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After reading Which Firm Would You Invest in First (copied below) consider why a company might use off-balance sheet manipulations. Consider the role of the accountant in providing stakeholders with the most accurate financial data on a company. Think about the impact off-balance sheet manipulation has on the financial statements of companies who are consolidating resources. Consider consolidation theories and reflect on the extent to which a company should use off-balance sheet manipulation during company consolidation.

Which Firm Would You Invest In First: A case study

You should read the following table and select the firm that you would be more likely to invest in. After you have selected the firm, please read the history associated with the choice of firms.

Prepared by: Dr. Darryl E. Allen

University of Central Florida

Orlando, Florida

Which Firm Would You Invest In First?

You have inherited a large sum of money and you were advised that you can buy any one of the three firms below. The firms just completed their first year of operations. Which of the three firms would you be more likely to invest in?

Comparative Balance Sheets

($000) 12/31/XX

Company A Company B Company C

Assets

Cash 20,000 20,000 20,000

Investment 0 0 0

Plant, Property 300,000 150,000 10,000

Other 0 0 0

Total Assets 320,000 170,000 30,000

Liabilities

Current Liabilities 0 0 0

Long-term debt 280,000 140,000 0

Other 0 0 0

Total Liabilities 280,000 140,000 0

Shareholders Equity

Equity 10,000 10,000 10,000

Minority Interest 10,000 0 0

Retained Earnings 20,000 20,000 20,000

Total Equity 40,000 30,000 30,000

Liabilities and Equity 320,000 170,000 30,000

Comparative Income Statements

19XX

Company A Company B Company C

Revenues 80,000 40,000 -

Expenses (20,000) (10,000) -

Income from Investments 30,000

Gross Profits 60,000 30,000 30,000

Less: Minority Interest (30,000)

Admin/Taxes (10,000) (10,000) (10,000) Net Income 20,000 20,000 20,000

The history of Consolidation Accounting

Much has been written about Enron and their abuse of the Special Purchase Entities (SPE) regulations to maintain off-balance sheet assets and liabilities. Since the 1970s, parent firms could avoid consolidating SPE projects by ensuring that there was at least three percent (now 10%) outside equity money invested in the project. In many cases, assets were transferred to the SPE and used as security for equity or bank financing. The SPE formation facilitated asset securitization, since the SPE generally had a single purpose and the risks to the assets were more easily isolated by the creditors and the assets could be securitized at lower cost financing. Because of Enrons abuse of the SPE regulations, the Security and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) have promulgated changes to the consolidation accounting provisions. The history of the GAAP consolidation accounting rules is reviewed in the next paragraphs.

In 1959, FASB issued original consolidation instruction in Accounting Research Bulletin (ARB) 51. Essentially ARB 51 set the bar for consolidation at more than 50% ownership or voting control (para. 2). ARB 51, however, allowed the exclusion of nonhomogeneous subsidiaries from consolidation requirements (para. 3). There were no parameters placed around the meaning of nonhomogeneous. Subsequently, firms avoided consolidating the assets and liabilities of their subsidiaries they deemed to be outside the parent firms main course of business, however, they did include the income of the subsidiary. Most commonly, firms used the nonhomogeneous provision to exclude their finance, insurance, real estate, and leasing subsidiaries of manufacturing and merchandising firms. Some firms went so far as to consider foreign affiliates as nonhomogeneous (para. 8). In 1971, the Accounting Principles Board issued APB Opinion 18 that defined the rules for using the cost and equity basis for investment in the common stock of an entity. Essentially, ownership of less than 20% of the total stock required the cost basis of accounting; ownership of 20 to 50%, without voting control, allowed the use of equity accounting. APB Opinion 18 left the nonhomogeneous provisions intact. In 1987, to further define the rules for consolidation, FASB issued Statement of Financial Accounting Standard (SFAS) 94, Consolidation of All Majority-Owned Subsidiaries, restating the requirement for the consolidation of all subsidiaries more than 50% controlled or where there is voting control. SFAS 94 rescinded the nonhomogeneous provision of ARB 51, but left the equity accounting rules of APB Opinion 18 intact. In 1996 and 2003, respectively, the FASB issued SFAS 125, Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities and its revision SFAS 140, Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities that dealt with accounting for assets and liabilities transferred to SPEs. More recently, FASB issued Interpretation (FIN) 46R that tightened the rules for consolidation of assets and liabilities transferred into SPEs. FIN46R introduced a new concept of Variable Interest Entity (VIE) that requires consolidation of previously non-consolidated entities based on the amount of subordinated financing, voting control, ownership of the responsibility for absorbing any losses or residual income of the VIE. In 2009, SFAS 167 amended FIN46R to prescribe additional tests to determine when a SPE requires consolidation on a parent companys statement of financial position, and to address questions raised by SFA 166 which amended SFAS 125 above (para. 1). In 2008, FASB issued SFAS 160, Noncontrolling Interest in Consolidated Financial Statements that better defined how minority equity interest should be displayed on the parents statement of financial position and how the income attributable to minority interest should be displayed on the income statement. (para. 1).

