Thanks to Enron, special purpose entities (IFRS term) / variable interest entities (GAAP term) are household words. These entities aren't all bad though. They were originally (and still are) used to isolate financial risk.

Introduction

An SPE/VIE is an unique legal entity to be used for a specific purpose based on some set of financing or operating needs, such as leasing arrangements or project development activities. Structured financing is used to place assets and corresponding liabilities into this separate legal structure such as a trust, partnership, joint venture, or a corporation.

Examples:

• General Motors created SPEs to redevelop closed factories with environmental problems.
• Airlines created SPEs to hold airplane leases.
• Mortgage companies used them to consolidate and sell mortgages to investors.
• AOL Time Warner and Microsoft used SPEs to create synthetic leases (using sales-and-leasebacks through the SPEs).
• GE used SPEs to resell credit card & trade receivables.

Rationales:

• SPEs are created for specific tasks involving financial risks; for example, a SPE can have a higher credit rating (and lower interest rates) than the parent.
• The financial risk of the sponsor may be limited to its investment or explicit recourse obligation in the SPE. In many instances, creditors of a bankrupt SPE cannot seek additional assets from the sponsor beyond what was invested or contracted for by that sponsor. In other words, the sponsor may not become the deep pockets for damages exceeding the assets of the SPE.
• SPEs can be used for tax avoidance, such as synthetic leases.
• Banks use SPEs to securitize pools of mortgages, credit card balances, accounts & other receivables - it generates cash & eliminates the receivables from the parent's books.

SPE Usage in the Past

To illustrate how an SPE was commonly used in the financial marketplace, consider the following example of a financial asset securitization. Typically, in these types of transactions the SPE was formed to facilitate the sale of specific financial assets belonging to the sponsor company. The assets were sold to the SPE and could include trade accounts receivable, equity securities, notes receivable, etc. A minimum 10% investment from an independent third-party investor was contributed, representing a legal equity ownership interest in the SPE.

In exchange for its investment, the third-party equity investor controlled the SPE activities and retained the substantial risks and rewards of its ownership in the SPE assets. For an SPE to be an arms length entity, not consolidated into the sponsor's financial statement, the third-party investor must bear the risk of its investment. If an investor contributed equity as a note payable to the SPE or secured the investment by a letter of credit, insurance or guarantee, the investment would not be considered "at risk." Once the 10% was established, the SPE then financed the remaining funds to acquire the financial assets from the sponsoring company by issuing debt and/or additional equity to institutional investors or public shareholders.

As long as the specific qualifications were met, the assets and the corresponding debt and equity of the SPE achieved off-balance sheet treatment with respect to the sponsor's financial statements. Further, if the SPE had no indebtedness other than the asset-secured loan and routine trade payables, the SPE was unlikely to become insolvent as a result of its activities being limited. Therefore, in financial asset securitizations, SPEs provided the sponsor the ability to legally isolate a group of assets from the sponsor's bankruptcy risk and to reflect the transfer of financial assets as a sale in its financial statements.

The New Rules

The key component of SPE analysis is determining when they have to be consolidated in the financial statements rather than off-balance-sheet and unreported.

• IAS 27 now requires the consolidation if the SPE is controlled by the sponsor. However, there is no explicit guidance about the circumstance under which an SPE should be consolidated.

• Under GAAP FIN 46R, the primary beneficiary of a VIE must consolidate it as its subsidiary regardless if how much of an equity investment it has in the VIE. In essence, companies that have the controlling financial interest of another entity through interests other than voting equity are required to consolidate the controlled entity, even though historically, voting equity interests have been the principal indicator of financial control.
  The U.S. GAAP used to allow for qualified SPEs (QSPEs) to avoid consolidation if the sponsor was not the primary beneficiary. QSPEs did not exist under IFRS.