Capital Markets

Off the Balance Sheet, in a Nutshell

What a difference a few words can make, especially when those words change financial reporting requirements.
Marie LeoneJanuary 1, 2003

This month the Securities and Exchange Commission and the Financial Accounting Standards Board are handing down new rules and guidance aimed at improving the transparency of financial statements — in particular, off-balance-sheet transactions.

The SEC is rewriting its guidance on MD&A disclosure, introducing Regulation G, and rewriting its rules governing Form 8-K. FASB is trained on consolidation of variable interest entities, or VIEs (until now, better known as special-purpose entities, or SPEs) and on loan guarantees.

Collectively, the new mandates are intended to help investors view companies through the “eyes of management”; detractors say that these initiatives only cloud the issues.

The SEC’s MD&A Disclosure Rules

According to SEC officials, the MD&A final rule — which will be promulgated on January 26, in accordance with Section 401(a) of the Sarbanes-Oxley Act of 2002 — lowers the disclosure threshold for reporting off-balance-sheet arrangements, contractual obligations, and contingent liabilities and commitments in annual reports. (Read the text of the proposed rule.)

Under the current standard, MD&A disclosure is required only when there is a “reasonable likelihood” that an off-balance-sheet transaction has a current material effect on the company’s financial expenditures or capital resources, or will have such an effect in the future. Under the new standard, disclosure is required if there is so much as a “remote” chance that the transaction will have such an effect.

The effort to improve transparency is laudable, say critics, but they add that the new rule is counterproductive because finance executives will include an avalanche of information in the MD&A to comply with the letter of the law, and not spend enough time detailing items that are truly material.

In a comment letter to the SEC, George Yungmann, vice president of financial standards for the National Association of Real Estate Investment Trusts, wrote that the trade group’s members were concerned about redundant disclosures in the financial-statement footnotes and in the MD&A that “may be misunderstood by users of the documents.” Overreporting, added Yungmann, could result in lengthy disclosures that evolve into boilerplate, marring the market’s ability “to discern those financial matters which are most relevant and meaningful.”

In addition, some CFOs maintain that the value of off-balance-sheet transactions must also reflect the additional time and resources that their companies must spend on these new MD&A disclosures.

The SEC’s Regulation G

A sweeping rule, Regulation G governs all public disclosure, including corporate press releases and SEC filings. (Read the text of the proposed rule.)

Like the proposed MD&A rule, Regulation G is the practical result of a Sarbanes-Oxley directive — specifically, Section 401(b) — and will also be made final on January 26. Regulation G is an “entirely new framework for regulating public disclosure of financial data” that is not part of generally accepted accounting principles (GAAP), said attorney Morton Pierce, chairman of the M&A practice at Dewey Ballantine, in a December report.

The proposed regulation would require CFOs to bolster any non-GAAP financial measures released to the public by including comparable financial measures calculated and presented in accordance with GAAP, and a reconciliation statement pegged to the appropriate GAAP measures.

Non-GAAP measures, in this case, include EBITDA (earnings before interest, taxes, depreciation and amortization). They also include pro forma concepts such as operating cash flow per share, as well as recurring or core earnings that exclude expenses or other charges because they are non-cash.

The SEC’s distaste for pro forma reporting dates back at least to 1973, when the commission issued Accounting Series Release No. 142, warning of possible investor confusion from the use of non-GAAP financial measures. Sarbanes-Oxley, however, finally sparked the codification of this concern.

The SEC’s Form 8-K

As part of its Sarbanes-Oxley mandate, the commission is also proposing to rewrite the rules governing Form 8-K to include a new Item 1.04, “Results of Operations and Financial Conditions.” (Read the text of the proposed rule.)

Companies would be required to file all press releases and other public announcements, whenever they include material, non-public information about the company’s results of operations or financial condition, in their 8-Ks. Filing would be required within two days following the public disclosure of the information.

The snag, say some CFOs, is that existing rules prohibit the inclusion of pro forma measures in 8-Ks — meaning that pro forma metrics would have to be stripped from press releases if the current proposal is not amended. Could this be the death of pro forma? Its opponents say, better late than never.

FASB’s Rules on Consolidation of VIEs

By mid-January FASB expects to finalize strict new rules for what it now calls variable interest entities, the vehicles typically used to remove assets and debt from company balance sheets. (Read FASB’s summary of the draft interpretation.) These entities are often created for a single purpose — for example, to facilitate securitization, leasing, hedging, research and development, or reinsurance.

(Editor’s note: On January 16 FASB finalized Interpretation No. 46, Consolidation of Variable Interest Entities. You may download the full text of the interpretation by visiting FASB’s web site.)

The proposal aims to ensure that unconsolidated VIEs are truly independent from their sponsoring companies (also called “primary beneficiaries” by FASB). A VIE would be subject to consolidation if either of two conditions were to exist.

The first condition is that “the total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support.” Generally this investment requirement of outside third parties, currently 3 percent, has been raised to 10 percent, though a lesser investment can be demonstrated sufficient if it meets certain specified criteria.

The second condition is that the equity investors lack a “controlling financial interest.” This lack would be established in any one of three ways: Either the investors could not make decisions regarding the entity through voting rights or some similar means, or the investors would not be obliged to absorb any expected losses of the entity, or they would not be entitled to any expected residual return.

Advocates of the rule maintain that FASB’s intent is to require consolidation only if VIEs do not effectively disperse the risks among the parties involved. For that reason, “qualifying” entities that meet the criteria of FAS 140 won’t be affected by the proposal, says Tom Glynn, an attorney with Wolf, Block, Schorr and Solis-Cohen.

Likewise, entities associated with more-traditional securitizations, such as those that use credit-card receivables, auto-lease receivables, or mortgages as collateral for asset-backed securities, will not be burdened by the rule change. (Read more about these traditional entities in our article “Reining in SPEs.”)

Critics argue that the proposed interpretation will distort financial statements because it is too complex to apply consistently, and therefore will be a breeding ground for loopholes. They also cite accounting and economic consequences, including inappropriate consolidation of VIEs that do, in fact, disperse risk effectively; the elimination of synthetic leases; and impaired capital flow that will result in higher costs to lessees, customers, and borrowers.

The rule will apply immediately to VIEs created after the final interpretation is issued in January. Public companies will apply the rule to existing VIEs as of the beginning of the first reporting period (interim or annual) after June 15.

FASB’s Interpretation on Loan Guarantees

Passed on November 25, 2002, this new interpretation, FIN No. 45, tightens disclosure rules for loan guarantees and requires companies to record certain liabilities before they are incurred.

The interpretation, which expands on the accounting guidance of FAS 5, 57, and 107, instructs companies to recognize loan-guarantee liabilities, at their market value, at the time the guarantee is issued. Previously, loan guarantees were kept off a company’s balance sheet until the company was required to honor them. The value of the guarantees must be disclosed in interim and annual financial statements.

The new rule would apply to letters of standby credit and to manufacturer’s recourse loans. It would not apply to guarantees issued by insurance companies, to guarantees accounted for as derivatives, to product warranties, or to lessees’ residual value guarantees embedded in capital leases.