FASB Kills the “Q,” Stiffens Off-Balance-Sheet Reporting

The accounting standards-setter approves rules aimed at unveiling attempts to hide losses.

The Financial Accounting Standards Board decided on Monday to require companies to disclose more about how they consolidate variable-interest entities and classify the transfer of financial assets as a sale. Further, the board will issue a standard in June that finally gets rid of qualifying special-purpose entities.

The moves seemed to track a statement at the end of April by James Kroeker, the acting chief accountant of the Securities and Exchange Commission. Kroeker said that off-balance-sheet reporting would soon supplant fair value as the biggest of accounting issues.

The guidance approved by FASB appears to be in line with the goal of eliminating the appearance of joint control of off-balance-sheet assets when, in reality, the original owner retains the risk.

On Monday, the board approved two proposals on off-balance-sheet reporting that it issued for comment last September and confirmed a 2010 effective date. The board will amend FAS 140, Transfers of Assets, and FIN 46(R), Consolidation of Variable Interest Entities. 

FIN 46(R) is the existing guidance on how a company should meld variable-interest entities into its financial reporting. Thinly capitalized business structures that enable investors to hold controlling interests without having voting majorities, VIEs include many include many off-balance-sheet vehicles called “special-purpose entities.” 

The main amendment FASB is making to FIN 46(R) concerns how a company should choose whether to consolidate a VIE. Under generally accepted accounting principles, a company must consolidate any entity in which it has a “controlling interest.” If the company has an interest in a VIE that provides it with control over the VIE’s most significant activities (and the right to some of its benefits or the responsibility to absorb its losses), the company must consolidate the VIE with the company’s own financials.

FASB decided yesterday, however, to require a company to perform a new qualitative analysis to decide if it must consolidate a VIE. FASB has decided that the quantitative analysis companies have often used should no longer, on its own, hold sway. 

In contrast to existing guidance, which requires a company to decide about consolidating a VIE only when certain events occur, the new standard will require companies to make ongoing reassessments to determine if a VIE should be brought onto the company’s balance sheet. 

“Under existing guidance, as expected credit losses increased significantly due to unpredicted market events, some companies did not reconsider whether they should consolidate a variable interest entity,” FASB said in a memo.  

Further, the revisions to 46(R) will require a company to provide added disclosures about its involvement with VIEs and any significant changes in risk exposure stemming from that involvement. Companies will also be required to disclose how the involvement with a VIE affects the company’s financial statements. 

Back on the Balance Sheet                                                                                                            The revisions to Statement 140, the second standard that FASB will amend, will provide “greater transparency about transfers of financial assets and a company’s continuing involvement in transferred financial assets,” according to FASB. The revised standard will erase the notion of a QSPE (commonly known as a “Q”) from U.S. GAAP, change the requirements for derecognizing financial assets, and require added disclosures about a transferor’s continuing involvement in transferred financial assets. 

Without the QSPEs, the off-balance-sheet vehicles that enabled banks to keep securitized assets off their balance sheets, some banks will have to absorb losses that have until now been hidden. 

Created “to fulfill narrow, specific, or temporary objectives,” SPEs in general are typically used by companies to shed financial risks, according to the memo. “A company will transfer assets to the SPE for management or use the SPE to finance a large project — thereby achieving a narrow set of goals without putting the entire firm at risk.”

On the issue of derecognition, the standard will curb when a company may transfer part of a financial asset and account for the transferred portion as being sold. “Existing guidance enables companies to report many transfers of portions or components of financial assets as sales,” according to the memo. “Under the new standard, 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.” 

The newly approved standard also drops an exception that currently allows companies to derecognize “certain transferred mortgage loans when the company has not surrendered control over those loans,” according to the board. 

The amended FASB standards will be effective by the start of 2010 and will mostly apply to existing entities. But the amendments on how to account for transfers of financial assets will apply to transfers occurring on or after the effective date. 

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