Off-Balance Sheet Debt (SPEs, Equity Method)

RCJ Chapter 11 (pg 583-585) & Chapter 16 (pg 891-895)

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Key Issues1. Special Purpose Entity (SPE)2. Definition, types of activity3. Rules for off-B/S accounting4. Partial vs. full consolidation (to put on B/S)5. Example6. Ratio effects

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Off-Balance Sheet Debt In order not to appear too risky firms that operate in

debt intensive industry, such as energy, communication and airline, try to keep debt off the balance sheet.

Construct deals in such a way as to avoid reporting debt/liabilities.

We’ll review several forms of off-balance sheet financing:

Special purpose entities Equity method vs. consolidation of subsidiaries Operating leases (vs. capital lease) Synthetic leases

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Special Purpose Entity (SPE) Subsidiary, partnership, etc. set up for specific,

finite period, activity. Often highly leveraged (high ratio of debt/equity

or debt/assets). Also for ongoing investments, subs, joint

ventures.

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Consolidation of Subs, SPEsTo avoid consolidation of SPE subsidiary, investment, or joint venture, parent must have:1. 50% or less of sub’s common O/E, or 2. for SPE’s outside residual claim must bear substantial

risk; de facto implementation has required 3% of total assets.

Example: A = L + ESPE 100 94 6P=parent 97 94 (upto 97) 3 (or less)Outside owner 3 0 3

key point: keep debt off of the Balance Sheet

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Equity Method vs. Consolidation

Equity method for parent investment in A or B:DRInvestment 1

CR Cash or C/S 1

A = L + E D/E D/AP=parent

2 1 1 1.0 .50

Sub A 1 0 1 0 0Sub B 10 9 1 9.0 .90note: both sub’s have same BV of O/E = 1 (assume BV = MV, so GW = 0)

Consolidation of A into P

Consolidation of B into P

DR Assets 1 CR Cash or C/S 1

DR Assets 10 CR Cash or C/S 1 CR Liab. 9

sub’s A’s and L’s not recognized; only O/E recognized

sub’s A’s and L’s recognized

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One Line Consolidation Under the equity method, subsidiaries’ net

assets (A-L) collapse into one line usually called ‘investment’.

Equity method is often called “one line consolidation”

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Effect of Consolidation on D/E and D/A

A = L + E D/E D/APay cash 2* 1 1 1.0 .50Pay C/S 3 1 2 .50 .33

* no change since DR to sub’s assets is cancelled by CR to cash

A = L + E D/E D/APay cash 2 1 1 1.0 .50Pay C/S 3 1 2 .50 .33

A = L + E D/E D/APay cash 11 10 1 10 .91Pay C/S 12 10 2 5 .83

P’s Equity method for A and B:

P consolidates A: (same as equity method since L = 0)

P consolidates B:

key issue: incentives for equity method vs. consolidation

Start with P’s A=L+E and add JE’s effects from slide #6

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Correction JETo go from equity method to consolidation: sub A

DR Assets 1CR Investment 1

sub B DR Asset 10CR Investment 1 CR Liab 9

 Key point: replace investment with assets and liabsEx. P16-16, sections 1-3

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Solution (Correction JE): Partial or Full ConsolidationP’s owns x% in Sub’s common O/E P’s investment in sub: External interest: common equity of sub owned by parties

other than parent Note: (3) I + E = O/E = A – L

Key point: replace investment with assets and liabs  

L)-x%(AO/E x%I (1)

L)-x%)(A1(O/E x%)1( E(2)

Partial consolidation: recognized fractional share of Sub’s Assets and Liab’s

Full consolidation: recognized all of Sub’s Assets and Liab’s and External Interest

DR x% Assets CR x% Liab CR Investment [Must balance from (1) above]

DR Assets CR Liab CR Investment CR External interest [Must balance from (3) above]

Assume GW=0

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Example Ex: Parent = Petroleum and Sub = Supply P owns 40% of S and uses equity method (GW = 0)

A = L + ECashInventoryA/RPPEInvestment

100

200

300

280

20

A/PLT debt

200

200

500

900

400

500

A = L + ECash Inventory A/RPPE

205050180

A/PLT debt

80170

50

300

250

50

Parent:

Sub:

Q: What indicates the % Parent owns of Sub?

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Proportionate (Partial) Consolidation Petroleum Equity Method + 40% * Supply = consolidated B/SAssetscash 100 8 DR 108inventory 200 20 DR 220A/R 300 20 DR 320PPE 280 72 DR 352investment 20 (20) CR - total assets 900 100 1000liabs A/P 200 32 CR 232LTDebt 200 68 CR 268O/E 500 - 500tot liab+O/E 900 100 1000

Remember: this j.e. eliminates investment (see slide #10)

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Full Consolidation (balance sheet)Petroleum Equity Method + 100% * Supply = consolidated B/SAssetscash 100 20 DR 120inventory 50 DR 250A/R 300 50 DR 350PPE 280 180 DR 460investment 20 (20) CR - total asset 900 280 1180liabs A/P 200 80 CR 280LT Debt 200 170 CR 370external interest - 30 CR 30O/E 500 - 500tot liab +O/E 900 280 1180

Remember: this j.e. eliminates investment (see slide #10)

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Example (cont’d)Note: What % of subs’ A + L are recognized?equity method < proportionate consolidation < full

consolidation: recognize more and more of the Sub’s assets and liabilities

Note: P’s O/E is equal for

equity method; proportionate consolidation; and full consolidation

So D/E

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Income Statement (assume no inter-company sales)

Sub’s NI = 10; 40% * 10 = 4 = P’s equity in NI of S P S Prop Full

Rev 1000 200 1080 1200Equity in NI of Sub 4 - - -CGS 800 140 856 940SG&A 80 26 90 106Int exp 20 17 27 37 External interest in S’s NI - - - 6pre-tax inc 104 17 107 111tax exp 40 7 43 47NI 64 10 64 64 Note: #’s in bold are positive; #’s not in bold are negative 

Note: NI is equal for equity method, proportionate consolidation, full consolidation.

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Consolidation JE for I/S Proportionate:

Full:

DR CGS 56 SGA 10 Int 7 Tax 3 Equity in NI 4

CR Revenue 80

eliminate

DR CGS 140 SGA 26 Int 17 external 6 Tax 7 Equity in NI 4

CR Revenue 200

eliminate

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RatiosRatio Equity method Proportionate Consol Full ConsolLTDebt/OE 200/500 = .40 268/500=.54 370/500=.74ROA (NI/TA) 64/900=.071 64/1000=.064 64/1180=.054

Note:equity method proportionate consolidation full consolidation:

ROA LTDebt/OE

Note: Since P’s NI and O/E are equal under all 3 methods,

ROE (= NI ÷O/E) is equal

Ex. C16-5 Ratios

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Ex: Partial or Full Consolidation with GW (GW = MV - BV of P’s Investment)x% = P’s ownership % in Sub’s common O/E I = Investment = x% O/E + GW = (x% Assets - x% Liab) +

GW E = external interest = (1-x%) O/E = (1-x%) Assets - (1-x%)

Liab I + E = O/E + GW = A - L + GW

Note: don’t recognize GW for external interest; only for fraction owned by parent

Partial consolidation: recognized fractional share of Sub’s Assets and Liab’s

Full consolidation: recognized all of Sub’s Assets and Liab’s and External Interest

DR x% AssetsDR GW CR x% Liab CR Investment

DR AssetsDR GW CR Liab CR Investment CR External interest