While recent FASB rule making has sought to better define the rules for consolidation, firms can still use equity accounting to avoid consolidation. Non-majority owned and non-voting controlled projects other than SPEs can use equity accounting. The use of equity accounting by these projects has the same off-balance sheet effects as SPEs. The firms that use equity accounting nets total assets against total liabilities and show the difference as a one-line entry in the investment section of the balance sheet. For instance, a parent firm having $100 million in assets and $80 million in liabilities for an equity accounting subsidiary, would show $20 million in the parent investment account; the $100 million in assets and $80 in liabilities are off-balance sheet.

References

Accounting Principle Board. 1971. The Equity Method of Accounting for Investments in Common Stock. Opinion 18. Norwalk, Connecticut.

Committee on Accounting Procedure of the AICPA. 1959. Consolidated Financial Statements. Accounting Research Bulletin. No. 51, Norwalk, Connecticut.

Financial Accounting Standards Board. 1990. Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions. Emerging Issue Task Force. No. 90-15, Norwalk, Connecticut.

Financial Accounting Standards Board. 1979. Capitalization of Interest Costs. Statement of Financial Accounting Standard No. 34. para. 6. Norwalk, Connecticut.

Financial Accounting Standards Board. 2007. Business Combinations, Statement of Financial Accounting Standard No. 141. Norwalk, Connecticut.

Financial Accounting Standards Board. 2008. Noncontrolling Interests in Consolidated Financial Statements an amendment of ARB no. 51, Statement of Financial Accounting Standard No. 160. Norwalk, Connecticut.

Financial Accounting Standards Board. 2009. Amendment to FASB Interpretation No. 46(R), Statement of Financial Accounting Standard No. 167. Norwalk, Connecticut.

Financial Accounting Standards Board. 1987. Consolidation of All Majority- Owned Subsidiaries. Statement of Financial Accounting Standard No. 94. para. 6, 9, and 10. Norwalk, Connecticut.

Financial Accounting Standards Board. 1996. Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities. Statement of Financial Accounting Standard No. 125. Norwalk, Connecticut.

Financial Accounting Standards Board. 2000. Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities. Statement of Financial Accounting Standard No. 140. Norwalk, Connecticut.

Financial Accounting Standards Board. 2001. Accounting for the Impairment or Disposal of Long-lived Assets. Statement of Financial Accounting Standard No. 144. Appendix C:2a. Norwalk, Connecticut.

Financial Accounting Standards Board. 2003. Consolidation of Variable Interest Entities, an Interpretation of ARB 51. Staff Position Financial Interpretation No. 46R. Norwalk, Connecticut.

Case: Which Firm Would You Invest In First?

