When to consolidate a special purpose entity. (Accounting and Auditing).

Generally accepted accounting principles require that companies consolidate all entities in which they have a controlling financial interest, including special purpose entities. Although FASB has not defined "controlling financial interest," it has identified situations in which an SPE should be consolidated, thereby presenting various examples of a controlling financial interest.

CURRENT GUIDANCE

Current authoritative guidance on SPEs and their consolidation can be found primarily in EITF Issue 90-15, EITF Topic D-14, and EITF Issue 96-21. Guidance on consolidation in general is provided by ARB 51 and FAS 94.

While most of the guidance specific to SPEs involves leasing activities, it has been applied to all types of SPEs, such as those purchasing or receiving assets and, in turn, issuing commercial paper backed by the transferred assets.

An SPE is created for a specific purpose or transaction and does not have the elements of a normal operating company, such as employees and long-lived assets.

Once an entity is determined to be an SPE, a determination must be made whether it should be consolidated with its "creator," also known as the transferor (of the assets) or the sponsor (in a financing arrangement). In making that determination, the presence of a controlling financial interest in the SPE is a significant consideration. If there is no controlling financial interest in the SPE, no consolidation is required.

NO CONTROLLING FINANCIAL INTEREST

To establish that the creator has no controlling financial interest, the following conditions must be met:

* The majority SPE owner(s) is an independent third party with a substantial residual equity capital investment in the SPE. EITF 90-15 states that 3 percent or more is considered substantial;

* SPE activities are controlled by the owners, not the creator;

* The independent third-party owner possesses the substantive risks and rewards of SPE ownership, generally meaning that the investment and related returns are "at risk" and not guaranteed by another party.

SPEs with these characteristics are known as "substantive" SPEs and receive off-balance sheet treatment. It is this treatment that creators find highly desirable since they are able to raise lower-cost funds without reflecting the debt on their balance sheets. Recently, however, the representational faithfulness of those balance sheets has been questioned.

NEW INTERPRETIVE GUIDANCE

In early June, FASB will issue an exposure draft with new interpretive guidance for SPEs. The new rules, which will be in the form of an interpretation of ARB 51 and FAS 94, introduce new concepts that will require many previously unconsolidated SPEs to be consolidated. They address SPEs whose activities support the "primary beneficiary," formerly known as the creator (transferor or agent). To qualify for non-consolidation, an SPE must have "sufficient independent economic substance" to stand financially on its own and meet certain qualitative characteristics.

There still is the requirement of substantive equity investment by an independent third-party owner, but the minimum investment will increase to 10 percent of the SPE's total capital. In addition, such investment must be "at risk" at all times during the SPE's life, and specific conditions will have to be met for it to be considered at risk.

Unlike in current practice, the risks and rewards of SPE ownership will be determined by who bears the risk for the first dollar of loss, and if the equity owner is not obligated to pay for the loss, the SPE will not be considered to have sufficient independent economic substance and will be consolidated. EASE also has indicated that the primary beneficiary of an SPE would include any identified related parties to the creator as defined by FAS 57.

The new provisions shall be applied to all SPEs created after the interpretation is issued; and for existing SPEs, as of periods beginning after Dec. 15, 2002. The interpretation will not affect the current accounting for qualifying SPEs.

Since thousands of SPEs exist, the new guidance will result in significant and considerable changes as companies try to restructure their SPEs to meet the non-consolidation requirements. There will be costs to companies, but the benefits derived from reading a representationally faithful financial statement may be well worth it.

A. Christine Davis CPA, is manager of litigation consulting and forensic accounting for Hemming Morse in San Francisco. She can he reached at [e-mail].