Off-Balance Sheet Debt

(SPEs, Equity Method)

RCJ Chapter 11 (pg 583-585) &
Chapter 16 (pg 891-895)
Paul Zarowin 2
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 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.
Well 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, SPEs
To avoid consolidation of SPE
subsidiary, investment, or joint venture, parent must have:
1. 50% or less of subs common O/E, or
2. for SPEs 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


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Equity Method vs. Consolidation
Equity method for parent investment in A or B:
DR Investment 1
CR Cash or C/S 1



A = L + E D/E D/A
P=parent 2 1 1 1.0 .50
Sub A 1 0 1 0 0
Sub B 10 9 1 9.0 .90
note: both subs 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
subs As and Ls not recognized;
only O/E recognized
subs As and Ls
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
8
Effect of Consolidation on D/E and D/A
A = L + E D/E D/A
Pay cash 2* 1 1 1.0 .50
Pay C/S 3 1 2 .50 .33
* no change since DR to subs assets is cancelled by CR
to cash
A = L + E D/E D/A
Pay cash 2 1 1 1.0 .50
Pay C/S 3 1 2 .50 .33
A = L + E D/E D/A
Pay cash 11 10 1 10 .91
Pay C/S 12 10 2 5 .83
Ps 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 Ps
A=L+E and add
JEs effects from
slide #6
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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

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Solution (Correction JE):
Partial or Full Consolidation
Ps owns x% in Subs common O/E
Ps 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%(A O/E x% I (1)
L) - x%)(A 1 ( O/E x%) 1 ( E (2)
Partial consolidation:
recognized fractional share of
Subs Assets and Liabs
Full consolidation:
recognized all of Subs Assets and
Liabs 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 + E
Cash
Inventory
A/R
PPE
Investment
100
200
300
280
20
A/P
LT debt
200
200
500
900 400 500
A = L + E
Cash
Inventory
A/R
PPE
20
50
50
180
A/P
LT debt

80
170
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/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)
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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)
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Example (contd)
Note:
What % of subs A + L are recognized?
equity method < proportionate consolidation < full consolidation:
recognize more and more of the Subs assets and liabilities

Note:
Ps 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)
Subs NI = 10; 40% * 10 = 4 = Ps equity in NI of S
P S Prop Full
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 Ss 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.

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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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Ratios
Ratio Equity method Proportionate Consol Full 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 Ps 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 Ps Investment)
x% = Ps ownership % in Subs 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: dont recognize GW for external interest; only for fraction
owned by parent

Partial consolidation:
recognized fractional share of
Subs Assets and Liabs
Full consolidation:
recognized all of Subs Assets and
Liabs and External Interest
DR x% Assets
DR GW
CR x% Liab
CR Investment
DR Assets
DR GW
CR Liab
CR Investment
CR External interest