The real estate subsidiary of a Fortune 10 firm was started in 1978 with $250 million of unexpected profits from the sale of a closed oil refinery in the Far East. The operating guidelines given to the real estate subsidiary was that it had a $250 million line of credit to develop residential and commercial real estate projects throughout the United States. The real estate subsidiary was to limit the parent companys total risk exposure to $250 million. In 1981, the real estate subsidiary commenced buying large parcels of undeveloped land and undertook the planning, engineering and zoning activities necessary to sell finished parcels of land to home builders. Some of the projects were expected to take 20 years or more before final sellout. During the period between 1981 and 1988, the real estate subsidiary had net annual cash flows ranging from a low of $0 to a high of $300 million; during this same period, income ranged from a low of $0 to a high of $90 million, depending on the timing of project startup and sellout. The parent company, a manufacturing firm, was not concerned about these uneven subsidiary income effects on parent income because the parent deemed the real estate subsidiary to be nonhomogeneous. Using ARB 51s nonhomogeneous provision, the assets and liabilities of the real estate subsidiary were off-balance sheet and only the real estate subsidiarys income was included in parents reported income. The parent firms balance sheet also excluded its retail and financing subsidiaries assets and liabilities by using the same nonhomogeneous reasoning. The parent firms income typically was $1 to $2 billion during this period, therefore, the real estate subsidiarys immaterial incomes were not commented upon in the annual report.

In 1987, FASB issued SFAS 94, requiring the consolidation of all subsidiaries and eliminating the nonhomogeneous provision. SFAS 94 left the requirement for consolidation at more than 50% ownership or voting control. At that same time, the parent firm started emphasizing return on capital employed (ROCE) as the primary performance metric for comparison of their results with other manufacturing firms in the same industry. ROCE was defined as before-tax operating income divided by debt plus equity. The parent advised all the previously unconsolidated subsidiaries of the ROCE focus and expected that all subsidiaries be similarly focused. Since SFAS 94 required consolidation of the assets and liabilities of the real estate subsidiary, the parent firm started pressuring the real estate subsidiary for more consistent results. Consolidating the real estate subsidiary into the parent firms $46 billion in assets increased the parents reported assets and liabilities by about $500 million. For a real estate entity with long-term projects, annual ROCE is a less meaningful performance metric. In long-term real estate operations, performance is measured by cash flow, net present value, payback and internal rate of return metrics. Common reported metrics for these firms are earnings before interest, taxes, depreciation and amortization (EBITDA) and net operating profit adjusted for cash tax.

The consolidation dilemma of the real estate division

In early 1990, the CFO of the real estate subsidiary received a phone call from the subsidiary president. The subsidiary president stated that he had a meeting with a developer who had assembled an 8,000 acre parcel of land in southwest Arizona to build a high-end, exclusive, gated golf course community. The developer had all the necessary zoning permits to develop the property but was running out of money and could not get additional financing. The developer had completed one of five planned golf courses, nearly finished a $40 million clubhouse, and had sold several $1 million lots to home builders. The developer indicated that a third party appraisal indicated that the remaining unsold project had a gross market value of $300 million, offset by $280 million of current bank loans on the property, leaving a net market value of $20 million. The developer knew that the subsidiary president was the chief operating officer of the real estate subsidiary of a larger manufacturing firm with $46 billion in assets. The developer proposed that the subsidiary president pay $10 million for a 50% interest in the project. The developers motivation was that he knew that banks would be willing to loan more funds once the real estate subsidiary was part owner of the project. The subsidiary president asked the CFO of the real estate subsidiary (1) if there was enough room in the capital budget to purchase the 50% interest for $10 million and, (2) what level of approval authority was required for such an acquisition.

The CFO replied that the parent Capital Budget Approval Level Authority Manual established by the parent firm, was based solely on how much an acquisition increased the asset section of the parents balance sheet; the amount of off-balance sheet financing and off-balance sheet assets were not factors in establishing the approval authority level. This asset only focus was understandable since the parents Treasurers department was separately given authority to manage the overall firm debt levels. The Treasurer department managed parent and subsidiary debt in accordance with overall corporate financing and tax planning strategies. The Treasurer department would review the $280 million bank loans on the real estate property and decide if the terms were optimal for the parent. With over $15 billion of parent debt, the additional $280 million in debt would not be a significant factor.

