New Off-Balance Sheet Rules Not Just for Banks

Companies outside the financial services industry may want to pay heed to new securitization rules that, under the surface, extend far beyond bank balance sheets.

The Financial Accounting Standards Board adopted two new accounting standards in June designed to curb off-balance sheet treatment of the pooling and trading of financial assets—Financial Accounting Standard No. 166, Accounting for Transfers of Financial Assets, and FAS 167, Amendments to FASB Interpretation No. 46(R). (They now are contained in the Accounting Standards Codification under Sections 810 Consolidation and 860 Transfers & Servicing.)

The big change for banks is an end to the exception that has long existed for “qualifying special purpose entities,” a type of entity where banks have done much of their off-balance sheet dealing in loans and other types of assets. Under the new rules, banks can no longer engineer transactions that look like the sale of assets and, therefore, should be removed from the balance sheet, yet still retain control over, or benefit from, those assets.

Mainly, financial institutions have been paying close attention to the development and adoption of the new rules around variable interest entities, which include any kind of entity where a company may have an interest but not 100 percent control or ownership. Banks, in particular, have expressed concerns that the new rules will have a significant impact on their balance sheets and regulatory capital requirements.

Wright

Still, the rules don’t just extend to the financial services sector, says Chris Wright, managing director at consulting firm Protiviti. Companies in various industries make it a practice to securitize receivables, “so they are challenged by this every bit as much as financial services entities,” he says.

Beyond securitizations, the rules also contain new guidance on how to establish who should be regarded as the “primary beneficiary” of VIEs, and therefore should be reflected in the corporate financial statements. That may impact structures such as joint ventures, equity method investments, collaboration agreements, and co-manufacturing and power purchase arrangements, among others, says Sue Cosper, a partner with PricewaterhouseCoopers.

The new rules put an end to the strict, quantitative analysis used to determine whether a variable interest entity should be consolidated, says Cosper. “Now it’s more of a qualitative model,” she says. “Who has the power to direct the activities that most significantly affect the economic performance of that entity? It’s not just looking at the numbers.”

Bible

Pete Bible, a partner at accounting firm Amper, Politziner & Mattia, says the analysis could lead companies to look at relationships they’d never considered before, such as suppliers. “When you have an entity that exists by and large for your benefit, you really have to look at that relationship and ask, ‘Do I control or significantly influence the activities of that entity that are important to its results?’” he says. “That can be a different thought pattern for companies.”

FUTURE IMPACT

The following excerpt is from SAB74: “Disclosure of the Impact That Recently Issued Accounting Standards Will Have on the

Financial Statements of The Registrant When Adopted in a Future Period.”

FACTS: An accounting standard has been issued that does not require adoption until some future date. A registrant is required to include financial statements in filings with the Commission after the issuance of the standard but before it is adopted by the registrant.

QUESTION 1: Does the staff believe that these filings should include disclosure of the impact that the recently issued accounting standard will have on the financial position and results of operations of the registrant when such standard is adopted in a future period?

INTERPRETIVE RESPONSE: Yes. The Commission addressed a similar issue with respect to SFAS No. 52 and concluded that The Commission also believes that registrants that have not yet adopted SFAS No. 52 should discuss the potential effects of adoption in registration statements and reports filed with the Commission. The staff believes that this disclosure guidance applies to all accounting standards which have been issued but not yet adopted by the registrant unless the impact on its financial position and results of operations is not expected to be material. Management’s Discussion and Analysis (“MD&A”) requires registrants to provide information with respect to liquidity, capital resources and results of operations and such other information that the registrant believes to be necessary to understand its financial condition and result of operations.

In addition, MD&A requires disclosure of presently known material changes, trends and uncertainties that have had or that the registrant reasonably expects will have a material impact on future sales, revenues or income from continuing operations. The staff believes that disclosure of impending accounting changes is necessary to inform the reader about expected impacts on financial information to be reported in the future and, therefore, should be disclosed in accordance with the existing MD&A requirements. With respect to financial statement disclosure, generally accepted auditing standards specifically address the need for the auditor to consider the adequacy of the disclosure of impending changes in accounting principles if (a) the financial statements have been prepared on the basis of accounting principles that were acceptable at the financial statement date but that will not be acceptable in the future and (b) the financial statements will be restated in the future as a result of the change. The staff believes that recently issued accounting standards may constitute material matters and, therefore, disclosure in the financial statements should also be considered in situations where the change to the new accounting standard will be accounted for in financial statements of future periods, prospectively or with a cumulative catch-up adjustment.

