Regulators Advise on New Off-Balance-Sheet Rules

New accounting standards are about to take effect that will unmask assets and liabilities that companies have been hiding away off the balance sheet, and regulators are offering tips on how to assure compliance with the spirit of the rules.

Staff of the Securities and Exchange Commission told a national conference of the American Institute of Certified Public Accountants last week that they are seeing some early efforts to structure entities in a way that would let troubled assets remain off balance sheets—and warned attendees that such maneuvers won’t fly with SEC examiners. The officials also gave some advice on how to stay on the right side of the rules.

The new rules are contained in Financial Accounting Standards No. 166 and 167, which generally eliminate automatic off-balance-sheet accounting for entities that previously had qualified for it; the rules also spell out when a variable-interest entity belongs on the balance sheet. Corporations often use such devices as a parking lot for assets that have been transferred to investors, but the sellers of those assets (that is, the corporations) often keep some kind of continuing risk or responsibility that escapes view because it’s off the balance sheet.

Tom Barbieri, a partner at PricewaterhouseCoopers, told the AICPA conference that financial institutions aren’t necessarily the only ones who should be worried about such entities; retailers often use them to manage credit to customers, and operating companies can use similar vehicles to manage interests in joint ventures or in securitized accounts receivable.

FAS 166 and 167 establish a new model for when a company must consolidate—that is, add onto their balance sheets—an entity in which it has some interest, but not complete control. Instead of the typical quantitative analysis based on risks and rewards, the standards focus on a qualitative analysis of who has the power to direct significant activities of the entity.

Arie Wilgenburg, professional accounting fellow for the SEC, described the control concept as “a combination of power over the entity, and exposure to losses or benefits of the entity.” The two elements are closely linked, he said, and both must be present to assert control over an entity.

Wilgenburg said SEC staff has given some thought to qualitative factors companies should consider when determining if they have a controlling financial interest in a variable-interest entity, including the purpose and design of the entity, the terms and characteristics of the financial interest, and the business purpose for holding the financial interest. Companies need to apply judgment, he said.

“We learned a lot about applying the power criteria in the past few months. It was a little bit of a revelation for us.”

—Kimberly Scardino,

Head of Global Accounting Policy,

American Express

Brian Fields, another professional accounting fellow at the SEC, said the staff has already seen some creative efforts to avoid consolidating unattractive assets, even before the new rules take effect. Those efforts have involved selling preferred interests in a subsidiary that holds only financial assets, rather than selling senior interests in the financial assets themselves, he said.

“The idea seems to be that by describing the beneficial interests sold as equity in a consolidated subsidiary, it may be possible to classify the proceeds received as non-controlling equity interests rather than collateralized debt in the financial statements of the parent sponsor,” he said.

Fields said that approach might serve as a backup plan where, if derecognition isn’t possible, at least the proceeds received in a failed sale would look better in shareholders’ equity than in debt, perhaps even boosting capital for a distressed institution. But if the technique proliferates under FAS 166 and 167, that might make derecognition more difficult, “so now seems like a good time to share information about how to grapple with the issues they raise,” he said.

In a typical case, Fields said, banks may try to establish structures that contain only financial assets without the usual breadth and scope of a business, reasoning that beneficial interests sold as equity can qualify as non-controlling equity interests in the consolidated financial statements of the parent company.

Well, he continued, “We have reached a different view on these circumstances. When a subsidiary is created simply to issue beneficial interest backed by financial assets, rather than to engage in substantive business activities, we’ve concluded that sales of interests in the subsidiary should be viewed as transfers of interests in the financial assets themselves.”

Other Ideas

SEC, PCAOB DEVELOPMENTS

Below is an excerpt from SEC Fellow Arie Wilgenburg’s speech before the AICPA on current SEC and PCAOB developments:

One significant change in the consolidation model that I’ll highlight is the replacement of the prior, often quantitative-based risks and rewards analysis with a more qualitative assessment of who should consolidate a variable interest entity.

The core principle of Statement 167 is that a reporting enterprise should consolidate variable interest entities in which it has a controlling financial interest. This core principle is based on a control concept that is described as a combination of power over the entity and exposure to losses or benefits of the entity.

