Question

I am working on a research paper for my Advanced Financial Accounting class. Please provide additional insight in descriptive detail on the following:

Q1: What types of entities are referred to as special-purpose entities, and how have they been generally used?

Q2: What is meant by a noncontrolling interest in a subsidiary?

Q3: Are consolidated financial statements likely to be more useful to the creditors of the parent company or the creditors of the subsidiaries? Why or why not?

Answer 1

Ans : 1). Special purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives. Special purpose entities are typically used by companies to isolate the firm from financial risk. A formal definition is "The special purpose entity is a fenced organisation having limited predefined purposes and a legal personality.

Uses :-

Some of the reasons for creating special purpose entities are as follows :

Securitization : Special purpose entities are commonly used to securitize loans. For example a bank may wish to issue a mortgage backed security whose payments come from a pool of loans. However to ensure that the holders of the mortgage backed securities have the first priority right to receive payments on the loan. These loans need to be legally separated from the other obligations of the bank. This is done by creating a special purpose entity and then transferring the loans from bank to the special purpose entity.

Risk sharing : Corporates may use special purpose entities to legally isolate a high risk project or asset from the parent company and to allow other investors to take a share of the risk.

Finance : Multi tiered special purpose entities allow multiple tiers of investment and debt.

Asset transfer : Many permits required to operate certain assets are either non transferable or difficult to transfer. By having a special purpose entity own the asset and all the permits, the special purpose entity can be sold as a self contained package, rather than attempting to assign over numerous permits.

Financial engineering : special purpose entities are often used in financial engineering schemes which have as their main goal avoidance of tax or the manipulation of financial statements.

Regulatory reasons : A special purpose entity can sometimes be set up within an orphan structure to circumvent regulatory restrictions, such as regulations relating to nationality of ownership of specific asset.

Ans : 2). Non controlling interest is the portion of equity ownership in a subsidiary not attributable to the parent company who has a controlling interest ( greater than 50% but less than 100%) and consolidates the subsidiary's financial results with it's own. A non- controlling interest also known as minority interest, is an ownership position wherein a shareholder owns less than 50% outstanding shares and has no control over decisions. Non controlling interests are measured at the net asset value of entities and do not account for potential voting rights. Most shareholders of Public companies today would be classified as holding a non controlling interest, with even a 5% to 10% equity stake considered to be a large holding in a single company.

Ans : 3). The purpose of consolidated financial statements is to present primarily for the benefit of the shareholders and creditors of the parent company. The results of operations and the financial position of a parent company and it's subsidiaries essentially as if the group were a single company with one or more branches or divisions.

Consolidated financial statements often represent the only means of obtaining a clear picture of the total resources of the combined entity that are under the control of the parent company. The ultimate benefit of consolidated financial statements should be ease of understanding and analysis of a company's financial condition.

Consolidated financial statements are of limited use to the creditors of the subsidiary. The subsidiary creditors have a claim against the subsidiary alone, they cannot look to the parent company for payment. Thus the subsidiary's creditors are more interested in the subsidiary's individual financial statement than in the consolidated statements.

Because of these factors, annual reports always include the financial statements of the consolidated entity and sometimes include the  financial statements of certain subsidiary companies alone but never include the parent company's financial statement alone.