets
of that project will be included in the sponsor’s
accomplish their objectives, SPEs may take different forms.
For example, an airline that needs a fleet of airplanes
or a gas company that needs a pipeline can employ SPEs to
finance such projects. The off–balance-sheet entity
will own these assets for the specific use of the sponsors,
and use them as collateral to raise cash to finance them.
As long as these arrangements meet existing accounting guidelines,
the sponsoring companies need not consolidate these assets
and the associated debt. These off–balance-sheet arrangements
can take the form of synthetic leases, take-or-pay or throughput
contracts, or securitizations. Other forms of business transactions
that have been accomplished via off–balance-sheet
entities include investments accounted for under the equity
method, joint venture research and development arrangements,
and investments in low-income-housing projects. This article,
however, focuses on only a few of these arrangements.
leases. In a popular SPE known as a synthetic
lease, the sponsor establishes an SPE—a shell company—for
the purpose of buying and financing an asset for a specific
use by the sponsor. SPEs can be set up for sale-leasebacks
or build-to-order or buy-lease transactions. The SPE takes
the title to the property, collects the rent from the lessee/sponsor,
and pays off the loan. These arrangements became popular
after the 1980s real estate crunch, when it became less
attractive for companies to directly buy and finance the
assets they needed.
leases can serve two important purposes: First, for financial
accounting purposes, they enable lessees/sponsors to treat
leases as operating leases, whereby payments are recorded
as rent expense and the underlying assets and the associated
liabilities are kept off the lessee’s balance sheet.
This treatment of the lease enables the company to show
a stronger balance sheet than if the lease was treated as
a capital lease.
for federal income tax purposes, these contracts are structured
so that the lessee/sponsor may treat the transaction as
if it is, in substance, the owner of the leased property.
As such, the lessee/sponsor then treats the payments as
debt service, enabling it to deduct interest expense and
depreciate the asset. A company can be a tenant for financial
accounting purposes and an owner for tax purposes.
contract. A buyer agrees to pay certain periodic
amounts for certain products or services. The buyer must
make the specified periodic payments, even though it does
not take delivery of the products or services. For example,
two gas companies might form an SPE to build a refinery
and agree to pay specific annual amounts for refined oil.
These payments are made regardless of the actual delivery
of the product.
contracts. One party agrees to pay certain
periodic amounts to another party for the transportation
or processing of a product. For example, two gas companies
might form an SPE to build a network of pipelines and agree
to pay specific annual amounts for transporting oil through
these pipelines. These payments are made regardless of the
actual use of these pipelines.
Another widespread use of SPEs is in securitization transactions,
where a pool of financial assets, such as mortgage loans,
automobile loans, trade receivables, credit card receivables,
and other revolving charge accounts, is transformed into
securities. (Nonfinancial assets, such as patents, copyrights,
royalties, and even taxi medallions, can be securitized
as well.) In a typical securitization, an originator (the
transferor) establishes an SPE, or, as it is also called,
a special purpose vehicle (SPV). The SPV usually exists
in the form of a trust for the purpose of converting a bundle
of financial assets into cash on behalf of the sponsor.
The sponsor sells the pool of assets to the SPV, which will
hold them and issue debt securities for cash, which the
SPV uses to pay the sponsor for the transfer of the financial
assets. The sponsor then services the debt from the cash
flows generated from the securitized assets. Thus, the originator
of the SPV “securitizes” the assets—turns
them from loans into debt instruments.
securitization to work, the company disposing of financial
assets must structure the transaction so that it retains
no effective control over the assets removed from its balance
sheet. If it does not release effective control over the
transferred assets, then the transaction is treated as a
challenge for investors is the difficulty in spotting these
transactions. Unfortunately, the magnitude of the dollar
amounts involved in these transactions notwithstanding,
any available disclosures about them are buried in footnotes.
There is no easy way of estimating the amount of assets
or liabilities that are subject to these arrangements. Exhibit
1 demonstrates the results of a random review of 66
public companies, primarily in the energy, financial, and
industrial sectors. SPE transactions for this sample accounted
for close to $230 billion as of 2001. Of these transactions,
92% were securitizations of receivables, with leases accounting
for the remaining 8%. It should be noted that these off–balance-sheet
arrangements were disclosed in the footnotes; the real problem
is with SPEs hidden from financial statement users. The
amount of money involved in these transactions can only
be guessed, and one can only expect that the amount involved
recently, accounting standards have not responded to the
development of such sophisticated transactions and arrangements.