To respond to the subsidiary presidents question about the capital budget and approval level authority, the CFO advised the president that three accounting treatments were available, each of which would require different amounts of the capital budget and levels of approval authority. The three options are outlined in the following Table:

Which Firm Would You Invest In First?

You have inherited a large sum of money and you were advised that you can buy any one of the three firms below. The firms just completed their first year of operations. Which of the three firms would you be more likely to invest in?

Comparative Balance Sheets

($000) 12/31/XX

Company A Company B Company C

Assets

Cash 20,000 20,000 20,000

Investment 0 0 0

Plant, Property 300,000 150,000 10,000

Other 0 0 0

Total Assets 320,000 170,000 30,000

Liabilities

Current Liabilities 0 0 0

Long-term debt 280,000 140,000 0

Other 0 0 0

Total Liabilities 280,000 140,000 0

Shareholders Equity

Equity 10,000 10,000 10,000

Minority Interest 10,000 0 0

Retained Earnings 20,000 20,000 20,000

Total Equity 40,000 30,000 30,000

Liabilities and Equity 320,000 170,000 30,000

Comparative Income Statements

19XX

Company A Company B Company C

Revenues 80,000 40,000 -

Expenses (20,000) (10,000) -

Income from Investments 30,000

Gross Profits 60,000 30,000 30,000

Less: Minority Interest (30,000)

Admin/Taxes (10,000) (10,000) (10,000) Net Income 20,000 20,000 20,000

Under the first option (Firm A), the CFO advised the subsidiary president that if voting control was retained, even if he only owned 50% of the project, full consolidation accounting was required. The CFO pointed out that this option would result in the plant, and property assets (P&P) section increasing by $300 million and the liability section increasing by $280 million with a $10 million minority interest representing the outside partners interest in the acquisition. This increase of $300 million would require a $200 million capital budget transfer approval of the full Board of Directors of the parent firm since the real estate subsidiary only had a $100 million capital budget approved for the year.

For the second option (Firm B), the CFO advised that the partial consolidation method of accounting was appropriate if the subsidiary president only wanted to form a 50% joint venture with no voting control. The use of partial consolidation accounting is appropriate if there is no more than 50% ownership and no voting control according to ARB 51. The partial consolidation accounting option would result in the subsidiary recording its half of the assets, $150 million and its half of the debt, $140 million. The CFO stated that, since the P&P asset section of the balance sheet would increase by $150 million using partial consolidation accounting, the acquisition would require a budget transfer of $50 million ($150 million-$100 million already approved) and the approval of the CEO of the parent company. At the $50 million budget transfer level, parent full-board approval was not required.

For the third option (Firm C) using equity accounting, the CFO stated that careful drafting of the partnership agreement could result in the establishment of a separate legal entity to serve as a 50% equity partner in the new project as long as there was no voting control. The result of equity accounting on the parents balance sheet would be that the asset account (Investments), would increase by $10 million, reflecting the amount invested in the new company with the owners equity account increasing by $10 million. The CFO advised the subsidiary president that he had authority to approve the acquisition since the approval level was $10 million and would not require a budget transfer.

After consideration of all three options, the subsidiary president decided to opt for equity accounting due to the lower approval authority and the pressure coming from the parent company related to producing steadier earnings for ROCE reporting. Since the total real estate subsidiarys other assets, (about $500 million) were newly consolidated on the parents books due to SFAS 94 the previous year, the subsidiary president was hesitant to add another $300 million for this acquisition by implementing the full consolidation option.

During the final negotiations with the developer, the subsidiary president informed the CFO that he was concerned that the developer did not have the same borrowing capacity but had the same voting power. The CFO pointed out that SFAS 94 had a temporary control provision that allowed an unspecified temporary period of control without requiring full-consolidation (Para 2.) The CFO, in consultation with a senior member of the public audit firm, agreed that a five year temporary control period was not an unreasonable temporary period since the total project would take about 15-20 years to complete. [In 2001, FASB eliminated the temporary control provision of SFAS 94 with the issuance of SFAS 144 (para. 2), Accounting for the Impairment or Disposal of Long-Lived Assets].

