of the Sarbanes-Oxley Act of 2002 On Arrangements with
summary
The SEC Staff found that U.S. issuers concealed $1.25 trillion in operating leases and $535 billion in retirement liabilities off-balance-sheet due to accounting rules favoring form over substance, a problem epitomized by Enron’s $25B fraud, prompting reforms like FIN 46(R) but leaving persistent transparency gaps in leases, pensions, and derivatives.
paragraph
The SEC Staff’s study under Sarbanes-Oxley Section 401(c) revealed $1.25 trillion in operating lease obligations and $535 billion in unrecognized retirement liabilities disclosed only in footnotes, not on balance sheets, exposing systemic transparency failures rooted in accounting standards that prioritized technical compliance over economic substance. These gaps were magnified by Enron’s use of special-purpose entities to hide $25 billion in debt, leading to reforms such as FASB Interpretation No. 46(R) for consolidating variable interest entities and enhanced disclosure rules under SEC Release No. 33-8182 and Regulation S-K. Despite these improvements, significant off-balance-sheet risks remain in leases, pensions, guarantees, and derivatives due to complex, manipulable standards and inconsistent disclosures.
narrative
The U.S. Securities and Exchange Commission’s Staff, pursuant to Section 401(c) of the Sarbanes-Oxley Act, conducted a study of 200 issuers and uncovered massive off-balance-sheet exposures—$1.25 trillion in operating lease obligations and $535 billion in unrecognized retirement liabilities—hidden due to accounting rules that emphasized form over economic substance. This systemic opacity was starkly illustrated by Enron’s fraudulent use of special-purpose entities to conceal $25 billion in debt, which catalyzed regulatory scrutiny and reform. In response, the FASB issued Interpretation No. 46(R) to consolidate variable interest entities based on risk and reward rather than voting control, while the SEC mandated enhanced disclosures under Regulation S-K and Release No. 33-8182, and introduced SFAS No. 133 and No. 150 to improve derivative and equity/liability classification. However, significant gaps persist in accounting for leases, defined-benefit pensions, guarantees, and securitizations, where complex, rules-based standards continue to enable manipulation and obscure true financial risk. Investor understanding remains hindered by inconsistent, opaque disclosures that fail to convey the full scope of contractual obligations. The Staff urged the FASB and IASB to adopt principles-based, objectives-oriented standards, including fair value measurement for all financial instruments and cash flow-based lease accounting, to eliminate accounting-motivated structuring and restore transparency. Further recommendations included developing a unified disclosure framework to improve communication focus and ensure financial reporting reflects economic reality rather than technical loopholes.
Classified accounting-fraud(confidence 80%). EDGAR detection: forms 10-K/10-Q/8-K/NT 10-K· recall 80% / precision 48%. detection rule →
Statutes
15 U.S.C. 77g15 U.S.C. 78c(b)15 U.S.C. 79e(b)15 U.S.C. 80a-817 CFR 210.1-02(w)section 13 or 15 of the Securities Exchange Actsection 13 or 15 of the Securities Exchange Actsections 7, 19(a) and Schedule A, items (25) and (26) of the Securities Actsections 7, 19(a) and Schedule A, items (25) and (26) of the Securities Actsections 7, 19(a) and Schedule A, items (25) and (26) of the Securities Actsections 7, 19(a) and Schedule A, items (25) and (26) of the Securities Actsections 3(b), 12(b) and 13(b) of the Securities Exchange Actsections 3(b), 12(b) and 13(b) of the Securities Exchange Actsections 3(b), 12(b) and 13(b) of the Securities Exchange Actsections 8, 30(e), 31 and 38(a) of the Investment Company Actsections 8, 30(e), 31 and 38(a) of the Investment Company Actsections 8, 30(e), 31 and 38(a) of the Investment Company Actsections 8, 30(e), 31 and 38(a) of the Investment Company ActSections 12(b) and 12(g) of the Securities ActSections 12(b) and 12(g) of the Securities ActRule 3-09
Parties
staff of the u.s. securities and exchange commissionUnited States Securities And Exchange Commission
Keywords
financialaccountingfinancial reportingsheetoff-balance sheetfinancial statementsreportingbalance sheetwhichreportstaffarrangementsstandardsissuersoff-balance
Extracted insights
Dollar amounts 50
- $15000.00B $15 trillion ≥$1B
- $12400.00B $12.4 trillion ≥$1B
- $7750.00B $7.75 trillion ≥$1B
- $535.00B $535 billion ≥$1B
- $186.00B $186 billion ≥$1B
- $133.00B $133 billion ≥$1B
- $60.00B $60 billion ≥$1B
- $38.00B $38 billion ≥$1B
- $25.00B $25 billion ≥$1B
- $22.10B $22.1 billion ≥$1B
- $14.00B $14 billion ≥$1B
- $13.00B $13 billion ≥$1B
Entities 2
- agency staff of the u.s. securities and exchange commission
- agency United States Securities And Exchange Commission
Triples 5
- Office of the Chief Accountant Submitted Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers
- Office of Economic Analysis Submitted Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers
- Division of Corporation Finance Submitted Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers
- United States Securities and Exchange Commission Submitted Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers
- Staff of the U.S. Securities and Exchange Commission Produced Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers
Text layers
Extracted body text (402,945c)
Report and Recommendations Pursuant to Section 401(c)
of the Sarbanes-Oxley Act of 2002 On Arrangements with
Off-Balance Sheet Implications, Special Purpose Entities,
and Transparency of Filings by Issuers
Submitted to the President of the United States, the Committee on
Banking, Housing, and Urban Affairs of the United States Senate and
the Committee on Financial Services of the United States House of
Representatives
OFFICE OF THE CHIEF ACCOUNTANT
O
FFICE OF ECONOMIC ANALYSIS
D
IVISION OF CORPORATION FINANCE
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
This is a report by the Staff of the U.S. Securities and Exchange Commission. The
Commission has expressed no view regarding the analysis, findings, or conclusions
contained herein.
TABLE OF CONTENTS
ABBREVIATIONS iii
EXECUTIVE SUMMARY 1
I Introduction 6
A. How the Study and Report Fulfill the Statutory Mandate 6
1. The Statutory Mandate 6
2. The Structure of this Report 8
B. The Financial Reporting Framework 10
1. The Balance Sheet 11
2. Other Basic Financial Statements 12
3. Notes to the Financial Statements, MD&A and Other Disclosures 14
C. Historical Context of the Study and Report 15
1. Enron 15
2. Standard Setting Environment 19
3. Accounting Motivated Transaction Structuring 22
4. Improvements in the Financial Reporting Regime Since the Passage of the
Sarbanes-Oxley Act 23
II Study Methodology 27
III Arrangements with Potential Off-Balance Sheet Implications 32
A. Investments in the Equity of Other Entities 32
1. Nature of Arrangements and Financial Reporting Requirements 32
2. Off-Balance Sheet Issues in Accounting for Investments 36
3. Empirical Findings from Study of Filings by Issuers 38
B. Transfers of Financial Assets With Continuing Involvement 40
1. Nature of Arrangements and Financial Reporting Requirements 40
2. Off-Balance Sheet Issues in Accounting for Transfers of Financial Assets 44
3. Empirical Findings from Study of Filings by Issuers 46
C. Retirement Arrangements 49
1. Nature of Arrangements and Financial Reporting Requirements 49
2. Off-Balance Sheet Issues in Accounting for Retirement Arrangements 52
3. Empirical Findings from Study of Filings by Issuers 53
D. Leases 60
1. Nature of Arrangements and Financial Reporting Requirements 60
2.
Off-Balance Sheet Issues in Accounting for Leases 62
3. Empirical Findings from Study of Filings by Issuers 63
E. Contingent Obligations and Guarantees 65
1. Nature of Arrangements and Financial Reporting Requirements 65
i
2. Off-Balance Sheet Issues in Accounting for Contingent Obligations and
Guarantees 68
3. Empirical Findings from Study of Filings by Issuers 69
F. Derivatives 72
1. Nature of Arrangements and Financial Reporting Requirements 72
2. Off-Balance Sheet Issues in Accounting for Derivatives 78
3. Empirical Findings from Study of Filings by Issuers 80
G. Other Contractual Obligations 86
1. Nature of Arrangements and Financial Reporting Requirements 86
2. Off-Balance Sheet Issues in Accounting for Contractual Obligations 88
3. Empirical Findings from Study of Filings by Issuers 89
IV Empirical Findings on Certain Post-Sarbanes-Oxley Improvements in Financial
Reporting On Off-Balance Sheet Arrangements 91
A. Consolidation of Variable Interest Entities 91
1. Discussion 91
2. Empirical Findings from Study of Filings by Issuers 92
B. Disclosure in Management's Discussion and Analysis about Off-Balance
Sheet Arrangements and Aggregate Contractual Obligations 96
1. Discussion 96
2. Empirical Findings from Study of Filings by Issuers 97
V Initiatives to Improve Financial Reporting Transparency 98
A. Eliminate (or at least Reduce) Accounting Motivated Transactions 99
B. Continue Implementation of Objectives-Oriented Approach to Standard
Setting 101
C. Improve the Consistency and Relevance of Disclosures 103
D. Improve Communication Focus in Financial Reporting 103
VI Recommendations Related to Accounting Standards 105
A. Standards on Accounting for Leases 105
B. Standards on Accounting for Defined-Benefit Retirement Arrangements 107
C. Continue Work on Consolidation Policy 109
D. Continue to Explore the Feasibility of Reporting All Financial Instruments at
Fair Value 110
E.
Develop a Disclosure Framework 113
ii
ABBREVIATIONS
ABO Accumulated Benefit Obligation
APBO Accumulated Postretirement Benefit Obligations
Act The Sarbanes Oxley Act of 2002
AICPA American Institute of Certified Public Accountants
AIMR Association for Investment Management and Research (currently
known as the Certified Financial Analyst Institute)
APB Accounting Principles Board
ARB Accounting Research Bulletin
Board Financial Accounting Standards Board
CFA Institute Certified Financial Analyst Institute (formerly known as the
Association for Investment Management and Research)
Commission United States Securities and Exchange Commission
DIG Derivatives Implementation Group
EDGAR Electronic Data Gathering, Analysis, and Retrieval system
EITF Emerging Issues Task Force
ERISA Employee Retirement Income Security Act of 1974
FASB Financial Accounting Standards Board
FR Final Reporting Release
Interpretation No. FASB Interpretation Number
GAAP Generally Accepted Accounting Principles
GSE Government Sponsored Enterprise
IASB International Accounting Standards Board
IOSCO International Organization of Securities Commissions
LIBOR London Inter-bank Offering Rate
MD&A Management’s Discussion and Analysis of Financial Position and
Results of Operations
OBS Off-Balance Sheet
OPEB Other Post-Employment Benefits
PBO Projected Benefit Obligation
QSPE Qualifying Special Purpose Entity
SAB Staff Accounting Bulletin
Sarbanes Oxley Act The Sarbanes Oxley Act of 2002
SEC United States Securities and Exchange Commission
SFAC Statement of Financial Accounting Concepts
SFAS Statement of Financial Accounting Standards
SOP Statement of Position
SPE Special Purpose Entity
Staff Staff of the United States Securities and Exchange Commission
VaR Value at Risk
VIE Variable Interest Entity
iii
Report and Recommendations Pursuant to Section 401(c)
of the Sarbanes-Oxley Act of 2002 On Arrangements with
Off-Balance Sheet Implications, Special Purpose Entities,
and Transparency of Filings by Issuers
EXECUTIVE SUMMARY
In 2001 and 2002, a spate of major corporate accounting scandals came to light
that exposed weaknesses in corporate governance, audit practices, and financial
reporting. Congress responded by passing the Sarbanes-Oxley Act of 2002 (the
“Sarbanes-Oxley Act” or “Act”),
1
the most significant piece of securities legislation since
the 1930s. Among the many provisions of the Act, Section 401(c) mandates that the
Securities and Exchange Commission (“SEC” or “Commission”) conduct a study of
filings by issuers (the “Study”) and issue a report (the “Report”) that addresses two
primary questions: (1) the extent of off-balance sheet (“OBS”)
arrangements, including
the use of special purpose entities (“SPEs”), and (2) whether current financial statements
of issuers transparently reflect the economics of off-balance sheet arrangements. To
answer these questions, the staff of the Commission (the “Staff”) conducted an empirical
analysis of the filings of issuers as well as a qualitative analysis of pertinent U.S.
Generally Accepted Accounting Principles (“GAAP”) and Commission disclosure rules.
The mandate also asks for recommendations, if any. In this Report, which is intended to
fulfill the statutory mandate, the Staff describes the Study, reports its findings and
provides recommendations.
For purposes of the Study and Report, the Staff takes a relatively expansive
approach to the scope and meaning of the term “off-balance sheet.” The Staff examines a
variety of business arrangements that may be viewed as having off-balance sheet
implications and that are deemed important from a policy perspective. The arrangements
examined in the Study 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
Staff broadly concludes that significant progress has been made in several areas since the
passage of the Act, 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.
The Study was performed by analyzing data collected from the filings of a sample
of 200 issuers, including the notes to the financial statements, and Management’s
1
The Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 2002.
1
Discussion and Analysis of Financial Position and Results of Operations (“MD&A”).
2
The Staff determined that a sample size of 200 was sufficient to construct a representative
sample of the population of active U.S. issuers.
3
Given the possibility that the use of
arrangements with off-balance sheet implications, as well as special purpose entities,
might be disproportionately concentrated in the very largest issuers, a “stratified”
sampling approach was adopted such that the sample would consist of the 100 largest
issuers (in terms of market capitalization)
4
and 100 additional issuers, randomly
selected.
5
The Staff reports findings on the extent to which issuers report the existence of
certain business arrangements with off-balance sheet implications, how such
arrangements are presented on issuer balance sheets, and the transparency of the
supporting disclosures in the financial reports. The empirical findings and estimates are
limited by what is actually reported and/or disclosed in issuers’ financial reports. The
Staff was not in a position to address whether and to what extent there may be other
arrangements that are not reflected in the financial reports. The empirical portion of the
Study is largely descriptive in nature.
In addition to the empirical work, the Report is also informed by the Staff’s
experience in reviewing periodic financial statements filed with the Commission, which
provides it with information about the application of accounting and disclosure standards.
In particular, the qualitative analysis of the content and application of pertinent
accounting standards relies in part on the collective experience of the Staff. Further, the
Report is informed by the Staff’s experience in dealing with standard setters and
international regulators that are grappling with comparable issues. For example, both the
Financial Accounting Standards Board (“FASB”) and the International Accounting
Standards Board (“IASB”) have dealt with (and continue to consider) the accounting for
each of the topics addressed in this Report, and the Technical Committee of the
International Organization of Securities Commissions (“IOSCO”) has recently released
its
Report on Strengthening Capital Markets Against Financial Fraud, which, among
other things, discusses whether additional disclosures related to the use of SPEs are
warranted.
In excess of 100 Staff members directly contributed to the Study and Report
through participation in project planning, methodology design, data collection and
analysis, research, critical analyses of standards and rules, and the drafting, editing, and
review of the Report. Primarily, this included Staff from the Office of the Chief
Accountant, the Office of Economic Analysis and the Division of Corporation Finance.
2
Management’s Discussion and Analysis of Financial Condition and Results of Operations is required by
Item 303 of Regulation S-K, Items 303(a), (b) and (c) of Regulation S-B, Item 5 of Form 20-F and
Paragraphs 11 and 12 of General Instruction B of Form 40F.
3
In statistical terms, the sample size is sufficient to test for a 20% difference from the sample mean at 95%
significance and with 90% power.
4
This is with certain exceptions, as explained below.
5
See Section II for more details on the sample selection methodology.
2
In many cases, when considering the appropriateness of accounting for various
transactions, the focus is on the standards themselves and recommendations tend to focus
on what changes the FASB, as the accounting standard-setter in the U.S., should
consider. However, the Staff believes that to focus only on the FASB activities is too
narrow, as the FASB is only one part of the financial reporting framework. Thus, in
formulating its recommendations, the Staff considered potential improvements that could
be made to improve transparency by various participants in the financial reporting
process.
The Staff identified several key initiatives to improve transparency in reporting,
as follows:
i.
Discourage transactions and transaction structures primarily motivated by
accounting and reporting concerns, rather than economics. The Staff believes
that use of transaction structuring to achieve accounting and reporting goals that
do not conform to the economic substance of the arrangements reduces
transparency in financial reporting. As discussed below, many of the areas
dealing with off-balance sheet arrangements involve significant use of
accounting-motivated structured transactions.
ii.
Expand the use of objectives-oriented standards, which would have the
desirable effect of reducing complexity in accounting standards. The Staff’s
previous report on objectives-oriented standards
6
described many of the benefits
of such standards, as well as the risks inherent in accounting standards that rely
to a significant extent on rules and bright lines. The Staff continues to support
the recommendations in its prior study.
iii.
Improve the consistency and relevance of disclosures that supplement the basic
financial statements. In many cases, the Staff does not believe issuer
disclosures are as informative as they could be. Nowhere is this clearer than in
regards to financial instruments disclosures. While new standards might help in
this area, substantial progress can be made through attention of issuers in
improving disclosures under existing standards.
iv.
Improve communication focus in financial reporting. The Staff believes that
many issuers interpret financial reporting narrowly, and regard technical
compliance with the requirements as satisfactory. However, if investors and
other users are misled or have insufficient information to understand the
activities of the issuer, such “compliance” does not serve the purpose of
financial disclosure. Moreover, such a mindset puts the burden on regulators
and standard-setters to drive all improvements in reporting. The Staff believes
that if issuers focus on clear and transparent communication with investors in
preparing financial statements, both accounting and disclosures will improve.
6
Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States
Financial Reporting System of a Principles-Based Accounting System (“
Objectives-Oriented Accounting
Standards Study”).
3
In addition, the Report includes several standard-setting recommendations that
would help further these initiatives.
a. The Staff recommends that the FASB continue its work on the accounting
guidance that determines whether an issuer would consolidate other entities.
While it may be too early to fully understand the effects of recent improvements
in consolidation guidance for SPEs, the consolidation guidance continues to be
complex and decisions regarding consolidation greatly affect which items are on
the balance sheet.
b. The Staff recommends the accounting guidance for defined-benefit pension
plans and other postretirement benefit plans be reconsidered. Under the current
accounting guidance (circa 1985), the trusts that administer these plans, which
are conceptually similar to SPEs, are exempt from consolidation by the issuers
that sponsor them, effectively resulting in the netting of assets and liabilities on
the balance sheet. In addition, issuers have the option to delay recognition of
certain gains and losses related to the retirement obligations and the assets used
to fund these obligations. An extrapolation of the findings from the sample of
issuers in the Study to the approximate population of active U.S. issuers
suggests that there may be approximately $535 billion in retirement obligations
that are not recognized on issuer balance sheets.
c. The Staff recommends that the accounting guidance for leases be reconsidered.
The current accounting for leases takes an “all or nothing” approach to
recognizing leases on the balance sheet. This results in a clustering of lease
arrangements such that their terms approach, but do not cross, the “bright lines”
in the accounting guidance that would require the lease to be recognized on the
balance sheet. An extrapolation of the findings from the sample of issuers in the
Study to the approximate population of active U.S. issuers 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, but are instead disclosed in the notes to the financial statements.
7
d. The Staff recommends the continued exploration of the feasibility of reporting
all financial instruments at fair value. Supporters of greater use of fair values on
the balance sheet argue that the most useful information is that which reflects
the current values of assets and obligations. Fair value accounting for all
financial instruments also would appear to have benefits in terms of reduced
complexity (for example, by eliminating the need for hedge accounting and its
attendant documentation and effectiveness testing requirements, in many
instances), more understandability, and less motivation to structure transactions
so as to achieve certain accounting treatments. Of course, some have expressed
significant concerns with requiring fair value accounting for all financial
instruments, such as the potential manipulability and degree of difficulty in
auditing some fair values. However, in light of the potential benefits, the Staff
7
This figure is not discounted to its present value, as would be the case if these cash flows were recognized
as a liability on issuer balance sheets.
4
believes that methods should be sought to eliminate the obstacles to this
treatment.
e. The Staff believes that, in general, disclosures in the filings of issuers need to be
better organized and integrated. 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.
While the Staff concludes in this Report that there remains room for improvement
in the transparency of financial reporting related to the balance sheet, it also wishes to
acknowledge that much has been accomplished since the passage of the Sarbanes-Oxley
Act in terms of improving the financial reporting of arrangements with off-balance sheet
implications.
8
This includes, among other things, additional guidance from the FASB—
for example, Interpretation No. 46(R),
Consolidation of Variable Interest Entities (revised
December 2003)—an interpretation of ARB No. 51—which is intended to address some
of the concerns with the failure of issuers to consolidate certain special purpose entities
under earlier guidance.
9
The FASB has also promulgated new guidance in several other
areas, including the accounting for guarantees in Interpretation No. 45 and distinguishing
liabilities from equity in SFAS No. 150. Further improvements come from regulatory
requirements promulgated by the Commission that an issuer explain its off-balance sheet
arrangements in a separately captioned subsection of its MD&A.
10
While not directly
related to the topics addressed in this Report, the Staff also notes the substantial
improvement in transparency that will result from the implementation of SFAS No. 123R
“Share-Based Payment”, which requires accounting for stock options based on their fair
values.
Underpinning this Report is the Staff’s focus on “full and fair disclosure.” The
Staff believes that investors—and the market as a whole—are best served by financial
information that is presented fully and clearly. For example, the Staff believes that
investors will benefit from an income statement that reflects changes in asset values so
long as the sources of those changes are disclosed, and the manner in which those values
are determined (
i.e., what measurement attribute is used and what assumptions underlie
the value) is understandable. What presents difficulties for investors, as well as the
market as a whole, is a
lack of information about potential positive and negative cash
flows. Thus, while some participants in the financial reporting process favor accounting
standards that enable the presentation of consistent or smooth income statement figures,
8
For a more complete list of improvements in financial reporting since the Act see Section I.C.4.
9
See Section IV infra. for discussion.
10
See Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and
Aggregate Contractual Obligations Release No. 33-8182 (January 28, 2003) (“FR-67”). This rule was
promulgated by the Commission in January 2003 in response to Section 401(a) of the Act.
5
the Staff believes that transparent balance sheets are very important and that investors are
better served by seeing any volatility that exists, along with explanations for why such
volatility exists. To that end, it seems desirable to the Staff for standard setters to focus
on balance sheet measures and to consider transparent ways in which to address concerns
about showing volatility in the income statement.
Finally, it is important that both regulation and standard setting keep pace with
business changes in the private sector, which are extremely fast paced. That being said,
the Staff appreciates the extraordinary resource demands that have been imposed on
preparers and auditors as a result of the Sarbanes-Oxley Act coupled with the various
other efforts at improving financial reporting, auditing, and standard setting that have
followed in its wake. Nonetheless, the Staff believes that the issues raised in this Report
should be addressed to improve the transparency of the balance sheet in particular and of
financial reporting in general.
I. Introduction
A. How the Study and Report Fulfill the Statutory Mandate
1. The Statutory Mandate
The mandate for this Report comes from the Sarbanes-Oxley Act of 2002, which
introduced a broad array of reforms to the U.S. financial reporting system.
11
The Act
called for increased oversight of auditors of public companies through the creation of the
Public Company Accounting Oversight Board.
12
It directed the Commission to establish
rules prohibiting auditors from providing certain non-audit services to audit clients
13
and
requiring management and auditor reporting on the effectiveness of public companies’
internal controls.
14
It increased penalties for violations of securities laws and required
certification of financial results by key corporate officers.
15
Through these and other
provisions, the Act called for improvement in the system of checks and balances that
govern the production of financial information provided to investors.
The Act also mandated that the Commission conduct a Study of off-balance sheet
transactions and the use of special-purpose entities. Specifically, Section 401(c)(1) of the
Act requires the Commission to: “complete a study of filings by issuers and their
disclosures to determine—
(A) the extent of off-balance sheet transactions, including assets, liabilities, leases,
losses, and the use of special purpose entities; and
11
See the Sarbanes-Oxley Act.
12
See sections 101-109 of the Act.
13
See section 201 of the Act.
14
See section 404 of the Act.
15
See sections 901 to 906 of the Act.
6
(B) whether generally accepted accounting rules result in financial statements of
issuers reflecting the economics of such off-balance sheet transactions to investors
in a transparent fashion.”
In addition, Section 401(c)(2) requires the Commission to: “submit a report to the
President, the Committee on Banking, Housing, and Urban Affairs of the Senate, and the
Committee on Financial Services of the House of Representatives, setting forth—
(A) the amount or an estimate of the amount of off-balance sheet transactions,
including assets, liabilities, leases, and losses of, and the use of special purpose
entities by, issuers filing periodic reports pursuant to section 13 or 15 of the
Securities Exchange Act of 1934;
(B) the extent to which special purpose entities are used to facilitate off-balance
sheet transactions;
(C) whether generally accepted accounting principles or the rules of the
Commission result in financial statements of issuers reflecting the economics of
such transactions to investors in a transparent fashion;
(D) whether generally accepted accounting principles specifically result in the
consolidation of special purpose entities sponsored by an issuer in cases in which
the issuer has the majority of the risks and rewards of the special purpose entity;
and
(E) any recommendations of the Commission for improving the transparency and
quality of reporting off-balance sheet transactions in the financial statements and
disclosures required to be filed by an issuer with the Commission.”
In order to fulfill the mandate and produce this Report, the Staff has characterized
the terms “off-balance sheet transaction,” “economics” of an arrangement, and
“transparency” of financial reporting. When used in other contexts, these terms may
have different definitions or meanings.
In recent times, following the accounting scandals exposed in 2001 and
subsequently, the term “off-balance sheet” has sometimes carried the connotation of
something underhanded, or at least less than fully transparent. The insinuation is that
something that should be on the balance sheet is not, and that the reporting issuer has
designed the transaction or arrangement to produce that result. However, questions about
whether items should be reflected on the balance sheet do not arise only when there is an
attempt to deceive financial statement users. Many legitimate transactions generate such
questions, and there are, of course, bounds as to what should be included on a balance
sheet. It is this broader, more-inclusive question of the proper bounds of what should be
included on the balance sheet that draws the Staff’s attention in this Report. The common
characteristic of the arrangements addressed in this Report is that they create or involve a
situation in which there may be a legal or economic nexus between the issuer and risks,
rewards, rights or obligations not reflected (or not fully-reflected) on the balance sheet.
Sections 401(c)(1)(B) and 401(c)(2)(C) both use the term “economics,” with the
latter section asking “whether generally accepted accounting principles or the rules of the
7
Commission result in financial statements of issuers reflecting the
economics of such
transactions to investors in a transparent fashion.”
16
For purposes of this Report, when
the Staff refers to the “economics” of an arrangement, the reference is meant to speak
generally to the risks, rewards, rights, and obligations associated with the arrangement,
rather than a formal categorization.
The words “transparent” or “transparency” appear in sections 401(c)(1)(B),
401(c)(2)(C) and 401(c)(2)(E), with the final subsection asking for “any
recommendations of the Commission for improving the
transparency and quality of
reporting off-balance sheet transactions in the financial statements and disclosures
required to be filed by an issuer with the Commission.”
17
The Staff believes transparency
can best be gauged in terms of the informational needs of investors, creditors and other
users of financial statements. For purposes of this Report, the Staff characterizes
“transparent” financial reporting as reporting that provides investors and other users of
financial statements with appropriate information to assess the material risks, rewards,
rights, and obligations associated with arrangements. The Staff notes that transparency is
not always improved with the provision of more information.
18
Thus, while some might
argue that the greatest transparency would come from putting all things on the balance
sheet, thereby eliminating “off-balance sheet” arrangements entirely, the Staff believes
that putting too many things on the balance sheet could result in less understanding of the
differences between the rights and obligations associated with each of the items reported.
2. The Structure of this Report
The Report is arranged topically, analyzing the accounting and reporting for
various types of arrangements in turn. This structure allows the Staff to provide the
requested information for various types of arrangements in an integrated manner that is
intended to facilitate understanding.
By way of background, the next sub-section presents a short primer summarizing
the financial reporting framework, including the basic accounting concepts necessary to
understand the issues discussed in the Report. Those who are familiar with the financial
reporting framework may skip this section of the Report with no loss of continuity. The
remainder of the introduction provides a discussion of the historical context of the Study
and Report, including, among other things, a discussion of certain arrangements
involving Enron.
16
Emphasis added.
17
Emphasis added.
18
For example, as noted in the December 29, 2003 Release No. 33-2950 Commission Guidance Regarding
Management's Discussion and Analysis of Financial Condition and Results of Operations:
MD&A must specifically focus on known material events and uncertainties that would cause
reported financial information not to be necessarily indicative of future operating performance or
of future financial condition. Companies must determine, based on their own particular facts and
circumstances, whether disclosure of a particular matter is required in MD&A. However, the
effectiveness of MD&A decreases with the accumulation of unnecessary detail or duplicative or
uninformative disclosure that obscures material information.
8
Section II of the Report—entitled “Study Methodology”—addresses
methodological issues including the construction of a stratified sample, the data
collection process, descriptive statistics on the sample and a description of the technique
for extrapolating to the population.
Section III of the Report—entitled “Arrangements with Potential Off-Balance
Sheet Implications”—addresses particular types of arrangements with potential off-
balance sheet implications. Section III covers investments in the equity of other entities,
transfers of financial assets with continuing involvement, retirement arrangements,
leases, contingent liabilities and guarantees, derivatives, and other contractual
obligations. Each of the sub-sections includes the following:
i.) A description of the transactions or reporting issues being addressed combined
with a discussion of the related accounting and financial reporting requirements;
ii.) A discussion of the potential off-balance sheet questions that arise from the
arrangements and a discussion of why standard setters have made the decisions
currently reflected in the accounting guidance; and
iii.) A presentation and discussion of the empirical data gathered from the Study of
filings by issuers to provide information regarding the percentage of issuers
reporting the arrangements discussed in the Report, and how these arrangements
are recognized on issuer balance sheets and in notes to the financial statements.
The discussions of each area are intended to be illustrative. The Staff focuses on
different ways that the arrangements in question could be analyzed in terms of what
assets or liabilities would be recorded. Sections 401(c)(1)(A), (2)(A) and (2)(B) of the
Act require a study of “the extent of” off-balance sheet transactions. Where the data were
obtainable, this portion of the mandate is answered in the subsections of Section III titled
“Empirical Findings from Study of Filings by Issuers.”
Sections 401(c)(1)(B) and (2)(C) of the Act require a study of whether generally
accepted accounting principles and the rules of the Commission result in financial
statements of issuers “reflecting the economics of such off-balance sheet transactions to
investors in a transparent fashion.” The Staff addresses this question for each of the
substantive accounting areas addressed in Section III in the subsections entitled “Off-
Balance Sheet Issues in Accounting for [...]”
Section IV addresses certain post-Sarbanes Oxley improvements to the financial
reporting regime as they relate to off-balance sheet arrangements. This section includes a
discussion of FASB Interpretation No. 46(R),
which was meant to achieve more
consistent application of consolidation policies for special purpose entities. Section
401(c)(2)(D) of the Act inquires as to “whether generally accepted accounting principles
specifically result in the consolidation of special purpose entities sponsored by an issuer
in cases in which the issuer has the majority of the risks and rewards of the special
purpose entity.” This can simply be answered in the affirmative in that Interpretation No.
46(R) essentially requires this.
19
However, as is discussed in Section IV, the
19
See Section IV for additional information on Interpretation No. 46(R).
9
determination of which party has “the majority of the risks and rewards of the special
purpose entity” may involve complex judgments in some circumstances.
Section 401(c)(2)(E) of the Act calls for recommendations, if any, for “improving
the transparency and quality of reporting off-balance sheet transactions” in financial
statements. Section V discusses several goals toward which all those involved in the
financial reporting community should work. The discussion explains the goal and its
benefits to financial reporting, and explains how various constituents in the capital
markets can help to achieve the goals. Section VI provides recommendations for changes
in accounting and reporting requirements that would further the initiatives discussed in
Section V. The recommendations in Sections V and VI do not, in all cases, follow only
from the analysis of the various types of transactions. That is, the Staff draws as well
from its own experiences in dealing with issuer financial statements on a daily basis.
B. The Financial Reporting Framework
The Commission has responsibilities under the securities laws to specify
acceptable standards for the preparation of financial statements.
20
However, the
Commission has for virtually its entire existence looked to the private sector for
assistance in this task. Currently, the body that the Commission looks to for the setting of
financial reporting standards is the FASB.
21
The FASB has promulgated accounting
standards in many areas, and has also created a conceptual framework for accounting and
financial reporting that it uses in setting accounting standards. This framework specifies
that the objective of financial reporting is to provide information useful to investors and
creditors in their decision-making processes.
22
Filings by issuers include four main financial statements: the balance sheet, the
income statement, the cash flow statement, and the statement of changes in equity.
23
Each financial statement provides different types of information, but they are interrelated
in that they “reflect different aspects of the same transactions or other events affecting an
entity,” as well as complementary in that “none is likely to serve only a single purpose or
provide all the financial statement information that is useful for a particular kind of
assessment or decision.”
24
A complete set of financial statements also includes notes,
which disclose quantitative and qualitative information not in the basic four financial
statements. Public filings may also be required to include additional information,
20
See, for example, sections 7, 19(a) and Schedule A, items (25) and (26) of the Securities Act of 1933, 15
U.S.C. 77g, 77s(a), 77aa(25) and (26); sections 3(b), 12(b) and 13(b) of the Securities Exchange Act of
1934, 15 U.S.C. 78c(b), 78l(b) and 78m(b); sections 5(b), 14, 15 and 20 of the Public Utility Holding
Company Act of 1935, 15 U.S.C. 79e(b), 79n, 79o and 79t; sections 8, 30(e), 31 and 38(a) of the
Investment Company Act of 1940, 15 U.S.C. 80a-8, 80a-29(e), 80a-30 and 80a-37(a).
21
See Release No. 33-8221 (April 25, 2003), Policy Statement: Reaffirming the Status of the FASB as a
Designated Private-Sector Standard Setter.
22
Statement of Financial Accounting Concept No. 1, Objectives of Financial Reporting by Business
Enterprises, November 1978, paragraph 32.
23
SFAC No. 5, paragraphs 39-41 and 55-57.
24
SFAC No. 5, paragraph 23, see also paragraph 24.
10
including information about the company’s business, the risk factors it faces, and a
discussion of its financial condition and results of operations.
1. The Balance Sheet
Given the topic of this Report, our main focus is on the balance sheet. The
balance sheet portrays an issuer’s financial position at a point in time. Its basic
components include:
• Assets, which are “probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events”;
25
• Liabilities, which are “probable future sacrifices of economic benefits arising
from present obligations of a particular entity to transfer assets or provide services
to other entities in the future as a result of past transactions or events”;
26
and
• Equity, which is “the residual interests in the assets of an entity that remains after
deducting its liabilities.”
27
While the above definitions appear straightforward, many questions and issues
arise in determining which items should be reflected on the balance sheet. Additionally,
questions arise regarding whether certain items that are included in the balance sheet
should be reported as liabilities or as equity.
Perhaps the most pervasive question is whether, in deciding which assets and
liabilities to include in the balance sheet, one should look to those assets and liabilities
legally
controlled by an issuer, or to those assets and liabilities that expose an issuer to
risks and rewards. In most simple structures, these two approaches to analyzing the
question produce similar answers as to whether or not to consolidate. However, more
complex structures have developed in business practice for which these two different
philosophies produce different answers.
Determining the contents of the balance sheet using a control approach generally
makes sense if one is interested in what value company management can generate from
the resources that it manages. That is, a control approach is compatible with a
“stewardship” view of the financial statements. On the other hand, a risks and rewards
analysis makes sense to those who see the financial statements as a way to understand
how various events might affect the value of their holdings in the entity. Current GAAP
generally relies on a control approach to determine which items appear in the balance
sheet. Thus, even when a majority of the risks and rewards of an asset belong to other
parties, the controlling entity will record the asset on its books. Furthermore, an issuer
that owns a controlling voting interest in another entity will generally consolidate that
other entity, even if its controlling interest represents a minority of the total capital
invested.
25
SFAC No. 6, paragraph 25.
26
Id., paragraph 35.
27
Id., paragraph 49.
11
While the focus on control has been generally consistent, there are various
analyses that are used to identify the controlling party. The common indicator of control
is a legal analysis regarding the ability to direct the use of the asset in question or, in a
consolidation situation, voting control over the entity in question. However, there are
some instances in which a legal control analysis has been found lacking, and therefore is
not used. The decision of whether to consolidate certain SPEs is one such area. Even
before the Enron and other scandals, many had realized that looking for the more
common indicators of control does not work well in regard to SPEs, mainly because so
many SPEs have all of their significant activities “pre-programmed” at their formation,
such that voting control is rendered rather irrelevant.
28
Under recent accounting guidance
for SPEs, a risks and rewards analysis is performed in order to get at which party, if any,
should consolidate the SPE.
Another issue that pervasively affects which assets and liabilities are included in
the balance sheet is whether to record assets and liabilities individually in the financial
statements, or to net them. This is particularly important in that most contracts provide
both counterparties with rights that could be considered assets, while simultaneously
subjecting them to obligations that could be considered liabilities. Pension obligations,
when recognized, are generally reported net of assets set aside to fund them,
29
while other
obligations for which funds are set aside generally are reported on a “gross” basis—that
is, both the obligation and the funds set aside are separately reported in the balance sheet.
In contrast, transfers of financial assets may be reported on either a gross or net basis,
depending on a myriad of factors. Similar to questions of control vs. risk and rewards,
both gross and net reporting can provide information that is useful to investors. For
example, in the partial transfer of a financial asset, a gross reporting approach may signal
to investors that an issuer still owns the entire asset, and has merely agreed, through a
separate contract, to forward a portion of the payments received to another party, in
return for the payments received from that other party. Net reporting, however, lets
investors know that the issuer is really no longer exposed to the full change in value of
the financial asset, because a portion of the related risks and rewards has passed to the
purchaser.
2. Other Basic Financial Statements
The other three basic financial statements describe, each in its own way, the
changes in various balance sheet items from one period to the next. We discuss each in
turn.
The
income statement reflects the issuer’s revenues and expenses, gains and
losses, and, thus, is intended to capture “the extent to which and the ways in which the
equity of an entity increased or decreased from all sources other than transactions with
28
See, for example, page 82 of the Commission’s 2000 Report to Congress, which comments that “existing
[consolidation] standards do not adequately address circumstances involving entities with specific limits on
their powers, also referred to as SPEs. The FASB is urged to continue its efforts to provide guidance
concerning these entities.”
29
See discussion in Section III.
12
owners during a period.”
30
Over the years, tremendous controversy about what should be
reported in the income statement has arisen. In large part, the controversy can be traced
to the fact that net income (often expressed as a per share measure) has been focused on
more than any other single characteristic in evaluating performance. As such, the
decision to change accounting standards in a way that would result in more volatility
being reported has often prompted controversy.
Due to the complementary and integrated nature of the balance sheet and income
statement, choosing the accounting treatment for one statement has implications for the
other.
31
One of the most critical and timely examples to illustrate such conflicts relates to
recent standards that require the recognition of more assets and liabilities on the balance
sheet at their fair values. Moving to fair values on the balance sheet requires that a
decision also be made regarding whether the unrealized changes in these fair values are
reported on the income statement. Unrealized gains and losses related to assets and
liabilities are those that occur while an issuer holds the asset or liability, as opposed to
realized gains and losses that occur when an asset or liability is sold or settled.
Proponents of the “all inclusive” approach to defining net income would argue
that it is appropriate to include both realized and unrealized gains and losses in net
income because this information enables users to better predict future earnings or cash
flows. However, others point out that recording unrealized gains and losses in the
income statement may lead to increased earnings volatility such that earnings become
less predictive of future earnings or cash flows. The alternative to reporting unrealized
gains and losses as part of net income is to report these changes in “other comprehensive
income,” which most often appears in the statement of shareholder equity, until the gain
or loss is realized through sale of the asset or settlement of the liability.
The
statement of changes in equity reflects the ways in which assets and liabilities
have changed due to transactions with owners during the period, such as declarations of
dividends, issuances of stock options, exchanges of shares in mergers and acquisitions,
and items that are classified as “other comprehensive income,” as discussed above.
32
The
cash flow statement reflects “an entity’s cash receipts classified by major
sources and its cash payments classified by major uses during a period.”
33
This statement
30
SFAC No. 5, paragraph 30. In truth, there are several transactions that meet the criteria to be included in
the income statement, but have nonetheless been excluded from net income, and instead categorized as
“other comprehensive income”.
31
Historically, the relative focus of standard setters on the balance sheet versus the income statement (or
vice versa) has varied. The balance sheet was emphasized in the early part of the 20
th
Century (and before),
in part because creditors had little reliable information available to them. Liquidation values and
conservatism were of central importance. By the late 1930s, the focus shifted to a shareholder orientation,
the income statement and value in use rather than liquidation value. Hendriksen, Elden S., 1982,
Accounting Theory, Irwin, Homewood, Illinois, 257.
32
With the exception of the changes in the value of international subsidiaries that result from translating
their financial statements into U.S. dollars, these issues are discussed in detail in Section III.
33
Id., paragraph 52.
13
groups the inflows and outflows of cash into three broad categories: operating cash flows,
investing cash flows, and financing cash flows.
Operating cash flows include cash received from customers, cash spent on
materials and labor, cash paid for utilities, insurance, executive salaries, and many other
types of operating items. When the operating section of the cash flow statement is
presented based on categories such as these, it is known as a “direct method” cash flow
statement. The FASB noted that “[t]he principal advantage of the direct method is that it
shows operating cash receipts and payments [and that] [k]nowledge of the specific
sources of operating cash receipts and the purposes for which operating cash payments
were made in past periods may be useful in estimating future operating cash flows.”
34
Another option, known as the “indirect method,” allows issuers to prepare this
section by reconciling net income to operating cash flow. Using this method involves
adjusting net income for non-cash items, such as depreciation and changes in certain
current assets or liabilities. For example, issuers would adjust net income for changes in
accounts receivable (which indicate a difference between accrual basis revenue and cash
received from customers) or changes in accounts payable (which indicate a difference
between accrual basis expenses and cash received to providers of goods and services).
The FASB noted that “[t]he principal advantage of the indirect method is that it focuses
on the differences between net income and net cash flow from operating activities.”
35
When the FASB promulgated SFAS No. 95, The Statement of Cash Flows, it
required presentation of the indirect method in all cases, and expressed a preference that
the direct method
36
also be presented, but did not require its use. Most issuers do not
present direct method cash flow statements.
37
The other two sections of the cash flow statement report investing cash flows and
financing cash flows. Investing cash flows include cash inflows and outflows related to
purchases or sales of property, plant and equipment, investments in equity or debt of
other entities, and other types of investments. Financing cash flows include cash inflows
from raising capital through issuing stock or debt, cash outflows to repay mortgages and
other liabilities, cash paid for dividends, and the like.
3. Notes to the Financial Statements, MD&A, and Other
Disclosures
The basic financial statements alone often do not provide sufficient information
for investment decisions. The FASB’s concept statements note that: “[s]ome useful
information is better provided by financial statements and some is better provided, or can
only be provided, by notes to financial statements or by supplementary information or
34
SFAS No. 95, paragraph 107.
35
SFAS No. 95, paragraph 108.
36
SFAS No. 95, paragraph 119.
37
The Staff agrees with the FASB’s preference and encourages issuers to voluntarily present their cash flow
statements using the direct method.
14
other means of financial reporting.”
38
These disclosures in the notes to the financial
statements are intended to provide information that balance sheets, income statements,
and cash flow statements cannot (or do not) provide.
In addition, although the notes provide much information that is not provided in
the basic financial statements, they generally do not provide an explanation of the
business activities underlying the numbers. Recognizing that such information may be as
important to investors as the information in the financial statements and notes, the
Commission requires issuers to include a section called Management’s Discussion and
Analysis of Financial Position and Results of Operations in many filings. MD&A
requires a discussion of significant events, trends, and uncertainties, explanations of key
financial statement figures, disclosures regarding events reasonably likely to affect the
issuer’s operations or liquidity in the near future and other information that provides
context to the financial statements. As noted in FR 67:
The disclosure in MD&A is of paramount importance in increasing the
transparency of a company's financial performance and providing investors with
the disclosure necessary to evaluate a company and to make informed investment
decisions. MD&A also provides a unique opportunity for management to provide
investors with an understanding of its view of the financial performance and
condition of the company, an appreciation of what the financial statements show
and do not show, as well as important trends and risks that have shaped the past or
are reasonably likely to shape the future.
Because of the importance of the notes to the financial statements and other
disclosures, including MD&A, in providing information that is not provided by the basic
financial statements themselves, questions of whether items should or should not be
included on the balance sheet and whether sufficient transparency in reporting has been
achieved must be assessed in light of the presence and role of these other reporting tools.
C. Historical Context of the Study and Report
1. Enron
While the Act does not discuss why off-balance sheet arrangements and SPEs are
identified for special attention, looking back at the scandals that preceded the passage of
the Act appears instructive. At the beginning of 2001, Enron Corp. enjoyed a market
capitalization that exceeded $60 billion, ranked as the seventh largest corporation in the
world by revenue,
39
and had won Fortune magazine’s award as the ‘most innovative
company in the United States’ six years running.
40
Yet, toward the end of 2001, Enron
38
SFAC No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, (Dec. 1984),
paragraph 7.