The accounting standards dealing with off–balance-sheet
entities have produced inconsistent results, because the
standards are incomplete and fragmented. An original pronouncement
that indirectly established the foundation for SPE accounting
is Accounting Research Bulletin (ARB) 51, Consolidated
Financial Statements, issued in 1959. The principles
built into ARB 51 were that “the usual condition for
a controlling financial interest is ownership of a majority
creators of these sophisticated SPEs, however, have been
able to design entities where sponsors maintain control
without owning majority voting power. The intended transactions
for these entities were packaged into legal forms that have
no voting interest. The interest of the sponsor, or the
sponsor’s control, is secured through legal restrictions
on the ways the SPE uses its assets, particularly in regard
to what parties the entity may permit access. Consequently,
companies have been able to avoid consolidating these entities
where in substance they had control, but such control did
not meet the definition of ARB No. 51.
3% rule. The nonconsolidation feature of SPEs
became possible due to an accounting rule established by
the now-defunct EITF Issue 90-15, according to which the
sponsor of a SPE did not have to consolidate the assets
and liabilities of the SPE as long as the equity interest
of a third-party owner was at least 3% of the SPE’s
total capitalization; at the same time, the majority of
equity voting rights cannot reside with the beneficiary.
2 lists accounting standards that directly or indirectly
deal with off–balance-sheet entities. These standards
may be referred to as “pre-Enron” standards
that did not go far enough to provide an accurate picture
of the relationships between the sponsoring companies and
their SPEs. FASB was not totally inactive in this area:
Recognizing the loopholes in the accounting for securitizations,
FASB attempted to reform the existing GAAP for those transactions
through SFAS 125, Accounting for Transfer and Servicing
of Financial Assets and Extinguishment of Liabilities,
after issuing SFAS 125, FASB became aware of flaws that
necessitated its revision. SFAS 140, Accounting for
Transfer and Servicing of Financial Assets and Extinguishments
of Liabilities, is the end result. This statement establishes
the conditions where the transfer of financial assets should
be accounted for as a sale by the transferor, and the conditions
under which a liability should be deemed to have been extinguished.
It further defines qualifying SPEs, which should not be
consolidated in the financial statements of the transferor
or its affiliates.
140 significantly improved disclosure. With the concern
about the quality of assets on the balance sheet, the disclosure
requirements of SFAS 140 are more useful for investors and
analysts trying to decipher the riskiness of the assets
retained in securitizations. Securitizations can significantly
affect a company’s bottom line and be quite subjective
in their calculation. The disclosures are useful to investors
assessing earnings quality.
the Enron crisis brought attention to the use of SPEs, FASB
responded by issuing a proposed interpretation of existing
accounting principles aimed at putting many off–balance-sheet
entities back onto the balance sheet of the companies that
created them. In June 2002, FASB issued an exposure draft
to revise the accounting for SPEs. This exposure draft was
an Interpretation of ARB 51. The final Interpretation 46,
Consolidation of Variable Interest Entities, an Interpretation
of ARB 51, was issued in January 2003. Upon learning
that certain provisions were not being interpreted as the
board intended, FASB issued Interpretation 46(R), which
also incorporates guidance from FSP FIN 46-3, FSP FIN 46-4,
FSP FIN 46-6, and FSP FIN 46-7.
current accounting standards require an enterprise to include
in its consolidated financial statements subsidiaries in
which it has a controlling financial interest. The existing
common definition of “control” is met when a
parent company has more than 50% of the voting stock in
a subsidiary. Over the years, however, companies have found
ways to obtain economic control of other entities without
owning 50% of the voting stock, thereby avoiding consolidation
of these entities.
until recently, the accounting-for-consolidations policy
did little to answer the question many have been asking:
Who else has engaged in Enron-style SPE transactions? New
developments are expected to capture egregious SPEs, and
provide users of financial statement with clearer information.
objectives of Interpretation 46(R) are to explain how to
identify variable interest entities (VIE) and how to determine
when a business enterprise should include the assets, liabilities,
noncontrolling interests, and results of activities of a
VIE in its consolidated financial statements. Some entities
commonly referred to as SPEs are not subject to this interpretation,
and other entities that are not SPEs are subject to this
interpretation; thus the need for the designation VIE. Interpretation
46(R) defines a VIE as an entity that meets one of the following
The total equity investment at risk is not sufficient
to permit the entity to finance its activities without
additional subordinated financial support provided by
any parties, including equity holders.
The equity investors lack one or more of the following
essential characteristics of a controlling financial interest:
The direct or indirect ability through voting rights or
similar rights to make decisions about the entity’s
activities that have a significant effect on the success
of the entity.
The obligation to absorb the expected losses of the entity.
The right to receive the expected residual returns of
to this interpretation, such VIEs should be consolidated
in the financial statements of their primary beneficiaries.