When evaluating these two elements, it is important to note that each is necessary to have control. Like Frank Sinatra’s rendition of Love and Marriage, they "go together like a horse and carriage." I’ll stop there and spare you all the song and dance portion of my speech. The point is that power and economics go together.

Now let’s spend a few minutes on the relationship of one to the other. First, as it relates to power, it’s not just any power. It’s power over the activities that most significantly impact an entity’s economic performance. But power alone is not a sufficient basis for consolidation. The model requires it be combined with a significant financial interest in the entity.

So what is a significant financial interest? Well, Statement 167 describes such an interest as one that either obligates the reporting enterprise to absorb losses of the entity or provides a right to receive benefits from the entity that could potentially be significant. That description leaves us with an important judgment to make regarding what could potentially be significant.

In the past few weeks, the staff has been thinking about this concept. While there is no "bright-line" set of criteria for making this assessment, I thought it would be helpful to provide some thoughts in this area.

First, similar to how we have talked in the recent past about materiality assessments being based on the total mix of information, we believe that assessing significance should also be based on both quantitative and qualitative factors. While not all-inclusive, some of the qualitative factors that you might consider when determining whether a reporting enterprise has a controlling financial interest include:

1.The purpose and design of the entity. What risks was the entity designed to create and pass on to its variable interest holders?

2.A second factor may be the terms and characteristics of your financial interest. While the probability of certain events occurring would generally not factor into an analysis of whether a financial interest could potentially be significant, the terms and characteristics of the financial interest (including the level of seniority of the interest), would be a factor to consider.

3.A third factor might be the enterprise’s business purpose for holding the financial interest. For example, a trading-desk employee might purchase a financial interest in a structure solely for short-term trading purposes well after the date on which the enterprise first became involved with the structure. In this instance, the decision making associated with managing the structure is independent of the short-term investment decision. This seems different from an example in which a sponsor transfers financial assets into a structure, sells off various tranches, but retains a residual interest in the structure.

Source

Wilgenberg Speech on SEC and PCAOB Developments (Dec. 7, 2009).

Wilgenburg said he’s seeing other ideas for trying to keep under-performing assets off balance sheets. The common theme involves an owner of under-performing assets transferring them to a structure designed to comply technically with consolidation requirements, in a way that creates the appearance of shared power among equity holders. “However, the economic result leaves substantially all of the risks of ownership with the original owner rather than a more substantive sharing of the risks,” he said.

In one example, a company might transfer assets to a structure to be managed by a third party, but the manager’s equity interest in the structure is minimal “and appears to be guaranteed, given the management fee structure,” Wilgenberg said. That combination of conditions suggests the company hasn’t really relinquished control, but instead has enlisted the manager to act as an agent of the company, he said.

Other similar structures, he said, include the use of a buy-sell clause rather than a removal right as a way to dissolve the structure. But if the third-party doesn’t have the financial ability to exercise its rights under the buy-sell provision, the agreement is essentially just a call option for the parent company, Wilgenburg said—another sign that the third-party manager is an agent for the company rather than a buyer.

Kimberly Scardino, head of global accounting policy for American Express, said that after Amex studied the standards and its interest in various entities, the company determined that the servicer of trusts holding securitized assets would consolidate the entities, not Amex. “We learned a lot about applying the power criteria in the past few months,” she said. “It was a little bit of a revelation for us.”

The standards take effect for reporting periods that begin after Nov. 15, but the Financial Accounting Standards Board is planning a one-year deferral for certain investment funds. The deferral is intended to facilitate convergence, FASB Project Manager Chris Roberge said, because the International Accounting Standards Board has reached some different conclusions in its current project than FASB has in its final statement.

The deferral is not intended to apply to securitization entities, asset-backed financing entities, or entities formerly considered qualifying special-purpose entities.

Roberge said the new criteria for determining consolidation provide no bright lines, but instead will require companies to exercise some judgment. The new guidance is not yet fully integrated into the Accounting Standards Codification, he said, but it will be soon.

During a Q&A at the AICPA conference, Shelly Luisi, a senior associate chief accountant at the SEC, said it would be hard to imagine a situation where the SEC staff would approve of a “brain dead” special-purpose entity that truly doesn’t belong on some balance sheet somewhere. “But give us a call if you have something,” she said.