39
Second Interim Report of Neal Batson, Court Appointed Examiner (“Second Interim Batson Report”), In
re: Enron Corp., et al., Jan. 21, 2003, page 5.
40
The award was won in 1996 through 2001. See Christopher L. Culp and Hanke, Steve H., “Empire of the
Sun: An Economic Interpretation of Enron’s Energy Business,”
Policy Analysis, Cato Project on Corporate
Governance, Audit and Tax Reform, Feb. 20, 2003, page 2.
15
collapsed within a matter of months, filing for bankruptcy protection under Chapter 11.
Its collapse constituted the largest corporate bankruptcy up to that point in time.
This event acted as a catalyst—especially after it was rapidly followed by other
high-profile business and financial reporting failures, including those at Worldcom and
Adelphia —and raised many questions about corporate governance, the audit process,
and financial reporting in general. It eventually was reported that aspects of Enron’s
business were built on non-substantive trades and related-party transactions with no valid
business purpose. There were multiple violations of the company’s code of conduct,
some of which were specifically approved by the Board of Directors.
41
Compounding all
of this, it quickly became apparent that Enron’s financial reports had not revealed the
company’s true economic position to the market. Upon closer scrutiny, it also appeared
the use of and accounting for OBS arrangements and SPEs had hidden the risks that
played an important role in its rapid collapse.
42
The Enron scandal, along with other
financial reporting failures (several of which also involved OBS transactions and SPEs),
preceded the wave of reforms that included passage of the Act.
While it is beyond the scope of this Report to look in detail at Enron’s
transactions, a brief description of a few transactions may serve to illustrate the lack of
transparency that can result from some off-balance sheet arrangements. Enron’s
transactions have been examined in detail by others. For the examples provided below,
the Staff relies solely on the
Powers Report and the Second Interim Batson Report, both
of which are publicly available.
Enron’s court appointed bankruptcy examiner, Neal Batson, preliminarily
concluded that “through the pervasive use of structured finance techniques involving
SPEs and aggressive accounting practices, Enron so engineered its reported financial
position and results of operations that its financial statements bore little resemblance to
its actual financial condition or performance.”
43
The impact of these “techniques” was
profound. For 2000, barring the use of these techniques, Enron’s reported debt would
have been $22.1 billion rather than $10.2 billion.
44
On November 19, 2001, Enron filed its third quarter financial statements and
reported debt on its balance sheet of approximately $13 billion. Yet, on the same day, at
a meeting designed to help relieve its liquidity crisis, Enron informed its bankers that its
debt was approximately $38 billion; the difference of $25 billion was explained as being
either off-balance sheet or on the balance sheet as something other than debt. Batson
notes that approximately $14 billion of this off-balance sheet debt was “incurred through
structured finance transactions involving the use of SPEs.”
45
41
See, for example, Report of Investigation by the Special Investigative Committee of the Board of
Directors of Enron Corp. William C. Powers, Jr. Chair (Feb. 1, 2002) (“
Powers Report”), page 3.
42
See Second Interim Batson Report; see also Powers Report.
43
Second Interim Batson Report, page 15.
44
Id., page 3.
45
Id., page 9-10.
16
Similarly, a report by a Special Investigative Committee on Enron—
i.e., the
Powers Report—found, among other things, that transactions with certain SPEs “allowed
Enron to conceal from the market very large losses resulting from Enron’s merchant
investments by creating an
appearance that those investments were hedged.”
46
We rely
on the
Powers Report for the following example of an arrangement combining the use of
SPEs with derivatives to reduce transparency.
Enron had invested in a “high-tech” stock—Rhythms NetConnections, Inc.
47
The
investment had grown approximately 30-fold in value. Enron reflected this investment
on the balance sheet at its (estimated) fair value,
48
and recognized the increases in value
in the income statement. Theoretically, a decrease in value, if it occurred, would also
flow through the income statement. While there was concern that the value of the
investment might fall, Enron was not in a position to sell the shares due to a lock-up
agreement.
49
Further, as the Powers Report explains, “[g]iven the size of Enron’s
position, the relative illiquidity of Rhythms stock, and the lack of comparable securities
in the market, it would have been virtually impossible (or prohibitively expensive) to
hedge Rhythms commercially.”
50
Enron resolved this dilemma by entering into a “hedging” transaction with an SPE
that was designed (from an accounting perspective) to permit Enron to offset losses
associated with any potential decrease in the value of Rhythms NetConnections shares.
51
Enron received, from an SPE that had no other operations, a put option on Rhythms
NetConnections shares which appeared to protect Enron from decreases in the value of
those shares.
52
However, Enron provided the SPE with a large quantity of restricted
Enron stock, which the SPE would use to cover its obligations to Enron.
53
As a
consequence of this arrangement, the SPE would not be able to meet its obligations under
the derivatives contract if the value of Enron shares decreased (sufficiently) at the same
time as the value of Rhythms NetConnections shares did.
54
This transaction was one of many that highlighted problems with the then-existing
accounting guidance on the consolidation of SPEs. In the most egregious uses of SPEs,
most objective observers would have concluded that the “sponsor” of the SPE really was
in control of its actions, either through voting provisions, economic compulsion, or, most
likely, because the SPE’s activities were set forth upon its formation, and were entirely,
or almost entirely, performed for the benefit of the sponsor. The accounting guidance at
46
Powers Report, page 4.
47
Id., page 77.
48
Id.
49
Id.
50
Id., page 78.
51
Id.
52
Id., page 80 and 81.
53
Id., page 80.
54
Id., page 82.
17
the time, however, generally focused on voting control to determine whether all entities,
including SPEs, should be consolidated. By giving an independent third party who had
made a “substantive” investment (3% of the value of the assets of the SPE was generally
considered substantive) voting control of the SPE, a sponsor could generally avoid
consolidation, despite the fact that the activities of the SPE could not be substantively
changed by the “controlling” investor. Recognizing this as a problem, the FASB,
subsequent to the passage of the Act, issued new guidance, Interpretation No. 46(R),
regarding the consolidation of SPEs.
55
Interpretation No. 46(R) is discussed in Section
IV.
Another structuring technique used by Enron, again combining the use of SPEs
and derivatives, appears to have been designed to create the impression of operating cash
flows while disguising debt financing. The Staff relies on the
Second Interim Batson
Report for this example, which refers to these particular transactions as “prepay”
arrangements.
56
A typical Enron “prepay” involved three parties: an Enron affiliate, an
investment bank, and a conduit entity formed at the direction of the investment bank.
More specifically, a prepay had three component parts:
i.) The investment bank paid the conduit entity up-front in exchange for the conduit
entity’s future deliveries of a commodity at periodic intervals;
ii.) The conduit entity paid the Enron affiliate up-front for future deliveries of a
commodity; and
iii.) Enron promised to buy a commodity from the investment bank in the future, at
amount in excess of the amounts paid by the investment bank in step (i).
57
The circular nature of delivery and payments with respect to the commodities had
the effect of eliminating any material risk or any potential gain with respect to the
changes in the price of the underlying commodity. Each party’s apparent assumption of
price risk was illusory. With the elimination of price risk, “prepays” were effectively
debt. In other words, the conduit entity was an alter ego of the investment bank.
Therefore, the transaction was essentially between two parties—Enron and the
investment bank. The investment bank was making a large payment to Enron in
exchange for Enron’s promise to pay the bank an amount in excess of what Enron
received in the initial prepayment.
Each aspect of this arrangement, if considered separately, appears to have a
different economic intent than the economics of the transactions when analyzed together.
For example, cash today in exchange for a forward contract on oil and gas appears to be
nothing more than a common derivatives transaction. However, taking the totality of the
arrangement, the individual futures contracts have the effect of canceling price risk,
leaving money given today for a promise of money returned tomorrow as the economic
55
Interpretation No. 46(R), Consolidation of Variable Interest Entities
56
See Second Interim Batson Report, pages 58-67 and at Appendix E of that Report.
57
Id., page 64.
18
essence of the arrangement—
i.e., a loan, and loan accounting would have been the
appropriate accounting to apply to this series of transactions.
Enron’s accounting, however, inappropriately focused on its constituent parts.
Thus, the cash received by Enron in Step (ii) above was not recorded as cash flow from
financing (as would be appropriate for loan proceeds), but as cash flow from operations
58
(on the argument that it was associated with the forward contract on the oil and gas).
With respect to the balance sheet, Enron also failed to treat the liability associated with
Step iii—the promised future payments to the investment bank—as a debt liability.
Instead, the liability was recorded as a risk management liability.
59
Thus, these prepay
transactions allowed Enron to hide debt,
60
lower key financial ratios followed by
analysts,
61
and provide the illusion of cash flow from operations.
62
This structure also highlights what is referred to by accountants as the “unit of
account” problem. The economics of a transaction may look quite different depending on
how broadly or narrowly one defines the boundaries of the transaction. That is, a
particular contract may appear to have certain economic characteristics when viewed in
isolation—and may be given a certain accounting treatment that corresponds to those
economic characteristics—but if understood as a piece of a larger agreed-upon
transaction may actually have quite different economics, and be properly accorded
different accounting treatment. Thus, determining the actual bounds of a transaction is
fundamental to understanding both the underlying economics and the proper accounting
treatment. Determining these bounds has been and will remain an ongoing challenge to
standard setters, auditors, and regulators.
63
2. The Standard Setting Environment
The series of financial reporting scandals indicated to many that the system of
corporate governance and financial reporting was in need of repair. In response to these
scandals, the Sarbanes-Oxley Act called for improvement in the checks-and-balances that
govern the production of financial information provided to investors. In addition, various
enforcement actions served notice on bad actors that they would be discovered and dealt
with for their misrepresentations. But, for some, a question remained as to whether these
immediate legislative and enforcement responses completely addressed all of the causes
of these financial scandals. In particular, many asked whether, beyond the bad actors, the
58
Id., page 59.
59
Id.
60
Id.
61
Id., page 61.
62
Id.
63
See, for example, SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity, paragraphs 14 and A25-A29; EITF Issue No. 00-21, Accounting for Revenue
Arrangements with Multiple Deliverables, and Derivatives Implementation Group Issue K1, Determining
Whether Separate Transactions Should Be Viewed as a Unit.
19
accounting standards themselves might have played some role in facilitating or even
encouraging the bad behavior.
In a static world, one might expect standard setters and regulatory agencies to
examine each type of arrangement, determine how information about that arrangement
could best be communicated, and create standards that require specific financial reporting
treatments. Experience, however, suggests that such an approach to standard setting lags
behind the requirements of the marketplace and, ultimately, results in rules-based
guidance that lacks conceptual coherence. The volume of different arrangements that
must be analyzed under this approach—and the unexpected variants in these
arrangements—present substantial challenges. The fact is that we live in a world of
accelerating technological change, financial innovation, and globalization with rapidly
shifting competitive dynamics and regulatory action. Moreover, there is a constant
interaction among these forces, with each stimulating further change in the others. In
such a dynamic world, standard setters cannot possibly anticipate—and pre-determine
precise accounting rules for—every transactional innovation.
In light of these concerns, the Act mandated a study be conducted by the
Commission regarding the current form of U.S. accounting standards. More specifically,
section 108(d) of the Act called upon the Commission to conduct a study on the adoption
of “principles-based” accounting standards by the United States financial reporting
system.
64
This report has been completed and submitted to Congress on July 30, 2003.
In this study, the Staff noted several shortcomings of what are often denoted as
“rules-based” standards. Such standards often:
65
• Contain numerous bright-line tests, which ultimately can be misused by financial
engineers as a roadmap to comply with the letter but not the spirit of standards;
• Further a need and demand for voluminously detailed implementation guidance
on the application of the standard, creating complexity in and uncertainty about
the application of the standard; and
• Contain numerous exceptions to the principles purportedly underlying the
standards, resulting in inconsistencies in accounting treatment of transactions and
events with similar economic substance.
The Staff recommended a continued movement in the direction of (what the Staff
referred to as) “objectives-oriented” accounting standards. Objectives-oriented standards
are those which:
66
• Clearly state the accounting objective of the standard, with the objective
incorporated in the standard;
• Minimize the use of exceptions from the standard;
64
See Objectives-Oriented Accounting Standards Study.
65
Id.
66
Id.
20
• Avoid use of percentage tests (“bright-lines”) that allow financial engineers to
achieve technical compliance with the standard while evading the intent of the
standard;
• Are based on an internally consistent and consistently applied conceptual
framework; and
• Provide sufficient detail and structure so that the standard is operational and can
be applied on a consistent basis.
The study also notes that objectives-oriented standards have the potential to more
quickly adapt to today’s faster paced business environment better than rules-based
standards for (at least) two reasons:
67
First, standard setters should be able to move faster to address emerging
practice issues under an objectives-oriented regime. It is easier to come
to an agreement on a principle than on a highly detailed rule, even if the
principle is substantive and relatively specific in nature. It also takes
more time to develop and provide extensive implementation guidance on
a wide variety of hypothetical scenarios, as required by the rules-based
approach.
Second, by its very nature, a standard setting body cannot respond as
quickly to changes in the environment as can the professionals directly
involved in the marketplace. Because, when properly constructed,
objectives-oriented accounting standards are solidly based on a
conceptual framework, yet cabined by the specific, substantive
objectives embodied in each standard, they provide for a framework
within which the application of professional judgment can be exercised.
As such, managers and accountants should be able to draw upon the
objectives of the standard so that their accounting decisions better
capture economic reality in response to market developments. This
should render objectives-oriented accounting standards more durable
once they are in place than are rules-based standards. The latter tend to
be in greater need of constant tinkering by standard setters to reflect
changes in the environment than do objectives-oriented standards.
67
Id. (footnotes deleted from quotation).
21
Finally, the study also notes that significant hurdles exist to creating objectives-
oriented standards. Indeed, the bright lines, numerous exceptions, and voluminous
interpretive guidance that many see as problems with rules-based standards are
characteristics of many parts of U.S. GAAP precisely because constituents requested that
the FASB and other standard-setters include them in the guidance. The development of
objectives-oriented standards is continuously challenged by the constant requests
received by standard-setters that they provide new interpretive guidance and exceptions
to the principles underlying the accounting standards.
In addition, standard-setters must contend with the fact that just about any
proposed change will be unpopular with at least a segment of preparers, auditors and
other participants, including users. Even the improvements to the accounting guidance
identified in Section I.C.4 below—that have happened since the passage of the Sarbanes-
Oxley Act—generated significant debate, and these changes were made during a period
in which the FASB, the Commission and others were being actively encouraged to make
such improvements. The expectation that proposals for change will generate controversy
should not stop standard-setters from taking up a project in a needed area, but standard-
setters must nonetheless factor this into its processes and agenda decisions, ensuring that
sufficient opportunity for deliberation, comment, discussion, and dialogue will exist. In
addition, where new standards will result in the need for significant changes to internal
controls and financial reporting systems, adequate implementation time must also be built
into the process.
3. Accounting Motivated Transaction Structuring
Standard-setting is rendered difficult not only by the fast-paced business
environment, but also by the fact that the transactions themselves evolve in reaction to
the standards. As soon as a new standard is issued, questions immediately arise regarding
whether specific structures are within the scope of the new guidance, how interactions
between the new standard and existing standards should be addressed, and whether more
detail on the new guidance can or should be provided. Indeed, in many instances, the
issuance (or even expectation) of a new standard triggers a search to determine
techniques to structure and/or restructure transactions to avoid reporting the very
information sought by the new standard.
For example, when the FASB issued a standard in 1976 that required some lease
obligations to be recorded on the balance sheet as liabilities,
68
many lessees immediately
began to restructure their leases to avoid recognizing liabilities. Their efforts were aided
by parties who sought to profit from offering their expertise in structuring leases in ways
that provided “preferable” accounting. Such structuring tends to reduce transparency.
Indeed, oftentimes that is its point.
When we refer to accounting-motivated structured transactions, we are speaking
of those transactions that are structured in an attempt to achieve reporting results that are
not consistent with the economics of the transaction, and thereby impair the transparency
68
SFAS No. 13, Accounting for Leases.
22
of financial reports.
69
Standard setters have sometimes responded to structuring efforts
by refining and expanding the standards. However, this process can be a never-ending
circle, where restructuring of contracts and the creation of innovative new financial
structures lead to revisions in GAAP, which are then followed by the creation of
additional financial structures. As a result, the rules themselves come to provide a
roadmap for avoiding their intent, as issuers adjust arrangements to fall just outside the
scope of a particular accounting treatment.
Although this dynamic has long been recognized by regulators and standard
setters, there have been sweeping innovations in capital markets during recent years that
have substantially increased the potential (and in many cases, the expectation) for issuers
to engage in this type of structuring. With dramatically lowered transaction costs due to
technological and financial innovations, it has become economically feasible to isolate,
price and trade rights to specified streams of cash flows. This ability to un-bundle risk
and return, re-bundle it into new instruments, and sell these new instruments in the
marketplace has revolutionized capital markets. Economists sometimes refer to this
availability of a full range of financial alternatives as the “completion” of financial
markets (although markets remain far from fully complete).
70
Progress in the “completion” of financial markets has undeniable benefits,
allowing issuers to enhance liquidity, better manage risk exposure, and reduce borrowing
costs, while permitting investors to invest in instruments or entities best suited to their
investment preferences and risk tolerance. Nevertheless, as noted above, the very
complexity and flexibility inherent in these new financial tools and practices renders the
goal of transparency substantially more difficult to achieve. These innovative financial
instruments provide a new set of tools to those who would attempt to hide their exposure
to risk, or otherwise manipulate their financial statements. As one author who writes
about derivative markets states:
71
it is generally possible to create a given payoff in multiple ways. The
construction of a given financial product from other products is
sometimes called financial engineering. ... [B]ecause there are multiple
ways to create a payoff, ... regulatory arbitrage ... [in which the author
includes the circumvention of accounting rules] can be difficult to stop.
The propensity of certain issuers to combine engineered transactions with
aggressive accounting interpretations in order to obtain “desirable” accounting results
69
Thus, we do not mean to include situations where, for example, an issuer increases its sales efforts at the
end of a period to generate revenue. In that situation, the reporting of revenue would generally mirror the
economics if additional sales are generated. Such situations may, however, result in the need for
explanatory disclosures, particularly in MD&A.
70
See, for example, Mario Draghi, Giavazzi, Francesco, and Merton, Robert C. Transparency, Risk
Management and International Financial Fragility NBER Working Paper 9806, June 2003 (“[t]he role of
swaps and other privately negotiated derivative instruments is to complete financial markets, thus
increasing the ability of individuals, financial institutions, corporations and governments to manage risk.”)
71
McDonald, Robert L. Derivatives Markets (2003), pages 3 and 4.
23
poses difficult challenges to auditors, standard setters, and regulators, and reduces
investor understanding.
4. Improvements in the Financial Reporting Regime Since the
Passage of the Sarbanes-Oxley Act
There have been a number of significant events in the financial reporting system
since the passage of the Sarbanes-Oxley Act. Among others, these have included:
Accounting Developments:
•
Consolidation of Variable Interest Entities (revised December 2003)—an
interpretation of ARB No. 51 (“Interpretation No. 46(R)”)
72
, which requires a
“risks and rewards” approach to the consolidation of “variable interest entities” as
opposed to an approach based on control by ownership or legal authority,
addressing, among other things, some of the concerns with the failure of issuers
under earlier guidance to consolidate certain special purpose entities;
•
Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (“Interpretation No. 45”), which
requires the recognition of liabilities for obligations undertaken upon issuing
certain guarantees, as well as other disclosures;
73
•
Share-Based Payment, SFAS No. 123(R), which requires a fair-value based
method of accounting for stock options and other equity instruments used to
purchase goods and services, including employee services, eliminating the
previous accounting guidance that allowed compensation paid in a particular form
to go unreported in the financial statements;
74
•
Employers’ Disclosures about Pensions and Other Postretirement Benefits—An
Amendment of FASB Statements No. 87, 88, and 106, SFAS No. 132(R), which
revised employers’ disclosures about pension plans and other postretirement
benefit plans;
75
•
Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equities, SFAS No. 150, which established standards for how an
issuer classifies and measures certain financial instruments with characteristics of
both liabilities and equity;
76
72
More specifically, the FASB issued Interpretation No. 46 in January 2003 and 46(R)—the revised
interpretation—in December 2003.
73
The FASB issued Interpretation No. 45 in November 2002.
74
This Statement, revised in 2004, was a revision of FASB Statement No. 123, Accounting for Stock-Based
Compensation. It superseded APB Opinion No. 25, Accounting for Stock Issued to Employees, and its
related implementation guidance.
75
This was revised in December 2003.
76
This was issued by the FASB in May 2003.
24
•
Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the
Adoption by the United States Financial Reporting System of a Principles-Based
Accounting System, which is a Staff study that recommended that accounting
standards should be developed using an “objectives-oriented” approach;
77
and
•
The FASB Response to SEC Study on the Adoption of a Principles-Based
Accounting System,
78
in which the FASB indicated it’s general agreement with
the Staff’s recommendations regarding objectives-oriented accounting standards;
Regulatory and Other Developments:
•
Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet
Arrangements and Aggregate Contractual Obligations (“FR 67”),
79
which requires
an issuer to explain its off-balance sheet arrangements in a separately captioned
subsection of its MD&A and to provide an overview of certain known contractual
obligations in a tabular format;
80
•
Interpretation: Commission Guidance Regarding Management’s Discussion and
Analysis of Financial Condition and Results of Operations (“FR 72”),
81
which
explains how MD&A can provide more meaningful disclosure in a number of
areas, including its overall presentation and focus, with general emphasis on the
discussion and analysis of known trends, demands, commitments, events and
uncertainties, and specific guidance on disclosures about liquidity, capital
resources and critical accounting estimates;
•
Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date,
82
which adds certain disclosure requirements for public companies regarding
material changes in financial condition or operations, including (among other
things) disclosures if an issuer becomes directly or contingently liable for an
obligation that arises out of an off-balance sheet arrangement or if a triggering
event occurs causing an issuer obligation under an off-balance sheet arrangement
to increase or be accelerated, or its contingent obligation under an off-balance
sheet arrangement to become a direct on-balance sheet financial obligation;
•
Summary by the Division of Corporation Finance of Significant Issues Addressed
in the Review of the Periodic Reports of the Fortune 500 Companies,
83
in which
77
The Staff study on the adoption of objectives-oriented accounting standards was published by the
Commission in July 2003.
78
This was released by FASB in July 2004.
79
This rule was promulgated by the Commission in January 2003 in response to Section 401(a) of the Act.
80
Much of the language and many of the concepts in FR 67 are consistent with the language and concepts
embodied in the Commission’s January 2002 statement, which discussed the desirability of enhance
disclosure in MD&A of off-balance sheet arrangements.
81
FR 72 was promulgated by the Commission in December 2003.
82
This rule, which was proposed prior to the passage of the Act, is also responsive to the current disclosure
goals of Section 409 of the Sarbanes-Oxley Act.
83
This document is dated February 27, 2003, as modified.
25
the Division focused on disclosures that appeared to be critical to an
understanding of each company’s financial position and results, but which, at
least on their face, seemed to depart significantly from either GAAP or
Commission rules, or to be materially deficient in explanation or clarity; this
document included a discussion of the Division’s comments to issuers on off-
balance sheet arrangements, including securitized financial assets;
•
Certification of Disclosure in Companies’ Quarterly and Annual Report, as
directed in part by Section 302(a) of the Act, adopted rules to require, among
other things, that an issuer's principal executive and financial officers each certify:
the financial and other information contained in the issuer's quarterly and annual
reports; that they are responsible for establishing, maintaining and regularly
evaluating the effectiveness of the issuer's internal controls; that they have made
certain disclosures to the issuer's auditors and the audit committee of the board of
directors about the issuer's internal controls; and that they have included
information in the issuer's quarterly and annual reports about their evaluation and
whether there have been significant changes in the issuer's internal controls or in
other factors that could significantly affect internal controls subsequent to the
evaluation;
84
•
Management’s Report on Internal Controls Over Financial Reporting and
Certification Disclosure in Exchange Act Periodic Reports, which, as directed by
Section 404 of the Act, adopted rules requiring, among other things, that
companies subject to the reporting requirements of the Securities Exchange Act of
1934, other than registered investment companies, include in their annual reports
a report of management on the company's internal control over financial
reporting;
85
•
Standards Relating to Listed Company Audit Committees, which, as directed by
Section 301 of the Act, adopted a new rule to direct the national securities
exchanges and national securities associations to prohibit the listing of any
security of an issuer that is not in compliance with the audit committee
requirements mandated by the Act, relating to the independence of audit
committee members; the audit committee's responsibility to select and oversee the
issuer's independent accountant; procedures for handling complaints regarding the
issuer's accounting practices; the authority of the audit committee to engage
advisors; and funding for the independent auditor and any outside advisors
engaged by the audit committee;
86
•
Strengthening the Commission's Requirements Regarding Auditor Independence,
which, consistent with the direction of Section 208(a) of the Act, adopted
amendments to existing requirements regarding auditor independence to enhance
84
The effective date for these rules was August 29, 2002. Release Nos. 33-8124; 34-46427.
85
The effective date for these rules was August 14, 2003. Release Nos. 33-8238; 34-47986.
86
The effective date for this rule was April 25, 2003. Release Nos. 33-8220; 34-47654.
26
the independence of accountants that audit and review financial statements and
prepare attestation reports filed with the Commission; and
•
Proposed Interagency Statement on Sound Practices Concerning Complex
Structured Finance Activities, Office of the Comptroller of the Currency,
Treasury; Office of Thrift Supervision, Treasury; Board of Governors of the
Federal Reserve System; Federal Deposit Insurance Corporation; and Securities
and Exchange Commission, which, among other things, provided that financial
institutions should have effective policies and procedures in place to identify
those complex structured finance transactions that may involve heightened legal
and reputation risk, to ensure that the transactions receive enhanced scrutiny by
the institution, and to ensure that the institution does not participate in illegal or
inappropriate transactions.
87
To the extent possible, we consider the effects of these recent changes in financial
reporting throughout this Report. In addition, as part of the Study the Staff collected data
about the initial implementation of Interpretation No. 46(R) and FR 67. The Staff
presents these empirical findings in Section IV.
II. Study Methodology
This section presents the methodology for the Study, including 1) methodological
issues related to the construction of a representative sample of filings by issuers
appropriate to the questions addressed in the Study, and 2) the process by which the
sample findings are extrapolated to estimate the extent of arrangements with off-balance
sheet implications for the population. Descriptive statistics relating to the sample are also
presented in this section.
Certain characteristics common to many arrangements with off-balance sheet
implications were identified that could complicate the selection of a sample for the Study.
The prevalence of off-balance sheet arrangements may vary across issuers and is apt to be
correlated with size. Indeed, a disproportionate amount of certain off-balance-sheet
arrangements may occur in a small number of issuers.
88
Thus, in order to construct a
sample that will be representative of the population, it is important to stratify
89
the sample
87
On May 19, 2004, the Agencies requested public comment on a proposed Interagency statement. (69 FR
28980, May 19, 2004)
88
For example, see Credit Suisse First Boston Equity Research FIN 46: New Rule Could Surprise Investors,
page 6 (June 24, 2003).
89
The principle of stratification is to partition the population so that the units within a particular stratum are
similar in terms of the variable being measured. Then, even though the strata may differ markedly from
each other in terms of other measures, a stratified sample with the appropriate number of units in each
stratum will tend to be representative of the population as a whole. Then, the formula for the variance of
the estimator of the population mean with stratified sampling is a function of within-stratum variance
terms. In other words, the population estimate will be most precise if the population is partitioned into
strata such that within each stratum the units are similar. This point will underlie much of the analysis
below.
27
to ensure that the influence of different sized firms is appropriately captured in the Staff
estimates of the extent of off-balance sheet arrangements.
90
The Staff determined that a sample of n=94 issuers would satisfy the required
levels of power and hypothesis sensitivity for a stated level of significance.
91, 92
To
ensure observations from the largest issuers are included, the Staff constructed the sample
to include the 100 largest issuers (as measured by market capitalization) and randomly
selected an additional 100 issuers from the rest of the population. This results in a total
sample of n=200 observations within 2 strata. Thus, the Study sample is composed of
two sub-samples: 100 large issuers
93
(the “large issuer sub-sample”) and 100 randomly
selected issuers from the rest of the population (the “random issuer sub-sample”).
94
This
90
For a given total sample size n, one may choose how to allocate observations among the L strata. In the
absence of other information about the variances of a specified measure of interest across strata, a
reasonable initial choice may be to assume equal sample sizes for the strata. In this case, however, the
variance of the measure of interest in the stratum of largest issuers is likely to be very different from the
variance of the stratum of the smallest issuers for the distribution of total assets. In addition, the costs of
including additional observations differ substantially across strata. To construct an estimate that accounts
for this, the Staff first determined the stratum size allocations across the population that minimizes the
variance of the population estimate. Note that these estimates are dependent on the underlying assumed
parameter values. This method allowed the Staff to determine the appropriate strata sizes given the
importance of size and the importance of requiring that specific issuers be included in the sample.
91
The Staff follows the discussion of the stratification principle and optimal allocation in Chapter 11 of
Sampling, Steven K. Thompson, Wiley Interscience (2002) and also referred to Chapter 4 of Sampling
Techniques, William G. Cochran, Wiley (1977). The Staff used size (as measured by total assets) as the
stratification variable and then used the Compustat universe to estimate the optimal allocation of the sample
across strata to minimize the variance of the estimator and determine the appropriate sample size for the
study. This calculation depends on population variance so we use the natural log of total assets, which is
approximately normal, as the basis of the population distribution. The first two moments of the distribution
were used to establish the total sample size appropriate to ensuring the designated levels of power and
precision. The other variables in the study are assumed to be distributed like the natural log of total assets.
To the extent that other variables have distributions similar to the distribution of the natural log of total
assets, the above analysis is appropriate. Where possible, the Staff made conservative assumptions in order
to preserve the statistical integrity of the sampling method.
92
The Staff chose to construct a sample large enough to ensure that the power of the tests is no lower than
90% with an α level of significance of 5% throughout. More powerful tests and/or higher levels of
significance would require larger sample sizes. To establish the level of sensitivity of the hypotheses we
would expect from tests based on our sample, the sample sizes were determined assuming the difference
between the null and alternative hypotheses is 20%. The subsequent power calculations require a sample of
at least N=94 to satisfy these conditions.
93
With certain exceptions as discussed below.
94
As discussed above, the sample size that would be sufficiently representative to make inferences for the
total population subject to the required power, level of significance and hypothesis is less than 100. To
accommodate the prevalence of the variables of interest in the 100 largest issuers, a (much larger) total
sample of n=200, composed of 2 strata of 100 issuers each was constructed. The 2 strata are composed of
the 100 largest issuers and a random sample of size 100 from the rest of the population. This over-
sampling ensures the statistical validity of the results throughout. In addition, over-sampling large issuers
allowed statistically supportable observations to be made about these large issuers, which is a goal of the
Study. This is particularly relevant because the variables of interest may be more prevalent in the larger
issuers. The importance of large issuers to the Study was considered to justify the additional cost of
collecting information from all of the largest 100 issuers.
28
stratification method results in a sample that is sufficiently large to ensure the validity of
the statistical results subject to the specified power, hypothesis sensitivity, and
significance level requirements. In fact, this sampling method accommodates variation
across issuers and the importance of including the largest issuers in the Study.
The actual sample issuers in the large issuer sub-sample were selected based on
U.S. market capitalization as of December 31, 2003.
95
The random sample of issuers was
selected using a random number generator to identify issuers from a list of all issuers on
the Commission’s Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”)
system.
96
As noted above, the final sample that passed all the screening criteria and for
which data was successfully collected includes a total of 200 issuers. The tables below
describe the characteristics of the sample as well as each sub-sample, in terms of
securities registered with the Commission, size, industry membership, fiscal year-ends,
and the forms used by each issuer for their annual filings with the Commission.
Table II(A)(1) describes the securities registered with the Commission by our
sample of issuers. Approximately 93% of the sample issuers report common stock
registered with the Commission, and this average includes 100% of the large issuer sub-
sample. In contrast, only 6% of the sample issuers had registered preferred stock with the
Commission. Slightly more, almost 13% had registered debt securities.
95
Fannie Mae and Freddie Mac were excluded from the population and sample, even though they would
otherwise fall into the ranks of the top 100 issuers. This was done given the relatively unique features of
these two extremely large Government Sponsored Entities (“GSEs”). Two market indices (which would
otherwise fall into the ranks of the top 100 issuers) were also excluded from the sample because their assets
are predominantly the securities of other issuers that are eligible for the study. Two foreign private issuers
(which would otherwise fall into the ranks of the top 100 issuers) were also excluded from the sample.
Such issuers file 20-F annual reports and are not included in the study because foreign private issuers have
a one-year lag before they are required to implement some of the pertinent new standards.
96
Upon initial selection, the issuer was subjected to a screening to ascertain its viability as a participant in
the Study. If it was determined that an issuer was not a viable participant, the issuer was dropped and
another selected from the original list. Issuers were excluded if they were registered under the Investment
Act or if they were foreign private issuers. Issuers were also excluded if they did not have current financial
statements, notes to the financial statements, and MD&A disclosures available via annual filings (
i.e.,
forms 10-K or 10KSB) and quarterly filings (
i.e., form 10-Q or 10QSB), as the pertinent data would not be
available for such issuers. The selection and screening process was performed for a total of 276 issuers to
obtain a sample of 100 issuers that met all the requirements for membership in the sample.
29
TABLE II (A)(1): Major Classes of Securities Registered by Issuers in Sample
a
Sub-Samples
Full Sample
(n=200)
(%)
Large Issuers
(n=100)
(%)
Random Issuers
(n=100)
(%)
Issuers with Registered Common Stock
93 100 86
Issuers with Registered Preferred Stock 6 6 6
Issuers with Registered Debt Securities 12.5 23 2
a
These data were collected from the cover page of each issuer’s 10-K or 10KSB filing, which designates securities
registered under Sections 12(b) and 12(g) of the Securities Act of 1934. Additional types of securities (
e.g.,
registered preferred stock rights, trust preferred securities, and partnership units) are not reported in this table. Some
issuers not included in the categories above may have securities that are exempt from registration.
Table II(A)(2) describes the size of the issuers in the sample, in terms of U.S.
market capitalization, total assets, and total liabilities. The sample includes issuers with a
total equity market capitalization of $7.75 trillion. For comparison, the total U.S. equity
market capitalization for all issuers listed on the New York Stock Exchange (“NYSE”)
and the National Association of Securities Dealers Automated Quotations (“NASDAQ”)
as of December 31, 2003 was approximately $15 trillion.
97
The market capitalization of
the large issuer sub-sample is approximately 75 times that of the random issuer sub-
sample.
TABLE II (A)(2): Size of Issuers in Sample
Sub-Samples
Full Sample
(n=200)
(million)
Large Issuers
(n=100)
(million)
Random Issuers
(n=100)
(million)
U. S. Market Capitalization of Common
Stock
a
$7,771,753 $7,670,538 $101,215
Total Assets
b
$12,418,041 $12,242,146 $175,895
Total Liabilities
b
$10,219,198 $10,089,973 $129,225
a
These data were collected directly from the NYSE and the NASDAQ, for issuers traded on those exchanges. These
values do not include market capitalizations of issuers in the sample that were not traded on these two exchanges,
however, this omission is estimated to affect the total market capitalization for the random issuer sub-sample by less
than 1%.
b
These data were collected from the face of the balance sheet in the 10-K or 10KSB filing.
Total assets for the sample issuers are $12.4 trillion, virtually all of which relate to
the large issuers. Total assets for the large issuer sub-sample are almost 70 times as large
as total assets for the random issuer sub-sample. Total liabilities for the sample are $10.2
trillion, virtually all of which relate to the large issuer sub-sample. Total liabilities for the
large issuer sub-sample are approaching 90 times as large as total liabilities for the
random issuer sub-sample.
97
U.S. market capitalization figures for all issuers on the NYSE and the NASDAQ were obtained directly
from these markets as of December 31, 2003.
30
Table II(A)(3) describes the industry membership of the issuers in the sample.
Note that our sample has a relatively large representation of manufacturing issuers and
finance, insurance, and real estate issuers. These relative emphases are largely consistent
in the sub-samples.
TABLE II(A)(3): Industry Membership of Issuers in Sample
a
Sub-Samples
Full Sample
(n=200)
(%)
Large Issuers
(n=100)
(%)
Random Issuers
(n=100)
(%)
Mining, Oil & Gas, and Construction 3.5 1 6
Manufacturing 38.5 50 27
Transportation, Communication, Electric,
Gas, & Sanitary Services 11.5 9 14
Wholesale & Retail Trade 6.5 8 5
Finance, Insurance, & Real Estate 24 24 24
Services 15 8 22
Non-Classifiable 1 0 2
a
These data were collected from the cover page of each issuer’s 10-K or 10KSB filing.
Table II(A)(4) describes the year-ends of the issuers in the sample. The majority
of issuers in our sample had December 31 year-ends.
TABLE II(A)(4): Year Ends of Issuers in Sample
a
Sub-Samples
Full Sample
(n=200)
(%)
Large Issuers
(n=100)
(%)
Random Issuers
(n=100)
(%)
June-November 2003 Year End 17 16 18
December 2003 Year End 75 77 73
January-May 2004 Year End 8 7 9
a
These data were collected from the cover page of each issuer’s 10-K or 10KSB filing.
Table II(A)(5) describes the distribution of the sample in terms of issuers that file
Form 10-K vs. Form 10KSB. Small business issuers may file form 10KSB instead of
form 10-K. Form 10-K was filed by 87% of the sample issuers and form 10KSB was
filed by the remaining 13%.
31
TABLE II(A)(5): Forms Filed by Issuers in Sample
Sub-Samples
Full Sample
(n=200)
(%)
Large Issuers
(n=100)
(%)
Random Issuers
(n=100)
(%)
Issuers filing Form 10-K 87 100 74
Issuers filing Form 10KSB 13 0 26
a
These data were collected from the cover page of each issuer’s 10-K or 10KSB filing.
For each issuer in the sample, data was collected from the 10-K or 10KSB filing
corresponding to the fiscal year-ends described in Table II(A)(4) above.
98
The Staff
focused on collecting data that facilitated the measurement of the extent of off-balance
sheet arrangements, both in terms of the extent of issuers involved in such arrangements
and any related dollar amounts.
The Staff extrapolates the findings from the sample to estimate amounts for the
approximate population of active U.S. issuers. The Staff estimates the population of
active U.S. issuers to be approximately 10,100.
99
Subtracting the 100 issuers in the large
issuer sub-sample results in 10,000 issuers in the population that are represented by the
random issuer sub-sample. The Staff performs extrapolations by multiplying amounts
from the random issuer sub-sample by a factor of 100 (
i.e., 10,000 issuers in the
population divided by 100 issuers in the random issuer sub-sample) and adding amounts
from the large issuer sub-sample. If the extrapolated amounts are percentages, this
calculation is performed using the absolute counts in each sub-sample, after which the
total is divided by 10,100.
III. ARRANGEMENTS WITH POTENTIAL OFF-BALANCE SHEET
IMPLICATIONS
A. Investments in the Equity of Other Entities
1. Nature of Arrangements and Financial Reporting
Requirements
Issuers regularly invest in the equity of other entities. An issuer may invest for
the short term or the long term, for income or capital appreciation, or for strategic
98
As discussed in Section IV, some data related to the implementation of FASB Interpretation No. 46(R)
was also collected from the 10-Q or 10QSB filings of each issuer for the quarter that included May 15,
2004, which would include information about the full adoption of Interpretation No. 46(R) for many of the
issuers in the sample.
99
The estimate of the approximate number of active U.S issuers in the population (not including
international issuers filing form 20-F or issuers under the Investment Act) is based on the Staff’s judgment.
The actual number of active issuers is constantly changing. Some issuers discontinue filing because they
no longer meet the reporting requirements, while others are delinquent in their filings and still others
choose to file voluntarily. The estimate of 10,100 (versus the round number 10,000) is not meant to imply
a high level of precision, but, as noted above, is based on the Staff’s judgment, and also is chosen to render
the extrapolation calculations straightforward and easily understood by the reader.
32
purposes, such as expanding its product offerings into new territory, integrating the other
entity’s products or technology with its own, or diversifying its business. Investments
may be purely passive in nature, or may provide the issuer with some level of influence,
or even control, over the other entity. The accounting for investments in other entities
differs based on the level of the investor’s involvement with the other entity.
a. Investments Giving Rise to Neither Influence Nor
Control
Investments that give rise to neither influence nor control are common. These
investments are equivalent in nature to those an individual might hold in an investment
portfolio. Assuming the investment is in publicly traded equity, SFAS No. 115,
Accounting for Certain Investments in Debt and Equity Securities, provides the relevant
accounting guidance for these investments. SFAS No. 115 requires the investment to be
re-measured and presented on the issuer’s balance sheet at its fair value.
100
The
requirement to report these investments at fair value (
i.e., “mark to market”) raises the
issue of how to account for changes in these fair values (market fluctuations) that occur
during the period the issuer owns the stock of the other entity. Historically, the
accounting for these “unrealized holding gains and losses” has been the subject of much
debate.
101
During development of SFAS No. 115 there was some objection to recognizing
the effects of changes in the market price of investments held (
i.e., recognizing the effects
of market volatility) in an issuer’s earnings. Those expressing objections argued that
these unrealized holding gains and losses are different in character from income and
expense items that arise from past transactions with other parties. As such, some argued
(and still believe) that the gains and losses are only “potential” gains and losses, rather
than gains and losses that have already occurred, and therefore do not belong in an
issuer’s earnings.
In light of these views, the standard provides for alternative treatments of the
unrealized holding gains and losses. If the “purpose” of the investment is for
“trading,”
102
unrealized holding gains and losses must be recognized in earnings each
period. Investments held for other than trading purposes that do not provide the holder
100
See SFAS No. 115, paragraphs 3 and 12.
101
A realized gain or loss occurs if the issuer actually sells the shares; an unrealized holding gain or loss
occurs when the price of the shares increases or decreases, but the issuer continues to hold the shares. Once
the investment has been liquidated and any gain or loss realized, there is no longer a question as to
recognition of that gain or loss.
102
Paragraph 12(a) of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities,
states that “Securities that are bought and held principally for the purpose of selling them in the near term
(thus held for only a short period of time) shall be classified as trading securities. Trading generally
reflects active and frequent buying and selling, and trading securities are generally used with the objective
of generating profits on short-term differences in price.”
33
with either significant influence or control are classified as “available for sale,”
103
in
which case the investment is still recorded at fair value, but unrealized holding gains and
losses are excluded from earnings until the investment is ultimately sold and the gain or
loss is realized.
104
In the meantime, unrealized holding gains and losses are recorded in
the “other comprehensive income” section of the shareholder’s equity section of the
balance sheet.
As noted above, these investments are only “marked to market” each period if the
equity instruments are publicly-traded. If the instruments are not publicly traded, the
investment is accounted for under the cost method.
105
Under the cost method, changes in
value (
i.e., unrealized gains and losses) are not recognized in earnings until the
investment is sold. However, if the value of the investment declines (
i.e., the investment
is impaired) and this decline is “other than temporary,” a loss should be recognized.
106
Determining whether a loss is “other than temporary” is a judgmental assessment, based
on the relevant facts and circumstances.
In addition to the accounting described above, SFAS No. 115 requires disclosures
regarding investments where the issuer has neither significant influence nor control,
including, but not limited to:
• Gross unrealized holding gains and gross unrealized holding losses (separately
reported) for investments classified as “available for sale;”
• Proceeds from the sale of “available for sale” securities; gross realized gains and
gross realized losses on those sales;
• Gross gains and gross losses included in net income related to transfers of
securities from “available for sale” to “trading” categories; and
• Detailed information regarding the gains and losses included in other
comprehensive income and net income.
b. Investments Giving Rise to Influence but Not Control
An issuer’s investment in another entity may give rise to “significant influence”
over the other entity. The term “significant influence” refers to the ability of an issuer to
impact the other entity’s operating and financial policies. Such ability to exercise
influence may be attained, for example, through ownership of voting stock of the other
entity,
107
board representation, participation in policy making processes, or technological
103
Paragraph 12(b) of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities,
states that “Investments not classified as trading securities (nor as held-to-maturity securities) shall be
classified as available-for-sale securities.”
104
SFAS No. 115, Paragraph 16.
105
See APB No. 18, paragraph 6a.
106
See SFAS No. 115, paragraph 16 and APB Opinion No. 18, paragraph 19h.
107
Paragraph 17 of APB No. 18 includes a presumption that an issuer has “significant influence” over
another entity if the issuer owns more than 20% but no more than 50% of the voting stock of that entity.
However, the determination of whether an investor has significant influence often requires judgment.
34
dependency. If an investment in the equity of another entity affords the issuer the ability
to exercise “significant” influence over operating and financial policies of the other
entity, APB No. 18,
The Equity Method of Accounting for Investments in Common
Stock, requires that the issuer follow the “equity method” of accounting for this
investment. If, instead, an investment does not afford the issuer the ability to exercise
significant influence, the cost or fair value methods are used. Under the equity method,
the investment is recognized on the issuer’s balance sheet at its initial cost, adjusted over
time for the issuer’s share of changes in the other entity’s changes in net assets (
i.e.,
assets less liabilities). The issuer’s share of the other entity’s net income (loss) is
recognized as an increase (decrease) in the investment. Dividends received by the issuer
from the other entity are treated as a reduction of the investment. By way of these
mechanics, the equity method attempts to reflect an issuer’s share in the other entity’s
equity, and changes therein, in the issuer’s investment in the other entity recognized as an
asset on the issuer’s balance sheet. As with other unconsolidated investments,
impairment losses are recognized if the value of the investment declines below its
carrying value and the decline is deemed “other than temporary.”
