SEC Report on Off-Balance Sheet Arrangements

By: Cydney Posner

The SEC has now posted its last (I think) SOX-mandated staff report, this one on off-balance sheet arrangements, special purpose entities and related issues. The report addresses two primary questions: (1) the extent of off-balance sheet arrangements, including the use of special purpose entities, and (2) whether current financial statements of issuers transparently reflect the economics of off-balance sheet arrangements. The staff report describes the study, its findings and recommendations and includes an analysis of the filings of issuers as well as an analysis of GAAP and SEC disclosure rules. .

In the study, the Staff broadly defines the term "off-balance sheet" to include investments in the equity of other entities, transfers of financial assets (where there is continuing involvement), certain retirement arrangements, leases, contingent obligations and guarantees, derivatives and other contractual obligations—with an emphasis on the use of special purpose entities where relevant. The study used a "stratified" sampling approach, consisting of the 100 largest issuers (in terms of market cap) and 100 additional issuers, randomly selected. The Staff concludes that significant progress has been made in several areas since the passage of SOX, such as the adoption of FAS 45 (guarantees) and FAS 46 (consolidation of variable interest entities), but that there remains "room for improvement" in the financial reporting of several types of arrangements with off-balance sheet implications. The Staff also believes that reducing the complexity of the financial reporting requirements should increase transparency and understanding.

There are several recommended initiatives to improve transparency in reporting as follows:

• Discourage transactions and transaction structures primarily motivated by accounting and reporting concerns, rather than economics. The Staff believes that transactions should be structured to conform to the economic substance of the arrangements; accounting-motivated structuring can result in transactions that are essentially illusory and reduce transparency in financial reporting.
• Expand the use of objectives-oriented standards, sometimes referred to as "principles-based accounting." The Staff believes that these standards would reduce complexity in accounting. In addition, Principles-based accounting would reduce the risks inherent in accounting standards that rely to a significant extent on rules and bright lines and can be engineered to achieve technical compliance while evading the intent of the standard. (This may take some adjustment--they seem to be forgetting how much trouble the accountants are having with the principles-based auditing standard for internal controls, AS 2.)
• Improve the consistency and relevance of disclosures that supplement the basic financial statements. The Staff believes that issuer disclosures regarding financial instruments could be more informative.
• Improve communication focus in financial reporting. The Staff believes that issuers need to focus on clear and transparent communication with investors in preparing financial statements and avoid narrow interpretations and mere technical compliance with financial reporting requirements: "Moreover, such a mindset puts the burden on regulators and standard-setters to drive all improvements in reporting."

In addition, the report includes several recommendations for regulators engaged in standard-setting:

• Continue consolidation guidance. FASB should continue its work on the accounting guidance that determines whether an issuer would consolidate other entities: the guidance continues to be complex and decisions regarding consolidation greatly affect which items are on the balance sheet. ,
• Reconsider accounting guidance for defined-benefit pension plans and other post-retirement benefit plans. Under current accounting guidance, these plans, which may be analogous to SPEs, are typically exempt from consolidation by their sponsors. As a result, assets and liabilities are netted out on the balance sheet, and issuers may delay recognition of certain gains and losses related to the retirement obligations and the assets used to fund these obligations. The study found that, by extrapolation from the sample to all active U.S. issuers, there may be approximately $535 billion in retirement obligations that are not recognized on issuer balance sheets.
• Reconsider the accounting guidance for leases. Current lease accounting provides an example of the problems with the "bright line" approach where issuers construct transactions that "approach, but do not cross" the line that would require recognition. The Staff recognizes, however, that this project would not be simple. Extrapolating again to active U.S. issuers, the study suggests that there may be approximately $1.25 trillion in non-cancelable future cash obligations committed under operating leases that are not recognized on issuer balance sheets and disclosed only in the notes to the financial statements.
• Explore feasibility of reporting all financial instruments at fair value. The Staff believes that an effort should be made to overcome the obstacles to adoption of fair-value accounting treatment for assets and obligations (sometimes referred to as "marking to market.") Fair value accounting, in the Staff's view, would reduce complexity, enhance understanding and reduce motivation to structure transactions so as to achieve certain accounting treatments. However, there may be issues with respect to the potential for manipulation and the degree of difficulty in auditing some fair values.
• Improve disclosure requirements. The Staff believes that more useful and consistent disclosure requirements could be achieved if a framework were developed that clearly and concisely set forth the objectives and limitations of the notes to the financial statements. In addition, the Staff hopes to work with the FASB, users, preparers and others to improve disclosures for financial instruments, so that information is organized, streamlined and provides adequate specificity and detail, without overburdening preparers and auditors.

Although there has been significant progress, the Staff would like to see more transparency of financial reporting related to the balance sheet. The Staff believes that investors—and the market as a whole—are best served by financial information that is transparent and that investors are better served by seeing the volatility accompanies by appropriate explanations. The Staff believes that standard setters should "focus on balance sheet measures and...consider transparent ways in which to address concerns about showing volatility in the income statement."