New Consolidation Rules Flummox Financial Reporting

New accounting rules for consolidating business interests took effect at the start of 2010—but companies are still laboring to understand just what they need to add to their financial statements and how to do so.

Most companies have worked through the chore of taking inventory of all their business interests and determining whether they need to be “consolidated” (that is, added to the financial statements), in accordance with the new standard Accounting Standards Codification 810, Consolidation. The standard gives companies new criteria to consider in deciding when a particular business interest belongs on the balance sheet, focusing on whether a company has a monetary interest in a particular entity and whether it also has power over that entity’s key activities.

Research from Credit Suisse says the new rules will bring some $515 billion in off-balance-sheet assets back on to the balance sheets of S&P 500 companies in 2010. Nearly 150 companies outside the financial sector, however, are still trying to figure out how the new rules will affect them; 99 so far say they are still evaluating the effect of the new rules, and 42 say they are still trying to figure it out.

Wright

In some cases companies have struggled with how to apply ASC 810 to business interests that have fuzzy boundaries around control and power, says Chris Wright, managing director at consulting firm Protiviti. The more those entities resemble a traditional business with voting stock, board seats, or clear lines of authority, he says, the easier it is for a company to understand how ASC 810 should work. But when those entities are more “esoteric” interests—such as the take-or-pay agreements common in the energy sector, or trust arrangements—applying ASC 810 becomes much more difficult.

Adam Brown, a partner at audit firm BDO, says financial institutions have generally been paying attention to the accounting changes as they’ve approached. Other sectors, however, didn’t follow development of ASC 810 as closely and now find themselves struggling to keep up, he says. Many are surprised to discover that entities they’ve long treated as equity investments now need to be consolidated onto the balance sheet.

Brown

Brown gives the example of manufacturing or real estate companies that frequently form partnerships to develop new products or new properties. Such projects often involve multiple parties with various roles in funding and performing the work. Under the new consolidation criteria, if a company has a monetary involvement and has some power over the key activities of the entity, the accounting for it could change from an equity-method investment to consolidation.

“In the past, that might have been considered just an investment,” Brown says. “Now it’s quite a bit different from the prior test of whether you have more than 50 percent of the returns or losses. It’s a very judgmental conclusion.”

Beyond Decisions

And once companies do conclude that they must consolidate something that was previously off the balance sheet or treated as an equity investment, then the real work begins, experts say.

Dodyk

For starters, companies must apply acquisition accounting to the entity they will consolidate, going back as far as whenever the company’s relationship with the entity began, says Larry Dodyk, a partner at PricewaterhouseCoopers. That raises issues around whether data is available for prior years, how to account for it under accounting standards that were in place in those prior periods, and how to roll it forward to the current year. “That brings a lot of complications,” Dodyk says.

KEY POINTS

The following excerpt details some key points from the Credit Suisse report, “Off Again, On Again? The Effect of New Off-Balance-Sheet Rules”:

Balance sheets to grow. The new rules for off-balance-sheet entities (FAS

166/167) went into effect for most companies on January 1. Based on the

most recently released 10-Ks and 10-Qs, we estimate that the companies in

the S&P 500 will bring at least $515 billion in off-balance-sheet assets on-

balance-sheet in the first quarter, that’s roughly 9% of the total exposure.

Where did the other $5 trillion-plus in assets go? About $4 trillion will go to

Fannie Mae and Freddie Mac. The remainder may go to other companies or

in some cases on no one’s balance sheet.

Expect first quarter surprises. Keep an eye on the 99 companies that

claimed that they were still evaluating the impact of FAS 167 and the 42

companies that were still trying to figure out the impact of FAS 166 for

possible surprises. Note that most of those companies are not in the

Financials sector.

Navigating the grey areas. Consolidating what was once off-balance-sheet

can have an impact on almost every line in the financial statements. As a

result metrics like leverage, EBITDA, margins, interest coverage, return on

assets, and even net income can all look very different. In this report we

review the new rules and walk through some of the potential impacts based

upon what companies have disclosed so far.

Source

Credit Suisse on Off-Balance-Sheet Rules (April 7, 2010)

Impairments are one example of those headaches. Companies consolidating an entity for the first time will be required to look back into prior periods, apply the accounting requirements of that period, and determine the estimates and assumptions they would have established at that time to decide whether a given asset was impaired, and if so by how much, Dodyk says.

Depending on whether an entity is newly consolidated or deconsolidated, accounting executives might need to apply guidance in Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, Accounting Principles Board Opinion No. 18, or FAS 144: Accounting for the Impairment or Disposal of Long-Lived Assets.

The new rules do allow some diversity on how to consolidate an entity for the first time, Brown says. That may or may not be a good thing, depending on your comfort zone.

ASC 810 “is clear that you have to go back to when your interest in this entity began,” he says. “But do you apply the rules that were in effect at that time, or do you use today’s business combinations accounting and push it back five years? There’s no explicit guidance on this point, so there are some accounting policy elections that some companies have to make.”

Augustyn

Dave Augustyn, a partner with KPMG’s transactions and restructurings group, says companies could re-create financial statements from the inception of the company’s interest in the entity and roll them forward to the present; that would give investors a sense of, “Had I consolidated this thing all along, this is what my financial statements would look like today,” he says.

KEY CHANGES

The following slide is rom the PwC Webcast: ASU 2009-17, Consolidations (Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities.

Key Changes

(1) Controlling financial interest vs. risks and rewards

New criteria for consolidation based on power to direct and

obligation to absorb losses/right to receive benefits

(2) No grandfathering of existing structures

(3) Deferred for certain investment management companies

Impact

(4) Consolidation / Deconsolidation conclusion is only the start

Source

Slides From the PwC Webcast (March 18, 2010)

On the other hand, companies could also try a more prospective approach, establishing fair values for all the assets and liabilities and booking them accordingly; that spares exercise of using hindsight in accounting for earlier periods, Augustyn says.

Hanson

Jay Hanson, national director of accounting for McGladrey & Pullen, says the proscriptive approach may be more direct, but has its own drawbacks with the investor and analyst communities. Analysts in particular like the retrospective view, so they can see what financial statements would look like today if the entity had been consolidated from the beginning.

“Analysts will say if management doesn’t do it, analysts are going to build their own models and analyze past information, trying to make predictions of the future,” Hanson says. “So wouldn’t it be better for management to just give the information in the first place?”

And Don’t Forget …

Bringing an entity onto the balance sheet will probably have other effects companies will want to consider, Dodyk warns, such as contractual arrangements or debt covenants that may be based on balance sheet ratios. Those ratios could change when the new entity hits the balance sheet, so companies should review any contracts or arrangements that are based on such numbers, he said.

Mayer

The process also raises many questions about control that will give pause to executives responsible for compliance with Section 404 of the Sarbanes-Oxley Act, says Jamie Mayer, senior manager at Grant Thornton. Companies will be searching for historic data, perhaps making assumptions, and developing new accounting processes that previously were not required.

Although most companies have worked through much of the analysis to comply with first-quarter reporting, long-term compliance with the new consolidation standard is still in its infancy, Mayer says. “There are additional implementation issues that are going to come out, probably nothing insurmountable, but we’re still in the early stages,” he says.