If unconsolidated joint ventures and minority equity stakes help your financial statements sing, get ready for a new tune. The Financial Accounting Standards Board (FASB) wants to clamp down on parent companies that squeeze earnings from unconsolidated subsidiaries without disclosing assets, liabilities, or operating costs.
Should FASB prevail, consequences will vary from company to company, depending on appraisals of each situation by accountants, investors, and securities analysts. But under the strictest interpretation of the proposal, known as the entity theory, the potential impact on such companies as Coca-Cola, Enron Corp., and Thermo Electron Corp. sends an alarming signal.
In Coke’s case, the most extreme change that FASB seeks would have reduced consolidated 1996 pretax income by 9 percent, or $431 million. Thermo Electron, a $3 billion (in revenues) manufacturer of biomedical products and analytical instruments, would have seen its 1996 pretax income cut by 29 percent. The impact on both companies’ stock market value depends on the degree to which investors focus on operating income instead of earnings per share. But 9 percent of Coke’s market value equals $11 billion, and 29 percent of Thermo’s is roughly $1.6 billion.
The effect on Enron, a $13 billion (in revenues) energy company, is more difficult to gauge, because of the way it reports its income. But the proposal would have reduced the $1.7 billion in earnings before interest, taxes, depreciation, and amortization that Enron reported last year by some 10 percent. And that equals about $1 billion of the company’s market value.
For now, FASB has postponed implementation slated originally for year-end 1996. Several other proposals are a higher priority for outgoing FASB chairman Dennis Beresford (see “Farewell to FASB,” CFO, May). But the board was scheduled to meet late last month to discuss the issue. At this point, a sufficient majority favors the entity theory for work on the proposal to proceed on that basis, says James F. Harrington, director of accounting and SEC technical services, and a member of the FASB task force overseeing the project.
FASB critics fear an end to the popular “equity” accounting method that permits a company to keep unconsolidated subs off the balance sheet. Instead of a full accounting, the parent’s income statement records the pro rata share of earnings and books the value of the investment on the balance sheet. No muss, no fuss.
That practice can dress up a parent’s results in several ways. Since the sub’s operating results are reported net of costs, the sub can be far less profitable than the parent, without hurting consolidated operating income. And the fact that the sub’s assets aren’t included on the parent’s balance sheet helps boost the parent’s return on assets. Meanwhile, leverage looks lower because the sub’s debt is also off the balance sheet. And by selling off pieces of its equity interests in such subs, a company can use any gains to make up for a decline in operating results, helping it manage bottom-line earnings. Magic, indeed.
The current FASB proposal chiefly affects minority stakes that effectively construe a controlling interest– where, for example, 30 to 40 percent of the stock is closely held, and the rest is widely dispersed. Corporate parents would have to record their share of a sub’s operating revenues and expenses on the income statement, and book the same share of assets and liabilities on the consolidated balance sheets. Moreover, sales of equity in these subsidiaries would be treated as issuance of treasury stock, keeping proceeds off the income statement.
Opponents rail against a loosely defined consolidation standard that, in their view, would only muddy performance comparisons. Worse, it would impose costs on companies and, ultimately, on their shareholders. “Accounting for our less than majority-owned bottlers as consolidated entities will diminish the financial characteristics of our concentrate business and could impact our company’s cost of capital,” Gary Fayard, vice president and controller at Coke, complained in a letter to FASB early last year. Coke officials now contend that even if the consolidation proposal is adopted as originally conceived, the company’s results would not be affected. Why not? The company insists that it still wouldn’t be deemed to control any of its bottlers.
The controversy highlights important questions about the true nature of control in minority stakes, but fails to vanquish them. Notes Jack Ciesielski, an outside adviser to FASB and editor of The Analysts’ Accounting Observer, a Baltimore-based newsletter, “If control of assets and responsibility for liabilities are the true substance of a situation, why should such information be submerged in footnotes?” As for the difficulty of applying a looser standard of control, he says that’s a matter for companies, auditors, and regulators to work out. And Ciesielski contends that the problem of obscuring the different businesses of a parent and its subs is easily addressed through more detailed segment reporting–which is the focus of a separate, forthcoming standard.