APB No. 18 has its own set of disclosure requirements, including:
• Name of the entity whose shares the issuer owns;
• Particulars of the issuer’s accounting policies under the equity method;
• Value of each investment based on current quoted market prices, if available; and
• Summarized financial information about assets, liabilities, and result of operations
of the other entities, if the investment is “significant.”
In addition to the requirements of APB 18, Rule 3-09 of the Commission’s
Regulation S-X requires that issuers file as part of their annual report on Form 10-K the
separate financial statements of investments in entities accounted for under the equity
method, if they meet the definition of a “significant subsidiary” under Regulation S-X 1-
02.
108
Presenting these separate financial statements of the other entity is intended to
provide added information regarding investments that comprise a significant portion of
an issuer’s assets, equity, or earnings.
c. Investments Giving Rise to Control
If an issuer controls another entity such that the issuer can direct the other entity’s
operations, ARB No. 51,
Consolidated Financial Statements, requires the issuer to
“consolidate” that other entity.
109
When consolidation is required, the issuer no longer
108
See 17 CFR 210.1-02(w) for definition of a significant subsidiary.
109
ARB No. 51, paragraph 1, states that “consolidated statements are more meaningful than separate
statements and that they are usually necessary for a fair presentation when one of the companies in the
group directly or indirectly has a controlling financial interest in the other companies.” SFAS No. 94,
Consolidation of All Majority Owned Subsidiaries, eliminated certain exceptions to the general rule under
ARB No. 51 that majority owned entities should be consolidated. These exceptions had allowed certain
controlled entities that were foreign, “non-homogeneous”, and where there were significant non-controlling
35
presents information about its investment in the other entity in terms of a “one-line”
investment account on the balance sheet, but rather, the assets and liabilities of the other
entity are combined with (or added to) the assets and liabilities of the issuer, and the
combined amounts are presented on the issuer’s consolidated financial statements. For
example, the cash of the other entity is combined with the issuer’s cash; the equipment of
the other entity is combined with the issuer’s equipment; the debt of the other entity is
combined with the issuer’s debt; and so on. Likewise, the consolidated income statement
combines the revenues and expenses of the other entity with those of the issuer.
One of the important benefits of consolidating entities controlled by the investor
is similar reporting for all of the assets, liabilities, equity and operating results of the
issuer and entities under the issuer’s direction. If entities are consolidated, an issuer
cannot simply transfer an asset or liability to another entity that it controls and remove
that asset or liability from its balance sheet. Issuers might be motivated to make such
transfers by a desire to move poorly performing assets off the balance sheet or a desire to
reduce the debt outstanding on the balance sheet to improve the appearance of the
issuer’s financial position and liquidity. However, if the other entity is consolidated by
the issuer, these assets and liabilities will be reflected on the consolidated balance sheet,
regardless of which entity (the issuer or a controlled entity) legally “owns” them. Indeed,
a part of the rationale for the consolidation standard was to prevent substantial
obligations and/or losses from being “hidden” in unconsolidated controlled entities.
In most instances, the balance sheet of an issuer that consolidates another entity
would reflect the same net assets (
i.e., assets less liabilities) as if the investment in the
stock of that entity had been accounted for using the equity method of accounting.
However, under the equity method of accounting the issuer “nets” the assets and
liabilities of the other entity and reports them on one line on the balance sheet. Similarly,
the income statement of an issuer that consolidates another entity would generally reflect
the same net income as if that entity had been accounted for using the equity method.
Again, the difference lies in the level of detail provided to the user of the financial
statements.
There are no specific disclosures related to consolidated entities. Rather,
disclosures are provided related to the assets and liabilities of the consolidated entities
just as they are for the issuer’s own assets and liabilities.
2. Off-Balance Sheet Issues in Accounting for Investments
The fact that so many different accounting treatments exist for these investments
certainly raises the question of whether each is necessary. Of course, multiple methods
are appropriate if each is used to reflect substantively different circumstances. In
analyzing the accounting for investments in other entities, the sub-section immediately
below begins by considering the guidance for determining which approach to use. Since
the largest difference in accounting, especially as it relates to whether assets or liabilities
shareholders (minority interests). The exception in ARB No. 51 for temporarily controlled entities was
eliminated through the issuance of SFAS No. 144,
Accounting for the Impairment or Disposal of Long-
Lived Assets.
36
are on or off the balance sheet, is between consolidation and any of the other methods, we
begin with the consolidation guidance.
a. Consolidation
As discussed above, the accounting guidance generally relies on the concept of
control to determine which entities to consolidate. Using control as the criterion for
consolidation has been the generally accepted standard for decades, and the standard-
setters have gradually eliminated exceptions to this general rule over time.
110
This
approach provides consistency, and is a concept the Staff believes users can readily
understand, even if determining whether control exists is sometimes a difficult
question.
111
Even before the Enron and other scandals, standard-setters had concluded that an
approach focused on legal or voting control was often not effective in addressing the
question of consolidation of special purpose entities. The nature of many SPEs is that
they are designed so that all of their significant activities are “pre-programmed” or built
into the operating structure of the entity at formation, such that voting control is
irrelevant. The FASB recently issued an interpretation of the general consolidation rule
under ARB No. 51 (
i.e., Interpretation No. 46(R)) which seeks to identify the party that
effectively controls the entity through an analysis of the risks and rewards of the SPE.
112
The addition of Interpretation No. 46(R) to the consolidation guidance has improved the
guidance for assessing consolidation of SPEs.
Since the issuance of Interpretation No. 46(R), an investor must determine
whether the investee is a Variable Interest Entity or a Voting Interest Entity. This
determines which consolidation approach—voting control or risks and rewards—is used
in evaluating whether the other entity needs to be consolidated. Once an issuer identifies
an entity that is required to be analyzed under the risks and rewards approach, additional
analysis is required to measure the exposure to risks and rewards of the entity. We
discuss Interpretation No. 46(R) in more detail in Section IV of this Report.
b. Unconsolidated Investments
As discussed above, investments in the equity of another entity that do not
provide the issuer with control are accounted for using four different methods. In
general, the Staff believes that the number of potential methods for these investments
should be reduced, as the different methods do not always correspond to investments with
110
See SFAS No. 94, paragraph 9 and paragraph C2.a of SFAS No. 144.
111
Including: when minority shareholders have significant participatory rights (EITF 96-16, Investor’s
Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority
Shareholder or Shareholders Have Certain Approval or Veto Rights), and where control may exist due to
contractual relationships rather than ownership (EITF 97-2,
Application of FASB Statement No. 94 and
APB No. 16 to Physician Practice Management Entities and Certain Other Entities with Contractual
Management Arrangements).
112
As noted previously, Interpretation No. 46(R), discussed in detail in Section IV of this Report, addresses
the accounting for Variable Interest Entities, which are generally understood to include the subset of
entities typically referred to as SPEs.
37
differing economics. Some support the equity method by arguing that significant
influence over another entity is a trigger that should change the accounting. Others
suggest that equity method investments should be reported at fair value. Still others
argue that fair value should not be used when that value is not evident from public market
transactions. Although all of these views have merit, the Staff nonetheless believes that
exploring the approach of recording all investments in other entities that do not result in
consolidation at fair value is warranted.
The benefits of reducing the number of alternative accounting treatments for
unconsolidated investments would include: 1) increased transparency for financial
statement users, 2) reduced complexity for financial statement preparers, 3) reduced
likelihood that investments with similar underlying economic characteristics are
presented differently in the financial statements, and 4) reduced incentives to structure
investments in an effort to achieve a particular accounting treatment. For example, an
issuer investing in another entity that is likely to incur losses in the short term may
currently have an incentive to structure its investment to avoid the equity method,
113
because it would require the investor to recognize its share of these losses.
3. Empirical Findings from Study of Filings by Issuers
In this section the Staff presents empirical findings from the Study of filings by
issuers related to investments in other entities. The Staff also extrapolates from these
findings to estimate amounts related to the approximate population of active U.S. issuers.
Table III(A)(1) describes the percentage of issuers reporting investments in the
equity of other entities. Almost 96% of the sample issuers present financial reports that
consolidate one or more other entities. As indicated in the table, approximately 50% of
the sample issuers report equity-method investments, and approximately 36% report cost-
method investments. Approximately 58% and 18% of the sample issuers report
investments categorized as “available for sale” and “trading”, respectively.
114
An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that approximately 24% of the population of issuers report equity-
method investments, approximately 17% report cost method investments, approximately
37% report available-for-sale investments and approximately 6% report trading
investments.
113
See, for example, EITF Issue No. 02-14, Whether an Investor Should Apply the Equity Method of
Accounting to Investments Other Than Common Stock.
114
Two-thirds of those issuers reporting trading investments are large banks, financial institutions,
insurance companies, and the like.
38
TABLE III(A)(1): Issuers Reporting Investments in the Equity of Other Entities
Sub-Samples
Categorized by Accounting
Treatment
a
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers presenting consolidated
financial statements
b
95.5 100 91 91.1
Issuers reporting equity method
investments
c
50.5 78 23 23.5
Issuers reporting cost method
investments
c
36 55 17 17.4
Issuers reporting available-for-sale
investments
c
58 79 37 37.4
Issuers reporting trading
investments
c
17.5 29 6 6.2
a
These categories are not mutually exclusive.
b
Determined by observation of the face of the balance sheet; issuers presenting consolidated financial statements will
include the term “Consolidated” in the titles of each statement.
c
Determined by examining the notes to the financial statements of issuers that report “Investments” to ascertain
whether these investments are accounted for as “trading,” “available for sale,” “cost method,” or “equity method
investments.”
Table III(A)(2) presents reported amounts related to equity method investments,
where such amounts can be determined. As discussed above, the amount presented on
the balance sheet for equity method investments represents the issuer’s interest in the net
assets of the other entity. For our sample of issuers, the total value on the balance sheet
for equity-method investments is reported at approximately $146 billion. A total of
almost $18 billion in income related to equity method investments is reported on the
sample issuers’ income statements.
TABLE III(A)(2): Reported Amounts Related to Equity Method Investments
a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Equity method investments reported
on issuer balance sheet
a
$145,914 $143,318 $2,596 $402,918
Income (loss) from equity method
investments reported on issuer
income statements
a
$17,664 $17,462 $202 $37,662
a
These data were collected from the notes to the financial statements and supplemental exhibits.
It is important to note that disclosure of the amount on the balance sheet related to
equity method investments may not be required, absent other factors that make the
39
information material to investors. For example, if the investment does not meet certain
requirements that designate it as “significant,”
115
the amount reported for the investment
may be combined with other items on the balance sheet and presented as “other assets”
with no further breakdown of the other asset categories required. In this case, investors
may not be able to determine the existence of some equity method investments (or other
types of investments) from the issuer’s filing.
If the investment is “significant,” disclosures about the financial position and
operating results of the other entity may be required in the notes to the financial
statements or in supplemental exhibits. The Staff notes that, due to the varying
placement of the disclosures and the different levels of disclosures required, it may
sometimes be difficult for investors to fully comprehend the extent of an issuer’s
involvement with equity method investments and to compare such involvements across
issuers. As a result, the Staff acknowledges that the values reported in Table III(A)(2)
may be understated.
In reviewing the sample data, the Staff notes that fair values of equity method
investments are not disclosed in many cases.
116
Where fair values were reported, the
Staff notes that there is little, if any, correlation among the fair values, the value reported
on the issuer’s balance sheet under the equity method, and the underlying equity in the
other entity.
B. Transfers of Financial Assets with Continuing Involvement
1. Nature of Arrangements and Financial Reporting
Requirements
Issuers often transfer financial assets (
e.g., customer receivables, notes,
mortgages, bonds) to other parties. In this subsection, we discuss the “derecognition” of
financial assets; that is, when is it appropriate for an issuer to consider financial assets to
be sold, and remove them from the balance sheet. If the transfer is treated as a sale (
i.e.,
if it receives “sale accounting”), the issuer would record the receipt of cash, remove (
i.e.,
“derecognize”) the assets from its balance sheet, and report any gain or loss in the income
statement. If a transfer of financial assets does not qualify for sale accounting, it is
instead accounted for as a borrowing. In these cases, the issuer transferring the assets
would record the receipt of cash, but would
not remove the assets from its balance sheet,
and would
not report any gain or loss in the income statement. Further, the issuer
transferring the assets would recognize a liability for the full amount of cash received
from the other party.
In a simple example, consider an issuer selling $1 million in customer receivables
to a finance company without recourse or further obligation on either party’s part. The
issuer receives cash today and its customers’ future payments are sent to the finance
115
See Regulation S-X Rules 3-09 and 4-08(g).
116
Paragraph 20(b) of APB No. 18 indicates that the “For those investments in common stock for which a
quoted market price is available, aggregate value of each identified investment based on the quoted market
price usually should be disclosed.”
40
company. In this case the finance company bears all the risk and, assuming no fraud or
other irregularities, the issuer is not required to reimburse the finance company if its
customers default. In this case, since the issuer surrenders all rights and retains no
obligations associated with ownership of the receivables, the transfer would typically be
treated as a sale.
In other arrangements, the issuer may continue to be involved with the transferred
assets. For example, an issuer might transfer customer receivables to a finance company
for cash, but accept an obligation to reimburse the finance company in the event that the
issuer’s customers default. Consider a transfer of $1 million in customer receivables
similar to that above, except that the issuer guarantees up to $10,000 of the amounts
transferred. Such a transfer would typically still be treated as a sale, since the continuing
obligation to which the issuer is exposed is relatively small, and does not result in the
issuer continuing to control the transferred assets..
The transaction looks less like a sale as the continuing involvement increases.
Indeed, in some cases, a transfer of financial assets with extensive continuing
involvement might be economically indistinguishable from a borrowing secured by the
“sold” assets. Consider a similar transfer of $1 million in customer receivables where the
issuer guarantees 100% of the amounts transferred, such that the issuer must reimburse
the finance company for any and all customer defaults. This transaction clearly has
economic similarities to a secured borrowing since the issuer has received cash today and
is obligated to remit cash to the finance company in the future, regardless of whether or
not its customers pay.
SFAS No. 140,
Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, provides the guidance for determining whether all, or any
portion of, a transfer of financial assets should be accounted for as a sale, in cases where
there is continuing involvement. SFAS No. 140 focuses on the concept of “control” of
the transferred financial assets; if control is deemed to be relinquished, the transaction is
treated as a sale. However, SFAS No. 140 does not impose a “sale” or “no sale”
determination for the entire transaction. Instead, what has been dubbed a “financial
components” approach is taken, such that the issuer continues to record as an asset any
portion of the original asset that it continues to control after the transfer, and removes
from its balance sheet the portion that it no longer controls. Thus, if control over only a
portion of the assets has been given up, an issuer would account for only that portion as
sold. The issuer would continue to include in its financial statements any portion of the
assets it did not sell and recognize any other assets or liabilities related to its continuing
involvement with the portion of the assets sold.
In our example above where the issuer guaranteed up to $10,000 of the amounts
transferred, assuming that sale accounting were appropriate, the issuer would recognize
the receipt of the cash, remove the customer receivables from its balance sheet, and
recognize a liability related to the $10,000 guarantee. If, in addition to the guarantee, the
issuer retained an undivided interest in 20% of the receivables, then the issuer would
recognize the receipt of the cash, remove
only 80% of the receivables’ carrying value
41
from its balance sheet, and recognize a liability related to the $10,000 guarantee.
117
In
the example above where the issuer guaranteed 100% of the amounts transferred, it is
likely that the transfer of the customer receivables would not receive sale accounting. In
this circumstance, as described above, a liability will be recorded to reflect the issuer’s
obligation to repay the full amount received to the finance company.
It is noteworthy that, under this approach, transfer of
control remains the key
criterion (as opposed to, say, some measure of risks and rewards), albeit applied to each
component of the transaction. In this context, transfer of control is generally considered
to have occurred for accounting purposes if:
118
• The assets have been “isolated” from the issuer transferring the assets
119
(that is,
put presumptively beyond the reach of the issuer or its creditors even in
bankruptcy);
• The purchaser
120
is not restricted from selling the assets or using them as
collateral for a loan; and
• The issuer transferring the assets does not continue to maintain effective control
over the assets by keeping a right or obligation to repurchase or redeem the assets
before their maturity.
Transfers of financial assets often take more complex forms than the simple
scenarios discussed above. For example, financial assets are often transferred into a
special purpose entity, which issues securities or commercial paper in order to fund the
purchase of the financial assets. If the SPE issues securities, the transaction is commonly
described as a “securitization” of those financial assets.
121
If the transaction involves the
transfer of mortgage loans and a related guarantee (such as one from a government-
sponsored agency), it is referred to as a “guaranteed mortgage securitization.” If the SPE
issues commercial paper, it might be referred to as a commercial paper conduit.
There are several reasons why issuers engage in these more complex transactions,
such as to enhance liquidity, manage risks, and/or to obtain lower-cost funding. In order
to achieve lower-cost funding, issuers generally maintain at least some level of
continuing involvement in the transferred assets that provides protection (
i.e., from credit,
interest rate, or other risks) to the purchasers of the securities or commercial paper issued
by the SPE. For example, a seller may provide credit enhancement through over-
collateralization of the assets sold. In a common type of over-collateralization, the seller
117
This would assume that all the criteria to qualify for sale accounting in paragraph 9 of SFAS No. 140
have been met.
118
See SFAS No. 140, paragraph 9.
119
This is a facts and circumstances determination, and often requires the advice of outside attorneys.
120
When the purchaser is a QSPE (as is discussed below), this criteria applies to restrictions on the QSPE’s
interest holder.
121
Paragraph 364 of SFAS No. 140, defines a securitization as “the process by which financial assets are
transformed into securities.”
42
would sell assets worth, say, $100 for $90, while retaining the right to the last $10
collected on those assets. Other types of continuing involvement include derivative
transactions with the SPE,
122
cash reserve accounts,
123
guarantees,
124
and/or servicing
obligations for the underlying assets. In the context of a securitization, the assets and
liabilities related to an issuer’s continuing involvement in the transferred assets are often
referred to as “retained interests.” Both the economics and the structural forms of these
contracts have evolved rapidly in recent years, in order to take advantage of opportunities
in financial markets and, at times, to achieve specific accounting results.
When an SPE is involved, in addition to determining whether or not sale
accounting is appropriate, there is also a need to determine whether the transferor is
required to consolidate the SPE for accounting purposes. If an issuer transfers financial
assets to an SPE in a transaction qualifying for sale accounting, but the SPE is
consolidated, the sale accounting allowed by SFAS No. 140 would be effectively
negated. That is, the issuer would recognize the outstanding portion of the assets
transferred on its consolidated balance sheet, as well as a liability reflecting the SPE’s
obligation to its debt-holders.
In order to facilitate sale accounting in securitization transactions, the accounting
guidance includes an exception to the consolidation requirements for certain SPE’s
commonly used in securitization transactions. In many cases the SPE in a securitization
transaction can be described as being on “auto-pilot”—
i.e., it merely collects cash flows
on the financial assets and pays those cash flows to investors, but does nothing else, such
that, in essence, no one controls or needs to control the operations of the entity. In such
cases, since all decisions are preprogrammed by the legal documents that create the SPE,
it has been argued that there is no need for any party to be deemed to control the entity—
and thus, no justification for consolidation. The FASB denoted this type of SPE as a
“qualifying” SPE or “QSPE” to differentiate it from other SPEs.
125
SFAS No. 140 also requires the following disclosures (among others):
126
• Total outstanding amounts of securitized assets, the portion that has been
derecognized, and the portion that continues to be recognized on the balance sheet
(
e.g., as retained interests); and
• Amounts of, delinquencies on, and net credit losses related to securitized assets
plus any other assets the issuer manages with them;
122
See discussion on derivatives in Section III(F).
123
A cash reserve account is a form of credit protection provided by the seller and is typically funded from a
portion of the seller’s proceeds from the securitization transaction. Losses of principal and/or interest in the
entity generally would be borne first by the cash reserve account up to the amount funded in such account,
thus providing a form of credit enhancement to the third-party investors.
124
See discussion on guarantees in Section III(E).
125
See SFAS No. 140, paragraph 46 and Interpretation No. 46(R), paragraph 4(c).
126
See SFAS No. 140, paragraph 17 a complete list of the disclosure requirements.
43
In addition, SFAS No. 140 requires the following disclosures for each
securitization asset type (such as credit card receivables, mortgage loans or automobile
loans):
• The characteristics of the securitization—that is, a description of the issuer’s
continuing involvement with the securitized assets and the amount of gain or loss
on sale;
• Cash flows between the issuer and the SPE;
• The issuer’s accounting policies for initially and subsequently measuring any
retained interests;
• Key assumptions in measuring the fair value of the retained interests; and
• Sensitivity analysis showing the effects of changes in the key measurement
assumptions.
The Commission’s Financial Reporting Release No. 67 (known as FR 67)
mandated by section 401(a) of the Act, also requires additional disclosures in the Off-
Balance Sheet section of MD&A regarding certain off-balance sheet arrangements. FR
67 requires issuers to provide disclosures about securitization transactions that involve
transfers to an unconsolidated entity with the issuer having retained or contingent
interests in the unconsolidated entity. Disclosure is required to the extent necessary to
provide an understanding of the issuer’s material off-balance sheet arrangements as well
as the material effects of those arrangements. For securitization transactions these
disclosures may include:
• Nature and business purpose of the arrangement, including a description of the
retained or contingent interests in assets transferred that serve as credit, liquidity,
or market risk support for the assets;
• Importance of the arrangement to liquidity, capital resources, market risk or credit
risk support, or other benefits;
• The financial impact of the arrangements and the issuer’s exposure to risk as a
result of the arrangements (
e.g., retained interests or contingent liabilities); and
• Known events, demands, commitments, trends or uncertainties that affect the
availability or benefits of such arrangements.
2. Off-Balance Sheet Issues in Accounting for Transfers of
Financial Assets
During the development of the guidance related to transfers of financial assets, the
FASB noted that transfers of financial assets in which the seller has some continuing
involvement (either with the transferred assets or with the purchaser) had grown
significantly in volume, variety, and complexity.
127
With this in mind, the FASB set out
127
See SFAS No. 140, paragraph 116.
44
to develop an approach that would be more responsive to developments in the financial
markets. The financial components approach was designed to be consistent with the way
market participants deal with financial assets, recognizing that the financial marketplace
can contractually separate and repackage the cash flows associated with financial assets
in many ways. The financial components approach was also designed to reflect the
economic consequences of contractual provisions underlying the financial assets and
liabilities, and conform to the FASB’s conceptual framework.
Application of the financial components approach may be challenging, as many of
these transactions (e.g., securitizations) can be complex and highly structured. For
example, it is often necessary to obtain legal opinions from attorneys with specific
expertise in these transactions. Additionally, determining the fair value of the various
components of the transaction, including any retained interests, requires the exercise of
judgment and may also involve subjective estimations, raising questions about the
preciseness of both the fair values and of gains or losses recorded upon the sale of the
financial assets. Nevertheless, the financial components approach, in general, provides a
consistent approach to derecognition, and is a substantial improvement from the
incomplete and sometimes inconsistent guidance that existed before that approach was
adopted. The financial components approach is also more flexible than an “all or
nothing” approach that would look at each instrument only as whole.
128
As discussed above, an alternative to using control as a basis for determining
which assets to record is a “risks and rewards” approach. Those who support a risks and
rewards approach to derecognition often suggest that an approach that focuses on control
of the financial assets makes it possible to have economically similar transactions treated
differently for accounting purposes. For example, consider an issuer selling customer
receivables and specifying in the sale agreement that it could, at some later date, select
from among those receivables a small portion to repurchase at a fixed price. Since any
individual receivable could be repurchased under this provision, according to SFAS No.
140 the issuer is deemed to have retained control over the entire pool of assets, even
though the issuer might not participate significantly in the risks and rewards associated
with the asset pool. As a consequence of this retained control, this transfer would not
qualify for sale accounting under SFAS No. 140.
Although there is debate about whether the guidance in SFAS No. 140 is
effective, much of the controversy is caused not by the standards themselves, but by
transaction structuring. Issuers often structure transfers in order to achieve or avoid sale
accounting, trigger or avoid the recognition of losses (or gains), or change the
measurement attribute applied to the recorded assets and liabilities. The Staff believes,
based on its reviews of issuer filings, that the most frequent structuring goal is to achieve
sale treatment without consolidation of any related SPEs. While economic motivations
for most asset transfers exist, some transfers of financial assets appear to be significantly,
primarily, or even solely entered into with accounting motivations in mind.
128
In contrast, lease accounting, discussed in Section III.D, takes such an “all or nothing” approach.
45
Some of this structuring has been undertaken by using QSPEs in situations that
appear to the Staff to be beyond those originally contemplated by the FASB. The FASB
originally intended a QSPE to be merely a pass-through entity to essentially serve as
custodian of the underlying financial assets,
129
and attempted to define it in such a way as
to ensure that this was the case. There are restrictions on the types of assets that an SPE
can hold while remaining “qualified,” and when it is acceptable for the QSPE to dispose
of certain non-cash financial assets.
130
Although the limitations on the activities of
QSPEs do not permit the QSPE to manage the assets on its balance sheet, there are few
explicit limitations on managing the balance sheet
liabilities.
131
That is, in structures
where the QSPE holds longer term assets and funds the purchase of such assets through
the issuance of shorter term interests to investors, decisions have to be made regarding
the nature of the new interests to be issued when the original short term interests mature.
In practice, these decisions are made by the issuer transferring the financial assets.
Accountants and auditors have concluded that the SPE – despite such management of
liabilities -- is a QSPE under SFAS No. 140, and is therefore exempt from consolidation.
These and other interpretations of the QSPE guidance have expanded the activities of
QSPEs beyond the simple pass-through entities originally envisioned by the FASB.
132
Despite persistent work by the FASB
133
and the Commission, the Staff considers
the accounting for sales of financial assets to be in need of improvement. Indeed, the
FASB already has several projects on its agenda relating to transfers of financial assets.
However, this area is challenging to standard setters, in large part because financial
structures are virtually limitless and continue to evolve at a rapid pace. However,
because the areas in need of improvement in their accounting stem mainly from
structured transactions that have accounting motivations, improvement in transparency
and comparability across issuers can perhaps most directly and quickly be accomplished
by eliminating the use of such structured transactions.
3. Empirical Findings from Study of Filings by Issuers
In this section the Staff presents empirical findings from the Study of filings by
issuers related to transfers of financial assets. The Staff also extrapolates from these
findings to estimate amounts related to the approximate population of active U.S. issuers.
Table III(B)(1) describes the percentage of issuers reporting transfers of financial
assets. As indicated in the table, approximately 17% of the sample issuers report
129
See SFAS No. 140, paragraph 177.
130
See SFAS No. 140, paragraph 35.
131
The FASB is currently considering these and other issues as part of a project to amend SFAS No. 140.
132
In acknowledging these interpretations, the Staff does not intend to signify its agreement with them.
133
For example, the FASB previously amended and added to the guidance in SFAS No. 125 through the
issuance of SFAS No. 140. Additionally, the FASB staff addressed 123 interpretive questions in a Special
Report, A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities. More recently, the FASB has undertaken a project to
amend the guidance in SFAS No. 140.
46
transfers of financial assets, mainly via securitizations, and most of these issuers are
members of the large issuer sub-sample. Approximately 13% of issuers report retained
interests related to these transfers and, again, most of these issuers are members of the
large issuer sub-sample. An extrapolation of the findings from the sample to the
approximate population of active U.S. issuers suggests that approximately 4% of the
population of issuers report transfers of financial assets, and approximately 3% report
retained interests from their continuing involvement with these assets.
TABLE III(B)(1): Issuers Reporting Transfers of Financial Assets
Sub-Samples
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers reporting transfers of
financial assets
a
17 30 4 4.3
Issuers reporting retained interests
a
13 23 3 3.2
a
These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
Table III(B)(2) presents reported amounts related to transferred financial assets.
Our sample of issuers reports approximately $791 billion in financial assets that were
transferred, and moved off issuer balance sheets, but are still outstanding. In addition,
our sample of issuers reported net gains of approximately $10 billion related to the sale of
financial assets during 2003. Our sample issuers report approximately $161 billion in
assets and liabilities related to the issuer’s continuing involvement with these assets. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that financial assets reported by the population as transferred but
still outstanding are close to $1 trillion, and that assets and liabilities reported by the
population as representing their continuing involvement in these transferred assets are
approximately $186 billion.
47
TABLE III(B)(2): Reported Amounts Related to Financial Assets Transferred
a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Financial assets transferred off
issuer balance sheets but still
outstanding
$790,925 $789,325 $1,600 $949,325
Gain/loss on transfers of financial
assets reported on issuer income
statements $10,287 $10,047 $240 $34,047
Retained interests reported on issuer
balance sheets
$161,175 $160,928 $247 $185,628
a
These data were collected from the notes to the financial statements.
Table III(B)(3) presents reported amounts for some of the major classes of
retained interests reported by our sample of issuers. Interest-only strips,
134
recorded as
assets on the issuer’s balance sheet, total approximately $5.6 billion for the sample. Of
the various types of retained interests, these are typically the most subordinate, and
consequently carry the highest concentration of risk. Servicing assets,
135
which carry risk
primarily related to prepayments, total approximately $23 billion for the sample. The
remainder of the retained interests, approximately $133 billion, includes but is not limited
to various types of more senior interests that, by their nature, are apt to carry lower risk
concentrations.
TABLE III(B)(3): Reported Amounts Related to Major Classes of Retained
Interests
a
Sub-Samples
Type of Retained Interest
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Interest-only Strip $5,628 $5,540 $88 $14,340
Servicing Assets $22,677 $22,518 $159 $38,418
Other Retained Interests
b
$132,870 $132,870 $0 $132,870
a
These data were collected from the notes to the financial statements.
b
These interests would include amounts representing, for example, overcollateralizations, senior or mezzanine bond
interests, and seller’s interests in credit card securitizations.
It appears that some issuers exclude information regarding securitization
transactions from their disclosures if they did not retain a subordinate interest, such as an
134
Interest-only strips are instruments that entitle the holder to a portion of the interest payments made on a
pool of loans or debt securities
135
Servicing assets involve the right to payments similar to an interest-only strip in return for collecting and
dispersing payments made on the underlying loans.
48
interest-only strip, following the transactions. Further, the Staff notes that the sample
issuers disclosed relatively little information regarding transactions with commercial
paper conduits, such as transfers of trade receivables.
C. Retirement Arrangements
1. Nature of Arrangements and Financial Reporting
Requirements
Many companies provide employees with retirement benefits. Cash payments
under pension plans are the most common, but other benefits, such as health-care
insurance, are also offered. Due in part to the magnitude of the obligations under these
plans, the significance of the unfunded or underfunded status of plans, and the
uncertainty inherent in measuring the obligations, the accounting for certain retirement
benefits has long been controversial. However, with the aging population, concerns over
the future of the social security system, and companies reducing or eliminating retirement
benefits altogether, discussions regarding the accounting for employee retirement benefits
occur at the highest levels within the U.S. government, corporate-America and the
workforce.
There are two primary types of pension benefit plans: defined contribution and
defined benefit. Under a defined contribution plan, the employer provides contributions
to the plan based upon its agreements with employees and its policies, but has no further
obligation to provide benefits under the plan. The future risks and rewards of these plans
rest with employees, not employers. Thus, the accounting for defined contribution plans
is quite straightforward and does not raise significant off-balance sheet questions; as
such, the accounting for these plans is not addressed in this Report.
In contrast, under a defined benefit plan, the employer is at risk and is obligated to
ensure that employees receive the predetermined benefits after retirement. An employer
might simply choose to pay such benefits as they become due. However, most issuers set
up a separate legal entity (usually a type of trust) to hold and manage retirement assets
and make the related payments. Even when a separate entity is established to accumulate
assets to fund pension benefits, the employer’s obligation is not satisfied merely by
making contributions to the plan. Because of its responsibility to ensure there are
sufficient assets to pay plan benefits, the employer retains the risk of underperforming
assets, and receives the benefit when those assets perform better than expected. Subject
to certain limitations in employment law, the employer, or a representative appointed by
the employer, also generally determines the plan’s investments.
Based on our discussions in the previous sections, and in view of the employer’s
continuing involvement and risk, it might seem that a separate legal entity that is
established to hold and manage pension plan assets and that is controlled by the issuer
should be consolidated. If consolidated, plan assets and liabilities would be separately
recognized on the issuer’s balance sheet. However, defined benefit pension plans are
exempt from consolidation.
136
Instead, the retirement plan assets and liabilities, to the
136
See, for example, Interpretation 46(R), paragraph 4(b), and SFAS No. 87, paragraphs 35-37.
49
extent recognized, are netted against each other, with only the net asset or net liability for
each plan recognized on the issuer’s balance sheet.
137
It is generally accepted that any liability for pension-related costs should be
recognized by the employer as its employees perform service. Pension and other
retirement plan costs are determined by developing best estimates of future benefit
payments, taking into account a number of factors, to the extent such factors are relevant,
including the employee’s age, length of service, retirement date, salary, expected trends
in medical costs, expected mortality. These estimated future benefit payments are then
discounted to their present value. Due to the complexities involved in estimating pension
obligations, actuaries are typically involved. Given the long-term nature of pension
plans, changes in the estimates and assumptions over time are expected. The accounting
guidance for these plans does not require adjustments to the pension obligation as a result
of changes in the estimates and assumptions to be recognized immediately.
138
Similarly,
differences between expected and actual returns on assets need not be recognized
immediately. All of these items, which are collectively referred to as pension gains and
losses, may be deferred and factored into the pension obligation or asset reported on the
balance sheet over future periods.
The approach to accounting for defined benefit pensions is designed to ensure that
the related pension costs are recorded over the service lives of the employees and that the
recorded obligation is sufficient to reflect all benefit payments obligations before they
become due. However, companies are afforded discretion under the guidance as to when
gains and losses are recorded during the service period, so long as they are recorded by
the time the obligations become due. An issuer that does not elect to defer pension gains
or losses as permitted by the accounting guidance will report a net retirement plan asset
or liability that is determined based on the fair value of the assets in the plan, and the
then-current best estimate of the retirement obligation. That issuer would likely report
significant volatility in its pension expense, as any changes in actuarial estimates and
assumptions would be immediately recognized, as would actual returns on pension plan
assets. On the other hand, an issuer that elects to defer pension gains and losses would
report much smoother pension expense from period to period, but would report a net
retirement plan asset or liability that could be affected as much by deferrals of gains and
losses as by actual changes in assets and obligations.
The FASB attempted to mitigate the effects of smoothing pension expense and
reduce the amount of retirement liability that may be off-balance sheet, by instituting a
“minimum liability rule.”
139
If issuers choose to defer pension gains and losses, they
137
In part, this acknowledges the fact that under U.S. employment law, there are certain protections of
retirement benefits so long as the company funds its pension plans adequately and meets other
requirements. See Employee Retirement Income Security Act of 1974.
138
SFAS No. 87, Employers’ Accounting for Pensions and SFAS No. 106, Employers’ Accounting for
Postretirement Benefits Other Than Pensions, are the primary accounting standards related to accounting
for retirement benefits.
139
See SFAS No. 87, paragraph 36. Health-care and other postretirement benefit plans are not subject to the
minimum liability rule.
50
must recognize a liability of at least the amount by which the accumulated benefit
obligation (“ABO”), which is defined as the best estimate of the present value of future
pension payments without taking into account future salary increases, exceeds the fair
value of pension plan assets.
140
However, even with recognizing the minimum liability, a
significant amount of an issuer’s pension obligation may remain off-balance sheet, since
the determination of the minimum liability is based on the ABO, rather than the projected
benefit obligation (“PBO”), a projection of benefit obligations which considers the effects
of expected future salary increases.
Extensive disclosures are required for pensions and other postretirement benefit
plans.
141
These disclosure requirements are intended to provide financial statement users
a more complete picture of the retirement plans. More particularly, the disclosures are
generally designed to accomplish three tasks. First, they provide consistent information
about benefit plans, no matter what choices have been made regarding balance sheet and
income statement presentation of retirement plan amounts. Second, they provide the
reader with information about certain key assumptions and estimates used in the pension
and postretirement benefit plan calculations. And finally, they explain whether the issuer
has elected to defer any of the gains or losses and provide information about the effect of
deferral.
Required disclosures include:
• A reconciliation of changes in employers’ retirement obligations from period to
period, and a reconciliation of changes in fair values of retirement plan assets
from period to period;
• Funded status of the plan (
i.e., the extent to which the retirement obligations ((as
measured by PBO for pensions and ABO for other postretirement benefit plans))
are funded with retirement assets to cover those obligations) and the amounts of
retirement-related obligations that are off-balance sheet;
• Qualitative and quantitative information about how retirement plan assets are
invested;
• Estimates of amounts expected to be contributed to the plan in the subsequent
year and the benefits to be paid to employees in the near term;
• The amount of net periodic benefit cost recognized in earnings; and
140
However, any such increase in liability does not appear on the income statement as a loss. Rather, the
“other side” of the accounting entry is also to the balance sheet, either to an intangible asset or to other
comprehensive income (a component of equity).
141
The accounting for other postretirement benefit plans is similar to defined benefit pension plans in that
the issuer is required to estimate and recognize the obligation and related cost of providing such benefits as
the employees perform services. Further, many of the same issues regarding estimation of the obligation,
netting plan assets and liabilities and deferral of certain changes in plan assets and liabilities exist under
other postretirement benefit plan accounting. However, other postretirement benefit plans are often not
funded through the establishment of a separate legal entity.
51
• Key assumptions used in measurement of plan assets, liabilities and retirement
cost, including the dates such measurements were determined.
142
2. Off-Balance Sheet Issues in Accounting for Retirement
Arrangements
Some investors have expressed concerns about the transparency of pension and
other postretirement benefit accounting and disclosure. The CFA Institute (formerly the
Association for Investment Management and Research or “AIMR”), a nonprofit
membership organization for investment professionals, recently commented that, because
the pension and other postretirement benefit accounting standard “fails to provide full
recognition in the financial statements of the effects on the firm of the pension and
postretirement benefit contracts, a huge and very costly burden has been shifted to those
for whom the statements are prepared, analysts and other users.”
143
Accordingly, some
investors have called for issuers to report actual gains and losses from changes in
expected assumptions versus actual plan results by eliminating the smoothing of gains
and losses currently allowed under GAAP and to separately recognize pension and other
postretirement benefit plan assets and liabilities on the balance sheet. The Staff agrees
that, under the current standards, the balance sheet is often not transparent as to the true
funded status of pension plans and that additional clarity is necessary.
In the deliberations that led to the issuance of the retirement accounting standards
that were in the mid-1980s and early-1990’s, the FASB stated that it would be preferable
conceptually to recognize retirement liabilities and assets with either no
delay in
recognition of gains and losses in net income, or with gains and losses reported currently
in other comprehensive income, but not in net income.
144
However, it was strongly
argued by issuers that recognizing these short-term gains and losses in the income
statement of the issuer may overwhelm the effects of the issuer’s continuing operations
and thus would not fairly reflect the primary business activities of the issuer.
Furthermore, as noted above, preparers argued that retirement plans are a long-term
commitment, and that the accounting should take a similar long-term view that avoids
excessive short-term volatility, so long as the obligation is recognized by the time it
becomes due. Ultimately, the FASB acknowledged that not permitting the deferral of
certain gains or losses would be “too great of a change from past practice” and was
satisfied that the standards “as a whole represented an improvement in financial
reporting.” However, the FASB also acknowledged that the issuance of such guidance
was only one step toward gradual, evolutionary change.
145
142
See paragraph 5 et. seq. of SFAS No. 132 Revised.
143
See the CFA Institute (formerly AIMR) Comment Letter to the FASB: Re: File Reference No. 1025-200-
Proposed Statement of Financial Accounting Standards: Employers’ Disclosures about Pensions and Other
Postretirement Benefits, Oct. 27, 2003.
See also CFA Institute (formerly AIMR) letter to the IASB: Re:
Improvement of IAS 19, Employee Benefits, June 16, 2002, in which CFA Institute states that they are not
in favor of smoothing pension losses and gains.
144
SFAS 87, paragraph 107.
145
SFAS No. 87, paragraph 107.
52
While the merits of the various positions can be debated, it is true that retirement
plan accounting is at times inconsistent with the accounting for similar assets and
liabilities. For example, there are many liabilities whose ultimate payment amount
depends on future events. When the estimate of the amount to be paid changes, those
other liabilities are adjusted to reflect the change in estimate. However, when estimates
of the amounts of retirement benefits to be paid change, the related liability is not
required to be adjusted immediately, as gains and losses may be deferred. Also, as noted
previously, assets held in retirement plans are not accounted for using the guidance that
would apply to such assets if not held in retirement plans. In addition, the existence of so
many optional treatments is itself a difference between retirement plan accounting and
the accounting for other significant assets and liabilities.
Application of the current pension and other postretirement benefit accounting
guidance has raised other questions. As noted above, estimation of retirement plan
liabilities depends upon multiple actuarial and other estimates and assumptions. Because
of the size of retirement obligations and their sensitivity to certain assumptions, even
relatively small changes in those assumptions or estimates can significantly change the
estimated obligation or pension expense. The Staff has therefore focused on retirement
plan assumptions in its reviews of issuer filings in the past. For example, pension plan
assumptions were identified as a significant issue in the “Summary by the Division of
Corporation Finance of Significant Issues Addressed in the Review of the Periodic
Reports of the Fortune 500 Companies” issued in 2003. That report noted that several
topics which merit improved MD&A disclosures, including information about the
significant assumptions used and how they were determined, sensitivity of the financial
statements to changes in assumptions, and the impact of any planned changes in
assumptions. The selection of appropriate assumptions and the use of judgment in
making estimates of retirement obligations would likely be as important even if the
accounting guidance were changed.
3. Empirical Findings from Study of Filings by Issuers
In this section the Staff presents empirical findings from the Study of filings by
issuers related to retirement plans. The Staff also extrapolates from these findings to
estimate amounts related to the approximate population of active U.S. issuers.
Table III(C)(1) describes the percentage of issuers reporting defined-benefit
retirement plans. Approximately 48% of the sample issuers report defined-benefit
pension plans, while approximately 44% report other postretirement benefit plans.
146
The
large issuer sub-sample reports a higher incidence of these plans in that 81% (74%) of
these issuers report defined-benefit pension (other postretirement benefit) plans. In
contrast, in the random issuer sub-sample, only 15% (14%) of the issuers report
information about defined-benefit pension (other postretirement benefit) plans. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that approximately 16% of the total population of issuers report
146
Issuers may have many individual plans, but often report information on an aggregate basis.
53
sponsoring defined-benefit pension plans, and 15% report sponsoring other defined-
benefit postretirement plans.
147
TABLE III(C)(1): Issuers Reporting Defined-Benefit Retirement Plans
a
Sub-Samples
Categorized by Type of Plan
b
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers reporting defined-benefit
pension plan(s) 48 81 15 15.7
Issuers reporting other post-
retirement benefit plan(s)
44 74 14 14.6
a
These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
b
These categories are not mutually exclusive.
Table III(C)(2) presents the reported obligations, plan assets, and funded status
related to defined-benefit pension plans. These issuers report pension benefit obligations
(“PBOs”) of approximately $764 billion and plan assets set aside for pension plans of
approximately $678 billion. Defined-benefit pension plans for our sample of issuers are
thus
underfunded, based on this set of measurements, by approximately $86 billion
(approximately 11% of total PBO), which means that the assets set aside for the plan(s)
are less than the estimated obligations related to the plan(s). In an economic sense, this
“underfundedness” represents the net economic liability of an issuer related to pension
plans.
147
Ciesielski, J.T., “Ugly OPEBs: Surveying the S&P 500,” The Analyst’s Accounting Observer, November
24, 2004, reports that 14.7% of the 9,852 companies reviewed from S&P’s Research Insight database have
other post-employment benefit plans (which includes other postretirement benefit plans).
54
TABLE III(C)(2): Amounts Reported Related to Funded Status of Defined-benefit
Pension Plans
a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Reported PBOs $764,497 $758,882 $5,615 $1,320,382
Reported ABOs $537,522 $533,498 $4,024 $935,898
Reported values of plan assets $678,019 $673,564 $4,455 $1,119,064
Funded Status
b
$86,478
(underfunded)
$85,318
(underfunded)
$1,160
(underfunded)
$201,318
(underfunded)
a
These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
b
The funded status is calculated as the value of reported plan assets less the reported PBO.
These amounts for the sample as a whole are dominated by the large issuer sub-
sample, which reports 99% of both the total reported obligation and the total value of
plan assets for the sample. An extrapolation of the findings from the sample to the
approximate population of active U.S. issuers suggests that defined-benefit pension plan
obligations and assets reported by the population approximate $1.320 trillion and $1.119
trillion, respectively. This extrapolation suggests that pension plans for the population
may be underfunded by approximately $201 billion on a net basis.
Table III(C)(3) presents amounts that are reported on issuer balance sheets related
to defined-benefit pension plans. The sample issuers report pension assets on the balance
sheet of approximately $181 billion and pension liabilities on the balance sheet of almost
$90 billion. Thus, issuers in the Study report a net
asset position on the balance sheet for
defined benefit pension plans of approximately $91 billion. The $177 billion difference
between the liability implied by the $86 billion underfundedness (as shown in Table
III(C)(2)) and the $91 billion net asset recognized on the balance sheet is the portion of
the net pension liability that remains off-balance sheet for the sample of issuers in the
Study due to the smoothing allowed by current pension accounting standards.
