Paul Zarowin2 Key Issues 1.Special Purpose Entity (SPE) 2.Definition, types of activity 3.Rules for off-B/S accounting 4.Partial vs. full consolidation (to put on B/S) 5.Example 6.Ratio effects
Paul Zarowin3 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
Paul Zarowin4 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.
Paul Zarowin5 Consolidation of Subs, SPEs To 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+E SPE P=parent 9794 (upto 97) 3 (or less) Outside owner 3 03 key point: keep debt off of the Balance Sheet
Paul Zarowin6 Equity Method vs. Consolidation Equity method for parent investment in A or B: DRInvestment 1 CR Cash or C/S 1 A=L+ED/ED/A P=parent Sub A10100 Sub B note: both sub’s have same BV of O/E = 1 (assume BV = MV, so GW = 0) Consolidation of A into PConsolidation 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
Paul Zarowin7 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 ”
8 Effect of Consolidation on D/E and D/A A=L+ED/ED/A Pay cash 2* Pay C/S * no change since DR to sub ’ s assets is cancelled by CR to cash A=L+ED/ED/A Pay cash Pay C/S A=L+ED/ED/A Pay cash Pay C/S 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
Paul Zarowin9 Correction JE To go from equity method to consolidation: sub A DRAssets1 CRInvestment 1 sub B DRAsset10 CRInvestment 1 CR Liab 9 Key point: replace investment with assets and liabs Ex. P16-16, sections 1-3
10 Solution (Correction JE): Partial or Full Consolidation P ’ 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 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
11 Example Ex: Parent = Petroleum and Sub = Supply P owns 40% of S and uses equity method (GW = 0) A=L+E Cash Inventory A/R PPE Investment A/P LT debt A=L+E Cash Inventory A/R PPE A/P LT debt Parent: Sub: Q: What indicates the % Parent owns of Sub?
12 Proportionate (Partial) Consolidation Petroleum Equity Method + 40% * Supply = consolidated B/S Assets cash DR 108 inventory DR 220 A/R DR 320 PPE DR 352 investment 20 (20) CR - total assets liabs A/P CR 232 LTDebt CR 268 O/E tot liab+O/E Remember: this j.e. eliminates investment (see slide #10)
13 Full Consolidation (balance sheet) Petroleum Equity Method + 100% * Supply = consolidated B/S Assets cash DR 120 inventory 50 DR 250 A/R DR 350 PPE DR 460 investment 20 (20) CR - total asset liabs A/P CR 280 LT Debt CR 370 external interest - 30 CR 30 O/E tot liab +O/E Remember: this j.e. eliminates investment (see slide #10)
Paul Zarowin14 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
15 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 Equity in NI of Sub CGS SG&A Int exp External interest in S ’ s NI pre-tax inc tax exp NI Note: # ’ s in bold are positive; # ’ s not in bold are negative Note: NI is equal for equity method, proportionate consolidation, full consolidation.
16 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
Paul Zarowin17 Ratios Ratio Equity method Proportionate Consol Full Consol LTDebt/OE 200/500 = /500= /500=.74 ROA (NI/TA) 64/900= /1000= /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
18 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% Assets DR GW CR x% Liab CR Investment DR Assets DR GW CR Liab CR Investment CR External interest