Consider Coke and its relations with so-called anchor bottlers like Coca-Cola Enterprises (CCE) of Atlanta and Coca-Cola Amatil Ltd. (CCA) of Australia. These unconsolidated subs, of which Coke owns 44 percent and 36 percent, respectively, depend on Coca-Cola concentrate, which Coke sells to them. Coke invests heavily in these bottling operations “to maximize the strength and efficiency of our production, distribution, and marketing systems around the world,” says its 1996 annual report. Coke officers also sit on CCE’s and CCA’s boards. Yet Coke accounts for CCE and CCA under the equity method–as it does for other bottlers in which it owns less than 50 percent. The box at right shows what that does for Coke.
HAVING IT BOTH WAYS
While Coke has long had it both ways with bottlers–exploiting them strategically without suffering the effects of their unattractive financials–equally creative instances of equity accounting are becoming more frequent, as companies scramble to tap opportunities abroad. Consider Enron, which had some $5.2 billion in off-balance-sheet debt as of last December 31, much of it a result of foreign joint ventures, compared with only $3.3 billion on its balance sheet. Add on all $5.2 billion in off-balance-sheet debt, and Enron’s debt-to-capital ratio would jump from its current level of less than 38 percent to 63 percent, sending its credit rating from BBB+, or strong investment grade, to B, or junk, according to John Bilardello, an analyst for Standard & Poor’s Corp. Bilardello is quick to note that “that’s not economic reality,” because the off-balance- sheet debt finances some 30 different projects, each with its own set of economics that must be analyzed. Enron itself says that all of that off-balance-sheet debt could stay where it is under the proposal, because its partners have almost as much, if not more, invested in those ventures.
Rules do not obligate a parent company to extinguish debts of an unconsolidated subsidiary. But S&P and other credit agencies often ignore such distinctions when evaluating a borrower’s financial position. Again, Coke’s case is classic. Although Nicole Delz Lynch of S&P acknowledged in a 1996 credit report that the company has no legal obligation for CCE’s or CCA’s debt, Lynch views Coke and its bottlers as one entity because Coke “has significant incentive to keep the bottlers viable because of its ownership positions, the size of its investments, and its unique customer-supplier relationship with them.”
With CCE and CCA adding debt to buy Coke’s interests in other bottlers, S&P has since put Coke’s AA credit rating under review for possible downgrade. While Lynch won’t comment on what Coke could do to maintain its rating, it’s possible that Coke would satisfy the rating agency by promising to reduce its own debt with the proceeds of those equity sales. But that might require Coke to buy back fewer shares than it has in recent years, unless it decides to do so through free cash flow it might otherwise use to reinvest in its business. Won’t that slow Coke’s growth? Investors who focus exclusively on earnings per share needn’t worry. Share repurchases funded by cash flow could offset the impact of lower sales and operating profits.
S&P’s view of Coke leads some companies to refuse to pay a premium for off-balance-sheet financing. “The credit agencies tend to add it back in anyway,” says Joseph Sarnowski, assistant treasurer of Mobil. So why bother to use it at all? Equity analysts tend to take at face value the financial ratios that a company reports, even if they ignore off-balance-sheet activity, and that can help a company’s stock price. “The equity analysts are not as rigorous,” says Geoffery Merszei, vice president and treasurer of Dow Chemical. “If we can impress them, then we can gain by it.”
In fact, Enron worries that the FASB proposal would hurt its stock price even if all the company’s off-balance-sheet debt stayed there. How so? The company depends increasingly on income from sales of equity stakes in consolidated subsidiaries to offset declines in operating income, smoothing out its trends in net income and earnings. In 1994, Enron even took public one of its consolidated subsidiaries, Enron Global Power & Pipelines, so it could have a ready buyer of its own equity in riskier emerging-market joint ventures. “An ingenious structure,” observes Dennis Coleman, a vice president at Duff & Phelps.
