SPEs are entities that are restricted by contract or corporate charter to engage
ID: 2597388 • Letter: S
Question
SPEs are entities that are restricted by contract or corporate charter to engage in specified and generally limited economic activities. Because of these restrictions, SPEs do not have the same ongoing control issues as ordinary firms, and their equity holders’ voting rights often are of little or no importance. Assuming that an SPE is not consolidated by the firms involved with it, The SPE enables those firms to obtain off-balance sheet financing of the assets held by the SPE and to recognize income on transactions with the SPE. What are the accounting issues in this context?
Explanation / Answer
IFRS 10 (Consolidated Financial Statements) introduces new rules which will impact which party, if any, consolidates a special purpose entity (SPE) created as part of a structured finance transaction.
IFRS 12 (Disclosure of Interests in Other Entities) is designed to enhance the financial statement disclosures that banks and other parties make concerning their involvement in other entities, particularly unconsolidated SPEs.
IFRS 10 changes the definition of control so that the same criteria are applied to all entities to determine control. Whilst application guidance is provided which indicates a variety of different ways in which a reporting entity (the ‘investor’) might control another entity, the standard gives few ‘bright lines’ and little guidance on how to weight differing indicators. Consequently, considerable judgement may be required in order to determine which party, if any, consolidates a (SPE) involved in a structured finance transaction.
SPEs are typically designed so that voting rights are not the dominant factor in deciding who controls the entity, the activities of the company being largely laid out in the transaction documents and the contractual arrangements entered into on or before closing of the transaction. In such cases, IFRS 10 requires an investor to consider the purpose and design of the SPE, including a consideration of the risks the SPE was expected to be exposed to, the risks it was designed to pass on to the parties involved with the SPE and whether the investor is exposed to some or all of those risks or potential returns. One then considers which activities have a significant.
impact on the SPE’s returns and determines which parties have an ability to direct each of those activities. Superficially some aspects of IFRS 10 might look similar to the substance based approach of SIC 12, but in practice IFRS 10 may result in some significant changes.
IFRS 10 also states the need to consider the purpose and design of the structure and the indicators of control referred to in SIC 12 also appear in IFRS 10. However, IFRS 10 introduces some differences in approach and emphasis that will result in a change in the consolidation treatment of a number of structured finance entities. In particular: Whilst IFRS 10 states that having a large exposure to variability of returns is a relevant indicator, more weight is given to the question of whether a party has a practical ability to direct the relevant activities of the SPE. Consequently a party which previously consolidated an SPE because it was exposed to the majority of the risks and rewards from the entity may now be able to avoid consolidation if it lacks control over decision making over those activities that significantly affect the SPE’s returns. Conversely, a party which has decision taking power and some significant financial interest in the SPE, may now need to consolidate even though it does not have the majority of the risks and rewards.
An SPE whose prime purpose is to provide funding to an entity was often consolidated by that entity on the basis of the ‘activities’ indicator in SIC 12. If the relationship between the SPE and the borrower only creates rather than absorbs variability from the SPE’s perspective, the borrower may avoid consolidating the SPE. So in securitisation structures involving more than one SPE, an originator might conclude that it is no longer required to consolidate issuing SPE and any hedging derivatives in the structure if it does not provide any credit enhancement to that SPE. Similarly synthetic CDO structures where a bank buys credit protection from an SPE were often consolidated by the bank under SIC 12 but may not be under IFRS 10.
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