VideoEarly in his tenure as chairman of the Financial Accounting Standards Board, while the Enron scandal was raging, Robert Herz was confronted on Capitol Hill by a senator from the South. As Herz tells it, imitating the lawmaker's distinctive drawl, the senator demanded to know when FASB was going to "outlaw the use of these dummy co-poh-ray-shuns."
Clearly, the senator had no use for Wall Street's preferred term, special purpose entities (SPEs). And he had a point: Corporate America was indeed lousy with paper companies that no one seemed to own. Enron, it had just been discovered, had used SPEs to avoid taxes and hide mountains of debt. But how could regulators distinguish those from the vehicles routinely used on Wall Street?
Herz's solution was FASB Interpretation No. 46 (FIN 46), an economic test designed to fill in when legal definitions of ownership fail. The crux of the test: who stands to gain or lose the most from an SPE whose ownership is otherwise unclear? (Such SPEs are now dubbed variable interest entities, or VIEs.) Whichever company proves to be the VIE's "primary beneficiary," said FASB, must consolidate the entity's financial data in its own statements.
Since it was first issued in January 2003, FIN 46 has dramatically reduced the number of orphaned entities. But recently it has also resulted in a few adoptions that FASB never saw coming — at least officially. As a result, some CFOs have found themselves saddled with unwelcome new responsibilities of corporate parenthood.
No More Make-Believe
Before FIN 46, the orphan status of SPEs was a large part of what made them so useful. Generally speaking, SPEs are dummy corporations, created to own assets that a company doesn't want on its own books for any of a variety of reasons. For example, for securitization purposes, an SPE increases the value of the assets as collateral by sheltering them from the company's creditors. As long as their "sponsor" company didn't have voting control or too large an equity stake, SPEs were considered independent.
As it turned out, Enron broke even those rules. But in the post-Enron environment, even SPEs long considered legitimate smelled bad to investors. Whatever the stated reason for doing so, keeping assets and liabilities off the balance sheet was hardly transparent.
Today, FIN 46 seems to be having the desired effect. Although no comprehensive impact study has been done, a sample of 300 quarterly reports reviewed by CFO shows that companies are now claiming ownership of many assets and liabilities that common sense has long said belong to them. And apart from the banking industry, which went through a torturous restructuring rather than put billions in securitized assets on bank balance sheets, most companies have quietly accepted the change.
Still, it's no easy task to define when one company controls another, as evidenced by the uproar in fast-food chains when the new standard was issued. "When FIN 46 first came out, people started thinking that franchisers might have to consolidate many of their franchisees," says David Thrope, a partner at Ernst & Young. But FASB's December 2003 revision of the rule, FIN 46R, put the franchisers at ease by stating that it did not apply to "businesses" that met certain standards as defined by FASB. (Still, a substantial debt or equity stake in another business can result in consolidation, as seen in the recent consolidations of franchisees by 7-Eleven and others.)
Power Struggles
Nonetheless, FIN 46 has resulted in some cases in which companies are understandably surprised to find themselves "owning" another business. Take Sempra Energy, the parent of California utility San Diego Gas and Electric. For the most part, the effects of the standard on Sempra were routine — the company put a $630 million synthetic lease back on its balance sheet and took a $26 million hit to income when it consolidated a money-losing company in the United Kingdom.
Controller Frank Ault says synthetic leases "clearly should be consolidated on the financials." And while he says figuring out whether to consolidate the company's U.K. investment was "a little more complicated" — Sempra had less than 50 percent equity, but most of the debt — that, too, made sense.
But FIN 46 got far more complicated when it came to a 1978 federal law that requires San Diego Gas and Electric and other utilities to buy power from small, local producers, such as cogeneration plants. Under a FASB staff interpretation, Ault explains, if a utility contracts for a substantial portion of power that a plant will generate in its lifetime (as is often the case with such small producers), the utility is considered the beneficial "owner."
Sempra identified seven plants that might meet that criterion, but quickly ran into a problem. "Every utility that has contracts with these facilities has sent letters saying, 'We need your financial statements so we can decide if we need to consolidate you,'" says Ault. "And every utility has either gotten no response or been told to go to hell."
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