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SEC Staff Issues Report on Off-Balance Sheet Transactions

An SEC staff report calls for the review of the accounting guidance for leases and for defined-benefit pension plans as part of the overall transparency of off-balance sheet transactions in financial reporting. The report, which was mandated by the Sarbanes-Oxley Act, also recommends exploring the feasibility of reporting all financial instruments at fair value.

Section 401(c) of the Sarbanes-Oxley Act required the report one year after the adoption of rules on off-balance sheet disclosures. As required by the statute, the report covers the extent of, and accounting for, off-balance sheet transactions. These transactions include the use of special purpose entities, now referred to as variable interest entities. Such entities were often allegedly used by Enron to move assets and liabilities off the balance sheets.

The staff believes that more time is needed to fully evaluate the effects of the Financial Accounting Standards Board's post-Enron interpretative guidance on special purpose entities. FASB Interpretation No. 46(R) requires consolidation of a variable interest entity by a party that has a majority of the risks and rewards associated with the entity. It also establishes a methodology for determining which party associated with the special entity should be responsible for the consolidation. While conceding that Interpretation No. 46(R) is an improvement over previous guidance, the staff said that many interpretive questions remain. The staff also said that many users of Interpretation No. 46(R) find it theoretically and practically challenging to apply.

In addition, the staff noted that Interpretation No. 46(R) has resulted in the consolidation of a number of non-special purpose entity-type organizations, such as joint ventures and jointly-owned limited liability companies. However, it is unclear whether the FASB interpretation has significantly increased the number of these entities that are being consolidated.

A broad principle enunciated by the staff report is that business transactions should be driven by an economic purpose and should not be motivated primarily by accounting and reporting goals. The staff urged the use of objectives-oriented standards designed to reduce complexity in accounting. In addition, consistent with the purpose of the Sarbanes-Oxley Act, the staff cautioned companies not to regard technical compliance with accounting requirements as satisfactory. Instead, if companies focus on transparent communication with investors in preparing financial statements, both accounting and disclosure will improve.

The "accounting-motivated" structured transactions that the staff discourages are those structured in an attempt to achieve reporting results that are not consistent with the economics of the transaction. These transactions impair the transparency of financial reports. They include transactions that would not have been undertaken but for the perceived benefits of the resultant financial reporting, and also include those that adopt a more complex form than would otherwise be the case in order to achieve an accounting result.

For example, a company might contemplate a secured borrowing transaction because it needs capital, a true business purpose. However, if that company transfers the assets to a special purpose entity, which then borrows the funds and transfers them to the company in a transaction that keeps the debt off the balance sheet while exposing the company to virtually the identical risks and rewards as if it had simply secured the borrowing, the staff would consider the transaction to be accounting-motivated. Such transactions reduce transparency in financial reporting, the staff said. Companies and auditors that implement transactions that are structured to portray them differently from their substance do not operate in the interests of investors and may be in violation of the securities laws.

While current accounting rules require that derivatives be recorded as assets or liabilities on the balance sheets at fair value, the staff noted that derivatives are often an integral part of off-balance sheet arrangements. Although the accounting for derivatives attempts to appropriately reflect the economics of hedged transactions, a company engaged in derivatives transactions is economically different from one that is not. The staff emphasized the importance of communicating the economic risks involved. Although fair value may reflect an important aspect of the economics of the derivative at a point in time, the staff said it does not provide the user of the financial statements with the information necessary to understand what may happen to the derivative in the future should conditions change.

Despite the disclosures required by the accounting standards and the Commission's rules, there is often a perceived lack of transparency as to an issuer's market risk exposures, use of derivatives and the potential impact of those derivatives. The staff believes that many companies could do a better job in the notes to the financial statements and management's discussion and analysis in providing disclosures on market risk exposures, hedge strategies and the results of those strategies.