Basically, this interpretation is designed to expand the
definition of control for consolidation of financial statements
to include consolidation based on “variable interest,”
as well as consolidation based on voting power.
first condition noted above requires good judgment on the
part of companies and their auditors. The sufficiency of
the equity investment must be evaluated at each reporting
period. To help determine “sufficiency,” the
interpretation increases the 3% threshold to 10%: “an
equity investment shall be presumed insufficient
to allow the entity to finance its activities without relying
on financial support from variable interest holders unless
the investment is equal to at least 10 percent of the entity’s
total assets” (emphasis added).
this may seem like a simple bright-line criterion, determining
the sufficiency of equity investment in a VIE is subject
to considerable judgment. Specifically, the interpretation
also allows an equity investment of less than 10% to be
considered sufficient to permit the VIE to finance its activities
if at least one of the following three conditions is met:
The entity has demonstrated that it can finance its activities
without additional subordinated financial support.
The entity has at least as much equity invested as other
entities that hold only similar assets of similar quality
in similar amounts and operate with no additional subordinated
The amount of equity invested in the entity exceeds the
estimate of the entity’s expected losses, based
on reasonable quantitative evidence.
the 10% threshold does not automatically mean that the equity
level is sufficient to permit the entity to finance its
activities without additional subordinated financial support.
In other words, the interpretation leaves room for flexibility
in determining what the equity investment in an entity should
be in order to avoid consolidation of such an entity by
its variable interest holder.
Based on Variable Interests
entity must first be evaluated for consolidation based on
straightforward voting-interests criteria. If such criteria
are not met, a VIE may still be subject to consolidation
by its primary beneficiary based on variable interests.
The interpretation defines variable interests in a VIE as
“contractual, ownership, or other pecuniary interests
in an entity that change with changes in the entity’s
net asset value.” Basically, variable interests are
the means through which financial support is provided to
a VIE and through which the providers gain or lose from
the activities and events that change the values of the
VIE’s assets and liabilities. Exhibit
3 lists various transactions that may results in variable
interpretation considers a primary beneficiary to be an
enterprise that meets at least one of the following conditions:
Its variable interest in the VIE absorbs a majority of
the entity’s expected losses.
Its variable interest in the VIE absorbs a majority of
the entity’s expected returns.
It has the ability to make economic decisions about the
enterprise’s ability to make economic decisions that
significantly affect the results of the activities of a
VIE is not, however, by itself a variable interest. It is,
however, a strong indication that the decision maker should
carefully consider whether it holds sufficient variable
interests to be the primary beneficiary.
whether an enterprise is the primary beneficiary of an entity
should take place at the time the enterprise becomes involved
with the off–balance-sheet entity. At each reporting
date, however, an enterprise with an interest in a VIE should
reconsider whether it is the primary beneficiary, if the
entity’s governing documents or the contractual arrangements
among the parties change. Subsequent to the initial involvement
in a VIE, a primary beneficiary should also reconsider its
initial decision to consolidate the entity if it sells or
otherwise disposes of any of its variable interests. Similarly,
an enterprise that was not originally a primary beneficiary
in a VIE should reconsider if it acquires an additional
interest in the entity.
Losses and Expected Residual Returns
whether an interest holder in a VIE is a primary beneficiary
depends on the entity’s expected losses and expected
residual returns. These
calculations are forward-looking and subject to estimation.
In addition, an entity’s expected losses are key factors
in determining whether such an entity is a VIE. A VIE’s
expected losses and expected residual returns include the
The expected negative variability in the fair value of
the entity’s net assets, exclusive of variable interests.
The expected positive variability in the fair value of
the entity’s net assets, exclusive of variable interests.
FASB Staff Position 46(R)-2 makes clear that even an entity
that has no history of net losses and expects to continue
to be profitable in the foreseeable future can be a VIE
that should be consolidated in its primary beneficiary’s
financial statements. This position clarifies the definition
of expected losses as based on the variability in the fair
value of the entity’s net assets exclusive of variable
interests, not on the anticipated amount or variability
of the net income or loss.
to Interpretation 46(R), expected losses and expected residual
returns refer to amounts derived from expected cash flows
as described in FASB Concept Statement 7, Using Cash
Flow Information and Present Value in Accounting Measurements.
The following example illustrates how to compute expected
losses and expected residual returns. This illustration
assumes that an off–balance-sheet entity’s estimated
annual cash flows and changes in the entity’s assets
continue for two years; also that the present value of the
probability-weighted expected outcomes for each of the next
two years is the same as their fair value. In most cases,
however, this assumption may not hold, and thus the present
values should be adjusted for appropriate market factors.
The fair value amount of the estimated outcomes becomes
the benchmark for determining the entity’s expected
losses and expected residual returns. Exhibit
4 shows the range and probability of estimated annual
outcomes expected to occur and their present values (based
on a 5% discount rate).
