R13 - Lesson 4 - Investments in SPEs - VIEs

11/02/2021 CFA Exam Review - Level 2 - Lesson 4: Investments in SPEs/VIEs
Overview
Lesson 4: Investments in SPEs/VIEs
This lecture was recorded by Mr. Peter Olinto. He teaches straight from the Study Guide, so there are no
handouts for this lesson.
Upon completion of this lesson, candidates should be able to:
LOS 13a: Describe the classification, measurement, and disclosure under International Financial
Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint
ventures, 4) business combinations, and 5) special purpose and variable interest entities.
LOS 13b: Distinguish between IFRS and U.S. GAAP in the classification, measurement, and disclosure of
investments in financial assets, investments in associates, joint ventures, business combinations, and
special purpose and variable interest entities.
LOS 13c: Analyze how different methods used to account for intercorporate investments affect financial
statements and ratios.
https://wel.instructure.com/courses/4129/modules/items/1306607 1/9
Study Guide
LOS 13a: Describe the classification, measurement, and disclosure under International Financial
Reporting Standards (IFRS) for special purpose and variable interest entities. Vol 2, pp 8–45
LOS 13b: Distinguish between IFRS and U.S. GAAP in the classification, measurement, and disclosure of
special purpose and variable interest entities. Vol 2, pp 8–45
4.1 Variable Interest Entities (U.S. GAAP) and Special Purpose

Entities (IFRS)
Special Purpose Entities (SPEs) are established to meet specific objectives of the sponsoring company.
They are structured in a manner that allows the sponsoring company to retain financial control over the
SPE's assets and/or operating activities, while third parties hold the majority of the voting interest in the
SPE. Typically, these third parties funded their investments in the SPE with debt that was (directly or
indirectly) guaranteed by the sponsoring company.
In the past, such an arrangement enabled sponsoring companies to avoid consolidation of SPEs on their
financial statements due to a lack of “control” (i.e., ownership of a majority voting interest) of the SPE. As a
result, sponsoring companies were able to:
Avoid disclosures of guarantees relating to the debt of the SPE made by the sponsoring company.
Transfer assets and liabilities from their own balance sheets to the SPE and record revenues and
gains related to these transactions.
Avoid recognition of assets and liabilities of the SPE on their financial statements.
Consequently, reported financial performance (as presented by unconsolidated financial statements) of

sponsoring companies was economically misleading as it indicated improved asset turnover, higher
profitability, and lower levels of operating and financial leverage. Enron provides an excellent example of
the use of off-balance-sheet financing to improve reported financial performance. The company's
subsequent collapse was (in part) related to the guarantees it provided on the debt of the SPEs that it had
created.
IFRS and U.S. GAAP now require sponsoring companies to prepare consolidated financial statements that
account for arrangements where parties other than the holders of majority voting rights exercise financial
control over another entity. Further, standards relating to measurement, reporting, and disclosure of
guarantees have been revised. For example, under U.S. GAAP, the primary beneficiary of a VIE must
consolidate it as its subsidiary regardless of how much of an equity investment it has in the VIE.
The primary beneficiary (which is often the sponsor) is defined as the entity that is (1) expected to
absorb the majority of the VIE's expected losses, (2) receive the majority of the VIE's residual returns,
or (3) both.
If one entity will absorb a majority of the VIE's expected losses while another entity will receive a
majority of the VIE's expected profits, the entity absorbing a majority of the losses must consolidate
the VIE.
If there are noncontrolling interests in the VIE, these would also be shown in the consolidated
balance sheet and consolidated income statement of the primary beneficiary.
4.2 Securitization of Assets
SPEs are often set up to securitize receivables held by the sponsor. The SPE issues debt to finance the
purchase of these receivables from the sponsor, and interest and principal payments to debt holders are
made from the cash flow generated from the pool of receivables.
The motivation for the sponsor to sell its accounts receivable to the SPE is to accelerate inflows of cash.
However, an important aspect of the arrangement is whether the SPE's debt holders have recourse to the
sponsor if sufficient cash is not generated from the pool of receivables. In this case, the transaction is
basically just like taking a loan and collateralizing it with the receivables. If the receivables are not entirely
realized, the loss is borne by the sponsor.
When the receivables are first sold by the sponsor, accounts receivable decrease, and the cash received
contributes to CFO. However, if the risk of nonrealization is still borne by the sponsor (e.g., through a debt
guarantee), an analyst must adjust accounts receivable and current liabilities upward. Further, the cash
inflow previously classified as CFO must be reclassified as CFF to reflect the fact that the transaction is
effectively merely a collateralized borrowing. See Example 4.1.
Adjusted Values Upon Reclassification of Sale of Receivables:
CFO Lower
CFF Higher
Total cash flow Same
Current assets Higher
Current liabilities Higher
Current ratio (Assuming it was greater than 1) Lower
Example 4.1
Securitization of Receivables
4.3 Additional Issues in Business Combinations

