June 2009

Existing accounting guidance permits companies to report transfers of portions of financial assets as sales. The off-balance-sheet entities that enabled banks to keep securitized assets and other activities off their financial statements will now need to be included on their sponsor’s consolidated financial statements. An important accounting change which will be finalized this month will help ensure that a financial statement issuer considers its continuing involvement before determining whether a transfer of financial assets may be accounted for as a sale (and thus removed from the financial statements). The newly approved standard also eliminates an exception that currently permits a company to derecognize certain transferred mortgage loans when the company has not surrendered control over those loans.

According to federal regulators, the change will result in $900 billion in liabilities being put on the balance sheets of the nation’s 19 largest banks that just completed the Treasury’s stress tests. Some banks will have to record related losses that have previously been hidden. James Kroeker, acting chief accountant at the U.S. Securities and Exchange Commission said the change “addresses the critical need for continued improvement to the accounting for arrangements that were at the epicenter of the financial crisis”.

Off-balance-sheet entities that are the focus of the change typically (i) are thinly capitalized (ii) have no independent management, and (iii) have their administrative functions performed by a designated trustee or other intermediary whose activities are controlled by service agreements.

Accounting Research Bulletin (ARB) 51, (“Consolidated Financial Statements”), issued in 1959, is the original pronouncement that addressed the question of whether to include an entity in one’s consolidated financial statements. When concluding when a separate legal entity should be included in the consolidated financial statements, ARB 51 stated “the usual condition for a controlling financial interest is ownership of a majority voting interest.” This rule worked well for years, until clever accountants and lawyers designed sophisticated legal entities and related agreements that allowed one to sponsor and control an entity without owning majority voting power. The sponsor’s interest and control was instead secured through legal restrictions on how the controlled entity uses its assets. By design, companies avoided consolidating these entities even though substantive control exists, but where such control did not meet ARB 51’s definition.

The current changes are part of a continuing effort to reduce the accounting use of off-balance sheet entities and transactions. The first attempt was Statement of Financial Accounting Standard (SFAS) 140 (“Accounting for Transfer and Servicing of Financial Assets and Extinguishments of Liabilities”), which issued about a year before Enron’s failure became known, but too late to require a timely fix of Enron’s abuse. SFAS 140 establishes the conditions where the transfer of financial assets should be accounted for as a sale by the transferor, and the conditions under which a liability should be deemed to have been extinguished. It further defines a qualifying special purpose entity (SPE), which should not be consolidated in the financial statements of the transferor or its affiliates.

After Enron’s GAAP-compliant accounting brought additional attention to SPE’s abuse, FASB responded by issuing Interpretation 46 (“Consolidation of Variable Interest Entities, an Interpretation of ARB 51”). These changes were not sufficiently broad, or at least were not interpreted as broadly by some as the FASB intended. This became apparent in the current financial meltdown, when it was disclosed that numerous financial institutions had exposure to risky assets that were not reflected in their financial statements. After learning that accountants and auditors were not applying certain provisions as the FASB intended, FASB began the current changes.

When the current change was drafted and released for public comment, Robert Herz (Chairman of the Financial Accounting Standards Board (FASB)) expressed anger about the current accounting, saying that some financial institutions had misinterpreted them.

“I am chagrined at what we discovered. … We are not an enforcement agency, we are not regulators, but it seems fair to me with the benefit of hindsight, the kind of reporting that was made by a number of preparers, including several large financial institutions, did not live up to the expectations of investors and the community at large. While we acknowledge that 140 could be improved, it is also clear to me that the notion of QSPEs was stretched beyond recognition.”

Current FASB guidance on removing assets and liabilities from the financial statements permits issuers of financial statements to report transfers of components of financial assets as sales. In the current change, FASB removed (i) the concept of a qualifying SPE from Statement 140, and (ii) the scope exception for qualifying SPEs from Interpretation 46(R). Under the new rules, a transfer of a portion of a financial asset may be reported as a sale only when that transferred portion is a pro-rata portion of an entire financial asset, no portion is subordinate to another, and other restrictive criteria are met. As a result, if a company has control over an SPE’s most significant activities, it must be included in the consolidated financial statements. This will (i) prevent the current complex dissection and removal of portions of transactions from the financial statements, and (ii) eliminate an exception that allows a company to “derecognize certain transferred mortgage loans when the company has not surrendered control over those loans.”

A variable interest entity (VIE) is a business structure t