55
TABLE III(C)(3): Amounts Reported on Issuer Balance Sheets Related to Defined-
benefit Pension Plans
a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Pension asset reported on issuer
balance sheets
b
$181,045 $179,544 $1,501 $329,644
Pension liability reported on issuer
balance sheets
$89,960 $89,682 $278 $117,482
Other comprehensive income
reported in equity section of issuer
balance sheets $50,181 $50,134 $47 $54,834
a
These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
These items are presented on the balance sheets of issuers, but since balance sheet items are often aggregated, the
detailed data can often only be obtained from the notes.
b
This total includes reported prepaid pension benefits of $172,248 (representing those retirement plans in a net asset
positions and intangible assets of $8,797. The intangible assets relate to prior service costs and exist only to offset part
of the additional minimum pension liability.
An extrapolation of the findings from the sample to the approximate population of
active U.S. issuers suggests that net pension assets and net pension liabilities reported on
issuer balance sheets approximate $330 billion and $117 billion, respectively, which nets
to approximately a $213 billion
asset position. The underfundedness estimated for the
population and presented in Table III(C)(2) suggests that there may be a net economic
liability related to defined benefit pension plans of approximately $201 billion. Thus,
these extrapolations suggest that a total of approximately $414 billion in net pension
liability may remain off-balance sheet for the approximate population of active U.S.
issuers.
Table III(C)(4) presents the reported obligations, plan assets, and funded status
related to other postretirement benefit plans, as well as any associated amounts reported
on issuer balance sheets. The issuers in our sample report total obligations, denoted as
accumulated postretirement benefit obligations (“APBOs”),
148
of almost $260 billion, but
they report total plan assets set aside for other postretirement benefit plans of only
approximately $42 billion (
i.e., 16% funded). As a result, other postretirement benefit
plans for our sample of issuers are underfunded by approximately $217 billion
(approximately 84% of the total APBO), which represents the net economic liability for
these issuers related to other postretirement benefit plans. Note that other postretirement
benefit plans are substantially more underfunded than defined-benefit pension plans—in
fact, other postretirement benefit plans are often not funded at all. An extrapolation of
the findings from the sample to the approximate population of active U.S. issuers
suggests that other postretirement benefit obligations and assets reported by the
population approximate $389 billion and $52 billion, respectively. This extrapolation
148
Note that GAAP does not require the calculation of a PBO for other postretirement benefit plans; in
general, such benefits are not affected by future salary increases.
56
suggests that other postretirement benefit plans may be underfunded by approximately
$337 billion for the population.
149
TABLE III(C)(4): Amounts Reported Related to Funded Status of Other
Postretirement Benefit Plans and Amounts on Issuer Balance Sheets Related to
Other Postretirement Benefit Plans
a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Reported APBOs $259,865 $258,560 $1,305 $389,060
Reported Values of plan assets $42,406 $42,306 $100 $52,306
Funded status
b
$217,459
(underfunded)
$216,254
(underfunded)
$1,205
(underfunded)
$336,754
(underfunded)
Other postretirement benefit plan
assets reported on issuer balance
sheets
$693 $693 $0 $693
Other postretirement benefit plan
liabilities reported on issuer balance
sheets
$146,741 $146,034 $707 $216,734
a
These data were collected from the financial statements in the filings of issuers selected for the Study
b
The funded status is defined as the reported value of plan assets less the reported APBO. However, not all issuers
reported the funded status directly—some simply reported the value of plan assets and the APBO. Issuers directly
reported total underfundedness of $210,056 for the sample as a whole, $208,929 for the large issuer sub-sample, and
$1,127 for the random issuer sub-sample.
Table III(C)(4) also presents amounts that are reported on issuer balance sheets
related to other postretirement benefit plans. The sample issuers report net liabilities on
the balance sheet related to other postretirement benefit plans of almost $147 billion, as
compared to net assets of less than $1 billion (
i.e., $693 million). The underfundedness
presented in Table III(C)(4) implies that there is a net economic liability related to other
postretirement benefit plans of $217 billion. The difference between the
underfundedness of $217 billion and the $146 billion net liability recognized on the
balance sheet is approximately $71 billion. This $71 billion net other postretirement
benefit liability remains off-balance sheet for the sample of issuers in the Study.
An extrapolation of the findings from the sample to the approximate population of
active U.S. issuers suggests that the liability for other postretirement benefit plans
reported on the balance sheet may be approximately $216 billion. The underfundedness
estimated for the population and presented in Table III(C)(4) suggests that there may be a
net economic liability related to other postretirement benefit plans of $337 billion. Thus,
149
Ciesielski, J.T., (2004), (cited previously) reports APBO of approximately $382 billion and plan assets
of approximately $65 billion from S&P 500 issuers with have other post-employment benefit plans (which
includes other postretirement benefit plans).
57
these extrapolations suggest that approximately $121 billion in other postretirement
benefit liability may remain off-balance sheet for the population.
150
For retirement plans
overall (
i.e., including pension and other postretirement benefit plans), the extrapolations
from the sample data suggest that liabilities of approximately $535 billion may remain
off-balance sheet.
The values reported above are all based on the amounts reported in financial
statements. However, given the sensitivity of retirement obligations to various estimates
and assumptions, it is important to also discuss some of these assumptions. For example,
one of the most critical assumptions is the choice of discount rate used to calculate the
present value of future benefit payments. Current accounting guidance specifies that
issuers should select discount rates that reflect the yield on high quality bonds of duration
similar to that of their projected annual benefit payments.
151
Table III(C)(5) presents information about discount rates used by issuers to
calculate the obligations for defined-benefit pension plans. The rates used by our sample
of issuers range from approximately 5.10% to 6.75% and the average is 6.18%. The
average discount rate is slightly higher for the random issuer sub-sample (at 6.26%) than
for the large issuer sub-sample (at 6.18%). By way of comparison, using the Bloomberg
fair value index bond yields for maturities of 10 years to 30 years, AA bond rates as of
December 31, 2003 ranged from 4.7% to 5.7%.
152
As another point of comparison,
S&P’s Creditweek Corporate Industrial AA Bond Yields for maturities of 10 years to 25
years, ranged from 5.09% to 6.0%. The Staff understands that there are a variety of other
indices that issuers rely on when selecting discount rates for pension calculations.
However, it appears that on average issuers may be using discount rates that are at the
high end.
153
150
It is important to note that a portion of the amount of liability that remains off the balance sheet likely
results from issuer’s elections to recognize the effects of applying the new accounting guidance under
SFAS No. 106, which became effective in the early 1990s, over long periods of time.
151
SFAS No. 87, SFAS No. 106 as well as EITF Topic D-36 Selection of Discount Rate Used for
Measuring Defined Benefit Pension Obligations and Obligations of PostRetirement Benefit Plans Other
Than Pensions provide explicit instructions on how issuers should select the discount rate used to calculate
their obligations.
152
The Staff notes that this index is based on coupon-bearing bonds. To match maturities with precision
would theoretically require rates equivalent to those of zero-coupon bonds, which rates would likely be
slightly higher.
153
One of the principal subjects of comment by the Division of Corporation Finance in their reviews of the
annual reports filed by the Fortune 500 in 2002 was pension accounting and disclosure. One of the
requested disclosures was of the assumptions, estimates, and data source used to determine the discount
rate. See the Staff document
Summary by the Division of Corporation Finance of Significant Issues
Addressed in the Review of the Periodic Reports of the Fortune 500 Companies at
http://www.sec.gov/divisions/corpfin/fortune500rep.htm. In addition, the Division Staff provides
information and guidance to registrants on accounting and disclosure issues in various ways. For example,
see the Staff document
Current Accounting and Disclosure Issues in the Division of Corporation Finance at
http://www.sec.gov/divisions/corpfin/acctdis030405.pdf, as well as the Staff document
Frequently
Requested Accounting and Financial Reporting Interpretations and Guidance at
http://www.sec.gov/divisions/corpfin/guidance/cfactfaq.htm, which contain information on the selection of
discount rates for pension and post retirement benefit plans.
58
TABLE III(C)(5): Reported Discount Rates used in Defined-benefit Pension
Calculations
a
Sub-Samples
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Minimum 5.10
c
5.10
c
6.00 NA
Average
b
6.18 6.18 6.26 NA
Maximum 6.75
d
6.75
d
6.75 NA
a
These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
These items are presented on the balance sheets of issuers, but since balance sheet items are often aggregated, the
detailed data can often only be obtained from the notes.
b
The average is weighted by PBO and is calculated only for issuers reporting discount rates in the notes to the financial
statements.
c
This is the minimum reported for a U.S. defined benefit pension plan. The actual minimum of the reported discount
rates for a defined benefit pension plan of 3.7% relates to a non-U.S. plan.
d
This is the maximum reported for a U.S. pension plan. The actual maximum of the reported discount rates of 6.8%
relates to a non-U.S. plan.
For illustrative purposes, the Staff notes that a ½% increase (e.g., from 5.5% to
6%) in the discount rate applied to a stream of annual cash flows of equal amounts for 20
years (compounded daily) would reduce the present value of that stream of cash flows by
approximately 4%. While it is not possible to illustrate the effect on PBOs because the
timing of payments is unknown, the Staff’s estimate of pension underfundedness may
itself be understated due to the interest rates selected by issuers for discounting.
Further, the accounting measure of underfundedness represents only one method
of calculating this measure. For example, the Pension Benefit Guaranty Corporation
(“PBGC”) measures retirement liabilities based on the estimated cost of purchasing
annuities to settle pension obligations when a company no longer can afford to maintain
its plan. Thus, the discount rate used by the PBGC is based on periodical surveys of
insurance companies which, in combination with a mandated mortality table, results in a
present value representative of group annuity purchase prices. The 20 year select
discount rate used by the PBGC as included in its fiscal year 2003 annual report was
4.40%. On the other hand, discount rates used to determine minimum funding of plan
liabilities are calculated using rates either selected by a company’s actuary (ERISA
Liability) based on how pension assets are invested or the current liability which is based
on a statutory range of rates. The statutory range at December 31, 2003 approximated
5.90% to 6.60%.
59
D. Leases
1. Nature of Arrangements and Financial Reporting
Requirements
A lease is a contractual obligation that allows assets owned by one party to be
used by another party, for specified periods of time, in return for a payment or series of
payments. Assets that are commonly leased include automobiles, airplanes, buildings
and other real estate, machinery, computer equipment, and many other tangible assets.
An issuer may be motivated to lease, rather than purchase, an asset for many reasons,
including economies of scale or scope, increased flexibility, tax advantages, improved
access to capital, reduced costs of upgrading equipment, and improved risk sharing.
154
SFAS No. 13, Accounting for Leases (issued in 1976), provides the basic
guidance for leases.
155
Leases that transfer most of the benefits and responsibilities of
ownership to the party using the asset may be economically similar to sales with attached
financing agreements. This is recognized in SFAS No. 13, which states that “a lease that
transfers substantially all of the benefits and risks incident to the ownership of property
should be accounted for as the acquisition of an asset and the incurrence of an obligation
by the lessee and as a sale or financing by the lessor.”
156
Otherwise, the lease should be
accounted for as a rental contract. We concentrate on the case where an issuer is the
lessee, that is, where the issuer is the party using the asset, as this is the scenario most
likely to result in no elements of the lease or leased asset being on the balance sheet.
Leases can transfer control of the asset from the lessor to the lessee for as much of
the asset’s life as desired, and can also transfer as many of the risks and rewards of
ownership as desired. Leasing transactions can take many forms and include many
different terms. Yet, despite this diversity in leasing arrangements, all leases receive one
of two opposing accounting treatments; either the lease is treated as if it were a sale or as
if it were a rental.
If “most” of the risks and rewards of ownership are transferred to an issuer leasing
an asset, the lease is treated as a sale of the entire asset by the owner (
i.e., the lessor) and
a purchase of an asset financed with debt by the issuer using the asset (referred to as the
‘whole-of-the-asset’ approach). This kind of lease is called a “capital lease.”
157
In these
cases, the lessor removes the cost of the asset from its balance sheet and reports a sale of
the asset for proceeds equal to the present value of the required lease payments, plus the
expected remaining value of the leased asset at the end of the lease term. The issuer
154
The Equipment Leasing Association indicates that of the $668 billion of productive assets acquired by
businesses in 2003, $208 billion, or 31 percent, was acquired through leasing.
See the Equipment Leasing
Association’s website: http://www.elaonline.com/industrydata/overview.cfm.
155
Leases are defined as the right to use property, plant, or equipment for stated periods of time and can
include agreements that are not nominally identified as leases.
See paragraph 1 of SFAS 13, Accounting
for Leases. Also see EITF Issue 01-8, Determining Whether an Arrangement Contains a Lease, which
describes other arrangements than are not nominally identified as leases but may contain a lease.
156
See SFAS No. 13, paragraph 60.
157
Such a lease would be referred to as either a “sales-type” or “direct financing” lease for lessors.
60
using the asset records the asset and a related liability for the present value of the required
lease payments on its balance sheet.
If the lease does not transfer sufficient risks and rewards to the lessee to be treated
as a sale and purchase, it is instead treated like a rental contract. This kind of lease is
called an “operating lease.” In this case, the owner of the asset retains the asset on its
balance sheet and records lease rental revenue (as well as depreciation, property taxes,
etc.) in its income statement on a period-by-period basis. The issuer using the asset does
not record the asset, or a related liability for the future contractual rental payments, on its
balance sheet, but records leasing expense in its income statement, also on a period-by-
period basis.
SFAS No. 13 specifies that a lease is a capital lease if:
• The lease transfers ownership to the issuer (
i.e., the lessee) using the asset by the
end of the lease term; or
• The lease contains an option whereby the issuer can purchase the leased property
at a price sufficiently lower than the expected fair value of the leased property at
the end of the lease term; or
• The term of the lease is equal to or greater than 75% of the estimated economic
life of the leased property; or
• The present value of the minimum lease payments to be made by the issuer is
equal to or greater than 90% of the fair value of the leased property.
158
While in the majority of cases the evaluation of whether these criteria have been
met is straightforward, in certain circumstances it can be challenging, as leases
sometimes contain contingent or variable payment requirements, optional term
extensions, and other clauses that affect the calculations under one or more of the tests
described above. However, such determinations are very important, as they can
completely change the accounting for the lease.
The identification of which agreements should be accounted for
as leases, and
thus subject to the tests listed above, is also challenging in some situations. In order to
reduce the chances of like arrangements being accounted for differently, the accounting
guidance defines leases by their characteristics, not by their label. Thus, any contract, or
portion of a contract, that meets the definition of a lease must be accounted for as one.
159
While most leases are indeed explicitly identified as such, some are not.
The accounting guidance also includes extensive disclosure requirements for
leases. These requirements vary based upon the type of lease and whether the issuer is
the lessor or lessee. These disclosure requirements provide investors with the following
information:
158
In addition, lessors must also consider the following additional criteria: collectibility of the minimum
lease payments is reasonably predictable and no important uncertainties surround the amount of
unreimbursable costs yet to be incurred by the lessor under the lease.
See SFAS 13, paragraphs 7 and 8.
159
See, for example, EITF Issuer No. 01-8, Determining Whether an Arrangement Contains a Lease.
61
• General description of the nature of leasing arrangements;
• The nature, timing and amount of cash inflows and outflows associated with
leases;
• The amount of lease revenues and expenses reported in the income statement each
period;
• Description and amounts of leased assets by major balance sheet classification
and related liabilities; and
• Amounts receivable and unearned revenues under lease agreements.
160
In addition, FR 67
requires presentation of both capital and operating lease
obligations in the contractual obligations table in MD&A.
2. Off-Balance Sheet Issues in Accounting for Leases
A lease is a particular kind of contractual obligation. As discussed in Section
III.G, the most significant accounting issue with respect to most contractual obligations is
whether to record the rights and obligations inherent in the contracts as assets and
liabilities when neither party to the contract has performed. With respect to leases,
however, the question is really how to assess whether performance has occurred. As
noted above, the current lease accounting standards focus on a determination as to which
party to a lease agreement has the risks and rewards of ownership of the leased asset.
This, in turn, determines whether the owner is deemed to have sold the asset and whether
the issuer using the asset is deemed to have purchased the asset.
As a consequence of this approach, the issuer leasing the asset will either
recognize the entire leased asset on its books and a liability for all of its contractually
required payments, or it will recognize no asset and no liability. The lease accounting
guidance either treats the contract as if all of the performance occurs at the beginning of
the lease, or as if none of it does. The intention is to treat those leases that are
economically equivalent to sales as sales, and to treat other leases similar to service
contracts. This approach, while a significant improvement from previous lease
accounting, which rarely if ever required recognition of a capital lease, does not allow the
balance sheet to show the fact that, in just about every lease, both parties have some
interest in the asset, as well as some interest in one or more financial receivables or
payables.
161
The “all-or-nothing” nature of the guidance means that economically similar
arrangements may receive different accounting—if they are just to one side or the other
of the bright line test. For example, most would agree that there is little economic
160
See SFAS 13, as amended for detailed lists of disclosure requirements.
161
In contrast, the model used for transfers of financial assets with continuing involvement, discussed in
Section III.B, does attempt to recognize this fact, by requiring the transferor to continue to recognize those
components that it continues to control, while requiring it to derecognize the components it no longer
controls.
62
difference between a lease that commits an issuer to payments equaling 89% of an asset’s
fair value vs. 90% of an asset’s fair value. Nonetheless, because of the bright-line nature
of the lease classification tests, this small difference in economics can completely change
the accounting. Conversely, economically different transactions may be treated
similarly.
162
For example, most would agree that there is a significant economic
difference between a one-month lease of a building and a 10-year lease of that building.
However, if both leases qualified for operating lease treatment, they would likely both
have little to no effect on the balance sheet. The extensive disclosures required for leases
do provide some information about the rights and obligations inherent in operating leases.
Problems with the all-or-nothing character of the accounting have been magnified
because many issuers involved in leases, taking advantage of the bright-line nature of the
lease classification guidance, structure their lease arrangements to achieve whatever
accounting (sales-type/capital or operating) is desired. These issuers have been aided in
these endeavors by a large number of attorneys, lenders, investment banks, accountants,
insurers, industry advocates, and other advisers. Indeed, lease structuring to meet various
accounting, tax, and other goals, has become an industry unto itself in the last 30 years.
The significant amount of structuring of leases also makes analyzing potential
changes to the lease guidance very difficult. Indeed, the current accounting guidance,
which is criticized by many, would likely be held in much higher regard were it being
applied to the lease arrangements that existed when it was debated and created. Changes
in lease terms in response to the accounting guidance have caused undue focus on the
weaknesses of the guidance. The fact that lease structuring based on the accounting
guidance has become so prevalent will likely mean that there will be strong resistance to
significant changes to the leasing guidance, both from preparers who have become
accustomed to designing leases that achieve various reporting goals, and from other
parties that assist those preparers.
3. Empirical Findings from Study of Filings by Issuers
In this section, the Staff presents empirical findings from the Study of filings by
issuers related to leases. The Staff also extrapolates from these findings to estimate
amounts related to the approximate population of active U.S. issuers.
Table III(D)(1) describes the percentage of issuers reporting cash flows
committed under operating and capital leases. Approximately 77% of issuers in the
sample report information about operating leases, while approximately 31% report
information about capital leases. An extrapolation of the findings from the sample to the
approximate population of active U.S. issuers suggests that approximately 63% of the
total population of issuers report operating leases, and 22% report capital leases.
162
See paragraph 119 of SFAC 2 which states “Greater comparability of accounting information, which
most people agree is a worthwhile aim, is not to be attained by making unlike things look alike any more
than by making like things look different. The moral is that in seeking comparability accountants must not
disguise real differences nor create false differences.”
63
TABLE III(D)(1): Issuers Reporting Future Cash Flows Committed under
Operating and Capital Leases
a
Sub-Samples
Categorized by Type of Lease
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers Reporting Operating Leases 77 91 63 63.3
Issuers Reporting Capital Leases 30.5 39 22 22.2
a
These data were collected from the contractual obligations table in the MD&A of the filings of issuers selected for the
Study.
b
These categories are not mutually exclusive.
Table III(D)(2) presents the total future cash flows committed under operating
and capital leases, as reported in the contractual obligation table in MD&A. Assets and
liabilities related to capital leases are recorded on issuer balance sheets, but assets and
liabilities related to operating leases are not.
TABLE III(D)(2): Reported Future Cash Flows Committed under Operating and
Capital Leases
a
Sub-Samples
Categorized by Type of Lease
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Undiscounted cash flows committed
under operating leases $205,971 $195,506 $10,465 $1,252,006
Undiscounted cash flows committed
under capital leases
$16,095 $15,802 $293 $45,102
a
These data were collected from the contractual obligations table in the off-balance sheet arrangements section of the
MD&A (required by FR67) for the filings of issuers selected for the Staff Study. It is important to note that the data
include only non-cancelable leases. It is also important to note that these amounts are not discounted
The undiscounted sum of the future committed cash flows related to non-
cancelable operating leases for our sample issuers is approximately $206 billion. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that total (undiscounted) cash flows associated with these off-
balance sheet operating leases for the population may approach $1.25 trillion.
If these lease obligations had been reported on issuer balance sheets, the related
assets and liabilities would have been required to be recognized at their present (
i.e.,
discounted) values.
163
The Staff did not attempt to determine the appropriate discount
rates that would be used to estimate these amounts. For illustrative purposes, the
163
However, if the present value exceeds the fair value, issuers would be required to measure the lease
obligation using the fair value of the related asset.
64
discounted value of a series of five (ten) equal annual cash flows, using a discount rate of
8%, would be approximately 80% (67%) of the total undiscounted cash flows.
For comparison purposes, Table III(D)(2) also presents the total dollar amounts of
cash flows committed under capital leases for the 200 issuers in the sample. As noted
earlier, these leases are presented on issuer balance sheets. The undiscounted sum of the
cash flows related to capital leases for our sample issuers is approximately $16 billion.
The Staff notes that the ratio of the total cash flows related to non-cancelable operating
leases to capital leases is more than 12 to 1 within the sample and is estimated to be more
than 25 to 1 for the population.
E. Contingent Obligations and Guarantees
1. Nature of Arrangements and Financial Reporting
Requirements
Issuers are often involved in situations where uncertainty exists about
whether an
obligation to transfer cash or other assets has arisen and/or the
amount that will be
required to settle such obligation. Examples include:
• Where an issuer is a defendant in a lawsuit and any payment is contingent
upon the outcome of a settlement or an administrative or court proceeding;
• Where an issuer provides a warranty for a product it sells and any payment is
contingent on the number of products that actually become defective and
qualify for benefits under the warranty; and
• Where an issuer acts as a guarantor on a loan for another entity and any
payment is contingent on whether the other entity defaults.
Broadly, these kinds of situations are referred to as contingent obligations.
164
The
difficult accounting question is what, if any, liability should be recognized
before such
contingencies are resolved. SFAS No. 5,
Accounting for Contingencies, provides general
guidance regarding the accounting for contingent obligations, although certain contingent
obligations are specifically addressed in other standards.
165
Under SFAS No. 5,
contingent obligations are treated in one of three ways depending on the circumstances.
In order to conclude which treatment is applicable, an initial two-fold determination is
made as to whether the loss itself is deemed “probable” to occur and whether the amount
of the loss is estimable.
Recognition of a liability is required if the loss is deemed “probable” and
estimable; the amount to be recognized is the most likely outcome—
i.e., the individual
loss amount with the highest probability. No liability is recognized on the balance sheet,
but disclosures are required to inform users of the existence of the potential loss if a) the
164
Although contingencies may represent either potential assets or liabilities, the Staff focuses here on
contingent
obligations, as these tend to result in more reporting questions.
165
For example, guidance related to the accounting for insurance is provided by SFAS No. 60 and other
standards, and guidance related to the accounting for derivatives is provided by SFAS No. 133.
65
loss is deemed “probable,” but an amount cannot be reasonably estimated, or b) the loss
is deemed “reasonably possible,” but not “probable.” Neither recognition of a liability
nor disclosure is required if the probability of loss is deemed “remote.”
Consider an example where an issuer is a defendant in a lawsuit. Assume the
following three possible outcomes and related probabilities of occurrence:
Outcome
Probability
(A)
Amount to be Paid
(B)
Probability-Weighted
Amount to be Paid
(A x B)
Issuer is found liable 5 % $500,000 $ 25,000
Issuer settles 90 % $ 50,000 $ 45,000
Issuer wins lawsuit 5 %$ 0 $ 0
Total 100 % $70,000
Under SFAS No. 5, the loss would be deemed “probable,” given the 95%
likelihood of a loss occurring. A liability would be recognized in the amount of $50,000,
because this amount is the most likely loss amount.
Required disclosures under SFAS No. 5 include the nature of the contingency, the
range of the reasonably possible losses, and the amount recognized on the balance sheet,
if any.
166
SFAS No. 5 addresses uncertainty by using the probability of loss as a threshold
in determining
whether a liability should be recognized and for how much. In the context
of SFAS No. 5, there appear to be some range of interpretations as to how high the
likelihood of occurrence must be to be deemed “probable,” but by all accounts this
likelihood is substantially higher than a 50%+ threshold that common parlance might
assign to the term. If a liability
is recognized, that liability is measured as the amount
that constitutes the most likely outcome.
In contrast to the SFAS No. 5 approach, some recent accounting guidance
requires that certain obligations that include contingencies be recognized at fair value.
Under a fair value approach, the degree of uncertainty associated with a contingent
liability is reflected in the
measurement of the liability, rather than in the determination of
whether a liability is recognized.
Interpretation No. 45,
Guarantor’s Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others, issued in 2002 in
light of the then-recent corporate scandals and passage of the Sarbanes-Oxley Act,
requires certain guarantees to be initially recognized on the balance sheet at fair value.
167
166
Additional disclosures regarding loss contingencies may be required by Staff Accounting Bulletin Topic
5Y,
Accounting and Disclosures Relating to Loss Contingencies, Statement of Position No. 94-6,
Disclosure of Certain Significant Risks and Uncertainties, and Statement of Position No. 96-1,
Environmental Remediation Liabilities, among others. In addition, Item 103 of Regulation S-K requires
certain descriptive information to be disclosed regarding legal proceedings.
167
In developing the fair value model, FASB indicated that, over the life of a guarantee, a guarantor takes
the obligation to “stand ready” to honor the guarantee, and that the stand-ready obligation is not itself
66
One method used by issuers in determining the fair value of contingent obligations is
presented by SFAC No. 7,
Using Cash Flow Information and Present Value in
Accounting Measurements. This method of estimating fair value is based on probability-
weighted discounted cash flows consistent with the economic concept known as
“expected value”.
For example, consider a simple example in which an issuer who writes a
guarantee covering the default on a third-party’s debt with the following three outcomes
and probabilities:
Outcome
Probability
(A)
Amount to be Paid
(B)
Probability Weighted
Amount to be Paid
(A x B)
Third party defaults entirely 5 % $100,000 $ 5,000
Third party defaults on ¾ of debt 10 % $ 75,000 $ 7,500
Third party does not default 85 %$ 0 $ 0
Total 100 % $12,500
If a contingency accounted for under the SFAS No. 5 approach had the above
potential outcomes, no liability would be recognized, since the occurrence of a loss is not
“probable” (
i.e., a loss occurs with only 15% probability). However, under the
accounting specified by Interpretation No. 45, the writer of this guarantee would
recognize a liability of $12,500, which constitutes the fair value
168
of the guarantee.
Notably, all types of guarantees are not included in the scope of Interpretation No.
45. Further, the requirement of Interpretation No. 45 to recognize guarantees on the
balance sheet at fair value only applied to those issued or modified after December 31,
2002. However, Interpretation No. 45 introduced new disclosure requirements, which
were applicable regardless of the date of the guarantee’s issuance or modification. The
disclosures required in the notes to the financial statements include, but are not limited to,
the following:
169
• Nature of the guarantee;
• Maximum potential future payments;
• Current amount of liability on the balance sheet; and
• Certain product warranty information, including a reconciliation of changes in
the liability.
The Commission’s Financial Reporting Release No. 67, mandated by section
401(a) of the Act, also requires additional disclosures in the Off-Balance Sheet section of
MD&A regarding certain guarantee contracts. Disclosure is required to the extent
contingent. The liability for the stand-ready obligation is reduced over time as the guarantee performs (that
is, as it fulfills its obligation to stand ready over the life of the contract).
168
The time value of money is ignored in this example.
169
The required disclosures are presented in paragraphs 13-16 of Interpretation No. 45.
67
necessary to provide an understanding of the issuer’s material off-balance sheet
arrangements as well as the material effects of those arrangements. For guarantee
contracts these disclosures may include:
• Nature and business purpose of the guarantee contracts;
• Importance of the guarantee contracts to liquidity, capital resources, market
risk or credit risk support, or other benefits;
• The financial impact of the guarantee contracts and the issuer’s exposure to
risk as a result of the guarantees; and
• Known events, demands, commitments, trends or uncertainties that affect the
availability or benefits of the guarantee contracts.
2. Off-Balance Sheet Issues in Accounting for Contingent
Obligations and Guarantees
In accounting for contingent liabilities, how uncertainty is taken into account will
affect which items are reflected on the balance sheet. Although both approaches appear
to generate information that would be useful to users of financial statements, differing
views exist as to which treatment provides the most relevant information.
If uncertainty is taken into account in the recognition of liabilities, as is the case
for contingencies accounted for under SFAS No. 5, the balance sheet will report those
liabilities that are highly likely to reduce cash or other assets available for distribution to
shareholders. In addition, the items on the balance sheet would be reported at the amount
most likely to be paid or received. However, several issues arise from this treatment.
First, while the SFAS No. 5 accounting results in the recording of a liability that reflects
the most likely payment, the balance sheet reflects information about only that outcome.
Information about the other potential outcomes is ignored for the purpose of recording
the liability. While disclosures in the notes to the financial statements might help to
provide this information, in practice those disclosures are rarely detailed enough to allow
an investor to take into account multiple possible loss outcomes.
Difficulties in applying the SFAS No. 5 approach also arise because that approach
requires an analysis of whether a loss is probable. Although accountants generally agree,
in practice, on the percentage likelihood that is necessary to conclude that a loss is
probable, determining whether the loss in a particular situation exceeds that threshold can
be subjective. In addition, it may be difficult for others to independently verify
management’s judgments in these areas. Application issues have also arisen in regards to
determining the most likely amount of a loss when a range of possible losses exists. If
one amount within the range is a better estimate than any other amount, that amount
should be recognized. If no amount is considered a better estimate than any other
amount, the minimum amount in the range is recognized.
170
In practice, zero may
arguably be the low point of the range in many cases, resulting in no liability being
170
FASB Interpretation No. 14, “Reasonable Estimate of the Amount of Loss”.
68
reflected. The Staff has long believed that the application of SFAS No. 5 by issuers
should be improved, and has commented on this numerous times in speeches and other
venues. The needed improvements include better application of both the recognition and
disclosure criteria of SFAS No. 5.
Some of the difficulties in accounting for contingencies under SFAS No. 5 are not
faced in accounting for contingencies under pronouncements in which uncertainty is
reflected in measurement, rather than recognition, of a liability. If uncertainty is taken
into account in measuring the contingent liability, the value reflected on the balance sheet
represents the value the market would assign to the contingent liability in assessing the
value of the issuer; thus, information that a market participant would consider relevant is
not ignored. However, the liability recorded in these situations may not actually
represent a possible outcome upon ultimate resolution of the contingency.
171
Reflecting uncertainty in the measurement of the liability also removes some of
the pressure on the “probable” determination, and on the identification of the particular
outcome that is most likely. In addition, this approach would rarely, if ever, omit a
contingent obligation from the balance sheet entirely. However, if determining the
probability of loss and the most likely amount of that loss, as required under SFAS No. 5,
is difficult and subject to judgment, determining the probabilities of
multiple potential
outcomes, as required under Interpretation No. 45, may be even more difficult. Some
argue that a fair value approach could result in less reliable financial statements and make
auditing those statements even more challenging. Others, however, note that the fair
value approach ensures that contingencies relevant to assessing an issuer’s value are at
least acknowledged in a fair value approach, in contrast to the SFAS No. 5 approach,
which could allow many of those contingencies to go entirely unrecognized.
3. Empirical Findings from Study of Filings by Issuers
In this section, the Staff presents empirical findings from the Study of filings by
issuers related to contingent obligations, including guarantees. The Staff also
extrapolates from these findings to estimate amounts for the approximate population of
active U.S. issuers.
Table III(E)(1) describes the percentage of issuers reporting certain contingent
liabilities. As indicated in the table, approximately 64% of the sample issuers report
information about some litigation contingencies in their notes to the financial statements
and approximately 55% report information about guarantees. Substantially fewer, 21%,
report information about environmental contingent obligations. The Staff noted during
its analysis of the filings that disclosures about contingent obligations vary widely in
terms of format and location in the filing. As a result, the data for contingent obligations
was difficult to collect in a consistent manner across issuers.
171
In the example used previously, the three possible outcomes are losses of zero, $75,000, and $100,000,
yet the fair value that would be recorded is $12,500.
69
TABLE III(E)(1): Issuers Reporting Certain Contingent Obligations
a
Sub-Samples
Categorized by Type of Contingent
Obligation
b
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers reporting legal contingent
obligations
63.5 81 46 46.3
Issuers reporting environmental
contingent obligations
20.5 31 10 10.2
Issuers reporting guarantees 54.5 74 35 35.4
a
These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
b
These categories are not mutually exclusive.
Table III(E)(2) describes the percentage of issuers reporting recognition of
liabilities on their balance sheets for certain contingent liabilities. Less than 10% of the
sample issuers report that they have recognized
any amount of liability on their balance
sheets for
any legal contingent obligation, even though approximately 64% of the sample
issuers report general information regarding legal contingent obligations. Approximately
23% of the sample issuers report that they have recognized a liability for guarantees, less
than half of the 55% of issuers reporting information about the existence of guarantees.
Before the implementation of Interpretation No. 45 in 2002, the Staff suspects that few of
these guarantees would have been recognized as liabilities on issuer balance sheets.
TABLE III(E)(2): Issuers Reporting Liabilities for Certain Contingent Obligations
on their Balance Sheets
a
Sub-Samples
Categorized by Type of Contingent
Obligation
b
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers recognizing liabilities for legal
contingent obligations
9.5 14 5 5.1
Issuers recognizing liabilities for
environmental contingent obligations
10 15 5 5.1
Issuers recognizing liabilities for
guarantees
22.5 35 10 10.2
a
These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
b
These categories are not mutually exclusive.
The analysis of this topic so far has focused on the proportion of issuers reporting
information about various types of contingent obligations. We now turn to an analysis of
the amount of liabilities recognized on issuer balance sheets and the exposures reported
in the notes to the financial statements.
70
Table III(E)(3) presents reported amounts of contingent obligations recognized as
liabilities on issuer balance sheets, to the extent they are reported as such in the notes to
the financial statements.
172
Issuers in the sample report that they had recognized
liabilities on their balance sheets of approximately $10 billion related to legal contingent
liabilities, approximately $9 billion related to environmental contingent liabilities, and
almost $86 billion related to liabilities related to guarantees. In each of these three
categories, at least 98% of the total liability recognized was recognized by the large
issuer sub-sample.
173
An extrapolation of the findings from the sample to the
approximate population of active U.S. issuers suggests that legal contingent liabilities
reported by the total population are approximately $12 billion, environmental contingent
liabilities are approximately $19 billion, and guarantees are approximately $124 billion.
TABLE III(E)(3): Amounts Reported as Liabilities on Issuer Balance Sheet Related
to Certain Contingent Obligations
a
Sub-Samples
Categorized by Type of Contingent
Obligation
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Legal contingent liabilities $10,725 $10,714 $11 $11,814
Environmental contingent liabilities $9,219 $9,123 $96 $18,723
Guarantee liabilities $85,834 $85,449 $385 $123,949
a
These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
As discussed earlier, SFAS No. 5 and Interpretation No. 45 require disclosures
about exposure to “possible loss or range of loss” in the notes to financial statements.
174
Table III(E)(4) presents amounts related to these exposures reported by issuers. Issuers
in the sample report almost $32 billion in possible exposures related to legal
contingencies, only approximately $5 billion related to environmental contingencies, and
approximately $4 trillion related to guarantees. An extrapolation of the findings from the
sample to the approximate population of active U.S. issuers suggests that potential losses
reported by the population are approximately $52 billion potential losses for legal
contingent obligations, approximately $23 billion for environmental contingent
obligations, and more than $46 trillion for guarantees.
172
Many such contingencies may not be reported as a separate line item on the balance sheet. Thus, users
of financial statements must usually rely on disclosures to indicate the magnitude of the contingent
obligations recognized.
173
This represents a disproportionate difference between the large issuer sub-sample and the random issuer
sub-sample in that the ratio of total liabilities of the random issuer sub-sample to the large issuer sub-
sample is approximately 1:100; the difference in contingent liabilities recognized by the two groups is
1:1000.
174
See SFAS No. 5, paragraph 10.
71
TABLE III(E)(4): Reported Exposures for Certain Contingent Obligations
a
Sub-Samples
Categorized by Type of Contingent
Obligation
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Legal contingent obligations $31,762 $31,554 $208 $52,354
Environmental contingent
obligations
$4,604 $4,414 $190 $23,414
Guarantees $4,053,499 $3,624,389 $429,110 $46,535,389
a
These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
The Staff notes that the amounts of possible losses disclosed by the sample of issuers
are largely unrelated to the liabilities recognized by issuers as reported in Table III(E)(3).
For the most part, issuers seem to have concluded that they need not disclose quantitative
information concerning additional potential losses related to those contingent losses
recognized as liabilities on the balance sheet.175 The Staff further notes that in many
cases, issuers disclose the existence of the contingent legal obligation, but recognize no
liability and disclose no maximum loss or range of loss.
F. Derivatives
1. Nature of Arrangements and Financial Reporting
Requirements
A derivative is “simply a financial instrument (or even more simply, an agreement
between two people) which has a value determined by the price of something else.”
176
For example, a stock option contract derives its value, at least in part, from the price of
the underlying stock;
177
similarly, a gold futures contract derives its value from the price
175
For example, of the $10.328 billion in legal contingent liabilities recognized (see Table III(E)(3)), only
approximately $717 million are disclosed in conjunction with quantitative information about additional
potential losses. Indeed, approximately 97% of the $23,761 billion of potential legal contingent losses
disclosed for the entire sample relate to instances where no liability was reported as being recognized on
the balance sheet. In some cases, where liabilities are recognized, issuers may not deem additional losses
to meet the “reasonably possible” criteria in SFAS No. 5.
176
McDonald, Robert L., Derivatives Markets (2003), at 1.
177
A stock option may be defined as a “right to purchase or sell a stock at a specified price within a stated
period.”
Barron’s Dictionary of Finance and Investment Terms, 5
th
ed. (1998).
72
of the underlying gold;
178
an interest rate swap derives its value from the underlying
interest rates.
179
Derivatives permit issuers to mitigate and take on risk, and also to select which
risks they want to retain and manage, and which they want to shift to others willing to
bear them. For example, a manufacturer that requires oil as an input to production is
exposed to the risk of an oil price increase. If oil prices do increase, cost of production
increases and the manufacturer’s profitability may suffer. Such an issuer may choose to
contract with another party to effectively fix the price it will pay for oil at some future
date through a “forward” contract.
180
In this case, the issuer has “hedged” its exposure,
and is protected from the negative economic effects of an adverse change in oil prices.
Of course, locking in a price through such a forward contract also precludes any cost
savings the issuer might have experienced from a beneficial change in oil prices. If,
instead, the issuer wished to limit its exposure to price increases while still retaining the
benefits of price decreases, it could enter into an option contract to purchase oil at a fixed
price; if the price goes above the exercise price of the option, the issuer would gain upon
exercise of the option, while if the price fell, the issuer would allow the option to expire
while making its purchases through the spot market. Of course, entering into an option
may be more costly than entering into a forward or futures contract.
a. Accounting for Derivatives
The current accounting guidance for derivatives has only been in effect since
2001.
181
Prior to that, many believed that accounting standards had not kept pace with
changes in global financial markets and related financial innovations. As a result, the
Commission, members of Congress, the General Accounting Office, and others urged the
FASB to deal with reporting problems regarding derivatives.
182
During the almost 10
year period that this guidance was under development, there were several notable
derivatives issues that captured the attention of the public, various regulators, and the
178
A futures contract may be defined as an “agreement to buy or sell a specific amount of a commodity or
financial instrument at a particular price on a stipulated future date ... [where] [t]he price is established ...
on the floor of a commodity exchange ...” Barron’s Dictionary of Finance and Investment Terms, 5
th
ed.
(1998).
179
A swap may be defined as “[a] contract calling for the exchange of payments over time. Often one
payment is fixed in advance and the other is floating, based upon the realization of a price or interest rate.”
McDonald, Robert L., Derivatives Markets (2003), at 851.
180
Such a contract promises the delivery of a certain amount of oil at a certain date in the future, for a
certain price.
181
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (as amended), was
originally effective for fiscal years beginning after June 15, 1999. The effective date was subsequently
delayed by SFAS No. 137,
Accounting for Derivative Instruments and Hedging Activities-Deferral of
Effective Date of FASB Statement No. 133 to fiscal years beginning after June 15, 2000, or for the year
ended December 31, 2001 for calendar year end issuers.
182
SFAS No. 133, paragraph 212.
73
accounting standard setters.
183
These events influenced the deliberations that would
ultimately address the actual accounting for derivatives.
Financial reporting for derivatives centers around three main issues. The first is
whether derivative contracts should be recognized on issuer balance sheets. The second
is whether changes in the value of derivative contracts should be recognized in the
income statement. The third is how to convey the overall sensitivity of the issuer to
changes in important variables—for example, say, oil prices for an issuer that uses large
quantities of oil—in light of the derivative positions the issuer may have taken.
In general SFAS No. 133 requires that derivatives be recorded as assets or
liabilities on the balance sheet at fair value, and re-measured each period with changes in
fair value reflected in earnings. In part, the rationale for this approach was FASB’s view
that recognizing derivatives on the balance sheet based on measurements other than fair
value was generally less relevant and understandable.
184
For example, if historical cost
were used to measure derivatives, many would be reported at a value of zero because no
payment is made at the inception of the contract (
e.g., most forward contracts). In
addition, under a historical cost measurement principle, changes that may have a
significant effect on the issuer’s value would not be reflected in its financial statements.
While this is true for all assets and liabilities measured at historical cost, derivatives have
a potential for substantial variability in value typically exceeding that of more traditional
assets such as plant and equipment. Other methods proposed, such as intrinsic value and
lower of cost or market, were also considered inappropriate because they ignored
significant items that factor into the fair value of the derivative. In the end, the FASB
concluded that fair value was the only relevant measurement for derivatives.
185
Although the core principle in SFAS No. 133 of recording all derivatives on the
balance sheet at fair value is simply stated, many complexities become apparent with
further analysis. First is the issue of defining “derivative” for purposes of applying the
principle. As discussed below, the FASB started with a definition that looks to certain
characteristics of a contract to identify derivatives. However, various exceptions were
made to this definition in order to ease implementation of the standard or to acknowledge
that certain instruments that meet the characteristics-based definition were previously
addressed as insurance contracts or in some other manner in the existing accounting
guidance. In addition, the guidance includes a requirement that certain derivatives
embedded in other non-derivative financial instruments or other contracts be separated
out or “bifurcated” from those instruments and separately recognized in issuer financial
statements. This provision prevents an issuer from avoiding the recognition and
183
In particular, during 1994 there were some well-publicized incidents related to derivatives. The largest
was the bankruptcy of Orange County, California, which was partially attributed to what was considered
the imprudent use of derivatives. In addition, there were several significant corporate losses from
derivative transactions, including losses at The Proctor and Gamble Company, MG Corp. (a unit of
Germany's Metallgesellschaft AG) and Gibson Greetings Inc.
184
SFAS No. 133, paragraphs 221 and 223.
185
Paragraph 3(b) of SFAS 133 states: “Fair value is the most relevant measure for financial instruments
and the only relevant measure for derivative instruments.”
74
measurement requirements of SFAS No. 133 merely by embedding a derivative
instrument in a non-derivative financial instrument or other contract.
186
b. Hedge Accounting
Many issuers utilize derivative instruments to hedge their exposure to certain
economic risks. When a derivative is used to hedge an exposure, the value of the
derivative should have an inverse relation to the value of the exposure it is hedging.
While the core principle under SFAS No. 133 is to recognize changes in the value of
derivatives in the income statement, SFAS No. 133 provides for an exception to this
principle known as “hedge accounting,” to address potential timing differences in
recognizing offsetting gains and losses. These timing differences occur in part because
GAAP utilizes a “mixed-attribute” approach where some items are recognized at
historical cost, others at the lower of cost or market, and still others at fair value. As a
consequence, changes in the value of a derivative may not be reflected in earnings at the
same time as changes in the value of the hedged exposure unless hedge accounting is
used.
For example, consider an issuer that has a mortgage
obligation with a term of 30
years
at a fixed interest rate of 9% per year. The issuer enters into a contract designed to
have the same effect as if the fixed rate of interest in the mortgage were changed to a
variable rate of interest. The terms of the contract require the issuer to pay a variable rate
based on the current rate on U.S. Treasury securities in exchange for payments based on
the 9% rate in the mortgage. Economically, the issuer is in approximately the same
position as if its 9% fixed-rate mortgage
obligation were instead a variable rate mortgage
obligation. Such a derivative contract is called an interest rate swap. If interest rates
drop below 9%, the swap contract will have a positive value to the issuer; that is, it is an
asset. If interest rates rise above 9%, the swap will have a negative value to the issuer
and is a liability.