5 shows how expected losses are computed once the fair
value of the expected outcomes is determined. In this illustration,
because the estimated outcomes are different from Year 1
to Year 2, the expected losses for each year should be calculated
separately. For each year, estimated outcomes that are less
than the total expected outcome for that year contribute
to expected losses, which in this illustration is $989,000
in Year 1 and $987,000 in Year 2, for a total expected loss
of $1,976,000. The total expected losses are used as a base
for determining whether an entity is a VIE, and the primary
beneficiary of such an entity. Exhibit
6 shows how to compute expected residual returns for
the same pool of assets. Similarly, for each year, estimated
outcomes that are more than the total expected outcome for
that year contribute to expected residual returns, which
in this illustration is $990,000 in Year 1 and $986,000
in Year 2, for a total expected residual return of $1,976,000.
a VIE has different parties with different rights and obligations,
each party determines its own expected losses and expected
residual returns and compares that amount with the total
to determine whether it is the primary beneficiary. As shown
above, the party whose variable interests in a VIE absorb
the majority of the expected losses or expected residual
returns is considered the primary beneficiary and must consolidate
the entity. If one party receives a majority of the entity’s
expected losses and another party receives a majority of
the entity’s expected residual return, however, the
party absorbing a majority of the expected losses is required
to consolidate the VIE. FASB considered exposure to losses
to be the more important of the two conditions in determining
the primary beneficiary.
of Interpretation 46(R)
interpretation applies to transactions that are currently
invisible due to ambiguous ownership, where the voting equity
ownership does not give the owners a controlling financial
interest. The following entities, however, are specifically
excluded from the scope of this interpretation:
A qualifying SPE (QSPE) used in a transfer of financial
assets, as dictated in SFAS 140.
An employee benefit plan subject to the provisions of
SFAS 87, Employers’ Accounting for Pensions;
SFAS 106, Employers’ Accounting for Postretirement
Benefits Other Than Pensions; or SFAS 112, Employers’
Accounting for Postemployment Benefits, by the Employer.
An enterprise subject to SEC Regulation S-X Rule 6-03(c)(1)
is not required to consolidate any entity that is not
also subject to that same rule.
According to FASB Staff Position FIN 46-1, all not-for-profit
organizations as defined in SFAS 117, Financial Statements
of Not-for Profit Organizations, are exempt from
the provisions of this interpretation. A not-for-profit
organization, however, may be a related party for the
purpose of determining the primary beneficiary of a VIE.
In addition, a not-for-profit entity used by a business
enterprise in a manner similar to a VIE in an effort to
circumvent the provisions of Interpretation 46 is subject
to the interpretation.
Separate accounts of life insurance entities as described
in the AICPA Audit and Accounting Guide, “Life and
Health Insurance Entities.”
An enterprise with an interest in a VIE or potential VIE
created before December 31, 2003, is not required to apply
this interpretation to that entity if the enterprise cannot
obtain the necessary information to consolidate the VIE.
An entity that is deemed to be a business as described
in this interpretation does not have to be evaluated by
a reporting enterprise to determine if such an entity
is a VIE.
Governmental organizations and financing entities established
by governmental organizations are not required to apply
this interpretation, unless they are used by a reporting
enterprise to circumvent the provisions of this interpretation.
7 provides an overview of the scope of this proposed
interpretation, the requirements of which will nullify the
provisions of EITF Issues 84-40 and 90-15 and Topic D-14.
Furthermore, it will modify or partially nullify EITF Issues
No. 95-6, No. 96-21, No. 97-1, and No. 97-2, as well as
finalize the requirements of EITF Issue No. 84-30.
original Interpretation 46 arrived with a very short implementation
grace period. The requirements applied immediately to VIEs
created after January 31, 2003, and to VIEs in which an
enterprise obtains an interest after that date. The revised
Interpretation 46(R) is required in financial statements
of public entities for periods ending after December 15,
2003. Special provisions apply to enterprises that fully
or partially applied Interpretation 46 prior to issuance
of the revised Interpretation.
SPEs that this interpretation covers are currently invisible,
by design. There is no simple or reliable way for analysts
or investors to judge which companies are most likely to
be affected. Clues might be found in the management’s
discussion and analysis, but not enough to enable financial
statement users to reliably estimate how the interpretation
will affect companies’ financial statements. This
new interpretation might cause very few changes in corporate
balance sheets, because companies that would have to consolidate
their SPEs under the requirements of this interpretation
might already be taking steps to shut down or sell their
interests prior to the effective date. This scenario would
avoid the embarrassment for the sponsors of presenting what
they never professed to own. The other alternative is that
Interpretation 46(R) might cause significant adverse adjustments
to companies’ balance sheets and create technical
defaults in loan covenants.
Soroosh, PhD, CMA, KPMG Faculty Fellow, is a professor
of accounting at Loyola College, Baltimore, Md.
Jack T. Ciesielski, CPA, CFA, CMA, is president
of R.G. Associates, Inc., Baltimore, Md.