Prior to finalizing the acquisition, the parents Treasurers department reviewed the $280 million acquisition of debt and determined that concurrent with the acquisition, the old debt would be replaced with new lower cost nonrecourse debt. The nonrecourse debt feature limits the risk to the assets by isolating the risk to the acquisition, much the same as firms used the SPE vehicle to accomplish. However, the nonrecourse debt feature had two strategic tax benefits to the parent firm.

The first tax strategy involved IRS regulation 1.861-9T, requiring that parent corporate-wide interest expense be pooled and allocated to foreign and domestic income according to the ratio of foreign assets and domestic assets to total assets. Since the parent company was in a tax position where they could not use anymore current foreign tax deductions, they benefited from any interest expense that could be sourced to domestic income for current-year deductibility. IRS regulation 1.861.10T(b)1 allowed nonrecourse interest to be sourced to the location where the income was earned. Deducting the subsidiarys nonrecourse interest expense from domestic consolidated income reduced consolidated current domestic taxes paid. The subsidiary CFO felt that the equity accounting, off-balance sheet treatment helped support the nonrecourse tax treatment since off-balance sheet liabilities imply no direct liability.

The second tax benefit was related to the deduction of early-stage operating loss write-offs. It is often the case that long-term projects lose money for tax purposes at start up. The current tax deductibility of these losses is usually limited to the basis in the investment, $10 million in this case. However, a special provision of the at risk rules of IRS code 465(b)(6) allows the firm to write off the basis plus the firms share of nonrecourse financing ($140 million), meaning that the parent firm could currently deduct up to $150 of these early stage losses on the consolidated tax return. In this case, the tax losses occur because under IRS regulation 1.263A-12 (c), 2, Real Property, interest paid can be currently expensed until physical construction began on the individual parcels. The CFO and tax planners had reasoned that by separating the acquisition by parcels, physical construction would be limited to those parcels that would be developed during the next immediate year. Therefore, interest associated with the parcels not under development in the current year would be tax deductible for the parents consolidated tax return.

Unlike tax reporting however, for financial reporting, in accordance with SFAS 34, Capitalization of Interest, interest expense is required to be capitalized from the time of purchase (para. 6). The capitalization of interest for financial reporting required the parent to defer the recognition of interest expense for financial reporting during the startup period. This requirement for capitalization of interest for financial reporting (SFAS 34) helped the real estate subsidiary to respond to the ROCE focus of the parent firm by minimizing financially reported losses in the early stage of development of the acquisition. After the tax strategies were developed, a wholly owned unconsolidated equity subsidiary (Firm C) was formed as a 50% equity partner with the developer along with the operating agreement giving temporary voting control to the president for the first 5 years of development.

In summary, Table 1 demonstrates the three alternatives financial accounting methods available to the real estate subsidiary for recording the same acquisition. Firm A shows the acquisition if accounted for under full consolidation, Firm B shows the acquisition if accounted for under partial consolidation, and Firm C shows the acquisition if accounted for under equity accounting. None of the financial accounting methods have any economic advantage to the parent company nor the real estate subsidiary since cash flows, including taxes, are unaffected by the financial accounting method chosen. However, for financial reporting and due to ROCE pressures, equity accounting was clearly the best option for the real estate subsidiary. The equity accounting disclosure rules required by SFAS 94 would have little effect on the parent company results since it had $46 billion in assets and the new real estate acquisition recorded at $10 million would be less than 1% of parent firm assets. In addition, the parent firm was already reporting $7 billion in gross equity firm ventures with the parent firms share being $2 billion.

Firms using SPE off-balance sheet and off-balance sheet equity accounting methods must believe these accounting methods give them an advantage because they possess asymmetric information. There is ample evidence that industry favors off-balance sheet accounting wherever possible as evidenced by leasing equipment rather than buying prior to SFAS 13, use of the nonhomogeneous provision of ARB 51 to avoid consolidating some domestic and all foreign operations prior to SFAS 94, and the use of SPEs prior to the issuance of Fin 46R.

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