If changes in interest rates were recognized in the measurement of the mortgage,
then the accounting for this would be relatively straightforward. For example, suppose
interest rates dropped below 9%. Other things being equal, the recorded value of the
mortgage liability would increase, but by approximately the same amount that the
derivative asset (
i.e., the swap) increases in value. Thus, the changes in fair value would
approximately offset each other, mirroring the economics of such contracts. However,
changes in the fair value of the mortgage liability associated with changes in interest rates
are not recognized in current earnings. Instead, debt, such as the mortgage liability, is
recognized at its historical cost.
The FASB addressed the inconsistency resulting from recognizing the derivative
at fair value and the instrument the derivative is designed to work with at historical cost
by creating an exception to the general historical cost measurement for some
assets/liabilities that are hedged with derivative contracts. If an asset (liability) is
typically measured using historical cost and its fair value is hedged with a derivative,
then the asset (liability) can be reflected on the balance sheet at its fair value for the
186
Paragraph 293 of SFAS No. 133.
75
portion of the risk that is being hedged. This accounting treatment—known as a “fair
value hedge”—results in recognizing in the income statement both the change in fair
value of the mortgage liability (due to changes in interest rates), and the offsetting change
in fair value of the swap. Thus, this treatment reflects both sides of the economic story in
the financial statements.
While fair value hedge accounting resolves certain issues caused by the mixed-
attribute approach, another type of hedge accounting addresses situations where the issuer
has hedged its exposure to variability in expected future cash flows. For example,
consider an issuer that expects to purchase oil in the future and is thus exposed to market
variability in oil prices. The issuer enters into a forward contract to purchase oil in the
future at the current “spot” price of $25 per barrel in order to hedge this exposure. A
subsequent increase in the price of oil to $27 would have no net economic effect on the
issuer, because the forward contract would offset the effects of the price increase. That
is, while the value of the oil being purchased has increased $2 per barrel, the value of the
forward contract would offset such a price increase by approximately the same
amount.
187
Once the price of oil has risen above $25, the forward contract clearly
constitutes an asset, as it entitles the issuer to buy oil at less than the current market price.
However, the issuer’s balance sheet does
not recognize an obligation (or liability) related
to the expected
future purchase of oil—the item being hedged.
Such an accounting treatment introduces volatility into earnings that some believe
does not represent the underlying economics of such transactions. Thus, the FASB
developed an approach—known as a “cash flow hedge”—that allows the issuer to hold
changes in value of derivatives (to the extent these offset changes in value of the hedged
item) that hedge expected variability in future cash flows in a section of equity called
“accumulated other comprehensive income” until the transaction being hedged occurs.
188
When the future transaction that was designated as being hedged actually occurs and is
recognized in income, the amount initially recorded in equity is then also recognized in
income to reflect the offsetting effect of the hedge.
It is important to note that SFAS No 133 strictly limits the kinds of situations that
qualify for hedge accounting.
189
In addition, in order to qualify for hedge accounting, the
issuer has to meet specific documentation requirements. This is to avoid an opportunity
for an issuer, using hindsight, to freely pick the approach that presents the best results. It
is also important to note that the risks that are eligible for hedging are market-related
risks (changes in fair value and variability in cash flows), and not accounting risks, such
as variability in reported net income. Finally, except in very rare situations,
190
the
effectiveness of the derivative at offsetting the changes in value of the hedged item must
187
This is an oversimplification for expository purposes. It assumes that cash wasn’t paid upon the signing
of the contract. Also, it does not take into consideration the time value of money.
188
See SFAS No. 133, paragraph 30 for a discussion of the amounts to be deferred into accumulated other
comprehensive income in the case of cash flow hedges.
189
In addition to fair value and cash flow hedges, SFAS No. 133 provides for hedging the foreign currency
risk related to an issuer’s net investment in foreign operations.
190
See SFAS No. 133, paragraphs 65 and 68.
76
be periodically measured, and any ineffectiveness must be recognized in the income
statement, even when the relationship does qualify for hedge accounting.
191
c. Disclosures
SFAS No. 133 also provides disclosure guidance, intended to help investors and
creditors understand what an entity is attempting to accomplish through the use of
derivatives. These disclosures are required to facilitate the understanding of the nature of
an entity’s derivative activities and evaluation of the success of those activities, their
importance to the entity, and their effect on the entity’s financial statements. As a result,
SFAS No. 133 requires numerous qualitative disclosures about an entity’s use of
derivatives including, but not limited to:
192
• Its objectives for holding or issuing derivative instruments, the context needed to
understand those objectives, and its strategies for achieving those objectives;
• A description distinguishing between derivative instruments designated as fair
value, cash flow, and foreign currency hedging instruments, and all other
derivatives. The description shall also indicate the entity’s risk management
policy for each of those types of hedges, including a description of the items or
transactions for which risks are hedged. For derivative instruments not designated
as hedging instruments, the description shall indicate the purpose of the derivative
activity; and
• Certain quantitative information related to cash flow and foreign currency hedges.
In addition to the SFAS No. 133 required disclosures about derivatives and
hedging activities, Item 305 of Commission Regulation S-K requires certain additional
disclosures about market risks and how those risks are managed, including the use of
derivatives. In particular, Item 305 requires both quantitative and qualitative disclosures
about each type of market risk including interest rate, foreign currency, commodity price
and other relevant risks, such as equity price risk. In preparing the quantitative
disclosures, the issuer can choose from three alternatives:
• Tabular presentation of fair value information and contract terms relevant to
determining future cash flows – categorized by expected maturity dates;
• Sensitivity analysis assessing the potential loss in future earnings, fair values or
cash flows of market sensitive instruments resulting from hypothetical changes in
various market indices; or
191
Ibid, paragraphs 20, 22, 26, 28 and 30.
192
See SFAS No. 133, paragraphs 44 to 47 for a complete list of the disclosure requirements for derivatives
and hedging activities.
77
• Value at risk analysis estimating the potential loss in future earnings, fair values
or cash flows from market movements with a specified likelihood of
occurrence.
193
2. Off-Balance Sheet Issues in Accounting for Derivatives
As can be seen from the above discussion, derivatives are, in fact, on the balance
sheet. We include them in this Report, however, because derivatives are often an integral
part of arrangements that are considered off-balance sheet, such as the Enron prepay
transactions discussed in Section I.C. While many have criticized SFAS No. 133 (and its
related interpretive guidance) for its complexity, and its “rules-based” guidance, it must
be recognized that prior to the issuance of SFAS No. 133, many derivatives were indeed
“off-balance sheet,” and issuers’ exposures to related risks and changes in financial
condition was therefore entirely unreported. Furthermore, much of the complexity in
SFAS No. 133 relates to hedge accounting, which is optional. In fact, hedge accounting
is a modification or exception to the core principles of the standard. For the reasons
already discussed, the FASB felt that hedge accounting was an appropriate part of SFAS
No. 133. Nonetheless, it should be noted that, as is often the case with exceptions to
basic principles, the hedge accounting guidance is complex and relies on a substantial
number of rules.
There are over 850 pages of authoritative guidance on accounting for derivatives,
generated primarily by four related accounting standards
194
and over 180 implementation
and interpretive issues. What started out with a simple principle—“Record all derivatives
at fair value”—became very rules-based through a proliferation of scope exceptions and
extensive implementation and interpretive guidance, as preparers and auditors requested
more detailed guidance. Many issues contribute to the complexity and challenges of the
current approach to derivative accounting, but there appear to be four primary issues:
i.) The scope of the guidance, including the definition of and identification of a
derivative;
ii.) The application of hedge accounting;
iii.) The “bifurcation” requirements for embedded derivatives; and
iv.) The valuation methodologies used.
In defining the scope of SFAS No. 133, the FASB avoided simply listing the
instruments and contracts to which the standard would apply (for example, options,
forward contracts, interest rate swaps, etc). If the scope of an accounting standard were
defined in such a way, the definition would need to be revised regularly to deal with new
193
See Release Nos. 33-7386 and 34-38223 for full text of the rule.
194
SFAS No. 133, as well as SFAS No. 137, Accounting for Derivative Instruments and Hedging
Activities–Deferral of the Effective Date of FASB Statement No. 133, SFAS No. 138, Accounting for
Certain Derivatives and Certain Hedging Activities, and SFAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities.
78
instruments. Instead, SFAS No. 133 employed a characteristics-based definition
195
so
that any instrument or contract reflecting those characteristics would be covered by the
derivatives guidance. Further, to prevent issuers from avoiding the recognition and
measurement guidance in SFAS No. 133, the standard requires that derivatives embedded
in non-derivative financial instruments or other contracts be “bifurcated” from the host
instrument and separately valued.
196
Although FASB attempted to take an inclusive approach in developing SFAS No.
133, the Board also included a number of exceptions to the standard’s definition of a
derivative. These exceptions served to exclude certain contracts that otherwise would be
accounted for as derivatives. In some cases, the exceptions were included because other
accounting pronouncements already covered certain instruments. For example, from an
economic perspective, many insurance contracts are derivatives, but other guidance
197
already addressed such contracts. In addition, some contracts that would meet the
definition of a derivative, but are deemed to be “normal purchase and sale” contracts,
were excluded simply to be consistent with the current accounting for similar contracts
that would not qualify as derivatives under SFAS No. 133.
198
Finally, derivatives on an
issuer’s own equity are excluded because of questions surrounding whether such
instruments represent assets or liabilities, as opposed to equity.
199
While the scope issues present challenges, many more interpretive issues concern
hedge accounting. The underpinnings for allowing hedge accounting, as described
previously, are not all that difficult to understand. The principal idea is to avoid
recognizing volatility in earnings that does not represent true economic volatility.
However, because hedge accounting is optional, and results in changes in the way assets,
195
Those characteristics are discussed in paragraphs 6-9, and 57 of SFAS No. 133 (as amended), and in
over 20 interpretative issues addressed by the DIG (“Derivatives Implementation Group”). Those
characteristics generally are that a derivative has:
One or more underlyings and one or more notional amounts
or payment provisions or both. Those
terms determine the amount of the settlement or settlements, and, in some cases, whether or not a
settlement is required;
No initial net investment or an initial net investment that is smaller than would be required for
other types of contracts that would be expected to have a similar response to changes in market
factors; and
Terms that require or permit net settlement, it can readily be settled net by a means outside the
contract, or it provides for delivery of an asset that puts the recipient in a position not substantially
different from net settlement.
196
This guidance is found in paragraphs 12-16, 60-61, and 176-200 of SFAS No. 133 (as amended) and in
36 interpretative issues addressed by the DIG.
197
See, for example, SFAS No. 60. Also note that the FASB has taken up a project to provide additional
guidance on determining when an insurance contract that limits the amount of risk taken on by the insurer
should be accounted for as insurance, and when it should instead be accounted for as an investment by the
insured and a loan by the insurer.
198
See SFAS No. 133, paragraphs 271 and 272.
199
See SFAS No. 133, paragraph 11(a), EITF Issue No. 00-19, and SFAS No. 150.
79
liabilities, gains, and losses are reflected in the financial statements, the FASB felt it
necessary to limit its use to situations in which the effectiveness of the derivatives at
offsetting the risks being hedged were demonstrable. As such, to qualify for hedge
accounting, an issuer must meet a number of requirements relating to identification of the
hedging relationship and measurement of the effectiveness of that relationship – that is,
measurement of the extent to which the changes in the fair value of the derivative can be
expected to and in fact do offset changes in the value of the hedged item.
200
Although the accounting for derivatives attempts to appropriately reflect the
economics of hedged transactions, it is nonetheless true that an issuer engaged in
derivative transactions is economically different from an issuer that is not, all other things
being equal. Thus, it is important for disclosures to communicate the economic risks
involved. The disclosures required by the accounting guidance and by the Item 305 of
Regulation S-K are meant to provide the user with information that goes beyond the
current value of the derivatives. Although fair value may reflect an important aspect of
the “economics” of the derivative at a point in time, it nonetheless 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. For example, a gold
mining company that has entered into fixed price forward contracts to sell its gold has a
very different risk profile than one that has not entered into such contracts, other things
being equal. It is important for investors to understand what risk profile the issuer has
selected—specifically, whether or not the issuer will benefit from an increase in the price
of gold.
Despite the disclosures required by the accounting standards and the
Commission’s rules, there is still 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 issuers could do a better job in the notes to the financial
statements, MD&A, and item 305 disclosures of providing disclosures on market risk
exposures, hedge strategies, and the results of those strategies.
3. Empirical Findings from Study of Filings by Issuers
In this section the Staff presents empirical findings from the Study of filings by
issuers related to derivatives. The Staff also extrapolates from these findings to estimate
amounts related to the approximate population of active U.S. issuers.
As noted previously, instruments that meet the definition of a derivative pursuant
to SFAS No. 133 are reported on the balance sheet at fair value. However, also as noted
above, the scope exceptions in SFAS No. 133 allow certain arrangements having the
economic characteristics of derivatives to remain off-balance sheet. As there are no
required disclosures for these latter arrangements, the Staff cannot reach any conclusions
regarding the extent of these arrangements based on public filings.
200
There have been many interpretive issues that address whether hedge accounting can be applied to
certain situations. Indeed, over 180 issues have been addressed to date by the DIG, many of which
interpret the hedge accounting guidance in SFAS No. 133. The requirements further manifest themselves
in the level of documentation necessary to maintain hedge accounting.
80
Since derivatives subject to SFAS No. 133 are reported on the balance sheet at
fair value, the Staff did not make it a priority to report their extent in the Study of filings
by issuers. However, as a result of conducting the Study of filings by issuers, the Staff
notes that it is often difficult to determine the total dollar amounts that are on the balance
sheet related to derivatives. This difficulty stems from the fact that derivatives may be
presented as separate line items on the balance sheet, or alternatively, included as a
component of some broader category (
e.g., other assets).
201
This latter treatment occurs
predominantly for derivatives whose current values are not considered material to the
balance sheet presentation. Moreover, derivatives disclosures may be presented in
different places in an issuer’s 10-K filing.
Table III(F)(1) describes the percentage of issuers reporting derivatives for
trading and non-trading purposes. Although only approximately 10% of the sample
issuers report derivative transactions for trading purposes, approximately 63% of the
sample issuers report using derivatives for non-trading purposes. Note fully 95% of the
large issuer sub-sample report derivatives for non-trading (
i.e., hedging) purposes. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that approximately 3% of the population of issuers report that they
use derivatives for trading purposes, while more than 30% report the use of derivatives
for non-trading purposes.
TABLE III(F)(1): Issuers Reporting Purpose of Using Derivatives
a
Sub-Samples
Categorized by Purpose
b
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
For trading purposes 10.5 18 3 3.1
For non-trading purposes 62.5 95 30 30.6
a
These data were collected from the notes to the financial statements and the market risk disclosures in the filings of
issuers selected for the Study.
b
These categories are not mutually exclusive.
Table III(F)(2) describes the percentage of issuers reporting the use of different
types of derivative instruments. The largest percentages of issuers report the use of
forwards and swaps, while few report using credit derivatives and combinations of
derivatives. Again, these results are largely driven by the large issuer sub-sample.
201
SFAS No. 133 does not require separate disclosure of the fair value of derivatives in the notes to the
financial statements. Accordingly, many issuers do not provide this information, and the Staff noted that
the disclosures by those who do may appear in many different places in the notes.
81
TABLE III(F)(2): Issuers Reporting Types of Derivative Instruments Used
a
Sub-Samples
Categorized by Type of Derivative
Instrument
b
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Options 25.5 47 4 4.4
Futures 15 25 5 5.2
Forwards 39 66 12 12.5
Swaps 48 78 18 18.6
Credit derivatives 5.5 10 1 1.1
Combinations 4.5 8 1 1.1
a
These data were collected from the notes to the financial statements and the market risk disclosures in the filings of
issuers selected for the Study.
b
These categories are not mutually exclusive.
It is important to note, however, that even though the fair value of certain
derivatives is on the balance sheet, the risks inherent in these instruments are not, and can
not be, adequately presented on the balance sheet. Although it is true that the balance
sheet is also unable to capture the risks associated with owning, say, equipment, or
inventory, for the most part, investors understand the risks and rewards of such
“ownership” arrangements. The difference between these more familiar arrangements
and derivatives is the latter’s potential volatility, the low level of investment that may be
required, and the flexibility available in structuring the agreements. As a consequence,
supplemental disclosures are even more important for derivatives in understanding risk.
Thus, the Staff believed it was important in evaluating balance sheet transparency to
examine the disclosures related to derivatives in the Study of filings by issuers.
As described in Section III(F)(1)(c), disclosures about derivatives are presented in
the notes to the financial statements and in a section of the filing that reports on the
issuer’s exposure to market risks. The information in the notes to the financial statements
includes both qualitative and quantitative information about the issuer’s involvement with
derivatives. The issuer is required to report qualitative information about, among other
things, “its objectives for holding or issuing those instruments, the context needed to
understand those objectives, and its strategies for achieving those objectives.”
202
The
issuer is also required to report quantitative information, but most of this information
relates to hedge accounting, such as the amount of gain or loss temporarily deferred in
accumulated other comprehensive income (a component of shareholders’ equity), and the
amount of any ineffectiveness recognized in the income statement, resulting from the
hedging arrangements.
Table III(F)(3) describes the percentage of issuers reporting the use of certain
forms of hedge accounting. Approximately 46% of the sample issuers report using cash
flow hedges and 42% report using fair value hedges. However, as these results are
202
SFAS No. 133, paragraph 44.
82
largely driven by the large issuer sub-sample. An extrapolation of the findings from the
sample to the approximate population of active U.S. issuers suggests that only
approximately 17% of the population reports the use of cash flow hedges and
approximately 8% report the use of fair value hedges.
TABLE III(F)(3): Issuers Reporting Use of Hedge Accounting
a
Sub-Samples
Categorized by Type of Accounting
Hedge
b
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers reporting cash flow hedges 45.5 75 16 16.6
Issuers reporting fair value hedges 42 77 7 7.7
a
These data were collected from the notes to the financial statements and the market risk disclosures in the filings of
issuers selected for the Study.
b
These categories are not mutually exclusive.
As noted above, issuers are required to disclose information about market risks in
their filings; these issuers may or may not use derivatives to hedge such market risks.
These disclosures are both qualitative and quantitative in nature. The qualitative
information includes disclosures regarding the issuer’s primary market risk exposures,
how those risks are managed, and actual or expected material changes in the issuer’s
exposures. The quantitative information is intended to provide investors with
information to assess the potential impact of market risks on the issuer.
Table III(F)(4) describes the percentage of issuers reporting different types of
market risks. A total of 60% of the sample issuers report some type of exposure to
market risk. Note that the largest number of issuers report interest rate risk and currency
price risk—almost 50% and 43%, respectively—while fewer issuers report commodity
price risk or equity price risk. In the large issuer sub-sample, 82% of the issuers report
exposure to interest rate risk and 76% report currency price risk; but in the random issuer
sub-sample only 17% of issuers report interest rate risk and only 9% report currency price
risk.
83
TABLE III(F)(4): Issuers Reporting Market Risks
a
Sub-Samples
Categorized by Type of Market
Risk
b
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Any market risk 60 91 29 29.6
Commodity price risk 15 24 6 6.2
Interest rate risk 49.5 82 17 17.6
Currency price risk 42.5 76 9 9.7
Equity price risk 15.5 31 0 0
c
a
These data were collected from the notes to the financial statements and the market risk disclosures in the filings of
issuers selected for the Study.
b
These categories are not mutually exclusive.
c
Less than 1%
The Staff notes that one barrier to achieving transparency is that the disclosures
related to market risk are usually organized by type of market risk (e.g.
, commodity price
risk, interest rate risk, etc.), but the SFAS No. 133 disclosures in the notes to the financial
statements are usually organized by type of accounting hedge (e.g.
, cash flow hedges, fair
value hedges, etc.). Thus, it may be difficult for issuers and investors to effectively
integrate the disclosures.
Further, there is no one generally accepted method for characterizing and
communicating information about risk. As a result, Commission rules allow issuers to
choose among three types of quantitative disclosures. Issuers may simply disclose the
terms of any outstanding derivative contracts in a tabular format, including information
about fair values and contract terms relevant to determining future cash flows,
categorized by expected maturity dates. Alternatively, issuers may disclose sensitivity
analysis assessing the potential for loss (e.g.
, in terms of net income) resulting from
hypothetical changes in various market factors (e.g.
, oil prices). Issuers may also present
the results of a value-at-risk (“VaR”) analysis, which quantifies the potential loss in fair
values, earnings or cash flows, from market movements with a selected likelihood of
occurrence.
Table III(F)(5) describes the percentage of issuers using different types of
disclosures in reporting market risks. As noted above, 60% of sample issuers report some
type of exposure to market risk (see
Table III(F)(4)). More than half of this group (i.e.,
more than half of those disclosing information about market risks) present sensitivity
analysis in their disclosures; 12% present value-at-risk disclosures and another 9%
present tabular disclosures.
203
As a result, comparing the risk disclosures across issuers
can be difficult, due to lack of comparability. As is the case with regard to the earlier
results, these percentages are driven by the predominance of derivative use in the large
issuer sub-sample.
203
Issuers may use different methods to disclose information about different market risks.
84
TABLE III(F)(5): Issuers Reporting Risk Disclosures for Non-trading Derivatives
a
Sub-Samples
Categorized by Type of Risk
Disclosure
b
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Tabular 9 14 4 4.1
Sensitivity analysis 32 52 12 12.4
Value-at-risk 12 21 3 3.2
a
These data were collected from the market risk disclosures in the filings of issuers selected for the Study.
b
These categories are not mutually exclusive.
However, even if two issuers use the same type of disclosure about derivatives,
direct comparisons between issuers still may not be possible. Consider two issuers that
both use sensitivity analysis to communicate information about their risk exposure to
interest rate risk. These disclosures require that an issuer estimate the change in some
component of issuer value (the numerator) as a result of a change in some component of
market risk (the denominator). One issuer may report the change in net income (this
particular issuer’s choice of numerator) as a result of a 1% increase in LIBOR rates (this
issuer’s choice of denominator). Another issuer may report the change in a different
numerator as a result of a change in a different denominator. Both of these disclosures
may meet the requirements set up by the Commission, but investors may not be able to
effectively compare these two issuers based upon public filings.
As an example, Table III(F)(6) reports the numerators and denominators for the
sensitivity analyses related to interest rate risk for a set of pharmaceutical issuers (i.e.
,
SIC=2834). The disclosures identified in this table are for illustrative purposes only and
are not highlighted as being in any way insufficient or inconsistent with the disclosure
requirements under Item 305 of Regulation S-K, but were simply selected to show the
range of potential disclosures under Item 305 and the resulting difficulty of comparing
the disclosures of different companies.
85
TABLE III(F)(6) Empirical Findings Regarding Comparability of Sensitivity
Analysis Disclosures Related to Interest Rate Risk for Pharmaceutical Industry
(SIC=2834)
a,b
Numerator Denominator
Company A
b
Cash flows, income, or market
values
100 basis point change in interest
rates
Company B
b
Financial position, results of
operations, or cash flows
10% change in interest rate
structure
Company C
Fair value of derivative and other
interest rate sensitive instruments
10 basis point change in interest
rates
Company D Fair value of debt and investments
1 basis point change in interest
rates
Company E
Net income related to financial
instruments
10% adverse change in interest
rates
Company F
Fair value of outstanding long term
debt outstanding 10% decrease in interest rates
Company G Fair value of outstanding debt 1% point increase in interest rates
a
These data were collected from the market risk disclosures in the filings of issuers selected for the Study.
c
The sensitivity is reported to be immaterial for these issuers.
Overall, based on information available in public filings, not only is it difficult to
ascertain the magnitude of the fair values of derivatives that are reported on the balance
sheet, it is also difficult to ascertain the extent of the underlying market risk exposures, as
well as the effects of derivative transactions intended to hedge these risks. Although the
tradeoff between comparability and representational faithfulness presents significant
challenges, the Staff believes improvements can and should be made to enhance the
transparency of reporting issuer activities related to derivatives and risk management.
The Staff notes the FASB’s recently announced project to consider enhancing the
existing disclosure requirements of SFAS No. 133. The FASB has stated that it will also
consider whether to expand the scope of any disclosure enhancements to include financial
instruments outside the scope of SFAS No. 133.
G. Other Contractual Obligations
1. Nature of Arrangements and Financial Reporting
Requirements
Issuers are involved in any number of contractual obligations, including debt
obligations, retirement obligations, compensation agreements, leases, guarantees,
derivatives, and obligations to purchase goods and services. In many cases, liabilities are
recognized on the balance sheet at the inception of the contract, because one party has
performed. For example, if an issuer borrows money, it recognizes a liability upon
receipt of the funds. In other cases, liabilities are recognized as time passes, as in the
case of interest related to the borrowed funds. In still other cases, contractual obligations
remain off the balance sheet. Examples of these obligations may include operating
86
leases, portions of obligations related to retirement plans, certain guarantees, and certain
derivatives, all of which have been discussed above. Although the discussion generally
applies to other types of contractual obligations, this section will primarily focus on one
major class of contractual obligations that remain off issuer balance sheets—purchase
obligations.
204
A purchase obligation could be as simple as a standard one-time purchase order.
Alternatively, the purchase obligation may be attributable to the purchase of goods or
services to be delivered over an extended period of time. Generally, the accounting
question is whether or not a party to a contract should reflect the rights and obligations
inherent in the contract upon signing the contract, and, if so, in what way.
Consider a contract to purchase one million units of inventory per year for the
next three years.
205
Upon signing the contract, the purchaser could record an asset (e.g.,
“Inventory Receivable”) and a liability (e.g.
, “Purchase Obligation”). The seller could
also record an asset for the cash to be received and a liability reflecting its obligation to
deliver the inventory. However, at this point in time, nothing has been delivered and no
payment has been made. Nonetheless, one could argue that, even though no performance
has occurred, the issuers have many of the same risks and rewards as if the exchange had
already been completed, and thus should recognize the related assets and liabilities.
Under this view, it could be argued that binding contracts give rise to assets and liabilities
in advance of any performance under the contract.
The contrary view is that assets and liabilities should only be recognized to the
extent performance has occurred—that is, to the extent that one or both parties have
carried out the actions (duties) agreed to in the contract, such as delivering or paying for
the goods. Under this view, until some amount of performance has occurred on a
contract, the buyer does not have an asset for the goods or services to be received nor a
liability (i.e.
, a present obligation) to pay for them, and the seller does not have a
recognizable asset for the right to collect the contractual payments. Thus, no asset or
liability would be recorded until some performance has occurred. For example, if the
purchaser of the inventory paid for it in advance, the purchaser’s obligation to pay would
be considered performed, and the purchaser would at that time record an asset to
recognize its right to receive inventory.
The latter view underlies the more common financial reporting treatment. Thus,
signing a contract for the sale/purchase of goods generally does not result in the
recognition of an asset or liability by either party. However, there are exceptions to this
general treatment. Two of the major exceptions are addressed in separate sections of this
204
The Staff does not address loan commitments, lines of credit, and other similar arrangements in the
Study, due to their specialized industry-specific nature and the fact that these obligations to provide funding
under certain terms and conditions themselves constitute a financial service, which is arguably more similar
to an obligation to sell than an obligation to purchase.
205
The motivation to enter into such contractual commitments is straightforward. An issuer that uses
certain raw materials in its production may wish to secure its supply of those materials—and possibly the
price, as well—by entering into long-term purchase contracts. The provider of raw materials may also
benefit from knowing how much to produce.
87
report: leases and derivatives. In yet other cases, while the assets and liabilities related to
an unperformed contract are not separately recognized, losses embedded in those
contracts are recognized. This so called “loss contract” accounting is required when an
issuer has committed to purchase inventory at prices that ensure a loss on resale of that
inventory,
206
and when a long-term construction contract is expected to result in a loss.
207
In January 2002, the Commission released FR-61, “Commission Statement about
Management's Discussion and Analysis of Financial Condition and Results of
Operations,” which described the views of the Commission regarding certain disclosures
that should be considered by issuers, including disclosures about contractual obligations
and commercial commitments. This guidance was updated in the 2003 revision by the
Commission of Item 303(A)(4) of Regulation S-K. Item 303(A)(4) requires disclosures
about certain off-balance sheet arrangements, including certain contractual obligations.
Specifically, these new rules require tabular disclosure in MD&A of contractual
obligations, including open purchase orders, that will result in future cash payments.
This disclosure is intended to provide financial statement users with information about
unrecognized (as well as recognized) obligations. While the disclosures do not provide
information about the related assets to be received as a result of those cash payments, the
disclosures are an attempt to portray contractual obligations broadly.
2. Off-Balance Sheet Issues in Accounting for Contractual
Obligations
Conceptually, the accounting for unperformed contractual obligations could be
done in a variety of ways. For example, all contractual rights and obligations could be
recognized as assets and liabilities.
208
This would recognize the fact that once an entity
enters into a firm contract to buy or sell something, the entity is generally subject to many
of the same risks and rewards as if the transaction had already been completed. For
example, once an issuer has entered into a firm fixed-price contract to purchase
inventory, future declines in the value of that inventory affect the issuer. Similarly, once
an issuer has agreed to sell inventory for a particular price, future decreases in the value
of that inventory do not
affect the issuer.
However, to the extent neither party to a contract has performed, each party’s
rights and obligations are, at least implicitly, contingent upon the other party’s. As such,
some assert the rights and obligations in the contract do not qualify as assets and
liabilities because they do not result from past transactions. Others believe that, because
the rights and obligations are contingent upon one another, they should be accounted for
only as a group—that is, the “unit of account” would be the contract as a whole, rather
than the assets and liabilities individually. In this analysis, the assets and liabilities would
be offset against one another. Assuming the contract represents an exchange of equal
206
See ARB 43, Chapter 4, Statement 10.
207
See SOP 81-1, paragraphs 85-89.
208
The CFA Institute (formerly AIMR) has called upon standard setters to treat all executory contracts with
terms greater than one year as assets and liabilities.
See Financial Reporting in the 1990s and Beyond,
AIMR (1993), page 86.
88
values, the values of the assets and liabilities would likely net to zero, thus effectively
resulting in no impact on the balance sheet.
Although standard-setters have almost invariably determined that such
unperformed contracts should not result in the recording of assets and liabilities, the basis
for these decisions is not always stated.
209
For example, as mentioned above, losses on
certain contractual commitments, such as inventory purchases and construction contracts,
are required to be recognized before performance occurs. Conceptually, the loss in these
contracts might be viewed as akin to an asset impairment loss, even though the rights in
these contracts have not previously been reported as assets.
Another potentially confusing aspect of accounting for loss contracts is that the
accounting is applied far beyond the situations specifically addressed in the accounting
guidance. Although this guidance specifically applies to very narrow classes of
transactions, issuers and auditors have often applied it by analogy to other unperformed
contractual obligations. These analogies have been applied sporadically, meaning that
losses inherent in some unperformed contracts are recorded, while others are not. This
diversity led the EITF to consider two issues related to losses on unperformed contracts.
Neither, however, resulted in a consensus.
210
3. Empirical Findings from Filings by Issuers
In this section the Staff presents empirical findings from the Study of filings by
issuers related to purchase obligations, a subset of contractual obligations. Other major
categories of contractual obligations, such as leases, guarantees, and derivatives, have
been addressed in other sections of this Report. The Staff also extrapolates from these
findings to estimate amounts for the approximate population of active U.S. issuers.
Table III(G)(1) describes the percentage of issuers reporting purchase obligations.
Approximately 54% of issuers in the sample report cash flows committed under purchase
obligations. An extrapolation of the findings from the sample to the approximate
population of active U.S. issuers suggests that approximately 30% of the total population
of issuers report cash flows committed under purchase obligations.
209
Neither the FASB’s actual, or proposed, Statements of Financial Accounting Concepts clarifies, one way
or the other, whether recognition of contractual commitments fits within the current conceptual framework.
By commissioning a research report on Recognition of Contractual Rights and Obligations, the FASB gave
some recognition, in 1980, to the need to consider the conceptual framework in relation to executory
contracts. That research report was written by Yuji Ijiri,
Recognition of Contractual Rights and Obligations
(Stamford, CT: FASB, December, 1980).
210
See EITF 99-14 and EITF 00-26.
89
TABLE III(G)(1): Issuers Reporting Future Cash Flows Committed under
Purchase Obligations
a
Sub-Samples
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers Reporting Purchase
Obligations 54 78 30 30.5
a
These data were collected from the contractual obligations table in the MD&A of the filings of issuers selected for the
Study.
Table III(G)(2) presents the total future cash flows committed under purchase
obligations for the 200 issuers in the sample, which are not recorded on the balance
sheets of issuer. The undiscounted sum of the future committed cash flows related to
purchase obligations for our sample of issuers is approximately $434 billion. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that the total (undiscounted) cash flows associated with purchase
commitments reported by the population is approximately $725 billion.
TABLE III(G)(2): Reported Future Cash Flows Committed under Purchase
Commitments
a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Total undiscounted cash flows $433,661 $430,713 $2,948 $725,513
a
These data were collected from the contractual obligations table in the off-balance sheet arrangements section of the
MD&A (required by FR67) for the filings of issuers selected for the Staff Study. It is important to note that these
amounts are not discounted.
Issuers reported other types of contractual obligations in the Contractual
Commitments table in MD&A. In many cases, it is obvious whether the commitment in
question is, indeed, on the issuer’s balance sheet (e.g.
, debt). However, in some cases,
the Staff notes that whether the item is on or off the balance sheet remains unclear.
90
IV. EMPIRICAL FINDINGS ON CERTAIN POST-SARBANES-
O
XLEY IMPROVEMENTS IN FINANCIAL REPORTING ON
OFF-BALANCE SHEET ARRANGEMENTS
A. Consolidation of Variable Interest Entities
1. Discussion
After the downfall of Enron, attention became focused on special purpose entities,
a vehicle frequently used by Enron as a means to get assets and liabilities off the balance
sheet. In response to the attention on previous SPE accounting,
211
the FASB developed a
new accounting interpretation that targets what are now referred to as variable interest
entities (“VIEs”). FASB Interpretation No. 46, Consolidation of Variable Interest
Entities—an interpretation of ARB No. 51, was issued in January 2003, with a revision—
Interpretation No. 46(R),
Consolidation of Variable Interest Entities (revised December
2003)—an interpretation of ARB No. 51—issued in December 2003.
212
Variable interest entities include SPEs and can be generally described as entities
in which the equity investment at risk does not provide its holders with the characteristics
of a controlling financial interest or is not sufficient for the entity to finance its activities
without additional subordinated financial support.
213
These characteristics are meant to
identify arrangements in which control of the entity would not be achieved through
voting stock ownership, but through some other method.
FASB Interpretation No. 46(R) requires consolidation of a variable interest entity
by a party that has a majority of the risks and rewards (i.e.
, greater than 50%) associated
with the entity. Interpretation No. 46(R) also establishes a methodology for determining
which party associated with a VIE should consolidate the VIE. Essentially, the
requirement is that the party exposed to a majority of the variations in the outcome of the
performance of a VIE, both positive and negative, should consolidate the VIE, because
such exposure is likely to be indicative of control. Interpretation No. 46(R) refers to
such a party as the primary beneficiary of the VIE.
An issuer’s involvement with a VIE can manifest itself in debt instruments,
guarantees, service contracts, written put options, total return swaps, etc. These
arrangements with a VIE can put the issuer in a position akin to an equity holder in that
the issuer bears the same risks and rewards of the VIE as an equity holder would. For
example, consider an issuer that owns 50% of the voting stock of another entity and is the
sole guarantor of debt of the entity. Before Interpretation No. 46(R), such an issuer may
211
See EITF Topic D-14, Transactions involving Special-Purpose Entities; EITF 96-21, Implementation
Issues in Accounting for Leasing Transactions involving Special-Purpose Entities; EITF 90-15, Impact of
Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions.
212
As has been the convention in the rest of this document, the Staff will generally refer to the revised
version of the interpretation (
i.e., Interpretation No. 46(R)). However, there are some cases in this section
that require reference to the original version of the interpretation (
i.e., Interpretation No. 46).
213
See Interpretation No. 46(R), paragraph D2.
91
not have been required to consolidate the other entity based upon voting control.
However, subsequent to the promulgation of Interpretation No. 46(R), if this same entity
is deemed to be a VIE, then the issuer would likely be required to consolidate, due to the
issuer’s additional risk of loss from the outstanding guarantee.
In anticipation of the implementation of Interpretation No. 46 and Interpretation
No. 46(R), a number of entities restructured arrangements with potential VIEs such that
they would not require consolidation. Disclosures of such restructurings were noted in
the sample companies. The Staff also is aware anecdotally that many arrangements with
potential VIEs were restructured such that the entity either would not be considered a
VIE or such that no party would be required to consolidate the VIE. The effect of such
changes is difficult to measure. However, in some cases, it appears that the changes
made involved substantive changes to the economics of the variable interests or to the
decision-making capabilities of the investors, while in other cases, the changes may have
been less substantive.
Although Interpretation No. 46(R) constitutes an improvement over the
previously existing consolidation guidance, a number of interpretive questions remain.
Many users of Interpretation No. 46R find it theoretically and practically challenging to
apply. Currently, the FASB is considering ways to resolve an issue originally discussed
by the EITF in issue 04-07, Determining Whether an Interest Is a Variable Interest in a
Potential Variable Interest Entity. A consensus on this EITF issue may change how some
issuers apply Interpretation No. 46(R).
The Staff has noted that Interpretation No. 46(R) has resulted in a number of non-
SPE type entities being consolidated such as joint ventures and jointly owned entities
such as LLCs. However, it is unclear to the Staff whether Interpretation No. 46(R) has
significantly increased the number of SPE entities that are consolidated. In part, this may
be a result of practice being ahead of the standard setters, effectively restructuring
arrangements in advance of the effective date of standards in order to achieve desired
financial reporting results. Even so, if the changes made to SPEs in order to avoid
consolidation do indeed represent substantive changes, such that the issuers in question
no longer control the SPE, Interpretation No. 46(R) will have improved financial
reporting even if there is not a significant increase in the frequency of consolidation of
SPEs. The Staff believes more time is needed to fully evaluate the effects of
Interpretation No. 46(R).
2. Empirical Findings from Study of Filings by Issuers
This section summarizes the empirical findings from the Study of filings by
issuers related to VIEs. The Staff also extrapolates from these findings to estimate
amounts related to the approximate population of active U.S. issuers.
The Staff examined the disclosures related to Interpretation No. 46 and
Interpretation No. 46(R) in the annual 10-K filings used for the remainder of the Study.
However, as of that point in time, many of the sample issuers had not yet fully adopted
Interpretation No. 46(R), so the available data was primarily limited to disclosures about
92
the expected impact of adopting Interpretation No. 46(R).
214
In light of these limitations,
the Staff supplemented the data by collecting additional information regarding issuers’
implementations of Interpretation No. 46(R) from selected quarterly 10-Q filings.
Table IV(A)(1) describes the percentage of issuers reporting different levels of
actual or anticipated effects of implementing Interpretation No. 46 (and to some extent,
of Interpretation No. 46(R)) as of the date of our sample issuers’ annual 10-K or 10KSB
filings.
Table IV(A)(1): Anticipated Effects of Adoption of Interpretation No. 46 Presented
in Annual 10-K Filings
a
Sub-Samples
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers with no Interpretation No. 46
disclosures
18.5 7 30 29.8
Issuers reporting no VIEs
b
13 6 20 19.9
Issuers reporting no material VIEs
b
8.5 11 6 6.0
Issuers reporting that the effect of
adopting Interpretation No. 46 was not
material or not expected to be material
38 48
c
28 28.2
Issuers reporting no statement about
materiality for any VIEs
12 14 10 10.0
Issuers reporting they are still
evaluating for some VIEs
6.5 7 6 6.0
Issuers reporting that the impact of
adopting Interpretation No. 46(R) was
material or was expected to be
material for any VIEs
3.5 7 0 0.0
d
a
These data were collected from the notes to the financial statements in the 10-K filings of issuers selected for the
Study. In some cases, issuers had fully or partially implemented Interpretation No. 46(R) as well.
b
Issuers included in this category are not counted in the categories below, even though some of these issuers also stated
that the effects were not material.
c
Approximately 16% of the issuers in this group reported the existence of VIEs other than those for which they
considered impact of Interpretation No. 46(R) to be immaterial, but these issuers did not make any statement about
materiality for these other VIEs.
d
Less than 0.5%.
214
As of the 10-K filing dates for the sample, most issuers had either not adopted or had only partially
adopted Interpretation No. 46(R), because Interpretation No. 46(R) replaced Interpretation No. 46, but only
after the effective date of Interpretation No. 46. The effective date for Interpretation No. 46(R) was after
the balance sheet date for most 10-K filings in the sample. In addition, public small business issuers (
i.e.,
issuers that file a 10KSB) were not required to adopt Interpretation No. 46(R) until 9 months after other
public issuers.
93
The information gathered for this table mainly relies on disclosures under Staff
Accounting Bulletin No. 74, Disclosure of the impact that recently issued accounting
standards will have on the financial statements of the registrant when adopted in a future
period (“SAB 74”). As can be seen, less than 4% of the sample issuers reported that the
impact of the interpretations either was material or was expected to be material, and all of
these issuers were members of the large issuer sub-sample. An extrapolation of the
findings from the sample to the approximate population of active U.S. issuers suggests
that less than 1% of the issuers in the population would expect the effect of the
interpretations to be material.
In addition, as mentioned above, the Staff believes that some arrangements with
potential VIEs were restructured such that the entity would not be consolidated under
Interpretation No. 46 or 46(R). In fact, seven issuers in the large issuer sub-sample made
reference in their filings to restructurings that occurred in anticipation of or coincident
with the implementation of Interpretation No. 46 and 46(R).
The Staff supplemented its analysis of the annual 10-K filings by collecting
additional information about the application of Interpretation No. 46 and 46(R) from
selected quarterly 10-Q filings, which is presented in Tables IV(A)(2) and IV(A)(3).
215
Table IV(A)(2) describes the percentage of issuers reporting adoption of
Interpretation No. 46(R) and the percentage of issuers that are affected. Approximately
77% of the sample issuers report that they have adopted Interpretation No. 46(R).
216
Approximately 12% of the sample issuers report in their quarterly 10-Qs that they have
no VIEs, which is a similar proportion of those who reported no VIEs in their SAB 74
disclosures (i.e.
, 13%). Issuers reporting the existence of VIEs in their quarterly 10-Qs
amounted to approximately 32%. Finally, approximately 23% of the sample issuers
report the existence of VIEs that are consolidated.
215
The Staff selected the quarterly 10-Q filing for each issuer in the sample for the period in which
Interpretation No. 46(R) should have been fully adopted. Public small business issuers (
i.e., issuers that file
a 10KSB) were not required to adopt Interpretation No. 46(R) until 9 months after other public issuers. As
a result, the Staff cannot comment on the effects of Interpretation No. 46(R) for many of the issuers in this
category.
216
Some sample issuers may not have reported adoption if they had no arrangements that were in the scope
of Interpretation No. 46(R) and thus concluded that no disclosure was necessary.
94
Table IV(A)(2): Effects of Adoption of Interpretation No. 46(R) Presented in
Quarterly 10-Q Filings
a
Sub-Samples
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers Reporting Full Adoption of
Interpretation No. 46(R)
b
76.5 88 65
c
65
Issuers Reporting No VIEs 11.5 5 18 17.9
Issuers Reporting Existence of
VIEs
a
32 50 14 14.4
Issuers Reporting VIEs that are
Consolidated
b
22.5 39 6 6.3
a
These data were collected from the notes to the financial statements in the 10-Q filings of issuers selected for the
Study.
b
In many cases, filings did not clearly indicate whether the consolidations occurred as a result of adopting
Interpretation No. 46(R).
c
Includes 8 of the 26 small business issuers in the sample.
The findings for the sub-samples present a different picture. Only 5% of the large
issuer sub-sample report that they have no VIEs, compared to 18% of the random issuer
sub-sample. Approximately 50% of the large issuer sub-sample reports the existence of
VIEs, and 39% of this sub-sample reports consolidating at least some of these VIEs. In
contrast, only 14% of the random issuer sub-sample report the existence of VIEs, and
only 6% report any consolidation.
Table IV(A)(3) presents the reported amounts of assets and liabilities consolidated
under Interpretation No. 46(R). The sample issuers consolidated approximately $208
billion in assets and almost $170 billion in liabilities, the vast majority of which reflects
consolidations in the large issuer sub-sample. These assets and liabilities represent
approximately 2% of the total assets and 2% of the total liabilities for the sample (as
shown in Table II(A)(2)), and are proportionate for each of the sub-samples. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that VIEs with approximately $516 billion in assets and $444
billion in liabilities are consolidated by the population.
95
TABLE IV(A)(3): Reported Amounts Related to Consolidated Assets and
Liabilities of Variable Interest Entities
a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
VIEs Consolidated by Issuers:
Assets $208,312 $205,206 $3,106 $515,806
Liabilities $169,706 $166,938 $2,768 $443,738
a
These data were collected from the notes to the financial statements in the 10-K and 10-Q filings of issuers selected
for the Study. In most cases, filings did not clearly indicate whether the consolidations occurred as a result of adopting
Interpretation No. 46(R).
