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FIN 46 made companies admit paternity of special purpose entities. But it also resulted in some surprise adoptions.
Tim Reason, CFO Magazine
September 1, 2004
Early 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.)
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."
Fortunately, Fin 46R provides an out: if the financial data isn't available, then consolidation isn't required. But future contracts must include a right to review the power vendor's financials, which Ault says could make both sides reluctant to enter into long-term, exclusive contracts.
Although relatively rare, the need to consolidate otherwise independent businesses is also causing some CFOs headaches even if they can get the data they need. That's because consolidating privately owned franchisees or dealerships means certifying to the accuracy of their financial data and, under Section 404 of Sarbanes-Oxley, their financial controls.
"I have to be accountable for their control systems, even though I don't control them," complains one CFO, whose company had to consolidate a number of small, independently owned dealerships because it had guaranteed their leases or provided extended payment terms. "The 404 issue is as scary as anything. I'm relying on [the dealerships] to tell me what's going on in their business. How would you like to sign for that?"
Another objection appears in the second-quarter 10-Q for home-builder Hovnanian Enterprises, which complains that "FIN 46 was not clearly thought out for application in the homebuilding industry for land and lot options." Whenever Hovnanian options land and pays a nonrefundable deposit, the company explains, it must create a VIE under FIN 46 and is deemed to provide subordinated financial support. As of April, the company had $27.4 million at risk in land-option deposits, yet it put almost nine times that amount on its balance sheet as "minority interest from inventory not owned."
"In certain areas, FIN 46 is clear, and there is no room for interpretation," says E&Y's Thrope, who declined to comment on specific corporate complaints. "In other areas, issues have come up that weren't addressed, and FASB's Emerging Issues Task Force is still working through them."
Sempra's Ault thinks that FIN 46 is fairly stable at this point. "If you compare FIN 46 to something like FAS 133"--FASB's long-running effort to account for the value of derivatives — "then I don't think FIN 46 is all that complex."
Tim Reason is a senior writer at CFO.
In rare cases, FIN 46 has actually required shedding assets. The most notable example involved Amerco, the Reno, Nevada-based parent company of U-Haul. In March, the company announced that a Chapter 11 financial restructuring had triggered the deconsolidation of 281 self-storage facilities under FIN 46.
Ironically, Amerco's slide into bankruptcy began when it announced in March 2002 that it had incorrectly accounted for the special purpose entities (SPEs) that owned those self-storage facilities. With the help of PricewaterhouseCoopers, the company initially moved the facilities off the balance sheet, in part because it thought their financial profile confused investors about Amerco's core moving business. After realizing the SPE accounting was faulty, Amerco went through several rounds of consolidations and restatements. The result: IRS audits, SEC inquiries, plummeting stock, and multiple covenant violations.
Amerco subsequently sued PwC for approving the accounting during a seven-year period (according to Amerco's legal complaint, PwC also helped set up the SPEs). New Amerco CFO Jack Peterson would not comment on the suit, but says FIN 46 "provides for a clearer assessment of risk and responsibility and appropriately puts the reporting of financial information where the legal responsibilities lie." Deconsolidating the storage facilities, he says, allows for "a better portrayal of Amerco" — just what the company was trying to achieve in the first place. — T.R.