IFRS and U.S. GAAP differ on the treatment of contingent assets and liabilities.
Under IFRS, contingent assets are not recognized, while contingent liabilities are recognized
(given that their fair values can be measured reliably) separately during the cost allocation
process.
Under U.S. GAAP, contractual contingent assets and liabilities are recognized at their fair values
at the time of acquisition. Further, noncontractual contingent assets and liabilities may also be
recognized if it is “more likely than not” that they meet the definition of an asset or liability at
the acquisition date.
A parent may agree to pay additional amounts to the subsidiary's shareholders if the combined entity
achieves certain performance targets. This is referred to as contingent consideration.
Under both IFRS and U.S. GAAP, contingent consideration should initially be measured at fair
value and be classified as a financial liability or equity.
Subsequent changes in the fair value of these liabilities (and assets in case of U.S. GAAP) are
recognized in the consolidated income statement.
Contingent consideration classified as equity is not remeasured under both IFRS and U.S.
GAAP. Any settlements are accounted for within equity.
Under both IFRS and U.S. GAAP, in-process research and development (R&D) acquired in a business
combination is recognized as a separate intangible asset at fair value. In subsequent periods, IPR&D
is amortized.
Under both IFRS and U.S. GAAP, restructuring costs associated with a business combination are
expensed in the period in which they are incurred (they are not included in the acquisition price).
LOS 13c: Analyze how different methods used to account for intercorporate investments affect financial
statements and ratios. Vol 2, pp 8–45
To summarize:
Under the equity method, the investment is presented on the investor's balance sheet as a single-line item.
Further, the investor's share in investee's earnings is reported as a single-line item on the investor's income
statement. Nonrecognition of the investee's debt results in lower leverage ratios, while nonrecognition of
the investee's revenues results in higher profit margins.
Under the acquisition method, the fair value of the subsidiary's assets, liabilities, income, and expenses are
combined in their full amounts with those of the acquirer. As a result, the acquisition method results in
higher assets, liabilities, revenues, and expenses than the equity method. However, net income is the same
under both methods.
Within the acquisition method, the full goodwill method results in higher total assets and equity compared
to the partial goodwill method. Therefore, return on assets and return on equity will be lower if the full
goodwill method is used. Note that retained earnings and net income are the same under both methods,
but shareholders’ equity is different (due to different noncontrolling interests).
Usually, the equity method provides more favorable results than the acquisition method. See Table 4.1.
Table 4.1 Impact of Different Accounting Methods on Financial Ratios
Equity Method Acquisition Method
Leverage Both liabilities and equity will be lower under Both liabilities and equity will be higher under
the equity method. Impact on leverage will the acquisition method. Impact on leverage will
depend on which is affected more depend on which is affected more
proportionately proportionately
Net Better (higher), as sales are lower and net Worse (lower), as sales are higher and net
Profit income is the same income is the same
Margin
ROE Better (higher), as equity is lower and net Worse (lower), as equity is higher and net
income is the same income is the same
ROA Better (higher), as net income is the same and Worse (lower), as net income is the same and
assets are lower assets are higher
Flashcards
1
fc.L2R14L05.0001_1812
Special Purpose Entities (SPEs) allow the

Explain Special Purpose Entities (SPEs). sponsoring company to retain financial
control over the SPE's assets and/or
operating activities, while third parties hold
most of the voting interest in the SPE.
Typically, these third parties funded

investments in the SPE with debt directly or
indirectly guaranteed by the sponsoring
company.
2
fc.L2R14L05.0002_1812
Both IFRS and U.S. GAAP recognize record

How do IFRS and U.S. GAAP differ on the acquired assets at fair value as of the
treatment of contingent assets and liabilities? acquisition date.
Under IFRS, contingent liabilities are

recognized if fair value can be reliably
measured. U.S. GAAP requires inclusion of
probable contingent liabilities that can be
reasonably estimated.

R13 - Lesson 4 - Investments in SPEs - VIEs

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11/02/2021 CFA Exam Review - Level 2 - Lesson 4: Investments in SPEs/VIEs

Upon completion of this lesson, candidates should be able to:

4.1 Variable Interest Entities (U.S. GAAP) and Special Purpose

Consequently, reported financial performance (as presented by unconsolidated financial statements) of

4.3 Additional Issues in Business Combinations

Special Purpose Entities (SPEs) allow the

Typically, these third parties funded

Both IFRS and U.S. GAAP recognize record

Under IFRS, contingent liabilities are

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