B. Disclosure in Management's Discussion and Analysis about Off-
Balance Sheet Arrangements and Aggregate Contractual
Obligations
1. Discussion
As directed by Section 401(a) of the Act, the Commission adopted amendments to
its rules to require each annual and quarterly financial report required to be filed with the
Commission to disclose “all material off-balance sheet transactions, arrangements,
obligations (including contingent obligations), and other relationships of the issuer with
unconsolidated entities or other persons, that may have a material current or future effect
on financial condition, changes in financial condition, results of operations, liquidity,
capital expenditures, capital resources, or significant components of revenues or
expenses.”
217
The rule requires an issuer to provide an explanation of its off-balance
sheet arrangements in a separately captioned subsection of the Management's Discussion
and Analysis section of the issuer’s disclosure documents. It also requires issuers (other
than small business issuers) to provide an overview of certain known contractual
obligations in a tabular format.
FR 67 requires disclosure for any contractual arrangement to which an
unconsolidated entity is a party, and under which a registrant has:
• Any obligation under certain guarantee contracts;
• A retained or contingent interest in assets transferred to an unconsolidated entity;
• Any obligation under certain derivative instruments; or
• Any obligation under a variable interest held by the issuer in an unconsolidated
entity.
218
217
Final Rule: Disclosure in Management's Discussion and Analysis about Off-Balance Sheet Arrangements
and Aggregate Contractual Obligations, Release No. 34-47264, also codified in FR 67
218
See FR 67 for a more detailed description of these categories.
96
Disclosure is required to the extent necessary to provide an understanding of the
issuer’s material off-balance sheet arrangements as well as the material effects of those
arrangements on financial condition, changes in financial condition, revenues or
expenses, results of operations, liquidity, capital expenditures or capital resources. As the
Commission noted in the release accompanying the final rule, management has the
responsibility to identify and address the key variables and other qualitative and
quantitative factors that are peculiar to, and necessary for, an understanding and
evaluation of the issuer. More specifically, to the extent necessary for an understanding
of the issuer’s off-balance sheet arrangements, an issuer must provide the following four
items:
• The nature and business purpose of the issuer’s off-balance sheet arrangements;
• The importance of the off-balance sheet arrangements to the issuer for liquidity,
capital resources, market risk or credit risk support or other benefits;
• The financial impact of the arrangements on the issuer (e.g., revenues, expenses,
cash flows or securities issued) and the issuer’s exposure to risk as a result of the
arrangements (e.g.
, retained interests or contingent liabilities); and
• Known events, demands, commitments, trends or uncertainties that affect the
availability or benefits to the issuer of material off-balance sheet arrangements.
2. Empirical Findings from Study of Filings by Issuers
This section summarizes the empirical findings of the Staff Study of filings by
issuers related to off-balance sheet arrangements reported in the section of MD&A, as
required by FR 67. The Staff also extrapolates from these findings to estimate amounts
related to the approximate population of active U.S. issuers.
Table IV(B)(1) describes the percentage of issuers reporting different types of
arrangements in the off-balance sheet section of MD&A. Approximately 23% of issuers
report information about guarantees in the off-balance sheet section of their MD&A.
Only approximately 8% report information about variable interests held in
unconsolidated VIEs. Approximately 13% also report information about retained
interests in financial assets transferred to an unconsolidated entity. Even fewer issuers—
approximately 1% of the sample—report the existence of the derivatives required to be
disclosed under FR 67 (e.g.
, equity-linked derivatives).
97
TABLE IV(B)(1): Issuers Reporting Arrangements in MD&A Off-Balance Sheet
Section
a
Sub-Samples
Categorized by Type of
Arrangement
b
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Variable Interest Entities 7.5 14 1 1.1
Retained Interests 13 25 1 1.2
Guarantees 22.5 39 6 6.3
Equity-linked Derivatives
1 2 0 0
c
a
These data were collected from the section on off-balance sheet arrangements in the MD&A of the filings of issuers
selected for the Study.
b
These categories are not mutually exclusive.
c
Less than 0.5%.
In many cases, the Staff notes that a greater proportion of issuers report OBS
arrangements in the notes to the financial statements, as compared to the off-balance
sheet section of the MD&A. For example, more than twice as many issuers report
information on guarantees in the notes to the financial statements as in the off-balance
sheet section. One possible explanation for this is that FR 67 requires disclosures for
only a subset of the guarantees encompassed by the disclosure requirements under
Interpretation No. 45.
219
Specifically, FR 67 only requires disclosures for the types of
guarantees that are required to be recognized
as liabilities on the balance sheet under
Interpretation No. 45, while Interpretation No. 45 also requires disclosures for certain
arrangements, such as product warranties, that are not required to be recognized on the
balance sheet.
Nevertheless, it appears that issuers may not have identified all of the off-balance
sheet arrangements that are required to be discussed in the OBS section of MD&A.
Further, the Staff believes—based in part on the difficulties faced in gathering the data
necessary for the Study and Report—that the quality of the issuer disclosures provided in
the off-balance sheet section of MD&A can and should be improved. To some extent,
this is not surprising, given that this was the first year for such disclosures. The Staff
expects to focus on these areas in its reviews of issuer filings.
V. Initiatives to Improve Financial Reporting Transparency
This Report has presented analyses and discussion on various types of
transactions and arrangements that may give rise to questions regarding the content of the
balance sheet. The Staff does not, however, view these issues as totally separable from
certain other issues that arise in financial reporting. In the course of the Staff’s day-to-
day work, which includes working with issuers on accounting questions as well as
overseeing the work of the FASB in the development of accounting standards, the Staff
often develops views as to how financial reporting might be improved. While that
219
Recall that Interpretation No. 45 governs disclosures in the footnotes.
98
cumulative knowledge informs this Report, the work to produce this Report has also
reinforced some of the Staff’s prior views on several broad goals that it believes are key
to raising the level of quality of financial reporting. We present these items below.
Readers will note that the goals do not speak to particular improvements in
accounting standards. While we do provide specific recommendations related to
accounting standards in Section VI, it is the broad goals that we believe should guide the
work of the standard-setters, and, more importantly, that should be in the minds of
preparers, auditors, regulators, and others who affect financial reporting. The Staff
believes that discussions on improvements in financial reporting too often focus
inappropriately and singularly on standard-setting activities. The Staff believes that
improvement will best be achieved when all parties in the financial reporting process are
working towards the same goals. Indeed, the Staff believes that significant improvement
in the transparency of the balance sheet and of financial reporting in general is possible
without any changes in standards.
A. Eliminate (or at least Reduce) Accounting-Motivated Structured
Transactions
As noted in the introduction to this Report, we have not limited the scope of our
consideration of off-balance sheet transactions to only those transactions that involve
deliberate manipulation on the part of the issuer. Nonetheless, it is true that most of the
scandals that provided a catalyst to the passage of the Act did indeed involve transactions
that were structured so as to present information in a manner inconsistent with the
underlying economics. In fact, deliberate attempts to work around the intent of the
standards have contributed to many of the largest financial reporting failures. These
attempts normally involve transactions that are structured in an attempt to achieve
accounting results that do not mirror the economics of the transaction. With regard to
certain of Enron’s structured transactions, Neal Batson concluded that:
broad concepts have given way to rules-based, bright-line tests under
which the financial accounting for a transaction often depends on the
form of the transaction rather than its economic substance. In fact, in
many cases the very purpose of designing a structured finance
transaction to comply with the literal GAAP rules is to report the
transaction in accordance with its form rather than its economic
substance.
220
In addition, transparency and the degree to which accounting and disclosure
standards achieve their goals can be greatly diminished by the use of structuring, even
when that structuring appears to comply with the standards. Examples of this abound in
financial reporting, and touch on several of the topics that are addressed in this Report.
Leasing is a prime example of this. The guidance that currently exists was developed
with regard to the transactions that were commonplace at the time that guidance was
issued. And, indeed, it might have produced results that would have reflected the
220
See Second Interim Batson Report, pages 51 and 52.
99
economics of those transactions, if not for the fact that lease transactions changed in
response to the guidance. Interpretation No. 46(R), which addresses the consolidation of
variable interest entities (including SPEs), could well suffer a similar fate. In some cases,
securitizations and derivatives have been used in accounting-motivated transactions.
When we refer to accounting-motivated structured transactions, we are speaking
of those transactions that are structured in an attempt to achieve reporting results that are
not consistent with the economics of the transaction, and thereby impair the transparency
of financial reports.
221
Further, we include not only those transactions that would not
have been undertaken but for the perceived “benefits” of the resultant financial reporting,
but also those that adopt a more complex form than would otherwise be the case, in order
to achieve an accounting result. For example, an issuer might contemplate a secured
borrowing transaction because it needs capital—a true business purpose. However, if
that issuer transfers the assets to an SPE, which then borrows the funds and transfers
them to the issuer in a transaction that keeps the debt off the balance sheet while exposing
the issuer to virtually the identical risks and rewards as if the simple secured borrowing
had been undertaken, the Staff considers the transaction to be accounting-motivated.
It is tempting to blame the use of accounting-motivated transactions on
accounting standards that can be exploited. However, while the fact that accounting
standards may be vulnerable to exploitation may be thought of as representing a failure of
the standard-setter, it is the creation and use of a structured transaction undertaken with
purpose and intent to obfuscate, conceal and/or deceive that reduces transparency, not the
standards themselves. Issuers, auditors, and advisors who work to implement
transactions that are structured in ways that attempt to portray the transactions differently
from their substance do not operate in the interests of investors, and may be in violation
of the securities laws.
222
Underscoring the seriousness of the problems caused by
accounting-motivated transaction structures, the Commission has recently entered into
settlements with several entities that engaged in the development or facilitation of
transaction structures.
223
The Staff believes that the significant use of accounting-motivated transactions
has contributed to a reduction in the transparency and credibility of financial statements.
221
Thus, we do not mean to include situations where, for example, an issuer increases its sales efforts at the
end of a period to generate revenue. In that situation, the reporting of revenue would generally mirror the
economics if additional sales are generated. Such situations may, however, result in the need for
explanatory disclosures, particularly in MD&A.
222
See Release No. 34-49695, Policy Statement: Interagency Statement on Sound Practices Concerning
Complex Structured Finance Activities
223
See Commission Press Releases SEC Charges Merrill Lynch, Four Merrill Lynch Executives with
Aiding and Abetting Enron Accounting Fraud (where Merrill Lynch simultaneously settles charges for
permanent anti-fraud injunction and payment of $80 million in disgorgement, penalties and interest) (2003-
32);
SEC Settles Enforcement Proceedings against J.P. Morgan Chase and Citigroup (where J.P. Morgan
Chase agrees to pay $135 million to settle Commission allegations that it helped Enron commit fraud and
Citigroup agrees to pay $120 million to settle Commission allegations that it helped Enron and Dynegy
commit fraud) (2003-87);
see also American International Group, Inc. Agrees to Pay $126 Million to Settle
Fraud Charges Arising Out of Its Offer and Sale of An Earnings Management Product (2004-163).
100
In addition, transaction structuring has substantially contributed to the complexity of
accounting and reporting standards in certain areas, a point we address immediately
below.
B. Continue Implementation of Objectives-Oriented Approach to
Standard Setting
In many areas of accounting, including several of the areas discussed in Section
III, the accounting and reporting standards are complex. While complexity is not in-and-
of-itself a bad thing, and in some cases may be necessary, it nevertheless typically entails
added cost. On July 25, 2003, the Commission released a Staff study on the adoption by
the U.S. financial reporting system of a principles-based accounting system.
224
The Staff
recommended therein that FASB more consistently develop accounting standards on a
principles-based or “objectives-oriented” basis, as defined in the study. The FASB has
indicated that it “agrees with the recommendations” of the study.
225
The results of the
current Study of off-balance sheet arrangements have only served to reinforce the Staff’s
previous conclusion of the importance of taking an objectives-oriented approach to
standard setting.
As noted in Section I above, the Objectives-Oriented Accounting Standards Study
recommended that accounting standards should be developed using an objectives-
oriented approach and that such standards should have the following characteristics:
• Clearly state the accounting objective of the standard with the objective
incorporated in the standard;
• Minimize the use of exceptions from the standard;
• Avoid use of percentage tests (“bright-lines”) that allow financial engineers to
achieve technical compliance with the standard while evading the intent of the
standard;
• Be based on an improved and consistently applied conceptual framework; and
• Provide sufficient detail and structure so that the standard can be operationalized
and applied on a consistent basis.
Objectives-oriented standards would clearly establish the objectives for a class of
transactions—and incorporate those objectives as an integral part of the standard itself.
Under an objectives-oriented approach, preparers would be held responsible to present
financial statements that are in accordance with the substantive accounting objectives
built into the pertinent standards. Moreover, under an objectives-oriented approach, the
cost to investors and analysts of comprehending the standards themselves should be
lower. Indeed, ideally, an investor or analyst could obtain a reasoned conceptual
understanding of the meaning of reported numbers by simply studying the stated
224
The study was conducted pursuant to the provisions of Section of the Sarbanes-Oxley Act. See
Objectives-Oriented Accounting Standards Study.
225
FASB Response to SEC Study on the Adoption of a Principles-Based Accounting System, July 2004.
101
objectives of the pertinent standards. That is, under an objectives-oriented regime, each
standard’s stated objective assists the user in comprehending how the standard is
constructed, how it is to be applied to a class of transactions or events, and how those
transactions or events should be reflected in the financial statements. This intuitive
coherence serves to enhance transparency.
As noted in the previous study, rules-based standards “further a need and demand
for voluminously detailed implementation guidance on the application of the standard,
creating complexity in and uncertainty about the application of the standard.” For
example, the derivatives accounting guidance is often criticized as being excessively long
and overly complex, but much of that guidance is devoted to determining whether an
instrument qualifies for one of the exceptions from the definition of derivative, or one of
the exceptions in the application of hedge accounting. Objectives-oriented standards that
rely on a coherent and consistent conceptual framework with less bright lines and fewer
exceptions may allow a significant reduction in complexity of the accounting guidance.
Moreover, rules-based standards can provide a roadmap to avoidance of the
accounting objectives inherent in the standards. Internal inconsistencies, exceptions and
bright-line tests reward those willing to engineer their way around the intent of standards.
This can result in financial reporting that is inconsistent and not representationally
faithful to the underlying economic substance of transactions and events.
226
For example,
with respect to securitizations, current standards allow issuers to structure transactions to
achieve desired accounting results—that is, either sale or borrowing treatment for the
items being securitized—for what are economically similar transactions. Other examples
of accounting-motivated structured finance transactions are discussed throughout this
Report.
Again, it is tempting to look to the accounting standard-setter for progress
towards objective oriented standards. However, while the FASB must be a driver of
greater use of objectives-oriented standards and the accompanying reduction in
complexity of the guidance, they cannot do it alone. Other parties must also be
committed to these goals in order to make them a reality. As noted in the previous study,
the complexity in current standards exist in large part due to requests for guidance from
preparers and auditors, due to exceptions to basic principles that were requested by
preparers or others in the financial reporting process, and due to concerns about litigation
that might stem from standards that require a greater use of judgment on the part of
management and auditors. It is important that all participants in the financial reporting
process do their part to reduce complexity in financial reporting by being willing to apply
(and accept) reasonable judgments.
226
For example, as indicated in Batson’s Second Interim Report, “Enron’s intimate knowledge and carefully
calculated application and manipulation of the GAAP rules ... provided a leading example of how abuse of
the rules-based approach to GAAP standard setting can result in reported financial results materially
different from the underlying substance of the transactions reported.”
Batson’s Second Interim Report,
Appendix B (Accounting Standards), page 12.
102
C. Improve the Consistency and Relevance of Disclosures
As discussed in Section II above, the basic financial statements themselves cannot
convey all of the relevant information about an issuer’s rights, obligations, and
transactions. Disclosures outside of the basic financial statements are necessary to
complement that information in order to enhance the decision-usefulness of financial
reporting. In the process of conducting this Study, including the gathering of empirical
data, the Staff observed that the quality of the information presented in some areas varies
greatly from issuer to issuer, and among topical areas. Some of these issues are
mentioned in the subsections of Section III dealing with empirical data, as the Staff noted
that it was not able to comprehensively compile data in certain areas.
In addition, the Staff observed that disclosures sometimes appear haphazard, with
the disclosures required by each rule or standard developed independent of other
disclosures. While it was observed that disclosures made by issuers did in fact often
provide information about the potential variability of estimates, alternate measurement
attributes, assumptions used by management, and detail of summarized financial
statement captions, it was not always clear why particular disclosures were included in
various situations, or, in some cases, what the purpose of the disclosures was.
Indeed, both users and preparers in various industries have stated that they believe
that disclosures in the area of financial instruments, among others, do not provide a
complete or meaningful picture for investors. The Staff believes that it is important that
issuers take the time and make the effort to prepare disclosures in a meaningful way and
to provide sufficient disclosures to allow investors to understand the substance of the
issuer’s situation and activities.
227
D. Improve Communication Focus in Financial Reporting
An unfortunate effect of the large volume and complexity of financial reporting
requirements is that many accountants, lawyers, and others seem to view the goal of
financial reporting as achieving technical compliance with the rules without regard to
communicating effectively to investors. As we have noted, the Staff believes the goal is
to communicate effectively to investors while complying with the rules.
The Commission has previously noted the importance of clear communication in
financial reports. Perhaps most notable were the efforts to achieve greater use of “plain
English” in filings. The Commission issued rules in this area in 1998, noting in the
release that:
228
Full and fair disclosure is one of the cornerstones of investor protection
under the federal securities laws. If a prospectus fails to communicate
227
Cf. Exchange Act Rule 12b-20 which states that “In addition to the information expressly required to be
included in a statement or report, there shall be added such further material information, if any, as may be
necessary to make the required statements, in the light of the circumstances under which they are made not
misleading.”
228
See Release No. 33-7497, Plain English Disclosure (January 28, 1998)
103
information clearly, investors do not receive that basic protection...A
major challenge facing the securities industry and its regulators is assuring
that financial and business information reaches investors in a form they
can read and understand.
The plain English rules require the use of short sentences, everyday language, and
tabular presentation of complex information, amongst other things. Despite these and
other efforts to encourage better communication, the Staff believes that a substantial
number of issuers continue to focus the bulk of their efforts on technical compliance with
the rules, rather than true communication.
While this mindset is certainly not limited to off-balance sheet issues or the types
of transactions discussed in this Report, it does manifest itself in the volume of
accounting motivated transaction structures and in disclosures that may provide certain
required data, but remain insufficient to permit a true understanding of the issuer’s
activities or position. No matter how many improvements are made to accounting
standards, financial reporting will continue to suffer if it remains an accepted premise by
some practitioners that efforts to avoid the intent of standards while maintaining seeming
technical, minimal compliance with the letter of those standards are acceptable.
229
A stronger focus on communication with readers should also have the effect of
making financial reports easier to understand and digest. Turning again to the example of
financial instrument disclosures, the Staff noted during its work on the Study and Report
that even where significant information was available in filings, it was often spread in
several places, and there was little explanation of how the various disclosures related to
each other or to the amounts reported in the financial statements.
If all participants in the process came at financial reporting with a view of
complying with the objectives of the guidance and clearly and transparently
communicating material information to investors, significant improvements would occur
even if none of the other recommendations in this Report were to be adopted.
Conversely, the focus on seeming technical compliance results in a tendency to only
make improvements when new rules or standards require those improvements. This
burdens the standard-setters with the responsibility for driving all improvements, and
investors with the responsibility for deciphering reports that are not written clearly.
Changing this situation will not be a short-term proposition. However,
opportunities to improve exist, and most of the opportunities depend on the actions and
intentions of issuers. The Commission and the Staff will continue to attempt to assist.
For example, recent Commission rules that require auditors to make audit committees
aware of situations where management has chosen a less preferable method of accounting
may help preparers and auditors identify opportunities to improve.
230
The recent
229
Notably, proof of compliance with GAAP does not imply that an issuer or auditor acted in good faith and
that the “facts as certified were not materially false or misleading.”
See U.S. v. Simon 425 F.2d 796.
230
Release No. 33-8183, Strengthening the Commission’s Requirements Regarding Auditor Independence;
Section 210.2-07 Communication with audit committees
104
interpretive release on MD&A information also provides various suggestions to improve
the quality and transparency of these disclosures.
231
The Staff is also exploring the ways that technology can help to provide
information to investors that is easier to use and understand, and that increases the ability
to make comparisons across companies. Among other things, the Commission is
implementing a voluntary program to allow issuers to file certain information using
XBRL, which may facilitate the analysis of financial information by users.
232
It is hoped
that preparers and users will take advantage of this program to identify the most useful
information to provide in this format, including information relating to the arrangements
discussed in this Report. The Staff will continue to explore ways to encourage better and
more useful disclosures. However, efforts in this area will have a much greater chance of
success with the commitment of preparers to communicate with investors in the most
effective ways possible.
VI. Recommendations Related to Accounting Standards
The recommendations below represent suggestions for changes in accounting and
reporting standards that we believe have the greatest potential to result in improved
transparency. It is important to note that all of the standards that currently exist were
actively debated and discussed when they were set, and were subject to an open and
deliberative process. The Staff believes that this process has worked well, and is the
appropriate process by which improvements to the existing standards should be
considered and developed. Furthermore, by including these recommendations, the Staff
does not mean to suggest the primary responsibility for improvements in reporting rests
solely with the FASB. Rather, the recommendations are meant in part to make clear to
readers of this Report the kinds of changes which would likely flow from attempts by the
FASB to help achieve the goals discussed in Section V. In each case, the
recommendations speak directly to issues of transparency the Staff identified during its
work in preparing this Report.
A. Standards on Accounting for Leases
Lease accounting has been identified repeatedly as an area that should be
reexamined by the FASB.
233
The current “all or nothing” lease accounting guidance is
not designed to reflect the wide continuum of lease arrangements that are used, and
231
Release Nos. 33-8350; 34-48960 Interpretation: Commission Guidance Regarding Management’s
Discussion and Analysis of Financial Condition and Results of Operations FR 72.
232
Release Nos. 33-8529, 34-51129, 25-27944, 39-2432, IC-26747 XBRL Voluntary Financial Reporting
Program on the EDGAR System
233
See, for example, AICPA’s Special Committee on Financial Reporting, Improving Business Reporting—
A Customer Focus (Dec. 1994) (discussion of users’ concerns with accounting and disclosures on long
term leases); Robert C. Lipe “Lease Accounting Research and the G4+1 Proposal”
Accounting Horizons
(Sept. 2001); Dennis W. Monson “The Conceptual Framework and Accounting for Leases”
Accounting
Horizons (Sept. 2001) (Notes that “there is virtually universal agreement that SFAS No. 13 fails to achieve
its stated objectives and needs to be reconsidered.”)
105
therefore, it cannot transparently and consistently reflect the varying economics of the
underlying arrangements. In addition, the Staff is aware that sophisticated users, such as
credit-rating agencies, often adjust balance sheets in their work so they can analyze
companies as if all leases were reflected on the balance sheet. A project on lease
accounting would be consistent with several of the goals described above in Section V.
The lease accounting standards rely extensively on bright lines, greatly increasing
the potential for similar arrangements to be portrayed very differently. Indeed, for a
lessee, the accounting can flip between recording no assets and liabilities at lease
inception to recording the entire leased asset and entire loan price with only a very small
change in economics. As discussed previously, the bright line tests have served to
facilitate significant structuring of leases to obtain particular financial reporting goals.
The extensive structuring further erodes the effectiveness of the standards.
Some have suggested that lease accounting should focus on contractual cash
inflows and outflows
234
in determining the amount of assets and liabilities to record on
entities’ balance sheets. Lease accounting methods based on cash flows would generally
require both parties in lease agreements to report their economic interests in the leased
assets as well as assets and/or liabilities related to payments mandated by the lease
agreement. The FASB, as part of a group of standard setters known as the G4+1,
235
has
considered, in some depth, such approaches in the past.
236
The Staff believes that these
approaches, among others, remain worthy of further consideration.
In suggesting that the FASB should undertake a project to reconsider the
standards for accounting for leases, the Staff does not mean to suggest that such a project
would be simple. Leases can have many different terms, including contingent rents,
optional extensions, penalty clauses, purchase options, and others that each will require
consideration in any project. The challenges in developing an approach that considers
each of these terms in a conceptually consistent way are not insignificant. Furthermore, it
is likely that a project on lease accounting would generate significant controversy; many
issuers see leasing as an attractive form of financing asset acquisition in part because
leases can be structured so as to avoid recording debt. For these reasons, a project on
lease accounting would also likely take a significant amount of time as well as necessitate
a substantial commitment of FASB staff resources. Nonetheless, the Staff believes that
the potential benefits in terms of increased transparency of financial reporting would be
substantial enough to justify the time and effort required.
The project to reconsider the accounting for leases may be most effective if
conducted as a joint project with the International Accounting Standards Board (“IASB”).
234
See SFAC No. 1, paragraph 37.
235
Members of the G4+1 included the Australian Accounting Standards Board, the Canadian Accounting
Standards Board, the International Accounting Standards Committee, the New Zealand Accounting
Standards Review Board, the New Zealand Financial Reporting Standards Board, the United Kingdom
Accounting Standards Board and the United States Financial Accounting Standards Board.
236
See Financial Accounting Series Special Report: Accounting for Leases: A New Approach, July 1996
and Financial Accounting Series Special Report:
Leases: Implementation of a New Approach, February
2000.
106
The IASB’s standards are widely used outside of the United States. In an area as
pervasive as leasing, it would be beneficial to have similar accounting standards be used
around the world to the greatest extent possible.
B. Standards on Accounting for Defined-Benefit Retirement
Arrangements
The accounting for defined-benefit retirement arrangements provides a good
example of a situation in which different accounting is achieved solely due to the form of
arrangement used. An issuer could meet its pension obligations by paying them out as
they become due, and funding those payments from assets held by the issuer. If it did so,
the assets would be accounted for like any other assets held by the issuer, and the
obligation would be estimated and accrued like any other long-term compensation
arrangements. As discussed above, most U.S. companies choose instead to fund their
retirement arrangements by setting up separate entities for their pension plans and
funding those plans. Although the company generally has almost the same risks and
rewards and much of the same level of control over the assets and obligations whether
they are in a separate plan or not, the accounting changes completely if a plan is used.
The FASB itself questioned whether the accounting guidance that addresses defined-
benefit pension plans is sufficiently transparent, as pointed out in SFAS No. 87:
The Board believes that it would be conceptually appropriate and
preferable to recognize a net pension liability or asset measured as the
difference between the projected benefit obligation and plan assets, either
with no delay in recognition of gains and losses, or perhaps with gains and
losses reported currently in comprehensive income but not in earnings.
The Staff believes that a project that would reconsider the accounting for defined-
benefit pension plans is warranted.
The Staff believes that such an effort would further several of the initiatives
discussed previously in Section V. First, the accounting for defined-benefit pension plans
deviates from the accounting required for other business and compensation arrangements,
even when the economics are similar. While issues such as how to most appropriately
measure the pension obligation and report pension items in the income statement should
be considered, the Staff believes that work on the accounting for defined-benefit plans
should also focus on those areas that are inconsistent with the accounting for similar
items in other areas, including:
• Consolidation—Given the fact that the plan sponsor generally controls and is
subject to the vast majority of the risks and rewards of the pension plan, there
is not an obvious conceptual reason why the plan should not be consolidated,
especially since other trusts used to fund liabilities typically are consolidated.
In addition, the consolidation exemption results in a very different financial
statement presentation based on whether a separate entity is used to manage
the retirement benefits. While separate plans are common in the U.S. because
of employment and tax laws, laws in other jurisdictions vary, again raising the
possibility of different accounting for similar transactions.
107
• Deferral of Actuarial Gains and Losses—It is not clear why changes in
estimates related to retirement obligations should not be treated in the balance
sheet the same way as changes in estimates related to other obligations.
Changes in estimated amounts to be paid on obligations other than retirement
obligations almost invariably are recognized immediately as an adjustment to
the recorded liability, while such changes are permitted to be deferred and
recognized over time when they relate to defined-benefit pension plans.
• Valuation of Assets—The guidance for valuing assets of retirement plans and
recognizing related gains and losses is not consistent with the guidance that
applies to other entities. As the sponsor of a defined-benefit plan is affected
by the gains and losses on pension plan assets in almost the same way as it is
affected by gains and losses on other investments, this distinction appears
questionable.
237
The Staff also believes that the complex series of smoothing mechanisms, and the
disclosures to explain them, render financial statements more difficult to understand and
reduce transparency. SFAS No. 87 does require certain disclosures that help explain the
effect of SFAS No. 87’s many netting and smoothing provisions. In this case, however,
the disclosures seem designed to compensate for less than desirable accounting. A recent
FASB project revised the disclosure requirements to provide even more information.
238
While the disclosures are quite detailed, the Staff notes that it has long been accepted that
“good disclosure doesn’t cure bad accounting.”
239
The combination of the accounting
and disclosure provisions contribute to the length and complexity of financial statements,
a common complaint among users and preparers alike. Revisions to the guidance that
eliminate optional smoothing mechanisms would allow significant reduction in
disclosures without a loss of important information.
Much like the recommendation to undertake a project on lease accounting, it is
likely that a project on pension accounting would generate significant controversy.
Indeed, it was such controversy that caused the FASB to deviate from its preferred
accounting when it promulgated SFAS No. 87. Nevertheless, the Staff believes that a
project on pension accounting should be undertaken when resources permit. Like lease
237
This does not necessarily suggest that all assets of retirement plans should be recorded at fair value, as
this is not always the treatment that applies outside of retirement plans.
See SFAS No. 115 and APB No.
18.
238
See Statement of Financial Accounting Standard No. 132 (revised 2003): Employers’ Disclosures about
Pension and Other Postretirement Benefits—an amendment of FASB Statement No. 87, 88, and 106
(issued 12/2003). According to the FASB, the “Statement was developed in response to concerns
expressed by users of financial statements about their need for more information about pension plan assets,
obligations, benefit payments, contributions, and net benefit cost.”
See FASB Summary of Statement No.
132 (revised 2003) at FASB.org web site.
239
Remarks by Michael H. Sutton, Chief Accountant, U.S. Securities and Exchange Commission, to
American Institute of Certified Public Accountants 1996 Twenty-Fourth Annual National Conference on
Current SEC Developments, December 10, 1996.
108
accounting, the Staff believes that a pension accounting project may be most effective if
conducted as a joint project with the IASB, for similar reasons.
C. Continue Work on Consolidation Policy
Individual decisions relating to which entities should be reflected in the
consolidated financial statements of an issuer—that is, decisions relating to determining
the “reporting entity”—can create much more significant differences than individual
decisions about how to report particular transactions. This is because the consolidation
decision determines whether all of the assets and liabilities of another entity should be
included in the financial statements instead of one asset representing the issuer’s
investment in the other entity. As noted in Section III above, the consolidation decision
is typically based on whether or not control exists, with the determination of control
generally based on legal ability to control the entity. However, it is possible to
effectively control an entity without having legal control. An issuer that owns 49% of the
voting shares of an entity whose shares are otherwise widely distributed would almost
certainly be able to set policy for that other entity, but currently would not be deemed to
control that other entity for accounting purposes.
The FASB previously considered replacing legal control as the trigger for
consolidation with standards that focus on what has been called “effective control.”
240
A
consolidation standard based on effective control would seek to identify characteristics of
control other than a majority voting interest, in order to ensure that all entities for which
the issuer can direct policy and make decisions are included in the issuer’s consolidated
financial statements.
While the FASB discontinued its broad project on effective control,
Interpretation No. 46(R) is an attempt to deal with SPEs by creating a consolidation test
for those entities that is meant to identify which entity has the majority of the exposure to
variations in performance and in turn effective control. However, because that test is so
different from the test used to determine consolidation of other entities, a new series of
structures that straddle the lines between consolidation approaches has sprung up, and
various structures have been designed to work around the guidance in Interpretation No.
46(R). The Staff believes that more time should be taken to evaluate the results of
Interpretation No. 46(R) and to allow the development of interpretive guidance that may
assist in its application. Several projects currently being undertaken by the EITF and the
FASB staff may provide such guidance.
Clearly, the current consolidation guidance is complicated, despite the consistent
objective of requiring consolidation when an investor controls another entity. The Staff
believes additional standard setting efforts related to consolidation should be focused on
whether there are ways to achieve the objectives with less complex guidance. In
addition, once the questions regarding Interpretation No. 46(R) have been more fully
addressed, the FASB may also wish to consider whether it should again explore the use
of effective, rather than legal, control to guide all consolidation decisions. Finally,
240
See Exposure Draft, Proposed Statement of Standards: Consolidated Financial Statements: Policy and
Procedures, (1996).
109
additional work holds the promise of promoting further convergence between of
consolidation guidance in US GAAP and the consolidation guidance in the IASB’s
standards.
D. Continue to Explore the Feasibility of Reporting All
Financial Instruments at Fair Value
Whether financial instruments are reported at fair value or not is obviously not a
question of whether they are on or off the balance sheet. However, the Staff believes that
the issue of whether particular financial instruments are reported at fair value is related to
a number of the topics discussed in this Report, and is directly related to a number of the
goals discussed in Section V.
Questions of whether to record assets and liabilities based on their historical costs
or their current market values (“fair value”) have long been high profile issues in the
financial reporting world. Supporters of greater use of fair values in the balance sheet
argue that the most useful information is that which reflects the current value of the
issuer’s assets and obligations, as this represents the “opportunity cost” of the resources
being used by the issuer. As previously discussed, GAAP requires a mix of historical
costs and fair values on the balance sheet—what is often termed a “mixed-attribute
model.” Derivative assets and liabilities are generally recorded at their fair values.
Financial assets are often reflected at fair value, although there are significant exceptions.
Non-financial assets are generally reflected at historical cost, but are also generally
subject to an impairment test that is based in part on fair value. Both financial and non-
financial liabilities are generally recorded based on their historical basis, with accretion
over time to their final settlement values. For certain instruments, the accounting is
dependent upon the issuer’s intent or policy elections. In an extreme example, an issuer
could conceivably own three of the exact same corporate debt instruments, and account
for each in a different manner. This mixed-attribute model has developed in part because
of concerns as to whether fair value information is reliable enough to be included in the
balance sheet and income statement, and in part because of disagreements regarding the
relevance of fair value information.
The mixed-attribute model has prompted a significant amount of accounting-
motivated transaction structures. For example, as noted above, some sales of financial
assets seem motivated primarily by a desire to recognize gains that could not otherwise
be recognized, by selling (at least for accounting purposes) receivables, available-for-sale
securities, cost method investments, or other financial assets that are not recognized at
fair value with changes recorded in earnings. Others seem designed to change the assets’
form into assets with a different measurement basis in order to minimize income
statement volatility, match the measurement basis of assets with that of liabilities, or for
other reasons. Similarly, investments in the stock of other entities are often designed to
either achieve or avoid use of the equity method of accounting. In many of the
accounting-motivated transactions noted above, the motivation for the transaction or the
structuring could be essentially eliminated if all financial instruments were recorded at
fair value.
In addition, fair value accounting for all financial instruments would reduce the
complexity of financial reporting. Investors would not have to study the accounting
110
guidance or the choices made by management to determine what basis of accounting is
used for particular instruments. Further, fair value hedge accounting would no longer be
needed if all financial instruments were recorded at fair value, as the gains and losses
would naturally offset each other to the extent the hedges were effective. This would
eliminate the related documentation, record keeping, and other associated issues. In
addition, fair value accounting for all financial instruments would eliminate the need to
bifurcate and separately value derivatives embedded in financial instruments, as the
accounting would be the same for both the host instruments and the derivative. Users of
financial statements would be spared from having to comprehend a complicated set of
rules regarding which financial instruments are at fair value and which are at historical
cost.
As discussed above, fair value accounting for all financial instruments would
appear to have benefits in terms of reduced complexity, more understandability, and less
motivation to structure transactions to meet accounting goals. In addition, many believe
that fair value is simply the most relevant measure for financial instruments.
241
There
are, however, significant concerns with requiring fair value accounting for all financial
instruments including:
• Relevance
—Some supporters of historical cost measurements “believe that
amortized cost provides relevant information because it focuses on the
decision to acquire the asset, the earning effects of that decision that will be
realized over time, and the ultimate recoverable value of the asset. Among
other things, many argue that this is particularly valuable information in
monitoring the performance of management. They argue that fair value
ignores those concepts and focuses instead on the effects of transactions and
events that do not involve the enterprise, reflecting opportunity gains and
losses, whose recognition in the financial statements is, in their view, not
appropriate until they are realized.”
242
• Reliability
—“Opponents of fair value reporting also challenge the subjectivity
that may be necessary in estimating fair values and question the usefulness of
reporting fair values for securities if they are not readily marketable.”
243
• Manipulability
—When applied to instruments without readily available
markets, some are concerned that management may be able to use fair value
estimates to manage earnings, inflate reported equity, or otherwise deceive
users as to the value of the company.
244
241
For example, paragraphs 39 – 50 of SFAS No. 107 discuss the relevance of fair value information. It
states in part in paragraph 41, “Information about fair value better enables investors, creditors, and other
users to assess the consequences of an entity’s investment and financing strategies, that is, to assess its
performance.”
242
SFAS 115, paragraph 42.
243
SFAS 115, paragraph 43.
244
As Paton and Littleton (1940, 65) write: “The process of measuring periodic income involves the
division of the stream of costs incurred between the present and the future.” They also write: “In general,
111
The Staff appreciates these concerns, and acknowledges, in particular, the concern
about the potential manipulation of fair value measurements, which has been a part of
some of the recent financial reporting scandals. However, in light of the potential
benefits, the Staff believes that exploration of ways to eliminate the obstacles to fair
value accounting for financial instruments is warranted.
Of course, the broad issue of the reliability of fair value measurements will
continue to be a concern. The Staff notes, however, that it is now possible to reliably
value many instruments that could not be reliably valued in the past. The continued
development of financial markets should further expand the types of instruments for
which reliable information on fair value is available. In addition, the FASB plans soon to
issue a document that includes better guidance on fair value measurement than previously
existed.
245
This should help to encourage convergence of practices in this area.
One of the other significant obstacles to reporting financial instruments at their
fair values in the balance sheet is their treatment in the income statement. Many believe
that income statements become too difficult to understand if changes in the value of
reported assets and liabilities attributable to market fluctuations are combined with
changes in assets and liabilities related to business transactions. Some believe that
holding gains and losses are simply of a different character than transactional gains and
losses. Others believe that investing and financing activities should not be combined
with operating activities. Still others believe that unrealized and realized gains and losses
are different in character and should not be combined. There are also those who would
prefer that gains and losses related to highly subjective estimates be reported separately
from those related to measurements that are more certain.
Indeed, the ability to differentiate changes in equity that have these various
characteristics in different combinations could be useful to users in understanding the
results of operations and in evaluating the company’s ability to generate cash flows in the
future. The FASB and IASB currently have a joint project on Reporting Financial
Performance that could address this issue.
246
The Staff has encouraged the two Boards to
the only definite facts available to represent exchange transactions objectively and to express them
homogenously are the price-aggregates involved in the exchanges; hence such data constitute the basic
subject matter of accounting.” Paton, W. A. and A.C. Littleton, 1940, at 7,
An Introduction to Corporate
Accounting Standards, American Accounting Association, Sarasota, FL. Ijiri (1975) emphasizes that
historical cost is consistent with accountability, because it is both hard (difficult to manipulate) and tracks
managements’ actual decisions rather than would-be decisions tracked by fair values. (On the other hand,
one might argue that to choose to
not enter into a transaction that would serve to convert an asset into its
fair value also constitutes a decision. To wit, a decision to incur that opportunity cost. Such a decision,
and its measurement by means of fair value, might be of interest to investors.)
245
The FASB issued an Exposure Draft of a proposed statement, Fair Value Measurements, on June 23,
2004. The comment period ended on September 7, 2004 and on September 21, 2004, the FASB held a
public roundtable meeting. The FASB is currently deliberating both the results of the comment letters
received and the roundtable discussions. A final pronouncement is currently expected to be released during
the second quarter of 2005.
246
The first meeting of the joint international group on performance reporting took place on January 13-14,
2005. The FASB and IASB anticipate that an initial public discussion document in the form of a
112
focus on this project, consider the various views discussed, and devise ways to report
changes in values of assets and liabilities that are consistent and transparent and best
facilitate appropriate analysis of reported results.
247
Another important, and related, issue is to determine whether changes in an
issuer’s own credit risk should be reflected in the reported value of that issuer’s financial
instruments. This possibility raises concern because the effect of an increase in the
issuer’s credit risk would be to reduce the value of liabilities reported, resulting in an
increase in equity (and, potentially, income). This result seems counterintuitive to many.
The FASB has recently decided to specifically consider this issue.
248
The Staff hopes to promote further discussions regarding the use of fair value in
the coming year.
E. Develop a Disclosure Framework
The disclosures in the notes to the financial statements are a critically important
complement to the financial statements and are necessary to achieve transparency in
financial reporting. Based on this Study, as well as experience with issuer filings, the
Staff believes that disclosures can be improved. First, as discussed above, the Staff
believes that disclosures could be improved if issuers were to seek to achieve the goal of
communicating with investors, rather than focusing principally on technical compliance
with rules and regulations.
The Staff also believes that more useful and consistent disclosure requirements
for the notes to the financial statements could be achieved if a disclosure framework were
developed that set forth the objectives to be used in these disclosures. Currently, the
FASB’s conceptual framework does not contain a substantial amount of guidance related
to the notes to the financial statements. As a consequence, disclosure guidance tends to
vary from standard to standard. A project directed at developing a framework for use in
determining the content of notes to the financial statements might consider, for example,
whether (and if so, when) the following goals—each of which is evident in certain
currently required disclosures—are appropriate:
249
• Provide information about alternative measurement attributes;
Preliminary Views will be issued in late 2005. For more information about the project status see the
Project Updates section at www.fasb.org
247
For example, the IASB has considered a matrix format income statement that includes rows organized
into categories of: “business”, “financing”, “tax” and “discontinued operations”. The columns include:
“total,” “before re-measurements,” and “re-measurements.” International Accounting Standards Board,
2003,
IASB Project Summary: Reporting Comprehensive Income.
248
The FASB is currently considering adding a project to its agenda that would amend SFAS No. 133
addressing whether an issuer’s own credit risk should be considered when measuring derivative liabilities
at fair value. While this proposed project is narrow in that it relates only to derivative liabilities, the same
issue would also apply to other issuer liabilities that are measured at fair value. Accordingly, the Staff
believes that the FASB will likely consider this issue in other projects where fair value is the measurement
attribute for the liability
249
The list is not intended to be all-inclusive.
113
• Explain the nature and extent of uncertainty in the reported figures;
• Allow users to recompute certain items using different assumptions than those
used by management;
• Make it more difficult for management to engage in financial fraud;
• Allow comparisons between issuers that have chosen different accounting
policies;
• Explain the sensitivity of the issuer’s results to various risks;
• Provide detailed breakdowns of certain financial statement captions;
• Explain the issuer’s future cash requirements;
• Highlight the impact of unusual or non-recurring events;
• Disaggregate the issuer’s results;
• Explain how management’s intentions affected the reported financial position and
results of operations; and
• Confirm compliance with GAAP.
Disclosure relating to financial instruments, including derivatives, in particular,
could be improved through consistent objectives and principles. Changing the disclosure
requirements for financial instruments would not require changes in recognition and
measurement. Indeed, assets and liabilities could be carried on the books under the same
principles as before. Disclosures about fair values will be informative to users, even in
cases where there is variation inherent in the valuation (so long as it is disclosed that
there is variation in the valuation). The Staff notes that the IASB has recently
proposed/promulgated guidance in this area that could be used as a starting point for
work in this area in the U.S.
250
In order to stimulate thought and discussion, we identify below some possibilities
for financial instrument disclosures that arose from the Staff’s work in preparing this
Report, as well as its work reviewing filing and following the IASB’s project on financial
instrument disclosures that is referred to above:
• Carrying value as of balance sheet date;
• Explanation of changes in carrying value since last balance sheet date;
• Fair market value as of balance sheet date (include range as well as point
estimate);
• Changes in fair market value since last balance sheet date;
250
See International Accounting Standards Board Exposure Draft ED 7 Financial Instruments: Disclosures
July 2004.
114
• Description of valuation methods, including what proportions were valued based
on the different types of inputs, as well as description of significant assumptions
(and possibly access to example/actual valuation models);
• Related derivative positions as of balance sheet date;
• Fair value of related derivative positions as of balance sheet date;
• Description of income statement impact;
• Sensitivity of fair value and income to changes in significant underlying
variable(s) without
considering related derivative positions; and
• Sensitivity of fair value and income to changes in significant underlying
variable(s) net
of related derivative positions.
By highlighting potential objectives for disclosures in the notes to the financial
statements and explaining what factors might influence the decision as to which
objectives should drive disclosure requirements in a particular standard, the addition of
disclosure guidance to the FASB’s conceptual framework could drive more consistent
disclosures across various accounting issues, while helping users to understand why
certain disclosures are included in financial statements. The Staff has suggested to the
FASB that adding disclosures to its conceptual framework would be helpful.
Of course, insights generated by the development of such a disclosure framework
might also lead to recommendations from the Staff regarding the Commission’s
regulatory disclosure requirements. Indeed, some of the objectives noted above, each of
which is evident in the disclosure requirements for notes to the financial statements in
some areas, are also objectives of MD&A or other regulatory disclosure requirements.