TOSSING A WRENCH
But the FASB proposal would throw a wrench into Enron’s works. Under the strictest interpretation of the proposed standard, Enron could no longer report gains from such sales on its income statement without a subsequent loss of control, and, again, under the FASB definition, that wouldn’t necessarily mean reducing a 51 percent stake to 49 percent. Horror of horrors, says Enron. “The majority of the analysts who report on our stock consider these gains as recurring net income,” Jack Tompkins, Enron’s chief accounting officer, noted in a letter to FASB early last year. But, Tompkins, who has since left the company, went on, “we believe such gains will be ignored by these same analysts for valuation purposes to the extent the gains are omitted from reported income.” Tompkins’s successor, Richard Causey, says Enron would make an effort to convince analysts that “there is still value there, and we’d expect to get some credit for it.”
How significant would the remaining shortfall be? Since the company doesn’t break out its income from sales of equity interests in its annual report, it’s difficult to determine how much value investors actually assign to the gains. But consider this: While Enron’s operating income of $690 million in 1996 was about 4 percent lower than it was in 1994, its earnings per share rose by a total rate of 28 percent, and its stock has advanced by 42 percent since early 1995. Investors evidently don’t mind that Enron depended on sales of equity interests and other nonoperating income to make its earnings look as good as they did.
The impact of gains from sales of equity stakes in subsidiaries is clearer at a company like Thermo Electron, for which such gains “almost take on the appearance of an operating segment,” says Ciesielski. He estimates that the FASB proposal would have cost Thermo Electron 36 percent of its $241 million in cumulative net income from 1992 to 1994. Thermo Electron declined to comment.
Coke’s dependence on sales of interests in bottlers is also readily apparent. Were it not for the sale of its 49 percent stake in a U.K. bottler to CCE, Coke’s earnings for the first quarter of this year would have exceeded results for last year’s first quarter by only 4 cents instead of 12. Of course, proceeds from equity sales depend on market conditions, and losses might replace gains if conditions go sour.
If FASB doesn’t back down, CFOs may have one consolation. They’d no longer have to prepare one presentation for equity analysts and another for credit agencies. Unmollified? Tell it to Beresford’s successor, once FASB gets around to naming one. It had yet to do so when this issue went to press.
WOULD COKE TASTE AS SWEET?
For Coca-Cola, equity accounting supplies the financial equivalent of artificial sweetener– which makes FASB a purist that frowns on its use. In the interest of cleaner reporting, FASB might compel Coke to abandon equity accounting for its two main bottlers, Coca- Cola Enterprises (CCE) and Coca-Cola Amatil Ltd. (CCA). But shifting the bottlers’ assets and liabilities to the parent would make Coke taste less sweet to investors.
With the bottlers’ margins only half to a third as wide as Coke’s and their balance sheets laden with debt, Coke’s return on equity would look more like 39 percent than the 61 percent it reported for 1996. Add in just CCE’s $4.5 billion in long-term debt at the end of 1996, and Coke’s return on capital would have been only 25 percent, against the 37 percent it reported. (The above ratios are based on Coke’s methods for calculating them, which use income from continuing operations, adjusted for interest, divided by average shareholders’ equity or total capital.) Add in all of the two bottlers’ debt as of the end of last year, and Coke’s net debt to capital ratio would have exceeded 50 percent, well above the 31 percent that Coke reported for itself alone. And Coke’s leverage would have since climbed even higher, if it included the additional debt that CCE has taken on as a result of its purchases of Coke’s stakes in other bottlers. In fact, the latest deal has prompted Standard & Poor’s to place Coke’s AA credit rating on review for possible downgrade.
Then there’s the impact on Coke’s earnings from those sales. Last year, Coke reported $431 million in gains on sales of equity interests in its bottlers, accounting for 9 percent of its pretax income. None of those gains could be reported as income under the FASB proposal’s strictest application, say analysts.