Question

A U.S. company does business with a special purpose entity, formed to complete a one-year project. Qualitative factors are inconclusive regarding whether the SPE is a variable interest entity, so the company asks you to do a quantitative analysis. Here is information on expected cash flows for the SPE at the end of one year:

Expected Cash Flows Probability

$3,000,000 0.70

1,200,000 0.20

600,000 0.10

The SPE was formed with an investment of $2,000,000, financed with $1,750,000 in debt and $250,000 in equity. A discount rate of 20% is appropriate, given the project’s risk.

Required

a. Is this SPE a variable interest entity, based on your quantitative analysis? Show calculations clearly and explain your answer.

b. How could management manipulate the numbers to change the answer to Part a.?

c. If the answer to Part a. is “yes,” how should the company decide if it should consolidate the SPE?

d. If the answer to Part a. is “no,” how should the company decide if it should consolidate the SPE?

Answer 1

In order to identify whether this SPE is a variable interest entity or not. We need to do quantitative analysis based on the information mentioned in the case.

Expected Cash Flows	Probability	Expected Amount
3,000,0000	0.70	2,100,000
1,200,0000	0.20	240,000
600,000	0.10	60,000

Initial investment to form the SPE was 2,000,000 out of which 1,750,000 was raised through debt financing and 250,000 was raised through equity financing hence funding is in the ratio of 7:1 for debt and equity financing respectively

Factors which will determine whether the SPE is a variable interest entity are

• Inadequacy of at-risk capital
• In the case of Variable interest entity, equity investments lacks financial control

(a) Based on the quantitative analyses done above we can conclude that SPE is the Variable interest entity as we can clearly observe that there is inadequacy of at-risk capital as we are discounting it at 20% p.a. and equity shareholders don't have financial control on the entity as debt financing and equity financing is in the ratio of 7:1 which indicates that equity shareholders don't have much say in the decision making process due to lack of financial control. Hence this entity satisfy both the factors which are essential to be a variable interest entity.

(b) Management can either manipulate at-risk capital numbers or they are increase the equity financing in the overall investment of the project in order to change the answer to Part (a) as Variable interest entity are based on these two factors discussed. Management can increase the at-par risk capital or equity financing in order to change it.

(c) Yes SPE is the variable interest entity. Consolidation will be based on the variable interest. Primary beneficiary will have majority of variable interest and they will consolidate the SPE. If an entity has a controlling interest they should consolidate under the GAAP. Also in order to consolidate an entity should be the primary beneficiary of the Variable interest entity. Hence they are required to consolidate.

(d) If the SPE is neither a variable interest entity nor it is the primary beneficiary of the variable interest entity then in that case consolidation is not required. Moreover in case entity doesn't have variable interest it is not necessary to consolidate it. Consolidation is required when the entity satisfy above mentioned factors in Part (a).