As such, the Staff would be willing to work closely with the FASB in its development of
a disclosure framework, in order to consider whether complementary changes to the
Commission’s disclosure requirements would generate further improvement as well as to
ensure that disclosure is provided in the most appropriate location, whether it be in notes
to the financial statements, MD&A or in some other location.
115OCR text (366,726c · tika · 95% conf)
Report and Recommendations Pursuant to Section 401(c)
of the Sarbanes-Oxley Act of 2002 On Arrangements with
Off-Balance Sheet Implications, Special Purpose Entities,
and Transparency of Filings by Issuers
Submitted to the President of the United States, the Committee on
Banking, Housing, and Urban Affairs of the United States Senate and
the Committee on Financial Services of the United States House of
Representatives
OFFICE OF THE CHIEF ACCOUNTANT
OFFICE OF ECONOMIC ANALYSIS
DIVISION OF CORPORATION FINANCE
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
This is a report by the Staff of the U.S. Securities and Exchange Commission. The
Commission has expressed no view regarding the analysis, findings, or conclusions
contained herein.
TABLE OF CONTENTS
ABBREVIATIONS iii
EXECUTIVE SUMMARY 1
I Introduction 6
A. How the Study and Report Fulfill the Statutory Mandate 6
1. The Statutory Mandate 6
2. The Structure of this Report 8
B. The Financial Reporting Framework 10
1. The Balance Sheet 11
2. Other Basic Financial Statements 12
3. Notes to the Financial Statements, MD&A and Other Disclosures 14
C. Historical Context of the Study and Report 15
1. Enron 15
2. Standard Setting Environment 19
3. Accounting Motivated Transaction Structuring 22
4. Improvements in the Financial Reporting Regime Since the Passage of the
Sarbanes-Oxley Act 23
II Study Methodology 27
III Arrangements with Potential Off-Balance Sheet Implications 32
A. Investments in the Equity of Other Entities 32
1. Nature of Arrangements and Financial Reporting Requirements 32
2. Off-Balance Sheet Issues in Accounting for Investments 36
3. Empirical Findings from Study of Filings by Issuers 38
B. Transfers of Financial Assets With Continuing Involvement 40
1. Nature of Arrangements and Financial Reporting Requirements 40
2. Off-Balance Sheet Issues in Accounting for Transfers of Financial Assets 44
3. Empirical Findings from Study of Filings by Issuers 46
C. Retirement Arrangements 49
1. Nature of Arrangements and Financial Reporting Requirements 49
2. Off-Balance Sheet Issues in Accounting for Retirement Arrangements 52
3. Empirical Findings from Study of Filings by Issuers 53
D. Leases 60
1. Nature of Arrangements and Financial Reporting Requirements 60
2. Off-Balance Sheet Issues in Accounting for Leases 62
3. Empirical Findings from Study of Filings by Issuers 63
E. Contingent Obligations and Guarantees 65
1. Nature of Arrangements and Financial Reporting Requirements 65
i
2. Off-Balance Sheet Issues in Accounting for Contingent Obligations and
Guarantees 68
3. Empirical Findings from Study of Filings by Issuers 69
F. Derivatives 72
1. Nature of Arrangements and Financial Reporting Requirements 72
2. Off-Balance Sheet Issues in Accounting for Derivatives 78
3. Empirical Findings from Study of Filings by Issuers 80
G. Other Contractual Obligations 86
1. Nature of Arrangements and Financial Reporting Requirements 86
2. Off-Balance Sheet Issues in Accounting for Contractual Obligations 88
3. Empirical Findings from Study of Filings by Issuers 89
IV Empirical Findings on Certain Post-Sarbanes-Oxley Improvements in Financial
Reporting On Off-Balance Sheet Arrangements 91
A. Consolidation of Variable Interest Entities 91
1. Discussion 91
2. Empirical Findings from Study of Filings by Issuers 92
B. Disclosure in Management's Discussion and Analysis about Off-Balance
Sheet Arrangements and Aggregate Contractual Obligations 96
1. Discussion 96
2. Empirical Findings from Study of Filings by Issuers 97
V Initiatives to Improve Financial Reporting Transparency 98
A. Eliminate (or at least Reduce) Accounting Motivated Transactions 99
B. Continue Implementation of Objectives-Oriented Approach to Standard
Setting 101
C. Improve the Consistency and Relevance of Disclosures 103
D. Improve Communication Focus in Financial Reporting 103
VI Recommendations Related to Accounting Standards 105
A. Standards on Accounting for Leases 105
B. Standards on Accounting for Defined-Benefit Retirement Arrangements 107
C. Continue Work on Consolidation Policy 109
D. Continue to Explore the Feasibility of Reporting All Financial Instruments at
Fair Value 110
E. Develop a Disclosure Framework 113
ii
ABBREVIATIONS
ABO Accumulated Benefit Obligation
APBO Accumulated Postretirement Benefit Obligations
Act The Sarbanes Oxley Act of 2002
AICPA American Institute of Certified Public Accountants
AIMR Association for Investment Management and Research (currently
known as the Certified Financial Analyst Institute)
APB Accounting Principles Board
ARB Accounting Research Bulletin
Board Financial Accounting Standards Board
CFA Institute Certified Financial Analyst Institute (formerly known as the
Association for Investment Management and Research)
Commission United States Securities and Exchange Commission
DIG Derivatives Implementation Group
EDGAR Electronic Data Gathering, Analysis, and Retrieval system
EITF Emerging Issues Task Force
ERISA Employee Retirement Income Security Act of 1974
FASB Financial Accounting Standards Board
FR Final Reporting Release
Interpretation No. FASB Interpretation Number
GAAP Generally Accepted Accounting Principles
GSE Government Sponsored Enterprise
IASB International Accounting Standards Board
IOSCO International Organization of Securities Commissions
LIBOR London Inter-bank Offering Rate
MD&A Management’s Discussion and Analysis of Financial Position and
Results of Operations
OBS Off-Balance Sheet
OPEB Other Post-Employment Benefits
PBO Projected Benefit Obligation
QSPE Qualifying Special Purpose Entity
SAB Staff Accounting Bulletin
Sarbanes Oxley Act The Sarbanes Oxley Act of 2002
SEC United States Securities and Exchange Commission
SFAC Statement of Financial Accounting Concepts
SFAS Statement of Financial Accounting Standards
SOP Statement of Position
SPE Special Purpose Entity
Staff Staff of the United States Securities and Exchange Commission
VaR Value at Risk
VIE Variable Interest Entity
iii
Report and Recommendations Pursuant to Section 401(c)
of the Sarbanes-Oxley Act of 2002 On Arrangements with
Off-Balance Sheet Implications, Special Purpose Entities,
and Transparency of Filings by Issuers
EXECUTIVE SUMMARY
In 2001 and 2002, a spate of major corporate accounting scandals came to light
that exposed weaknesses in corporate governance, audit practices, and financial
reporting. Congress responded by passing the Sarbanes-Oxley Act of 2002 (the
“Sarbanes-Oxley Act” or “Act”),1 the most significant piece of securities legislation since
the 1930s. Among the many provisions of the Act, Section 401(c) mandates that the
Securities and Exchange Commission (“SEC” or “Commission”) conduct a study of
filings by issuers (the “Study”) and issue a report (the “Report”) that addresses two
primary questions: (1) the extent of off-balance sheet (“OBS”) arrangements, including
the use of special purpose entities (“SPEs”), and (2) whether current financial statements
of issuers transparently reflect the economics of off-balance sheet arrangements. To
answer these questions, the staff of the Commission (the “Staff”) conducted an empirical
analysis of the filings of issuers as well as a qualitative analysis of pertinent U.S.
Generally Accepted Accounting Principles (“GAAP”) and Commission disclosure rules.
The mandate also asks for recommendations, if any. In this Report, which is intended to
fulfill the statutory mandate, the Staff describes the Study, reports its findings and
provides recommendations.
For purposes of the Study and Report, the Staff takes a relatively expansive
approach to the scope and meaning of the term “off-balance sheet.” The Staff examines a
variety of business arrangements that may be viewed as having off-balance sheet
implications and that are deemed important from a policy perspective. The arrangements
examined in the Study 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
Staff broadly concludes that significant progress has been made in several areas since the
passage of the Act, 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.
The Study was performed by analyzing data collected from the filings of a sample
of 200 issuers, including the notes to the financial statements, and Management’s
1The Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 2002.
1
Discussion and Analysis of Financial Position and Results of Operations (“MD&A”).2
The Staff determined that a sample size of 200 was sufficient to construct a representative
sample of the population of active U.S. issuers.3 Given the possibility that the use of
arrangements with off-balance sheet implications, as well as special purpose entities,
might be disproportionately concentrated in the very largest issuers, a “stratified”
sampling approach was adopted such that the sample would consist of the 100 largest
issuers (in terms of market capitalization)4 and 100 additional issuers, randomly
selected.5
The Staff reports findings on the extent to which issuers report the existence of
certain business arrangements with off-balance sheet implications, how such
arrangements are presented on issuer balance sheets, and the transparency of the
supporting disclosures in the financial reports. The empirical findings and estimates are
limited by what is actually reported and/or disclosed in issuers’ financial reports. The
Staff was not in a position to address whether and to what extent there may be other
arrangements that are not reflected in the financial reports. The empirical portion of the
Study is largely descriptive in nature.
In addition to the empirical work, the Report is also informed by the Staff’s
experience in reviewing periodic financial statements filed with the Commission, which
provides it with information about the application of accounting and disclosure standards.
In particular, the qualitative analysis of the content and application of pertinent
accounting standards relies in part on the collective experience of the Staff. Further, the
Report is informed by the Staff’s experience in dealing with standard setters and
international regulators that are grappling with comparable issues. For example, both the
Financial Accounting Standards Board (“FASB”) and the International Accounting
Standards Board (“IASB”) have dealt with (and continue to consider) the accounting for
each of the topics addressed in this Report, and the Technical Committee of the
International Organization of Securities Commissions (“IOSCO”) has recently released
its Report on Strengthening Capital Markets Against Financial Fraud, which, among
other things, discusses whether additional disclosures related to the use of SPEs are
warranted.
In excess of 100 Staff members directly contributed to the Study and Report
through participation in project planning, methodology design, data collection and
analysis, research, critical analyses of standards and rules, and the drafting, editing, and
review of the Report. Primarily, this included Staff from the Office of the Chief
Accountant, the Office of Economic Analysis and the Division of Corporation Finance.
2Management’s Discussion and Analysis of Financial Condition and Results of Operations is required by
Item 303 of Regulation S-K, Items 303(a), (b) and (c) of Regulation S-B, Item 5 of Form 20-F and
Paragraphs 11 and 12 of General Instruction B of Form 40F.
3In statistical terms, the sample size is sufficient to test for a 20% difference from the sample mean at 95%
significance and with 90% power.
4This is with certain exceptions, as explained below.
5See Section II for more details on the sample selection methodology.
2
In many cases, when considering the appropriateness of accounting for various
transactions, the focus is on the standards themselves and recommendations tend to focus
on what changes the FASB, as the accounting standard-setter in the U.S., should
consider. However, the Staff believes that to focus only on the FASB activities is too
narrow, as the FASB is only one part of the financial reporting framework. Thus, in
formulating its recommendations, the Staff considered potential improvements that could
be made to improve transparency by various participants in the financial reporting
process.
The Staff identified several key initiatives to improve transparency in reporting,
as follows:
i. Discourage transactions and transaction structures primarily motivated by
accounting and reporting concerns, rather than economics. The Staff believes
that use of transaction structuring to achieve accounting and reporting goals that
do not conform to the economic substance of the arrangements reduces
transparency in financial reporting. As discussed below, many of the areas
dealing with off-balance sheet arrangements involve significant use of
accounting-motivated structured transactions.
ii. Expand the use of objectives-oriented standards, which would have the
desirable effect of reducing complexity in accounting standards. The Staff’s
previous report on objectives-oriented standards6 described many of the benefits
of such standards, as well as the risks inherent in accounting standards that rely
to a significant extent on rules and bright lines. The Staff continues to support
the recommendations in its prior study.
iii. Improve the consistency and relevance of disclosures that supplement the basic
financial statements. In many cases, the Staff does not believe issuer
disclosures are as informative as they could be. Nowhere is this clearer than in
regards to financial instruments disclosures. While new standards might help in
this area, substantial progress can be made through attention of issuers in
improving disclosures under existing standards.
iv. Improve communication focus in financial reporting. The Staff believes that
many issuers interpret financial reporting narrowly, and regard technical
compliance with the requirements as satisfactory. However, if investors and
other users are misled or have insufficient information to understand the
activities of the issuer, such “compliance” does not serve the purpose of
financial disclosure. Moreover, such a mindset puts the burden on regulators
and standard-setters to drive all improvements in reporting. The Staff believes
that if issuers focus on clear and transparent communication with investors in
preparing financial statements, both accounting and disclosures will improve.
6Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States
Financial Reporting System of a Principles-Based Accounting System (“Objectives-Oriented Accounting
Standards Study”).
3
In addition, the Report includes several standard-setting recommendations that
would help further these initiatives.
a. The Staff recommends that the FASB continue its work on the accounting
guidance that determines whether an issuer would consolidate other entities.
While it may be too early to fully understand the effects of recent improvements
in consolidation guidance for SPEs, the consolidation guidance continues to be
complex and decisions regarding consolidation greatly affect which items are on
the balance sheet.
b. The Staff recommends the accounting guidance for defined-benefit pension
plans and other postretirement benefit plans be reconsidered. Under the current
accounting guidance (circa 1985), the trusts that administer these plans, which
are conceptually similar to SPEs, are exempt from consolidation by the issuers
that sponsor them, effectively resulting in the netting of assets and liabilities on
the balance sheet. In addition, issuers have the option to delay recognition of
certain gains and losses related to the retirement obligations and the assets used
to fund these obligations. An extrapolation of the findings from the sample of
issuers in the Study to the approximate population of active U.S. issuers
suggests that there may be approximately $535 billion in retirement obligations
that are not recognized on issuer balance sheets.
c. The Staff recommends that the accounting guidance for leases be reconsidered.
The current accounting for leases takes an “all or nothing” approach to
recognizing leases on the balance sheet. This results in a clustering of lease
arrangements such that their terms approach, but do not cross, the “bright lines”
in the accounting guidance that would require the lease to be recognized on the
balance sheet. An extrapolation of the findings from the sample of issuers in the
Study to the approximate population of active U.S. issuers 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, but are instead disclosed in the notes to the financial statements.7
d. The Staff recommends the continued exploration of the feasibility of reporting
all financial instruments at fair value. Supporters of greater use of fair values on
the balance sheet argue that the most useful information is that which reflects
the current values of assets and obligations. Fair value accounting for all
financial instruments also would appear to have benefits in terms of reduced
complexity (for example, by eliminating the need for hedge accounting and its
attendant documentation and effectiveness testing requirements, in many
instances), more understandability, and less motivation to structure transactions
so as to achieve certain accounting treatments. Of course, some have expressed
significant concerns with requiring fair value accounting for all financial
instruments, such as the potential manipulability and degree of difficulty in
auditing some fair values. However, in light of the potential benefits, the Staff
7This figure is not discounted to its present value, as would be the case if these cash flows were recognized
as a liability on issuer balance sheets.
4
believes that methods should be sought to eliminate the obstacles to this
treatment.
e. The Staff believes that, in general, disclosures in the filings of issuers need to be
better organized and integrated. 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.
While the Staff concludes in this Report that there remains room for improvement
in the transparency of financial reporting related to the balance sheet, it also wishes to
acknowledge that much has been accomplished since the passage of the Sarbanes-Oxley
Act in terms of improving the financial reporting of arrangements with off-balance sheet
implications.8 This includes, among other things, additional guidance from the FASB—
for example, Interpretation No. 46(R), Consolidation of Variable Interest Entities (revised
December 2003)—an interpretation of ARB No. 51—which is intended to address some
of the concerns with the failure of issuers to consolidate certain special purpose entities
under earlier guidance.9 The FASB has also promulgated new guidance in several other
areas, including the accounting for guarantees in Interpretation No. 45 and distinguishing
liabilities from equity in SFAS No. 150. Further improvements come from regulatory
requirements promulgated by the Commission that an issuer explain its off-balance sheet
arrangements in a separately captioned subsection of its MD&A.10 While not directly
related to the topics addressed in this Report, the Staff also notes the substantial
improvement in transparency that will result from the implementation of SFAS No. 123R
“Share-Based Payment”, which requires accounting for stock options based on their fair
values.
Underpinning this Report is the Staff’s focus on “full and fair disclosure.” The
Staff believes that investors—and the market as a whole—are best served by financial
information that is presented fully and clearly. For example, the Staff believes that
investors will benefit from an income statement that reflects changes in asset values so
long as the sources of those changes are disclosed, and the manner in which those values
are determined (i.e., what measurement attribute is used and what assumptions underlie
the value) is understandable. What presents difficulties for investors, as well as the
market as a whole, is a lack of information about potential positive and negative cash
flows. Thus, while some participants in the financial reporting process favor accounting
standards that enable the presentation of consistent or smooth income statement figures,
8For a more complete list of improvements in financial reporting since the Act see Section I.C.4.
9See Section IV infra. for discussion.
10See Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and
Aggregate Contractual Obligations Release No. 33-8182 (January 28, 2003) (“FR-67”). This rule was
promulgated by the Commission in January 2003 in response to Section 401(a) of the Act.
5
the Staff believes that transparent balance sheets are very important and that investors are
better served by seeing any volatility that exists, along with explanations for why such
volatility exists. To that end, it seems desirable to the Staff for standard setters to focus
on balance sheet measures and to consider transparent ways in which to address concerns
about showing volatility in the income statement.
Finally, it is important that both regulation and standard setting keep pace with
business changes in the private sector, which are extremely fast paced. That being said,
the Staff appreciates the extraordinary resource demands that have been imposed on
preparers and auditors as a result of the Sarbanes-Oxley Act coupled with the various
other efforts at improving financial reporting, auditing, and standard setting that have
followed in its wake. Nonetheless, the Staff believes that the issues raised in this Report
should be addressed to improve the transparency of the balance sheet in particular and of
financial reporting in general.
I. Introduction
A. How the Study and Report Fulfill the Statutory Mandate
1. The Statutory Mandate
The mandate for this Report comes from the Sarbanes-Oxley Act of 2002, which
introduced a broad array of reforms to the U.S. financial reporting system.11 The Act
called for increased oversight of auditors of public companies through the creation of the
Public Company Accounting Oversight Board.12 It directed the Commission to establish
rules prohibiting auditors from providing certain non-audit services to audit clients13 and
requiring management and auditor reporting on the effectiveness of public companies’
internal controls.14 It increased penalties for violations of securities laws and required
certification of financial results by key corporate officers.15 Through these and other
provisions, the Act called for improvement in the system of checks and balances that
govern the production of financial information provided to investors.
The Act also mandated that the Commission conduct a Study of off-balance sheet
transactions and the use of special-purpose entities. Specifically, Section 401(c)(1) of the
Act requires the Commission to: “complete a study of filings by issuers and their
disclosures to determine—
(A) the extent of off-balance sheet transactions, including assets, liabilities, leases,
losses, and the use of special purpose entities; and
11See the Sarbanes-Oxley Act.
12See sections 101-109 of the Act.
13See section 201 of the Act.
14See section 404 of the Act.
15See sections 901 to 906 of the Act.
6
(B) whether generally accepted accounting rules result in financial statements of
issuers reflecting the economics of such off-balance sheet transactions to investors
in a transparent fashion.”
In addition, Section 401(c)(2) requires the Commission to: “submit a report to the
President, the Committee on Banking, Housing, and Urban Affairs of the Senate, and the
Committee on Financial Services of the House of Representatives, setting forth—
(A) the amount or an estimate of the amount of off-balance sheet transactions,
including assets, liabilities, leases, and losses of, and the use of special purpose
entities by, issuers filing periodic reports pursuant to section 13 or 15 of the
Securities Exchange Act of 1934;
(B) the extent to which special purpose entities are used to facilitate off-balance
sheet transactions;
(C) whether generally accepted accounting principles or the rules of the
Commission result in financial statements of issuers reflecting the economics of
such transactions to investors in a transparent fashion;
(D) whether generally accepted accounting principles specifically result in the
consolidation of special purpose entities sponsored by an issuer in cases in which
the issuer has the majority of the risks and rewards of the special purpose entity;
and
(E) any recommendations of the Commission for improving the transparency and
quality of reporting off-balance sheet transactions in the financial statements and
disclosures required to be filed by an issuer with the Commission.”
In order to fulfill the mandate and produce this Report, the Staff has characterized
the terms “off-balance sheet transaction,” “economics” of an arrangement, and
“transparency” of financial reporting. When used in other contexts, these terms may
have different definitions or meanings.
In recent times, following the accounting scandals exposed in 2001 and
subsequently, the term “off-balance sheet” has sometimes carried the connotation of
something underhanded, or at least less than fully transparent. The insinuation is that
something that should be on the balance sheet is not, and that the reporting issuer has
designed the transaction or arrangement to produce that result. However, questions about
whether items should be reflected on the balance sheet do not arise only when there is an
attempt to deceive financial statement users. Many legitimate transactions generate such
questions, and there are, of course, bounds as to what should be included on a balance
sheet. It is this broader, more-inclusive question of the proper bounds of what should be
included on the balance sheet that draws the Staff’s attention in this Report. The common
characteristic of the arrangements addressed in this Report is that they create or involve a
situation in which there may be a legal or economic nexus between the issuer and risks,
rewards, rights or obligations not reflected (or not fully-reflected) on the balance sheet.
Sections 401(c)(1)(B) and 401(c)(2)(C) both use the term “economics,” with the
latter section asking “whether generally accepted accounting principles or the rules of the
7
Commission result in financial statements of issuers reflecting the economics of such
transactions to investors in a transparent fashion.”16 For purposes of this Report, when
the Staff refers to the “economics” of an arrangement, the reference is meant to speak
generally to the risks, rewards, rights, and obligations associated with the arrangement,
rather than a formal categorization.
The words “transparent” or “transparency” appear in sections 401(c)(1)(B),
401(c)(2)(C) and 401(c)(2)(E), with the final subsection asking for “any
recommendations of the Commission for improving the transparency and quality of
reporting off-balance sheet transactions in the financial statements and disclosures
required to be filed by an issuer with the Commission.”17 The Staff believes transparency
can best be gauged in terms of the informational needs of investors, creditors and other
users of financial statements. For purposes of this Report, the Staff characterizes
“transparent” financial reporting as reporting that provides investors and other users of
financial statements with appropriate information to assess the material risks, rewards,
rights, and obligations associated with arrangements. The Staff notes that transparency is
not always improved with the provision of more information.18 Thus, while some might
argue that the greatest transparency would come from putting all things on the balance
sheet, thereby eliminating “off-balance sheet” arrangements entirely, the Staff believes
that putting too many things on the balance sheet could result in less understanding of the
differences between the rights and obligations associated with each of the items reported.
2. The Structure of this Report
The Report is arranged topically, analyzing the accounting and reporting for
various types of arrangements in turn. This structure allows the Staff to provide the
requested information for various types of arrangements in an integrated manner that is
intended to facilitate understanding.
By way of background, the next sub-section presents a short primer summarizing
the financial reporting framework, including the basic accounting concepts necessary to
understand the issues discussed in the Report. Those who are familiar with the financial
reporting framework may skip this section of the Report with no loss of continuity. The
remainder of the introduction provides a discussion of the historical context of the Study
and Report, including, among other things, a discussion of certain arrangements
involving Enron.
16Emphasis added.
17Emphasis added.
18For example, as noted in the December 29, 2003 Release No. 33-2950 Commission Guidance Regarding
Management's Discussion and Analysis of Financial Condition and Results of Operations:
MD&A must specifically focus on known material events and uncertainties that would cause
reported financial information not to be necessarily indicative of future operating performance or
of future financial condition. Companies must determine, based on their own particular facts and
circumstances, whether disclosure of a particular matter is required in MD&A. However, the
effectiveness of MD&A decreases with the accumulation of unnecessary detail or duplicative or
uninformative disclosure that obscures material information.
8
Section II of the Report—entitled “Study Methodology”—addresses
methodological issues including the construction of a stratified sample, the data
collection process, descriptive statistics on the sample and a description of the technique
for extrapolating to the population.
Section III of the Report—entitled “Arrangements with Potential Off-Balance
Sheet Implications”—addresses particular types of arrangements with potential off-
balance sheet implications. Section III covers investments in the equity of other entities,
transfers of financial assets with continuing involvement, retirement arrangements,
leases, contingent liabilities and guarantees, derivatives, and other contractual
obligations. Each of the sub-sections includes the following:
i.) A description of the transactions or reporting issues being addressed combined
with a discussion of the related accounting and financial reporting requirements;
ii.) A discussion of the potential off-balance sheet questions that arise from the
arrangements and a discussion of why standard setters have made the decisions
currently reflected in the accounting guidance; and
iii.) A presentation and discussion of the empirical data gathered from the Study of
filings by issuers to provide information regarding the percentage of issuers
reporting the arrangements discussed in the Report, and how these arrangements
are recognized on issuer balance sheets and in notes to the financial statements.
The discussions of each area are intended to be illustrative. The Staff focuses on
different ways that the arrangements in question could be analyzed in terms of what
assets or liabilities would be recorded. Sections 401(c)(1)(A), (2)(A) and (2)(B) of the
Act require a study of “the extent of” off-balance sheet transactions. Where the data were
obtainable, this portion of the mandate is answered in the subsections of Section III titled
“Empirical Findings from Study of Filings by Issuers.”
Sections 401(c)(1)(B) and (2)(C) of the Act require a study of whether generally
accepted accounting principles and the rules of the Commission result in financial
statements of issuers “reflecting the economics of such off-balance sheet transactions to
investors in a transparent fashion.” The Staff addresses this question for each of the
substantive accounting areas addressed in Section III in the subsections entitled “Off-
Balance Sheet Issues in Accounting for […]”
Section IV addresses certain post-Sarbanes Oxley improvements to the financial
reporting regime as they relate to off-balance sheet arrangements. This section includes a
discussion of FASB Interpretation No. 46(R), which was meant to achieve more
consistent application of consolidation policies for special purpose entities. Section
401(c)(2)(D) of the Act inquires as to “whether generally accepted accounting principles
specifically result in the consolidation of special purpose entities sponsored by an issuer
in cases in which the issuer has the majority of the risks and rewards of the special
purpose entity.” This can simply be answered in the affirmative in that Interpretation No.
46(R) essentially requires this.19 However, as is discussed in Section IV, the
19See Section IV for additional information on Interpretation No. 46(R).
9
determination of which party has “the majority of the risks and rewards of the special
purpose entity” may involve complex judgments in some circumstances.
Section 401(c)(2)(E) of the Act calls for recommendations, if any, for “improving
the transparency and quality of reporting off-balance sheet transactions” in financial
statements. Section V discusses several goals toward which all those involved in the
financial reporting community should work. The discussion explains the goal and its
benefits to financial reporting, and explains how various constituents in the capital
markets can help to achieve the goals. Section VI provides recommendations for changes
in accounting and reporting requirements that would further the initiatives discussed in
Section V. The recommendations in Sections V and VI do not, in all cases, follow only
from the analysis of the various types of transactions. That is, the Staff draws as well
from its own experiences in dealing with issuer financial statements on a daily basis.
B. The Financial Reporting Framework
The Commission has responsibilities under the securities laws to specify
acceptable standards for the preparation of financial statements.20 However, the
Commission has for virtually its entire existence looked to the private sector for
assistance in this task. Currently, the body that the Commission looks to for the setting of
financial reporting standards is the FASB.21 The FASB has promulgated accounting
standards in many areas, and has also created a conceptual framework for accounting and
financial reporting that it uses in setting accounting standards. This framework specifies
that the objective of financial reporting is to provide information useful to investors and
creditors in their decision-making processes.22
Filings by issuers include four main financial statements: the balance sheet, the
income statement, the cash flow statement, and the statement of changes in equity.23
Each financial statement provides different types of information, but they are interrelated
in that they “reflect different aspects of the same transactions or other events affecting an
entity,” as well as complementary in that “none is likely to serve only a single purpose or
provide all the financial statement information that is useful for a particular kind of
assessment or decision.”24 A complete set of financial statements also includes notes,
which disclose quantitative and qualitative information not in the basic four financial
statements. Public filings may also be required to include additional information,
20See, for example, sections 7, 19(a) and Schedule A, items (25) and (26) of the Securities Act of 1933, 15
U.S.C. 77g, 77s(a), 77aa(25) and (26); sections 3(b), 12(b) and 13(b) of the Securities Exchange Act of
1934, 15 U.S.C. 78c(b), 78l(b) and 78m(b); sections 5(b), 14, 15 and 20 of the Public Utility Holding
Company Act of 1935, 15 U.S.C. 79e(b), 79n, 79o and 79t; sections 8, 30(e), 31 and 38(a) of the
Investment Company Act of 1940, 15 U.S.C. 80a-8, 80a-29(e), 80a-30 and 80a-37(a).
21See Release No. 33-8221 (April 25, 2003), Policy Statement: Reaffirming the Status of the FASB as a
Designated Private-Sector Standard Setter.
22Statement of Financial Accounting Concept No. 1, Objectives of Financial Reporting by Business
Enterprises, November 1978, paragraph 32.
23SFAC No. 5, paragraphs 39-41 and 55-57.
24SFAC No. 5, paragraph 23, see also paragraph 24.
10
including information about the company’s business, the risk factors it faces, and a
discussion of its financial condition and results of operations.
1. The Balance Sheet
Given the topic of this Report, our main focus is on the balance sheet. The
balance sheet portrays an issuer’s financial position at a point in time. Its basic
components include:
• Assets, which are “probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events”;25
• Liabilities, which are “probable future sacrifices of economic benefits arising
from present obligations of a particular entity to transfer assets or provide services
to other entities in the future as a result of past transactions or events”;26 and
• Equity, which is “the residual interests in the assets of an entity that remains after
deducting its liabilities.”27
While the above definitions appear straightforward, many questions and issues
arise in determining which items should be reflected on the balance sheet. Additionally,
questions arise regarding whether certain items that are included in the balance sheet
should be reported as liabilities or as equity.
Perhaps the most pervasive question is whether, in deciding which assets and
liabilities to include in the balance sheet, one should look to those assets and liabilities
legally controlled by an issuer, or to those assets and liabilities that expose an issuer to
risks and rewards. In most simple structures, these two approaches to analyzing the
question produce similar answers as to whether or not to consolidate. However, more
complex structures have developed in business practice for which these two different
philosophies produce different answers.
Determining the contents of the balance sheet using a control approach generally
makes sense if one is interested in what value company management can generate from
the resources that it manages. That is, a control approach is compatible with a
“stewardship” view of the financial statements. On the other hand, a risks and rewards
analysis makes sense to those who see the financial statements as a way to understand
how various events might affect the value of their holdings in the entity. Current GAAP
generally relies on a control approach to determine which items appear in the balance
sheet. Thus, even when a majority of the risks and rewards of an asset belong to other
parties, the controlling entity will record the asset on its books. Furthermore, an issuer
that owns a controlling voting interest in another entity will generally consolidate that
other entity, even if its controlling interest represents a minority of the total capital
invested.
25SFAC No. 6, paragraph 25.
26Id., paragraph 35.
27Id., paragraph 49.
11
While the focus on control has been generally consistent, there are various
analyses that are used to identify the controlling party. The common indicator of control
is a legal analysis regarding the ability to direct the use of the asset in question or, in a
consolidation situation, voting control over the entity in question. However, there are
some instances in which a legal control analysis has been found lacking, and therefore is
not used. The decision of whether to consolidate certain SPEs is one such area. Even
before the Enron and other scandals, many had realized that looking for the more
common indicators of control does not work well in regard to SPEs, mainly because so
many SPEs have all of their significant activities “pre-programmed” at their formation,
such that voting control is rendered rather irrelevant.28 Under recent accounting guidance
for SPEs, a risks and rewards analysis is performed in order to get at which party, if any,
should consolidate the SPE.
Another issue that pervasively affects which assets and liabilities are included in
the balance sheet is whether to record assets and liabilities individually in the financial
statements, or to net them. This is particularly important in that most contracts provide
both counterparties with rights that could be considered assets, while simultaneously
subjecting them to obligations that could be considered liabilities. Pension obligations,
when recognized, are generally reported net of assets set aside to fund them,29 while other
obligations for which funds are set aside generally are reported on a “gross” basis—that
is, both the obligation and the funds set aside are separately reported in the balance sheet.
In contrast, transfers of financial assets may be reported on either a gross or net basis,
depending on a myriad of factors. Similar to questions of control vs. risk and rewards,
both gross and net reporting can provide information that is useful to investors. For
example, in the partial transfer of a financial asset, a gross reporting approach may signal
to investors that an issuer still owns the entire asset, and has merely agreed, through a
separate contract, to forward a portion of the payments received to another party, in
return for the payments received from that other party. Net reporting, however, lets
investors know that the issuer is really no longer exposed to the full change in value of
the financial asset, because a portion of the related risks and rewards has passed to the
purchaser.
2. Other Basic Financial Statements
The other three basic financial statements describe, each in its own way, the
changes in various balance sheet items from one period to the next. We discuss each in
turn.
The income statement reflects the issuer’s revenues and expenses, gains and
losses, and, thus, is intended to capture “the extent to which and the ways in which the
equity of an entity increased or decreased from all sources other than transactions with
28See, for example, page 82 of the Commission’s 2000 Report to Congress, which comments that “existing
[consolidation] standards do not adequately address circumstances involving entities with specific limits on
their powers, also referred to as SPEs. The FASB is urged to continue its efforts to provide guidance
concerning these entities.”
29See discussion in Section III.
12
owners during a period.”30 Over the years, tremendous controversy about what should be
reported in the income statement has arisen. In large part, the controversy can be traced
to the fact that net income (often expressed as a per share measure) has been focused on
more than any other single characteristic in evaluating performance. As such, the
decision to change accounting standards in a way that would result in more volatility
being reported has often prompted controversy.
Due to the complementary and integrated nature of the balance sheet and income
statement, choosing the accounting treatment for one statement has implications for the
other.31 One of the most critical and timely examples to illustrate such conflicts relates to
recent standards that require the recognition of more assets and liabilities on the balance
sheet at their fair values. Moving to fair values on the balance sheet requires that a
decision also be made regarding whether the unrealized changes in these fair values are
reported on the income statement. Unrealized gains and losses related to assets and
liabilities are those that occur while an issuer holds the asset or liability, as opposed to
realized gains and losses that occur when an asset or liability is sold or settled.
Proponents of the “all inclusive” approach to defining net income would argue
that it is appropriate to include both realized and unrealized gains and losses in net
income because this information enables users to better predict future earnings or cash
flows. However, others point out that recording unrealized gains and losses in the
income statement may lead to increased earnings volatility such that earnings become
less predictive of future earnings or cash flows. The alternative to reporting unrealized
gains and losses as part of net income is to report these changes in “other comprehensive
income,” which most often appears in the statement of shareholder equity, until the gain
or loss is realized through sale of the asset or settlement of the liability.
The statement of changes in equity reflects the ways in which assets and liabilities
have changed due to transactions with owners during the period, such as declarations of
dividends, issuances of stock options, exchanges of shares in mergers and acquisitions,
and items that are classified as “other comprehensive income,” as discussed above.32
The cash flow statement reflects “an entity’s cash receipts classified by major
sources and its cash payments classified by major uses during a period.”33 This statement
30SFAC No. 5, paragraph 30. In truth, there are several transactions that meet the criteria to be included in
the income statement, but have nonetheless been excluded from net income, and instead categorized as
“other comprehensive income”.
31Historically, the relative focus of standard setters on the balance sheet versus the income statement (or
vice versa) has varied. The balance sheet was emphasized in the early part of the 20th Century (and before),
in part because creditors had little reliable information available to them. Liquidation values and
conservatism were of central importance. By the late 1930s, the focus shifted to a shareholder orientation,
the income statement and value in use rather than liquidation value. Hendriksen, Elden S., 1982,
Accounting Theory, Irwin, Homewood, Illinois, 257.
32With the exception of the changes in the value of international subsidiaries that result from translating
their financial statements into U.S. dollars, these issues are discussed in detail in Section III.
33Id., paragraph 52.
13
groups the inflows and outflows of cash into three broad categories: operating cash flows,
investing cash flows, and financing cash flows.
Operating cash flows include cash received from customers, cash spent on
materials and labor, cash paid for utilities, insurance, executive salaries, and many other
types of operating items. When the operating section of the cash flow statement is
presented based on categories such as these, it is known as a “direct method” cash flow
statement. The FASB noted that “[t]he principal advantage of the direct method is that it
shows operating cash receipts and payments [and that] [k]nowledge of the specific
sources of operating cash receipts and the purposes for which operating cash payments
were made in past periods may be useful in estimating future operating cash flows.”34
Another option, known as the “indirect method,” allows issuers to prepare this
section by reconciling net income to operating cash flow. Using this method involves
adjusting net income for non-cash items, such as depreciation and changes in certain
current assets or liabilities. For example, issuers would adjust net income for changes in
accounts receivable (which indicate a difference between accrual basis revenue and cash
received from customers) or changes in accounts payable (which indicate a difference
between accrual basis expenses and cash received to providers of goods and services).
The FASB noted that “[t]he principal advantage of the indirect method is that it focuses
on the differences between net income and net cash flow from operating activities.”35
When the FASB promulgated SFAS No. 95, The Statement of Cash Flows, it
required presentation of the indirect method in all cases, and expressed a preference that
the direct method36 also be presented, but did not require its use. Most issuers do not
present direct method cash flow statements.37
The other two sections of the cash flow statement report investing cash flows and
financing cash flows. Investing cash flows include cash inflows and outflows related to
purchases or sales of property, plant and equipment, investments in equity or debt of
other entities, and other types of investments. Financing cash flows include cash inflows
from raising capital through issuing stock or debt, cash outflows to repay mortgages and
other liabilities, cash paid for dividends, and the like.
3. Notes to the Financial Statements, MD&A, and Other
Disclosures
The basic financial statements alone often do not provide sufficient information
for investment decisions. The FASB’s concept statements note that: “[s]ome useful
information is better provided by financial statements and some is better provided, or can
only be provided, by notes to financial statements or by supplementary information or
34SFAS No. 95, paragraph 107.
35SFAS No. 95, paragraph 108.
36SFAS No. 95, paragraph 119.
37The Staff agrees with the FASB’s preference and encourages issuers to voluntarily present their cash flow
statements using the direct method.
14
other means of financial reporting.”38 These disclosures in the notes to the financial
statements are intended to provide information that balance sheets, income statements,
and cash flow statements cannot (or do not) provide.
In addition, although the notes provide much information that is not provided in
the basic financial statements, they generally do not provide an explanation of the
business activities underlying the numbers. Recognizing that such information may be as
important to investors as the information in the financial statements and notes, the
Commission requires issuers to include a section called Management’s Discussion and
Analysis of Financial Position and Results of Operations in many filings. MD&A
requires a discussion of significant events, trends, and uncertainties, explanations of key
financial statement figures, disclosures regarding events reasonably likely to affect the
issuer’s operations or liquidity in the near future and other information that provides
context to the financial statements. As noted in FR 67:
The disclosure in MD&A is of paramount importance in increasing the
transparency of a company's financial performance and providing investors with
the disclosure necessary to evaluate a company and to make informed investment
decisions. MD&A also provides a unique opportunity for management to provide
investors with an understanding of its view of the financial performance and
condition of the company, an appreciation of what the financial statements show
and do not show, as well as important trends and risks that have shaped the past or
are reasonably likely to shape the future.
Because of the importance of the notes to the financial statements and other
disclosures, including MD&A, in providing information that is not provided by the basic
financial statements themselves, questions of whether items should or should not be
included on the balance sheet and whether sufficient transparency in reporting has been
achieved must be assessed in light of the presence and role of these other reporting tools.
C. Historical Context of the Study and Report
1. Enron
While the Act does not discuss why off-balance sheet arrangements and SPEs are
identified for special attention, looking back at the scandals that preceded the passage of
the Act appears instructive. At the beginning of 2001, Enron Corp. enjoyed a market
capitalization that exceeded $60 billion, ranked as the seventh largest corporation in the
world by revenue,39 and had won Fortune magazine’s award as the ‘most innovative
company in the United States’ six years running.40 Yet, toward the end of 2001, Enron
38SFAC No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, (Dec. 1984),
paragraph 7.
39Second Interim Report of Neal Batson, Court Appointed Examiner (“Second Interim Batson Report”), In
re: Enron Corp., et al., Jan. 21, 2003, page 5.
40The award was won in 1996 through 2001. See Christopher L. Culp and Hanke, Steve H., “Empire of the
Sun: An Economic Interpretation of Enron’s Energy Business,” Policy Analysis, Cato Project on Corporate
Governance, Audit and Tax Reform, Feb. 20, 2003, page 2.
15
collapsed within a matter of months, filing for bankruptcy protection under Chapter 11.
Its collapse constituted the largest corporate bankruptcy up to that point in time.
This event acted as a catalyst—especially after it was rapidly followed by other
high-profile business and financial reporting failures, including those at Worldcom and
Adelphia —and raised many questions about corporate governance, the audit process,
and financial reporting in general. It eventually was reported that aspects of Enron’s
business were built on non-substantive trades and related-party transactions with no valid
business purpose. There were multiple violations of the company’s code of conduct,
some of which were specifically approved by the Board of Directors.41 Compounding all
of this, it quickly became apparent that Enron’s financial reports had not revealed the
company’s true economic position to the market. Upon closer scrutiny, it also appeared
the use of and accounting for OBS arrangements and SPEs had hidden the risks that
played an important role in its rapid collapse.42 The Enron scandal, along with other
financial reporting failures (several of which also involved OBS transactions and SPEs),
preceded the wave of reforms that included passage of the Act.
While it is beyond the scope of this Report to look in detail at Enron’s
transactions, a brief description of a few transactions may serve to illustrate the lack of
transparency that can result from some off-balance sheet arrangements. Enron’s
transactions have been examined in detail by others. For the examples provided below,
the Staff relies solely on the Powers Report and the Second Interim Batson Report, both
of which are publicly available.
Enron’s court appointed bankruptcy examiner, Neal Batson, preliminarily
concluded that “through the pervasive use of structured finance techniques involving
SPEs and aggressive accounting practices, Enron so engineered its reported financial
position and results of operations that its financial statements bore little resemblance to
its actual financial condition or performance.”43 The impact of these “techniques” was
profound. For 2000, barring the use of these techniques, Enron’s reported debt would
have been $22.1 billion rather than $10.2 billion.44
On November 19, 2001, Enron filed its third quarter financial statements and
reported debt on its balance sheet of approximately $13 billion. Yet, on the same day, at
a meeting designed to help relieve its liquidity crisis, Enron informed its bankers that its
debt was approximately $38 billion; the difference of $25 billion was explained as being
either off-balance sheet or on the balance sheet as something other than debt. Batson
notes that approximately $14 billion of this off-balance sheet debt was “incurred through
structured finance transactions involving the use of SPEs.”45
41See, for example, Report of Investigation by the Special Investigative Committee of the Board of
Directors of Enron Corp. William C. Powers, Jr. Chair (Feb. 1, 2002) (“Powers Report”), page 3.
42See Second Interim Batson Report; see also Powers Report.
43Second Interim Batson Report, page 15.
44Id., page 3.
45Id., page 9-10.
16 Similarly, a report by a Special Investigative Committee on Enron—i.e., the
Powers Report—found, among other things, that transactions with certain SPEs “allowed
Enron to conceal from the market very large losses resulting from Enron’s merchant
investments by creating an appearance that those investments were hedged.”46 We rely
on the Powers Report for the following example of an arrangement combining the use of
SPEs with derivatives to reduce transparency.
Enron had invested in a “high-tech” stock—Rhythms NetConnections, Inc.47 The
investment had grown approximately 30-fold in value. Enron reflected this investment
on the balance sheet at its (estimated) fair value,48 and recognized the increases in value
in the income statement. Theoretically, a decrease in value, if it occurred, would also
flow through the income statement. While there was concern that the value of the
investment might fall, Enron was not in a position to sell the shares due to a lock-up
agreement.49 Further, as the Powers Report explains, “[g]iven the size of Enron’s
position, the relative illiquidity of Rhythms stock, and the lack of comparable securities
in the market, it would have been virtually impossible (or prohibitively expensive) to
hedge Rhythms commercially.”50
Enron resolved this dilemma by entering into a “hedging” transaction with an SPE
that was designed (from an accounting perspective) to permit Enron to offset losses
associated with any potential decrease in the value of Rhythms NetConnections shares.51
Enron received, from an SPE that had no other operations, a put option on Rhythms
NetConnections shares which appeared to protect Enron from decreases in the value of
those shares.52 However, Enron provided the SPE with a large quantity of restricted
Enron stock, which the SPE would use to cover its obligations to Enron.53 As a
consequence of this arrangement, the SPE would not be able to meet its obligations under
the derivatives contract if the value of Enron shares decreased (sufficiently) at the same
time as the value of Rhythms NetConnections shares did.54
This transaction was one of many that highlighted problems with the then-existing
accounting guidance on the consolidation of SPEs. In the most egregious uses of SPEs,
most objective observers would have concluded that the “sponsor” of the SPE really was
in control of its actions, either through voting provisions, economic compulsion, or, most
likely, because the SPE’s activities were set forth upon its formation, and were entirely,
or almost entirely, performed for the benefit of the sponsor. The accounting guidance at
46Powers Report, page 4.
47Id., page 77.
48Id.
49Id.
50Id., page 78.
51Id.
