Off-Balance-Sheet Deals: C’est la Vie?

In the eyes of the investing public, off-balance-sheet financing has fallen into disgrace. Will it deserve another look after the SEC and FASB have their say?

After evolving over the last quarter-century into one of the most popular corporate finance tools in the United States — taking such forms as securitizations, synthetic leases, and unconsolidated entities — it seems that off-balance-sheet financing is being deconstructed in a hurry.

Under congressional mandate, the Securities and Exchange Commission has proposed a new rule that will require disclosure of off-balance-sheet arrangements in the “management’s discussion and analysis” section of annual reports. In addition, the SEC is introducing Regulation G, for financial metrics that don’t conform with generally accepted accounting principles (GAAP), and beefing up the requirements governing 8-K filings.

The Financial Accounting Standards Board is also doing its part to increase corporate transparency. The rulemaker has proposed that companies consolidate variable interest entities, or VIEs (until now, better known as special-purpose entities, or SPEs) onto their balance sheets. Furthermore, in November 2002 FASB issued new rules that require companies to recognize loan guarantees on their books. (For more specifics on these rules, read “Off the Balance Sheet, in a Nutshell.”)

As of this writing, the rule changes (other than for loan guarantees) are within days of becoming permanent. The SEC set a January 26 deadline for the adoption of its MD&A rule; FASB expects that its guidance will be issued by mid-January.

(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.)

“Unnecessary”?

Many companies whose executives have sent comment letters to FASB seem generally opposed to the new interpretation, calling it “unnecessary” and a “distortion of financial statements.” Essentially, critics believe that tighter regulations will lead to more manipulation and less consolidation, and that bright-line standards will encourage the creation of new loopholes.

Apparently, financial executives would rather that FASB stick to its guns and issue a statement declaring that the use of an entity doesn’t change the underlying accounting treatment of a transaction. (These comments, it should be noted, were made in response to FASB’s June 2002 exposure draft.)

The spate of corporate scandals over the past 18 months has made investors suspicious of all off-balance-sheet activities, affirms John Peak, CFO of Hoffman Estates, Illinois-based Transamerica Distribution Finance. He says that Transamerica’s audit committee, as well as the boards of clients involved in deals with the $5 billion financial services company, are reviewing off-balance-sheet transactions with a fine-tooth comb. Four years ago, Peak adds, Transamerica began offering joint-venture arrangements as a stand-in for traditional securitizations.

The VIE consolidation rule will also affect synthetic leases, says Peak. He contends that if FASB requires him to consolidate the synthetic lease that Transamerica now carries on its own books, he will have to rethink his strategy, since the advantages — removing debt from Transamerica’s balance sheet, but retaining the tax benefit of an operating lease — would be wiped out.

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