Off-Balance Sheet Debt (SPEs, Equity Method)

1. Off-Balance Sheet Debt (SPEs, Equity Method) RCJ Chapter 11 (pg 583-585) & Chapter 16 (pg 891-895)

2. Key Issues • Special Purpose Entity (SPE) • Definition, types of activity • Rules for off-B/S accounting • Partial vs. full consolidation (to put on B/S) • Example • Ratio effects Paul Zarowin

3. 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 Zarowin

4. 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 Zarowin

5. Consolidation of Subs, SPEs To avoid consolidation of SPE subsidiary, investment, or joint venture, parent must have: • 50% or less of sub’s common O/E, or • for SPE’s outside residual claim must bear substantial risk; de facto implementation has required 3% of total assets. Example: A = L + E SPE 100 94 6 P=parent 97 94 (upto 97) 3 (or less) Outside owner 3 0 3 key point: keep debt off of the Balance Sheet Paul Zarowin

6. Equity Method vs. Consolidation Equity method for parent investment in A or B: DR Investment 1 CR Cash or C/S 1 note: both sub’s have same BV of O/E = 1 (assume BV = MV, so GW = 0) sub’s A’s and L’s not recognized; only O/E recognized sub’s A’s and L’s recognized Paul Zarowin

7. 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” Paul Zarowin

8. Effect of Consolidation on D/E and D/A P’s Equity method for A and B: Start with P’s A=L+E and add JE’s effects from slide #6 * no change since DR to sub’s assets is cancelled by CR to cash P consolidates A: (same as equity method since L = 0) P consolidates B: key issue: incentives for equity method vs. consolidation

9. Correction JE To go from equity method to consolidation: • sub A DR Assets 1 CR Investment 1 • sub B DR Asset 10 CR Investment 1 CR Liab 9 Key point: replace investment with assets and liabs Ex. P16-16, sections 1-3 Paul Zarowin

10. Solution (Correction JE): Partial or Full Consolidation Assume GW=0 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

11. Example • Ex: Parent = Petroleum and Sub = Supply • P owns 40% of S and uses equity method (GW = 0) Parent: Sub: Q: What indicates the % Parent owns of Sub?

12. Proportionate (Partial) Consolidation Petroleum Equity Method + 40% * Supply = consolidated B/S Assets cash 100 8 DR 108 inventory 200 20 DR 220 A/R 300 20 DR 320 PPE 280 72 DR 352 investment 20 (20) CR - total assets 900 100 1000 liabs A/P 200 32 CR 232 LTDebt 200 68 CR 268 O/E 500 - 500 tot liab+O/E 900 100 1000 Remember: this j.e. eliminates investment (see slide #10)

13. Full Consolidation (balance sheet) Petroleum Equity Method + 100% * Supply = consolidated B/S Assets cash 100 20 DR 120 inventory 50 DR 250 A/R 300 50 DR 350 PPE 280 180 DR 460 investment 20 (20) CR - total asset 900 280 1180 liabs A/P 200 80 CR 280 LT Debt 200 170 CR 370 external interest - 30 CR 30 O/E 500 - 500 tot liab +O/E 900 280 1180 Remember: this j.e. eliminates investment (see slide #10)

14. 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  Paul Zarowin

15. Income Statement (assume no inter-company sales) Sub’s NI = 10; 40% * 10 = 4 = P’s equity in NI of S PSPropFull Rev 1000 200 1080 1200 Equity in NI of Sub 4 - - - CGS 800 140 856 940 SG&A 80 26 90 106 Int exp 20 17 27 37 External interest in S’s NI - - - 6 pre-tax inc 104 17 107 111 tax exp 40 7 43 47 NI 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.

16. Consolidation JE for I/S • Proportionate: • Full: eliminate eliminate

17. Ratios RatioEquity methodProportionate ConsolFull Consol LTDebt/OE 200/500 = .40 268/500=.54 370/500=.74 ROA (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 Paul Zarowin

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