FIN 46 and
Balance-Sheet Consolidation
By Tim Reason
CFO
Magazine
29-September-2004
Close This Window
|
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.)
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."
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.
Control
Freaks
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.
Disowned
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.
© CFO Publishing Corporation
2004. All rights reserved. |