QUESTION 2: Does the staff have a view on the types of disclosure that would be meaningful and appropriate when a new accounting standard has been issued but not yet adopted by the registrant?

INTERPRETIVE RESPONSE: The staff believes that the registrant should evaluate each new accounting standard to determine the appropriate disclosure and recognizes that the level of information available to the registrant will differ with respect to various standards and from one registrant to another. The objectives of the disclosure should be to (1) notify the reader of the disclosure documents that a standard has been issued which the registrant will be required to adopt in the future and (2) assist the reader in assessing the significance of the impact that the standard will have on the financial statements of the registrant when adopted. The staff understands that the registrant will only be able to disclose information that is known.

The following disclosures should generally be considered by the registrant:

A brief description of the new standard, the date that adoption is required and the date

that the registrant plans to adopt, if earlier.

A discussion of the methods of adoption allowed by the standard and the method

expected to be utilized by the registrant, if determined.

A discussion of the impact that adoption of the standard is expected to have on the

financial statements of the registrant, unless not known or reasonably estimable. In that

case, a statement to that effect may be made.

Disclosure of the potential impact of other significant matters that the registrant believes

might result from the adoption of the standard (such as technical violations of debt

covenant agreements, planned or intended changes in business practices, etc.) is

encouraged.

Source

Staff Accounting Bulletin Number 74.

A key indicator of control may not be direct ownership in the entity, but perhaps providing or guaranteeing debt, providing a backup letter of credit, or making certain guarantees provided in purchase agreements. “All of those things can be indicators of financial support that can cause you to look at that relationship,” he says.

Cosper

The new rules provide no grandfathering for existing structures, says Cosper. “Every arrangement or structure you have currently will need to be evaluated under the new standard,” she says. And they need to be re-evaluated continually because there are no trigger events that specifically compel a re-evaluation as with the earlier standard, says Jamie Mayer, senior manager at Grant Thornton. That means companies need to establish controls to assure the evaluation occurs routinely, he says.

Although the new rules take effect for calendar-year companies with the 2010 reporting year, companies must evaluate now whether they will have new entities to consolidate to comply with Staff Accounting Bulletin No. 74 from the Securities and Exchange Commission, says Mayer. That’s the rule that says companies must disclose, to the extent they are able, the expected impact of new accounting pronouncements even before they are implemented.

Mayer says disclosures presumably will become more detailed approaching year-end. By then, the new rules will have been known to companies for up to six months and they will be taking effect in the next reporting period, so the SEC might reasonably expect companies to have done their homework.

Mayer

Where a company does that homework and determines it needs to consolidate an entity that it hasn’t consolidated previously, then the real work begins, says Mayer, especially if the entity hasn’t produced financial statements under Generally Accepted Accounting Principles or had them audited. “You have to get comfortable with their financial statements and then consolidate them in,” he says. “And you need for internal controls to be established. That will be a challenge.”

Bible likened it to acquiring a business. “It’s all the things that come with setting up a new business, but someone else may legally own the entity,” he says. “How do you get the financial statement comfort you need as well as the format that can be consolidated to your financial statements? You need a fairly substantial lead time to get everything into place.”

Where a company looks closely at an entity and decides not to consolidate it, there is still a disclosure requirement, says Mayer. “If you determine you have a material variable interest in an entity, you might need to get a lot of new information,” he says.

Wright says companies likely will develop new types of structures for variable-interest entities going forward as a result of the new approaches to consolidation. “The typical reaction to a new rule is often for a new structure to emerge,” he says. “Not many of those structures have emerged at this point but it’s reasonable to believe they might.”

For companies that are just getting started on the evaluation, time is precious, according to Cosper. “To the extent you get through the analysis and determine you have a new entity to consolidate, there are reverberating effects on the financial statements,” she says. “It’s important for companies to assess the impact sooner rather than later.”