Off the Balance Sheet, in a Nutshell

What a difference a few words can make, especially when those words change financial reporting requirements.

This month the Securities and Exchange Commission and the Financial Accounting Standards Board are handing down new rules and guidance aimed at improving the transparency of financial statements — in particular, off-balance-sheet transactions.

The SEC is rewriting its guidance on MD&A disclosure, introducing Regulation G, and rewriting its rules governing Form 8-K. FASB is trained on consolidation of variable interest entities, or VIEs (until now, better known as special-purpose entities, or SPEs) and on loan guarantees.

Collectively, the new mandates are intended to help investors view companies through the “eyes of management”; detractors say that these initiatives only cloud the issues.

The SEC’s MD&A Disclosure Rules

According to SEC officials, the MD&A final rule — which will be promulgated on January 26, in accordance with Section 401(a) of the Sarbanes-Oxley Act of 2002 — lowers the disclosure threshold for reporting off-balance-sheet arrangements, contractual obligations, and contingent liabilities and commitments in annual reports. (Read the text of the proposed rule.)

Under the current standard, MD&A disclosure is required only when there is a “reasonable likelihood” that an off-balance-sheet transaction has a current material effect on the company’s financial expenditures or capital resources, or will have such an effect in the future. Under the new standard, disclosure is required if there is so much as a “remote” chance that the transaction will have such an effect.

The effort to improve transparency is laudable, say critics, but they add that the new rule is counterproductive because finance executives will include an avalanche of information in the MD&A to comply with the letter of the law, and not spend enough time detailing items that are truly material.

In a comment letter to the SEC, George Yungmann, vice president of financial standards for the National Association of Real Estate Investment Trusts, wrote that the trade group’s members were concerned about redundant disclosures in the financial-statement footnotes and in the MD&A that “may be misunderstood by users of the documents.” Overreporting, added Yungmann, could result in lengthy disclosures that evolve into boilerplate, marring the market’s ability “to discern those financial matters which are most relevant and meaningful.”

In addition, some CFOs maintain that the value of off-balance-sheet transactions must also reflect the additional time and resources that their companies must spend on these new MD&A disclosures.

The SEC’s Regulation G

A sweeping rule, Regulation G governs all public disclosure, including corporate press releases and SEC filings. (Read the text of the proposed rule.)

Like the proposed MD&A rule, Regulation G is the practical result of a Sarbanes-Oxley directive — specifically, Section 401(b) — and will also be made final on January 26. Regulation G is an “entirely new framework for regulating public disclosure of financial data” that is not part of generally accepted accounting principles (GAAP), said attorney Morton Pierce, chairman of the M&A practice at Dewey Ballantine, in a December report.

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