by Glenn Cheney
What happens when almost $400 billion in assets and about as much in liabilities get moved onto the balance sheets of just 138 companies?
Corporate and public accountants cringe to think about it -not just the effects but the process. The new rules, set forth in Financial Accounting Standards Board Interpretation No. 46, call for a wide variety of “variable interest entities,” once known as “special purpose entities,” to be consolidated into the “primary beneficiary” companies that absorb most of their risk and stand to gain the most from expected returns.
In other words, no more three-card-monte, off-the-books shell companies skulking in the corporate closet or sunning their dubious buns offshore for no purpose beyond the secret storage of debt.
Variable interest entities can include a host of contractual agreements, including lease agreements, equity investments, debt instruments, forward contracts, operations and maintenance agreements, and purchase arrangements. Even in cases where VIEs are not consolidated, new Securities and Exchange Commission rules require more disclosure about the nature, purpose and risks of off-balance-sheet activities.
Such special entities needn’t be as byzantine as Enron’s were. In fact, they are common, legal, responsible, justifiable mechanisms for reducing risk, isolating assets and liabilities, and protecting the interests of investors. But after Enron’s disastrous abuse of SPEs, Congress and the SEC prodded FASB to sharpen the rules a bit.
The consequent FIN 46 expanded the scope of entities that must be consolidated, thus changing their names from SPEs to VIEs. The rule went into effect for new VIEs after Jan. 31, 2003, and for pre-existing entities as of July 1. The SEC rule became effective for fiscal years ending on or after June 15, 2003.
According to a report from Credit Suisse First Boston, some $379 billion worth of assets and $377 billion in liabilities will hit the balance sheets of 138 Standard & Poor’s 500 companies in the third quarter. Two-thirds of that belongs to just 10 companies - seven are financial institutions, two are car manufacturers, and one is General Electric.
ConocoPhillips said that its debt would increase by up to $2.4 billion. Citigroup may take on $55 billion in assets. Bank One could add over $39 billion, and Chase Manhattan may add $25 billion. Such shifts to the balance sheet affect almost every line in financial statements, and their sudden appearance will inevitably impact marketplace perceptions. The consolidation of VIEs is also likely to parallel a shift in risk.
Accountants and financial analysts are concerned not only about the changes, but about the correct way to calculate and record them. The CSFB report cites KPMG as saying that “experience to date indicates that the FIN 46 accounting model is severely non-operational.” The report tends to agree, calling the rule “complex, vague, [involving] significant amounts of management and auditor judgment, and must be applied to countless transactions.”
Uh-oh - the J-word, the one that rings the chimes of fear in the hearts of accountants. Judgment is the key to the success of the principles-based standards that FASB is starting to issue. It’s also the key to litigation.
“It’s a vague accounting standard, and it appears that that was done on purpose as the FASB moves more toward a principles-based approach so that companies account more for the substance of a transaction than for the form,” said David Zion, CSFB accounting analyst. “That type of approach is difficult for an auditor to deal with, especially auditors who are used to very specific rules that are almost like a cookbook. This is a pretty significant shift.”
FASB project manager Ron Lott explained that FIN 46 is strong on principle but not weak on rules and certainly not typical of the principles-based standards that the board plans on developing in the future.
“Interpretation 46 is a principles-based standard if you emphasize the word ‘based,’” Lott said. “It starts with a principle but overlays some rules for implementing the principle. However, I do not think it is what we have in mind when we use the words ‘principles-based’ to describe our goals.”
Lott noted that FASB has issued six proposed FASB Staff Positions that deal with FIN
46. Some 15 comment letters have been received, and final position documents were expected by the end of July. FASB is using FSPs to quickly address questions regarding the application of standards. They can be seen on the Web at
Zion foresees substantial inconsistencies in the accounting and consolidation of VIEs as accountants, lawyers, managers, FASB and the SEC all struggle toward a common understanding of how to treat entities that are by their very nature flexible and multifarious.
“It’s going to take some time,” Zion said. “A couple of years. Accounting rules eventually get ironed out as practices develop. The way that this standard is structured, there could be some inconsistencies across auditing firms and across companies. It’s open to interpretation.”
Jeffrey Ellis, professional standards group accounting principles partner at Grant Thornton, agreed that the interpretation is open to misinterpretation. “It is very confusing, a very frustrating document,” Ellis said. “The fact that there is no grandfathering makes it very difficult to apply. Accountants at public companies who haven’t started worrying about this are in trouble.”
Ellis warned that the calculations that are necessary to determine whether a VIE should be consolidated are “incredibly complex.” An entity is a VIE if the equity in the entity is not sufficient to absorb the entity’s “expected losses,” and if the equity investors do not have the ability to control the activities of the entity or are not obligated to absorb its losses or receive its residual returns.
To determine whether an entity can absorb an expected loss, a company must compare the expected outcome to possible outcomes. “Expected losses” include the failure of an investment to meet expected growth.
Possible outcomes must be associated with the probability of their occurrence. Accountants are worried that “probability” tends to mean “probably wrong” in terms of forecasts, and “probably painful” in the hindsight of litigation.
