Accounting Standards

Consolidation - Special Purpose Entities

Paragraph 11 of FRS 1, Presentation of Financial Statements, requires that financial statements should not be described as complying with Financial Reporting Standards unless they comply with all the requirements of each applicable Standard and each applicable Interpretation of the Financial Reporting Standard. INT FRSs are not intended to apply to immaterial items.

Reference: FRS 27, Consolidated Financial Statements and Accounting for Investments in Subsidiaries

1. An entity may be created to accomplish a narrow and well-defined objective (e.g., to effect a lease, research and development activities or a securitisation of financial assets). Such a special purpose entity ("SPE") may take the form of a corporation, trust, partnership or unincorporated entity. SPEs often are created with legal arrangements that impose strict and sometimes permanent limits on the decision-making powers of their governing board, trustee or management over the operations of the SPE. Frequently, these provisions specify that the policy guiding the ongoing activities of the SPE cannot be modified, other than perhaps by its creator or sponsor (i.e., they operate on so called "autopilot").


2. The sponsor (or enterprise on whose behalf the SPE was created) frequently transfers assets to the SPE, obtains the right to use assets held by the SPE or performs services for the SPE, while other parties ("capital providers") may provide the funding to the SPE. An enterprise that engages in transactions with an SPE (frequently the creator or sponsor) may in substance control the SPE.


3. A beneficial interest in an SPE may, for example, take the form of a debt instrument, an equity instrument, a participation right, a residual interest or a lease. Some beneficial interests may simply provide the holder with a fixed or stated rate of return, while others give the holder rights or access to other future economic benefits of the SPE's activities. In most cases, the creator or sponsor (or the enterprise on whose behalf the SPE was created) retains a significant beneficial interest in the SPE's activities, even though it may own little or none of the SPE's equity.


4. FRS 27 requires the consolidation of entities that are controlled by the reporting enterprise. However, the Standard does not provide explicit guidance on the consolidation of SPEs.


5. The issue is under what circumstances an enterprise should consolidate an SPE.


6. This Interpretation does not apply to post-employment benefit plans or equity compensation plans.


7. A transfer of assets from an enterprise to an SPE may qualify as a sale by that enterprise. Even if the transfer does qualify as a sale, the provisions of FRS 27 and this Interpretation may mean that the enterprise should consolidate the SPE. This Interpretation does not address the circumstances in which sale treatment should apply for the enterprise or the elimination of the consequences of such a sale upon consolidation.

In addition to the situations described in FRS 27.11, the following circumstances, for example, may indicate a relationship in which an enterprise controls an SPE and consequently should consolidate the SPE (additional guidance is provided in the Appendix to this Interpretation):

1. in substance, the activities of the SPE are being conducted on behalf of the enterprise according to its specific business needs so that the enterprise obtains benefits from the SPE's operation;
   
   
2. in substance, the enterprise has the decision-making powers to obtain the majority of the benefits of the activities of the SPE or, by setting up an "autopilot" mechanism, the enterprise has delegated these decision making powers;
   
   
3. in substance, the enterprise has rights to obtain the majority of the benefits of the SPE and therefore may be exposed to risks incident to the activities of the SPE; or
   
   
4. in substance, the enterprise retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities.

FRS 27.10 states that "a parent which issues consolidated financial statements should consolidate all subsidiaries". FRS 27.05 defines a parent as "an enterprise that has one or more subsidiaries", a subsidiary as "an enterprise that is controlled by another enterprise (known as the parent)", and control as "the power to govern the financial and operating policies of an enterprise so as to obtain benefits from its activities". Paragraph 31 of the FRS Framework and FRS 1.20(b)(ii) require that transactions and other events are accounted for in accordance with their substance and economic reality, and not merely their legal form.

Effective Date: INT FRS 12 comes into effect on 1 February 2003. Changes in accounting policies should be accounted for according to the transitional requirements in FRS 8.40.

The examples in paragraph 10 of this Interpretation are intended to indicate types of circumstances that should be considered in evaluating a particular arrangement in light of the substance-over-form principle. The guidance provided in the Interpretation and in this Appendix is not intended to be used as "a comprehensive checklist" of conditions that must be met cumulatively in order to require consolidation of an SPE.

(a) Activities

The activities of the SPE, in substance, are being conducted on behalf of the reporting enterprise, which directly or indirectly created the SPE according to its specific business needs.

Examples are:

• the SPE is principally engaged in providing a source of long-term capital to an enterprise or funding to support an enterprise's ongoing major or central operations; or
  
  
• the SPE provides a supply of goods or services that is consistent with an enterprise's ongoing major or central operations which, without the existence of the SPE, would have to be provided by the enterprise itself.

Economic dependence of an entity on the reporting enterprise (such as relations of suppliers to a significant customer) does not, by itself, lead to control.

(b) Decision-making

The reporting enterprise, in substance, has the decision-making powers to control or to obtain control of the SPE or its assets, including certain decision-making powers coming into existence after the formation of the SPE. Such decision making powers may have been delegated by establishing an "autopilot" mechanism.

Examples are:

• power to unilaterally dissolve an SPE;
  
  
• power to change the SPE's charter or bylaws; or
  
  
• power to veto proposed changes of the SPE's charter or bylaws.

(c) Benefits

The reporting enterprise, in substance, has rights to obtain a majority of the benefits of the SPE's activities through a statute, contract, agreement, or trust deed, or any other scheme, arrangement or device. Such rights to benefits in the SPE may be indicators of control when they are specified in favour of an enterprise that is engaged in transactions with an SPE and that enterprise stands to gain those benefits from the financial performance of the SPE.

Examples are:

• rights to a majority of any economic benefits distributed by an entity in the form of future net cash flows, earnings, net assets, or other economic benefits; or
  
  
• rights to majority residual interests in scheduled residual distributions or in a liquidation of the SPE.

(d) Risks

An indication of control may be obtained by evaluating the risks of each party engaging in transactions with an SPE. Frequently, the reporting enterprise guarantees a return or credit protection directly or indirectly through the SPE to outside investors who provide substantially all of the capital to the SPE. As a result of the guarantee, the enterprise retains residual or ownership risks and the investors are, in substance, only lenders because their exposure to gains and losses is limited.

Examples are:

• the capital providers do not have a significant interest in the underlying net assets of the SPE;
  
  
• the capital providers do not have rights to the future economic benefits of the SPE;
  
  
• the capital providers are not substantively exposed to the inherent risks of the underlying net assets or operations of the SPE; or
  
  
• in substance, the capital providers receive mainly consideration equivalent to a lender's return through a debt or equity interest.