52Id., page 80 and 81.
53Id., page 80.
54Id., page 82.
17
the time, however, generally focused on voting control to determine whether all entities,
including SPEs, should be consolidated. By giving an independent third party who had
made a “substantive” investment (3% of the value of the assets of the SPE was generally
considered substantive) voting control of the SPE, a sponsor could generally avoid
consolidation, despite the fact that the activities of the SPE could not be substantively
changed by the “controlling” investor. Recognizing this as a problem, the FASB,
subsequent to the passage of the Act, issued new guidance, Interpretation No. 46(R),
regarding the consolidation of SPEs.55 Interpretation No. 46(R) is discussed in Section
IV.
Another structuring technique used by Enron, again combining the use of SPEs
and derivatives, appears to have been designed to create the impression of operating cash
flows while disguising debt financing. The Staff relies on the Second Interim Batson
Report for this example, which refers to these particular transactions as “prepay”
arrangements.56 A typical Enron “prepay” involved three parties: an Enron affiliate, an
investment bank, and a conduit entity formed at the direction of the investment bank.
More specifically, a prepay had three component parts:
i.) The investment bank paid the conduit entity up-front in exchange for the conduit
entity’s future deliveries of a commodity at periodic intervals;
ii.) The conduit entity paid the Enron affiliate up-front for future deliveries of a
commodity; and
iii.) Enron promised to buy a commodity from the investment bank in the future, at
amount in excess of the amounts paid by the investment bank in step (i).57
The circular nature of delivery and payments with respect to the commodities had
the effect of eliminating any material risk or any potential gain with respect to the
changes in the price of the underlying commodity. Each party’s apparent assumption of
price risk was illusory. With the elimination of price risk, “prepays” were effectively
debt. In other words, the conduit entity was an alter ego of the investment bank.
Therefore, the transaction was essentially between two parties—Enron and the
investment bank. The investment bank was making a large payment to Enron in
exchange for Enron’s promise to pay the bank an amount in excess of what Enron
received in the initial prepayment.
Each aspect of this arrangement, if considered separately, appears to have a
different economic intent than the economics of the transactions when analyzed together.
For example, cash today in exchange for a forward contract on oil and gas appears to be
nothing more than a common derivatives transaction. However, taking the totality of the
arrangement, the individual futures contracts have the effect of canceling price risk,
leaving money given today for a promise of money returned tomorrow as the economic
55Interpretation No. 46(R), Consolidation of Variable Interest Entities
56See Second Interim Batson Report, pages 58-67 and at Appendix E of that Report.
57Id., page 64.
18
essence of the arrangement—i.e., a loan, and loan accounting would have been the
appropriate accounting to apply to this series of transactions.
Enron’s accounting, however, inappropriately focused on its constituent parts.
Thus, the cash received by Enron in Step (ii) above was not recorded as cash flow from
financing (as would be appropriate for loan proceeds), but as cash flow from operations58
(on the argument that it was associated with the forward contract on the oil and gas).
With respect to the balance sheet, Enron also failed to treat the liability associated with
Step iii—the promised future payments to the investment bank—as a debt liability.
Instead, the liability was recorded as a risk management liability.59 Thus, these prepay
transactions allowed Enron to hide debt,60 lower key financial ratios followed by
analysts,61 and provide the illusion of cash flow from operations.62
This structure also highlights what is referred to by accountants as the “unit of
account” problem. The economics of a transaction may look quite different depending on
how broadly or narrowly one defines the boundaries of the transaction. That is, a
particular contract may appear to have certain economic characteristics when viewed in
isolation—and may be given a certain accounting treatment that corresponds to those
economic characteristics—but if understood as a piece of a larger agreed-upon
transaction may actually have quite different economics, and be properly accorded
different accounting treatment. Thus, determining the actual bounds of a transaction is
fundamental to understanding both the underlying economics and the proper accounting
treatment. Determining these bounds has been and will remain an ongoing challenge to
standard setters, auditors, and regulators.63
2. The Standard Setting Environment
The series of financial reporting scandals indicated to many that the system of
corporate governance and financial reporting was in need of repair. In response to these
scandals, the Sarbanes-Oxley Act called for improvement in the checks-and-balances that
govern the production of financial information provided to investors. In addition, various
enforcement actions served notice on bad actors that they would be discovered and dealt
with for their misrepresentations. But, for some, a question remained as to whether these
immediate legislative and enforcement responses completely addressed all of the causes
of these financial scandals. In particular, many asked whether, beyond the bad actors, the
58Id., page 59.
59Id.
60Id.
61Id., page 61.
62Id.
63See, for example, SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity, paragraphs 14 and A25-A29; EITF Issue No. 00-21, Accounting for Revenue
Arrangements with Multiple Deliverables, and Derivatives Implementation Group Issue K1, Determining
Whether Separate Transactions Should Be Viewed as a Unit.
19
accounting standards themselves might have played some role in facilitating or even
encouraging the bad behavior.
In a static world, one might expect standard setters and regulatory agencies to
examine each type of arrangement, determine how information about that arrangement
could best be communicated, and create standards that require specific financial reporting
treatments. Experience, however, suggests that such an approach to standard setting lags
behind the requirements of the marketplace and, ultimately, results in rules-based
guidance that lacks conceptual coherence. The volume of different arrangements that
must be analyzed under this approach—and the unexpected variants in these
arrangements—present substantial challenges. The fact is that we live in a world of
accelerating technological change, financial innovation, and globalization with rapidly
shifting competitive dynamics and regulatory action. Moreover, there is a constant
interaction among these forces, with each stimulating further change in the others. In
such a dynamic world, standard setters cannot possibly anticipate—and pre-determine
precise accounting rules for—every transactional innovation.
In light of these concerns, the Act mandated a study be conducted by the
Commission regarding the current form of U.S. accounting standards. More specifically,
section 108(d) of the Act called upon the Commission to conduct a study on the adoption
of “principles-based” accounting standards by the United States financial reporting
system.64 This report has been completed and submitted to Congress on July 30, 2003.
In this study, the Staff noted several shortcomings of what are often denoted as
“rules-based” standards. Such standards often:65
• Contain numerous bright-line tests, which ultimately can be misused by financial
engineers as a roadmap to comply with the letter but not the spirit of standards;
• Further a need and demand for voluminously detailed implementation guidance
on the application of the standard, creating complexity in and uncertainty about
the application of the standard; and
• Contain numerous exceptions to the principles purportedly underlying the
standards, resulting in inconsistencies in accounting treatment of transactions and
events with similar economic substance.
The Staff recommended a continued movement in the direction of (what the Staff
referred to as) “objectives-oriented” accounting standards. Objectives-oriented standards
are those which:66
• Clearly state the accounting objective of the standard, with the objective
incorporated in the standard;
• Minimize the use of exceptions from the standard;
64See Objectives-Oriented Accounting Standards Study.
65Id.
66Id.
20
• Avoid use of percentage tests (“bright-lines”) that allow financial engineers to
achieve technical compliance with the standard while evading the intent of the
standard;
• Are based on an internally consistent and consistently applied conceptual
framework; and
• Provide sufficient detail and structure so that the standard is operational and can
be applied on a consistent basis.
The study also notes that objectives-oriented standards have the potential to more
quickly adapt to today’s faster paced business environment better than rules-based
standards for (at least) two reasons:67
First, standard setters should be able to move faster to address emerging
practice issues under an objectives-oriented regime. It is easier to come
to an agreement on a principle than on a highly detailed rule, even if the
principle is substantive and relatively specific in nature. It also takes
more time to develop and provide extensive implementation guidance on
a wide variety of hypothetical scenarios, as required by the rules-based
approach.
Second, by its very nature, a standard setting body cannot respond as
quickly to changes in the environment as can the professionals directly
involved in the marketplace. Because, when properly constructed,
objectives-oriented accounting standards are solidly based on a
conceptual framework, yet cabined by the specific, substantive
objectives embodied in each standard, they provide for a framework
within which the application of professional judgment can be exercised.
As such, managers and accountants should be able to draw upon the
objectives of the standard so that their accounting decisions better
capture economic reality in response to market developments. This
should render objectives-oriented accounting standards more durable
once they are in place than are rules-based standards. The latter tend to
be in greater need of constant tinkering by standard setters to reflect
changes in the environment than do objectives-oriented standards.
67Id. (footnotes deleted from quotation).
21
Finally, the study also notes that significant hurdles exist to creating objectives-
oriented standards. Indeed, the bright lines, numerous exceptions, and voluminous
interpretive guidance that many see as problems with rules-based standards are
characteristics of many parts of U.S. GAAP precisely because constituents requested that
the FASB and other standard-setters include them in the guidance. The development of
objectives-oriented standards is continuously challenged by the constant requests
received by standard-setters that they provide new interpretive guidance and exceptions
to the principles underlying the accounting standards.
In addition, standard-setters must contend with the fact that just about any
proposed change will be unpopular with at least a segment of preparers, auditors and
other participants, including users. Even the improvements to the accounting guidance
identified in Section I.C.4 below—that have happened since the passage of the Sarbanes-
Oxley Act—generated significant debate, and these changes were made during a period
in which the FASB, the Commission and others were being actively encouraged to make
such improvements. The expectation that proposals for change will generate controversy
should not stop standard-setters from taking up a project in a needed area, but standard-
setters must nonetheless factor this into its processes and agenda decisions, ensuring that
sufficient opportunity for deliberation, comment, discussion, and dialogue will exist. In
addition, where new standards will result in the need for significant changes to internal
controls and financial reporting systems, adequate implementation time must also be built
into the process.
3. Accounting Motivated Transaction Structuring
Standard-setting is rendered difficult not only by the fast-paced business
environment, but also by the fact that the transactions themselves evolve in reaction to
the standards. As soon as a new standard is issued, questions immediately arise regarding
whether specific structures are within the scope of the new guidance, how interactions
between the new standard and existing standards should be addressed, and whether more
detail on the new guidance can or should be provided. Indeed, in many instances, the
issuance (or even expectation) of a new standard triggers a search to determine
techniques to structure and/or restructure transactions to avoid reporting the very
information sought by the new standard.
For example, when the FASB issued a standard in 1976 that required some lease
obligations to be recorded on the balance sheet as liabilities,68 many lessees immediately
began to restructure their leases to avoid recognizing liabilities. Their efforts were aided
by parties who sought to profit from offering their expertise in structuring leases in ways
that provided “preferable” accounting. Such structuring tends to reduce transparency.
Indeed, oftentimes that is its point.
When we refer to accounting-motivated structured transactions, we are speaking
of those transactions that are structured in an attempt to achieve reporting results that are
not consistent with the economics of the transaction, and thereby impair the transparency
68SFAS No. 13, Accounting for Leases.
22
of financial reports.69 Standard setters have sometimes responded to structuring efforts
by refining and expanding the standards. However, this process can be a never-ending
circle, where restructuring of contracts and the creation of innovative new financial
structures lead to revisions in GAAP, which are then followed by the creation of
additional financial structures. As a result, the rules themselves come to provide a
roadmap for avoiding their intent, as issuers adjust arrangements to fall just outside the
scope of a particular accounting treatment.
Although this dynamic has long been recognized by regulators and standard
setters, there have been sweeping innovations in capital markets during recent years that
have substantially increased the potential (and in many cases, the expectation) for issuers
to engage in this type of structuring. With dramatically lowered transaction costs due to
technological and financial innovations, it has become economically feasible to isolate,
price and trade rights to specified streams of cash flows. This ability to un-bundle risk
and return, re-bundle it into new instruments, and sell these new instruments in the
marketplace has revolutionized capital markets. Economists sometimes refer to this
availability of a full range of financial alternatives as the “completion” of financial
markets (although markets remain far from fully complete).70
Progress in the “completion” of financial markets has undeniable benefits,
allowing issuers to enhance liquidity, better manage risk exposure, and reduce borrowing
costs, while permitting investors to invest in instruments or entities best suited to their
investment preferences and risk tolerance. Nevertheless, as noted above, the very
complexity and flexibility inherent in these new financial tools and practices renders the
goal of transparency substantially more difficult to achieve. These innovative financial
instruments provide a new set of tools to those who would attempt to hide their exposure
to risk, or otherwise manipulate their financial statements. As one author who writes
about derivative markets states:71
it is generally possible to create a given payoff in multiple ways. The
construction of a given financial product from other products is
sometimes called financial engineering. … [B]ecause there are multiple
ways to create a payoff, … regulatory arbitrage … [in which the author
includes the circumvention of accounting rules] can be difficult to stop.
The propensity of certain issuers to combine engineered transactions with
aggressive accounting interpretations in order to obtain “desirable” accounting results
69Thus, we do not mean to include situations where, for example, an issuer increases its sales efforts at the
end of a period to generate revenue. In that situation, the reporting of revenue would generally mirror the
economics if additional sales are generated. Such situations may, however, result in the need for
explanatory disclosures, particularly in MD&A.
70See, for example, Mario Draghi, Giavazzi, Francesco, and Merton, Robert C. Transparency, Risk
Management and International Financial Fragility NBER Working Paper 9806, June 2003 (“[t]he role of
swaps and other privately negotiated derivative instruments is to complete financial markets, thus
increasing the ability of individuals, financial institutions, corporations and governments to manage risk.”)
71McDonald, Robert L. Derivatives Markets (2003), pages 3 and 4.
23
poses difficult challenges to auditors, standard setters, and regulators, and reduces
investor understanding.
4. Improvements in the Financial Reporting Regime Since the
Passage of the Sarbanes-Oxley Act
There have been a number of significant events in the financial reporting system
since the passage of the Sarbanes-Oxley Act. Among others, these have included:
Accounting Developments:
• Consolidation of Variable Interest Entities (revised December 2003)—an
interpretation of ARB No. 51 (“Interpretation No. 46(R)”)72, which requires a
“risks and rewards” approach to the consolidation of “variable interest entities” as
opposed to an approach based on control by ownership or legal authority,
addressing, among other things, some of the concerns with the failure of issuers
under earlier guidance to consolidate certain special purpose entities;
• Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (“Interpretation No. 45”), which
requires the recognition of liabilities for obligations undertaken upon issuing
certain guarantees, as well as other disclosures;73
• Share-Based Payment, SFAS No. 123(R), which requires a fair-value based
method of accounting for stock options and other equity instruments used to
purchase goods and services, including employee services, eliminating the
previous accounting guidance that allowed compensation paid in a particular form
to go unreported in the financial statements;74
• Employers’ Disclosures about Pensions and Other Postretirement Benefits—An
Amendment of FASB Statements No. 87, 88, and 106, SFAS No. 132(R), which
revised employers’ disclosures about pension plans and other postretirement
benefit plans;75
• Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equities, SFAS No. 150, which established standards for how an
issuer classifies and measures certain financial instruments with characteristics of
both liabilities and equity;76
72More specifically, the FASB issued Interpretation No. 46 in January 2003 and 46(R)—the revised
interpretation—in December 2003.
73The FASB issued Interpretation No. 45 in November 2002.
74This Statement, revised in 2004, was a revision of FASB Statement No. 123, Accounting for Stock-Based
Compensation. It superseded APB Opinion No. 25, Accounting for Stock Issued to Employees, and its
related implementation guidance.
75This was revised in December 2003.
76This was issued by the FASB in May 2003.
24
• Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the
Adoption by the United States Financial Reporting System of a Principles-Based
Accounting System, which is a Staff study that recommended that accounting
standards should be developed using an “objectives-oriented” approach;77 and
• The FASB Response to SEC Study on the Adoption of a Principles-Based
Accounting System,78 in which the FASB indicated it’s general agreement with
the Staff’s recommendations regarding objectives-oriented accounting standards;
Regulatory and Other Developments:
• Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet
Arrangements and Aggregate Contractual Obligations (“FR 67”),79 which requires
an issuer to explain its off-balance sheet arrangements in a separately captioned
subsection of its MD&A and to provide an overview of certain known contractual
obligations in a tabular format;80
• Interpretation: Commission Guidance Regarding Management’s Discussion and
Analysis of Financial Condition and Results of Operations (“FR 72”),81 which
explains how MD&A can provide more meaningful disclosure in a number of
areas, including its overall presentation and focus, with general emphasis on the
discussion and analysis of known trends, demands, commitments, events and
uncertainties, and specific guidance on disclosures about liquidity, capital
resources and critical accounting estimates;
• Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date,82
which adds certain disclosure requirements for public companies regarding
material changes in financial condition or operations, including (among other
things) disclosures if an issuer becomes directly or contingently liable for an
obligation that arises out of an off-balance sheet arrangement or if a triggering
event occurs causing an issuer obligation under an off-balance sheet arrangement
to increase or be accelerated, or its contingent obligation under an off-balance
sheet arrangement to become a direct on-balance sheet financial obligation;
• Summary by the Division of Corporation Finance of Significant Issues Addressed
in the Review of the Periodic Reports of the Fortune 500 Companies,83 in which
77The Staff study on the adoption of objectives-oriented accounting standards was published by the
Commission in July 2003.
78This was released by FASB in July 2004.
79This rule was promulgated by the Commission in January 2003 in response to Section 401(a) of the Act.
80Much of the language and many of the concepts in FR 67 are consistent with the language and concepts
embodied in the Commission’s January 2002 statement, which discussed the desirability of enhance
disclosure in MD&A of off-balance sheet arrangements.
81FR 72 was promulgated by the Commission in December 2003.
82This rule, which was proposed prior to the passage of the Act, is also responsive to the current disclosure
goals of Section 409 of the Sarbanes-Oxley Act.
83This document is dated February 27, 2003, as modified.
25
the Division focused on disclosures that appeared to be critical to an
understanding of each company’s financial position and results, but which, at
least on their face, seemed to depart significantly from either GAAP or
Commission rules, or to be materially deficient in explanation or clarity; this
document included a discussion of the Division’s comments to issuers on off-
balance sheet arrangements, including securitized financial assets;
• Certification of Disclosure in Companies’ Quarterly and Annual Report, as
directed in part by Section 302(a) of the Act, adopted rules to require, among
other things, that an issuer's principal executive and financial officers each certify:
the financial and other information contained in the issuer's quarterly and annual
reports; that they are responsible for establishing, maintaining and regularly
evaluating the effectiveness of the issuer's internal controls; that they have made
certain disclosures to the issuer's auditors and the audit committee of the board of
directors about the issuer's internal controls; and that they have included
information in the issuer's quarterly and annual reports about their evaluation and
whether there have been significant changes in the issuer's internal controls or in
other factors that could significantly affect internal controls subsequent to the
evaluation;84
• Management’s Report on Internal Controls Over Financial Reporting and
Certification Disclosure in Exchange Act Periodic Reports, which, as directed by
Section 404 of the Act, adopted rules requiring, among other things, that
companies subject to the reporting requirements of the Securities Exchange Act of
1934, other than registered investment companies, include in their annual reports
a report of management on the company's internal control over financial
reporting;85
• Standards Relating to Listed Company Audit Committees, which, as directed by
Section 301 of the Act, adopted a new rule to direct the national securities
exchanges and national securities associations to prohibit the listing of any
security of an issuer that is not in compliance with the audit committee
requirements mandated by the Act, relating to the independence of audit
committee members; the audit committee's responsibility to select and oversee the
issuer's independent accountant; procedures for handling complaints regarding the
issuer's accounting practices; the authority of the audit committee to engage
advisors; and funding for the independent auditor and any outside advisors
engaged by the audit committee;86
• Strengthening the Commission's Requirements Regarding Auditor Independence,
which, consistent with the direction of Section 208(a) of the Act, adopted
amendments to existing requirements regarding auditor independence to enhance
84The effective date for these rules was August 29, 2002. Release Nos. 33-8124; 34-46427.
85The effective date for these rules was August 14, 2003. Release Nos. 33-8238; 34-47986.
86The effective date for this rule was April 25, 2003. Release Nos. 33-8220; 34-47654.
26
the independence of accountants that audit and review financial statements and
prepare attestation reports filed with the Commission; and
• Proposed Interagency Statement on Sound Practices Concerning Complex
Structured Finance Activities, Office of the Comptroller of the Currency,
Treasury; Office of Thrift Supervision, Treasury; Board of Governors of the
Federal Reserve System; Federal Deposit Insurance Corporation; and Securities
and Exchange Commission, which, among other things, provided that financial
institutions should have effective policies and procedures in place to identify
those complex structured finance transactions that may involve heightened legal
and reputation risk, to ensure that the transactions receive enhanced scrutiny by
the institution, and to ensure that the institution does not participate in illegal or
inappropriate transactions.87
To the extent possible, we consider the effects of these recent changes in financial
reporting throughout this Report. In addition, as part of the Study the Staff collected data
about the initial implementation of Interpretation No. 46(R) and FR 67. The Staff
presents these empirical findings in Section IV.
II. Study Methodology
This section presents the methodology for the Study, including 1) methodological
issues related to the construction of a representative sample of filings by issuers
appropriate to the questions addressed in the Study, and 2) the process by which the
sample findings are extrapolated to estimate the extent of arrangements with off-balance
sheet implications for the population. Descriptive statistics relating to the sample are also
presented in this section.
Certain characteristics common to many arrangements with off-balance sheet
implications were identified that could complicate the selection of a sample for the Study.
The prevalence of off-balance sheet arrangements may vary across issuers and is apt to be
correlated with size. Indeed, a disproportionate amount of certain off-balance-sheet
arrangements may occur in a small number of issuers.88 Thus, in order to construct a
sample that will be representative of the population, it is important to stratify89 the sample
87On May 19, 2004, the Agencies requested public comment on a proposed Interagency statement. (69 FR
28980, May 19, 2004)
88For example, see Credit Suisse First Boston Equity Research FIN 46: New Rule Could Surprise Investors,
page 6 (June 24, 2003).
89The principle of stratification is to partition the population so that the units within a particular stratum are
similar in terms of the variable being measured. Then, even though the strata may differ markedly from
each other in terms of other measures, a stratified sample with the appropriate number of units in each
stratum will tend to be representative of the population as a whole. Then, the formula for the variance of
the estimator of the population mean with stratified sampling is a function of within-stratum variance
terms. In other words, the population estimate will be most precise if the population is partitioned into
strata such that within each stratum the units are similar. This point will underlie much of the analysis
below.
27
to ensure that the influence of different sized firms is appropriately captured in the Staff
estimates of the extent of off-balance sheet arrangements.90
The Staff determined that a sample of n=94 issuers would satisfy the required
levels of power and hypothesis sensitivity for a stated level of significance.91, 92 To
ensure observations from the largest issuers are included, the Staff constructed the sample
to include the 100 largest issuers (as measured by market capitalization) and randomly
selected an additional 100 issuers from the rest of the population. This results in a total
sample of n=200 observations within 2 strata. Thus, the Study sample is composed of
two sub-samples: 100 large issuers93 (the “large issuer sub-sample”) and 100 randomly
selected issuers from the rest of the population (the “random issuer sub-sample”).94 This
90For a given total sample size n, one may choose how to allocate observations among the L strata. In the
absence of other information about the variances of a specified measure of interest across strata, a
reasonable initial choice may be to assume equal sample sizes for the strata. In this case, however, the
variance of the measure of interest in the stratum of largest issuers is likely to be very different from the
variance of the stratum of the smallest issuers for the distribution of total assets. In addition, the costs of
including additional observations differ substantially across strata. To construct an estimate that accounts
for this, the Staff first determined the stratum size allocations across the population that minimizes the
variance of the population estimate. Note that these estimates are dependent on the underlying assumed
parameter values. This method allowed the Staff to determine the appropriate strata sizes given the
importance of size and the importance of requiring that specific issuers be included in the sample.
91The Staff follows the discussion of the stratification principle and optimal allocation in Chapter 11 of
Sampling, Steven K. Thompson, Wiley Interscience (2002) and also referred to Chapter 4 of Sampling
Techniques, William G. Cochran, Wiley (1977). The Staff used size (as measured by total assets) as the
stratification variable and then used the Compustat universe to estimate the optimal allocation of the sample
across strata to minimize the variance of the estimator and determine the appropriate sample size for the
study. This calculation depends on population variance so we use the natural log of total assets, which is
approximately normal, as the basis of the population distribution. The first two moments of the distribution
were used to establish the total sample size appropriate to ensuring the designated levels of power and
precision. The other variables in the study are assumed to be distributed like the natural log of total assets.
To the extent that other variables have distributions similar to the distribution of the natural log of total
assets, the above analysis is appropriate. Where possible, the Staff made conservative assumptions in order
to preserve the statistical integrity of the sampling method.
92The Staff chose to construct a sample large enough to ensure that the power of the tests is no lower than
90% with an α level of significance of 5% throughout. More powerful tests and/or higher levels of
significance would require larger sample sizes. To establish the level of sensitivity of the hypotheses we
would expect from tests based on our sample, the sample sizes were determined assuming the difference
between the null and alternative hypotheses is 20%. The subsequent power calculations require a sample of
at least N=94 to satisfy these conditions.
93With certain exceptions as discussed below.
94As discussed above, the sample size that would be sufficiently representative to make inferences for the
total population subject to the required power, level of significance and hypothesis is less than 100. To
accommodate the prevalence of the variables of interest in the 100 largest issuers, a (much larger) total
sample of n=200, composed of 2 strata of 100 issuers each was constructed. The 2 strata are composed of
the 100 largest issuers and a random sample of size 100 from the rest of the population. This over-
sampling ensures the statistical validity of the results throughout. In addition, over-sampling large issuers
allowed statistically supportable observations to be made about these large issuers, which is a goal of the
Study. This is particularly relevant because the variables of interest may be more prevalent in the larger
issuers. The importance of large issuers to the Study was considered to justify the additional cost of
collecting information from all of the largest 100 issuers.
28
stratification method results in a sample that is sufficiently large to ensure the validity of
the statistical results subject to the specified power, hypothesis sensitivity, and
significance level requirements. In fact, this sampling method accommodates variation
across issuers and the importance of including the largest issuers in the Study.
The actual sample issuers in the large issuer sub-sample were selected based on
U.S. market capitalization as of December 31, 2003.95 The random sample of issuers was
selected using a random number generator to identify issuers from a list of all issuers on
the Commission’s Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”)
system.96 As noted above, the final sample that passed all the screening criteria and for
which data was successfully collected includes a total of 200 issuers. The tables below
describe the characteristics of the sample as well as each sub-sample, in terms of
securities registered with the Commission, size, industry membership, fiscal year-ends,
and the forms used by each issuer for their annual filings with the Commission.
Table II(A)(1) describes the securities registered with the Commission by our
sample of issuers. Approximately 93% of the sample issuers report common stock
registered with the Commission, and this average includes 100% of the large issuer sub-
sample. In contrast, only 6% of the sample issuers had registered preferred stock with the
Commission. Slightly more, almost 13% had registered debt securities.
95Fannie Mae and Freddie Mac were excluded from the population and sample, even though they would
otherwise fall into the ranks of the top 100 issuers. This was done given the relatively unique features of
these two extremely large Government Sponsored Entities (“GSEs”). Two market indices (which would
otherwise fall into the ranks of the top 100 issuers) were also excluded from the sample because their assets
are predominantly the securities of other issuers that are eligible for the study. Two foreign private issuers
(which would otherwise fall into the ranks of the top 100 issuers) were also excluded from the sample.
Such issuers file 20-F annual reports and are not included in the study because foreign private issuers have
a one-year lag before they are required to implement some of the pertinent new standards.
96Upon initial selection, the issuer was subjected to a screening to ascertain its viability as a participant in
the Study. If it was determined that an issuer was not a viable participant, the issuer was dropped and
another selected from the original list. Issuers were excluded if they were registered under the Investment
Act or if they were foreign private issuers. Issuers were also excluded if they did not have current financial
statements, notes to the financial statements, and MD&A disclosures available via annual filings (i.e.,
forms 10-K or 10KSB) and quarterly filings (i.e., form 10-Q or 10QSB), as the pertinent data would not be
available for such issuers. The selection and screening process was performed for a total of 276 issuers to
obtain a sample of 100 issuers that met all the requirements for membership in the sample.
29
TABLE II (A)(1): Major Classes of Securities Registered by Issuers in Samplea
Sub-Samples
Full Sample
(n=200)
(%)
Large Issuers
(n=100)
(%)
Random Issuers
(n=100)
(%)
Issuers with Registered Common Stock 93 100 86
Issuers with Registered Preferred Stock 6 6 6
Issuers with Registered Debt Securities 12.5 23 2
a These data were collected from the cover page of each issuer’s 10-K or 10KSB filing, which designates securities
registered under Sections 12(b) and 12(g) of the Securities Act of 1934. Additional types of securities (e.g.,
registered preferred stock rights, trust preferred securities, and partnership units) are not reported in this table. Some
issuers not included in the categories above may have securities that are exempt from registration.
Table II(A)(2) describes the size of the issuers in the sample, in terms of U.S.
market capitalization, total assets, and total liabilities. The sample includes issuers with a
total equity market capitalization of $7.75 trillion. For comparison, the total U.S. equity
market capitalization for all issuers listed on the New York Stock Exchange (“NYSE”)
and the National Association of Securities Dealers Automated Quotations (“NASDAQ”)
as of December 31, 2003 was approximately $15 trillion.97 The market capitalization of
the large issuer sub-sample is approximately 75 times that of the random issuer sub-
sample.
TABLE II (A)(2): Size of Issuers in Sample
Sub-Samples
Full Sample
(n=200)
(million)
Large Issuers
(n=100)
(million)
Random Issuers
(n=100)
(million)
U. S. Market Capitalization of Common
Stock a $7,771,753 $7,670,538 $101,215
Total Assets b $12,418,041 $12,242,146 $175,895
Total Liabilities b $10,219,198 $10,089,973 $129,225
a These data were collected directly from the NYSE and the NASDAQ, for issuers traded on those exchanges. These
values do not include market capitalizations of issuers in the sample that were not traded on these two exchanges,
however, this omission is estimated to affect the total market capitalization for the random issuer sub-sample by less
than 1%.
b These data were collected from the face of the balance sheet in the 10-K or 10KSB filing.
Total assets for the sample issuers are $12.4 trillion, virtually all of which relate to
the large issuers. Total assets for the large issuer sub-sample are almost 70 times as large
as total assets for the random issuer sub-sample. Total liabilities for the sample are $10.2
trillion, virtually all of which relate to the large issuer sub-sample. Total liabilities for the
large issuer sub-sample are approaching 90 times as large as total liabilities for the
random issuer sub-sample.
97U.S. market capitalization figures for all issuers on the NYSE and the NASDAQ were obtained directly
from these markets as of December 31, 2003.
30
Table II(A)(3) describes the industry membership of the issuers in the sample.
Note that our sample has a relatively large representation of manufacturing issuers and
finance, insurance, and real estate issuers. These relative emphases are largely consistent
in the sub-samples.
TABLE II(A)(3): Industry Membership of Issuers in Samplea
Sub-Samples
Full Sample
(n=200)
(%)
Large Issuers
(n=100)
(%)
Random Issuers
(n=100)
(%)
Mining, Oil & Gas, and Construction 3.5 1 6
Manufacturing 38.5 50 27
Transportation, Communication, Electric,
Gas, & Sanitary Services 11.5 9 14
Wholesale & Retail Trade 6.5 8 5
Finance, Insurance, & Real Estate 24 24 24
Services 15 8 22
Non-Classifiable 1 0 2
a These data were collected from the cover page of each issuer’s 10-K or 10KSB filing.
Table II(A)(4) describes the year-ends of the issuers in the sample. The majority
of issuers in our sample had December 31 year-ends.
TABLE II(A)(4): Year Ends of Issuers in Samplea
Sub-Samples
Full Sample
(n=200)
(%)
Large Issuers
(n=100)
(%)
Random Issuers
(n=100)
(%)
June-November 2003 Year End 17 16 18
December 2003 Year End 75 77 73
January-May 2004 Year End 8 7 9
a These data were collected from the cover page of each issuer’s 10-K or 10KSB filing.
Table II(A)(5) describes the distribution of the sample in terms of issuers that file
Form 10-K vs. Form 10KSB. Small business issuers may file form 10KSB instead of
form 10-K. Form 10-K was filed by 87% of the sample issuers and form 10KSB was
filed by the remaining 13%.
31
TABLE II(A)(5): Forms Filed by Issuers in Sample
Sub-Samples
Full Sample
(n=200)
(%)
Large Issuers
(n=100)
(%)
Random Issuers
(n=100)
(%)
Issuers filing Form 10-K 87 100 74
Issuers filing Form 10KSB 13 0 26
a These data were collected from the cover page of each issuer’s 10-K or 10KSB filing.
For each issuer in the sample, data was collected from the 10-K or 10KSB filing
corresponding to the fiscal year-ends described in Table II(A)(4) above.98 The Staff
focused on collecting data that facilitated the measurement of the extent of off-balance
sheet arrangements, both in terms of the extent of issuers involved in such arrangements
and any related dollar amounts.
The Staff extrapolates the findings from the sample to estimate amounts for the
approximate population of active U.S. issuers. The Staff estimates the population of
active U.S. issuers to be approximately 10,100.99 Subtracting the 100 issuers in the large
issuer sub-sample results in 10,000 issuers in the population that are represented by the
random issuer sub-sample. The Staff performs extrapolations by multiplying amounts
from the random issuer sub-sample by a factor of 100 (i.e., 10,000 issuers in the
population divided by 100 issuers in the random issuer sub-sample) and adding amounts
from the large issuer sub-sample. If the extrapolated amounts are percentages, this
calculation is performed using the absolute counts in each sub-sample, after which the
total is divided by 10,100.
III. ARRANGEMENTS WITH POTENTIAL OFF-BALANCE SHEET
IMPLICATIONS
A. Investments in the Equity of Other Entities
1. Nature of Arrangements and Financial Reporting
Requirements
Issuers regularly invest in the equity of other entities. An issuer may invest for
the short term or the long term, for income or capital appreciation, or for strategic
98 As discussed in Section IV, some data related to the implementation of FASB Interpretation No. 46(R)
was also collected from the 10-Q or 10QSB filings of each issuer for the quarter that included May 15,
2004, which would include information about the full adoption of Interpretation No. 46(R) for many of the
issuers in the sample.
99The estimate of the approximate number of active U.S issuers in the population (not including
international issuers filing form 20-F or issuers under the Investment Act) is based on the Staff’s judgment.
The actual number of active issuers is constantly changing. Some issuers discontinue filing because they
no longer meet the reporting requirements, while others are delinquent in their filings and still others
choose to file voluntarily. The estimate of 10,100 (versus the round number 10,000) is not meant to imply
a high level of precision, but, as noted above, is based on the Staff’s judgment, and also is chosen to render
the extrapolation calculations straightforward and easily understood by the reader.
32
purposes, such as expanding its product offerings into new territory, integrating the other
entity’s products or technology with its own, or diversifying its business. Investments
may be purely passive in nature, or may provide the issuer with some level of influence,
or even control, over the other entity. The accounting for investments in other entities
differs based on the level of the investor’s involvement with the other entity.
a. Investments Giving Rise to Neither Influence Nor
Control
Investments that give rise to neither influence nor control are common. These
investments are equivalent in nature to those an individual might hold in an investment
portfolio. Assuming the investment is in publicly traded equity, SFAS No. 115,
Accounting for Certain Investments in Debt and Equity Securities, provides the relevant
accounting guidance for these investments. SFAS No. 115 requires the investment to be
re-measured and presented on the issuer’s balance sheet at its fair value.100 The
requirement to report these investments at fair value (i.e., “mark to market”) raises the
issue of how to account for changes in these fair values (market fluctuations) that occur
during the period the issuer owns the stock of the other entity. Historically, the
accounting for these “unrealized holding gains and losses” has been the subject of much
debate.101
During development of SFAS No. 115 there was some objection to recognizing
the effects of changes in the market price of investments held (i.e., recognizing the effects
of market volatility) in an issuer’s earnings. Those expressing objections argued that
these unrealized holding gains and losses are different in character from income and
expense items that arise from past transactions with other parties. As such, some argued
(and still believe) that the gains and losses are only “potential” gains and losses, rather
than gains and losses that have already occurred, and therefore do not belong in an
issuer’s earnings.
In light of these views, the standard provides for alternative treatments of the
unrealized holding gains and losses. If the “purpose” of the investment is for
“trading,”102 unrealized holding gains and losses must be recognized in earnings each
period. Investments held for other than trading purposes that do not provide the holder
100See SFAS No. 115, paragraphs 3 and 12.
101A realized gain or loss occurs if the issuer actually sells the shares; an unrealized holding gain or loss
occurs when the price of the shares increases or decreases, but the issuer continues to hold the shares. Once
the investment has been liquidated and any gain or loss realized, there is no longer a question as to
recognition of that gain or loss.
102Paragraph 12(a) of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities,
states that “Securities that are bought and held principally for the purpose of selling them in the near term
(thus held for only a short period of time) shall be classified as trading securities. Trading generally
reflects active and frequent buying and selling, and trading securities are generally used with the objective
of generating profits on short-term differences in price.”
33
with either significant influence or control are classified as “available for sale,”103 in
which case the investment is still recorded at fair value, but unrealized holding gains and
losses are excluded from earnings until the investment is ultimately sold and the gain or
loss is realized.104 In the meantime, unrealized holding gains and losses are recorded in
the “other comprehensive income” section of the shareholder’s equity section of the
balance sheet.
As noted above, these investments are only “marked to market” each period if the
equity instruments are publicly-traded. If the instruments are not publicly traded, the
investment is accounted for under the cost method.105 Under the cost method, changes in
value (i.e., unrealized gains and losses) are not recognized in earnings until the
investment is sold. However, if the value of the investment declines (i.e., the investment
is impaired) and this decline is “other than temporary,” a loss should be recognized.106
Determining whether a loss is “other than temporary” is a judgmental assessment, based
on the relevant facts and circumstances.
In addition to the accounting described above, SFAS No. 115 requires disclosures
regarding investments where the issuer has neither significant influence nor control,
including, but not limited to:
• Gross unrealized holding gains and gross unrealized holding losses (separately
reported) for investments classified as “available for sale;”
• Proceeds from the sale of “available for sale” securities; gross realized gains and
gross realized losses on those sales;
• Gross gains and gross losses included in net income related to transfers of
securities from “available for sale” to “trading” categories; and
• Detailed information regarding the gains and losses included in other
comprehensive income and net income.
b. Investments Giving Rise to Influence but Not Control
An issuer’s investment in another entity may give rise to “significant influence”
over the other entity. The term “significant influence” refers to the ability of an issuer to
impact the other entity’s operating and financial policies. Such ability to exercise
influence may be attained, for example, through ownership of voting stock of the other
entity,107 board representation, participation in policy making processes, or technological
103Paragraph 12(b) of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities,
states that “Investments not classified as trading securities (nor as held-to-maturity securities) shall be
classified as available-for-sale securities.”
104SFAS No. 115, Paragraph 16.
105See APB No. 18, paragraph 6a.
106See SFAS No. 115, paragraph 16 and APB Opinion No. 18, paragraph 19h.
107Paragraph 17 of APB No. 18 includes a presumption that an issuer has “significant influence” over
another entity if the issuer owns more than 20% but no more than 50% of the voting stock of that entity.
However, the determination of whether an investor has significant influence often requires judgment.
34
dependency. If an investment in the equity of another entity affords the issuer the ability
to exercise “significant” influence over operating and financial policies of the other
entity, APB No. 18, The Equity Method of Accounting for Investments in Common
Stock, requires that the issuer follow the “equity method” of accounting for this
investment. If, instead, an investment does not afford the issuer the ability to exercise
significant influence, the cost or fair value methods are used. Under the equity method,
the investment is recognized on the issuer’s balance sheet at its initial cost, adjusted over
time for the issuer’s share of changes in the other entity’s changes in net assets (i.e.,
assets less liabilities). The issuer’s share of the other entity’s net income (loss) is
recognized as an increase (decrease) in the investment. Dividends received by the issuer
from the other entity are treated as a reduction of the investment. By way of these
mechanics, the equity method attempts to reflect an issuer’s share in the other entity’s
equity, and changes therein, in the issuer’s investment in the other entity recognized as an
asset on the issuer’s balance sheet. As with other unconsolidated investments,
impairment losses are recognized if the value of the investment declines below its
carrying value and the decline is deemed “other than temporary.”
APB No. 18 has its own set of disclosure requirements, including:
• Name of the entity whose shares the issuer owns;
• Particulars of the issuer’s accounting policies under the equity method;
• Value of each investment based on current quoted market prices, if available; and
• Summarized financial information about assets, liabilities, and result of operations
of the other entities, if the investment is “significant.”
In addition to the requirements of APB 18, Rule 3-09 of the Commission’s
Regulation S-X requires that issuers file as part of their annual report on Form 10-K the
separate financial statements of investments in entities accounted for under the equity
method, if they meet the definition of a “significant subsidiary” under Regulation S-X 1-
02.108 Presenting these separate financial statements of the other entity is intended to
provide added information regarding investments that comprise a significant portion of
an issuer’s assets, equity, or earnings.
c. Investments Giving Rise to Control
If an issuer controls another entity such that the issuer can direct the other entity’s
operations, ARB No. 51, Consolidated Financial Statements, requires the issuer to
“consolidate” that other entity.109 When consolidation is required, the issuer no longer
108See 17 CFR 210.1-02(w) for definition of a significant subsidiary.
109ARB No. 51, paragraph 1, states that “consolidated statements are more meaningful than separate
statements and that they are usually necessary for a fair presentation when one of the companies in the
group directly or indirectly has a controlling financial interest in the other companies.” SFAS No. 94,
Consolidation of All Majority Owned Subsidiaries, eliminated certain exceptions to the general rule under
ARB No. 51 that majority owned entities should be consolidated. These exceptions had allowed certain
controlled entities that were foreign, “non-homogeneous”, and where there were significant non-controlling
35
presents information about its investment in the other entity in terms of a “one-line”
investment account on the balance sheet, but rather, the assets and liabilities of the other
entity are combined with (or added to) the assets and liabilities of the issuer, and the
combined amounts are presented on the issuer’s consolidated financial statements. For
example, the cash of the other entity is combined with the issuer’s cash; the equipment of
the other entity is combined with the issuer’s equipment; the debt of the other entity is
combined with the issuer’s debt; and so on. Likewise, the consolidated income statement
combines the revenues and expenses of the other entity with those of the issuer.
One of the important benefits of consolidating entities controlled by the investor
is similar reporting for all of the assets, liabilities, equity and operating results of the
issuer and entities under the issuer’s direction. If entities are consolidated, an issuer
cannot simply transfer an asset or liability to another entity that it controls and remove
that asset or liability from its balance sheet. Issuers might be motivated to make such
transfers by a desire to move poorly performing assets off the balance sheet or a desire to
reduce the debt outstanding on the balance sheet to improve the appearance of the
issuer’s financial position and liquidity. However, if the other entity is consolidated by
the issuer, these assets and liabilities will be reflected on the consolidated balance sheet,
regardless of which entity (the issuer or a controlled entity) legally “owns” them. Indeed,
a part of the rationale for the consolidation standard was to prevent substantial
obligations and/or losses from being “hidden” in unconsolidated controlled entities.
In most instances, the balance sheet of an issuer that consolidates another entity
would reflect the same net assets (i.e., assets less liabilities) as if the investment in the
stock of that entity had been accounted for using the equity method of accounting.
However, under the equity method of accounting the issuer “nets” the assets and
liabilities of the other entity and reports them on one line on the balance sheet. Similarly,
the income statement of an issuer that consolidates another entity would generally reflect
the same net income as if that entity had been accounted for using the equity method.
Again, the difference lies in the level of detail provided to the user of the financial
statements.
There are no specific disclosures related to consolidated entities. Rather,
disclosures are provided related to the assets and liabilities of the consolidated entities
just as they are for the issuer’s own assets and liabilities.
2. Off-Balance Sheet Issues in Accounting for Investments
The fact that so many different accounting treatments exist for these investments
certainly raises the question of whether each is necessary. Of course, multiple methods
are appropriate if each is used to reflect substantively different circumstances. In
analyzing the accounting for investments in other entities, the sub-section immediately
below begins by considering the guidance for determining which approach to use. Since
the largest difference in accounting, especially as it relates to whether assets or liabilities
shareholders (minority interests). The exception in ARB No. 51 for temporarily controlled entities was
eliminated through the issuance of SFAS No. 144, Accounting for the Impairment or Disposal of Long-
Lived Assets.
36 are on or off the balance sheet, is between consolidation and any of the other methods, we
begin with the consolidation guidance.
a. Consolidation
As discussed above, the accounting guidance generally relies on the concept of
control to determine which entities to consolidate. Using control as the criterion for
consolidation has been the generally accepted standard for decades, and the standard-
setters have gradually eliminated exceptions to this general rule over time.110 This
approach provides consistency, and is a concept the Staff believes users can readily
understand, even if determining whether control exists is sometimes a difficult
question.111
Even before the Enron and other scandals, standard-setters had concluded that an
approach focused on legal or voting control was often not effective in addressing the
question of consolidation of special purpose entities. The nature of many SPEs is that
they are designed so that all of their significant activities are “pre-programmed” or built
into the operating structure of the entity at formation, such that voting control is
irrelevant. The FASB recently issued an interpretation of the general consolidation rule
under ARB No. 51 (i.e., Interpretation No. 46(R)) which seeks to identify the party that
effectively controls the entity through an analysis of the risks and rewards of the SPE.112
The addition of Interpretation No. 46(R) to the consolidation guidance has improved the
guidance for assessing consolidation of SPEs.
Since the issuance of Interpretation No. 46(R), an investor must determine
whether the investee is a Variable Interest Entity or a Voting Interest Entity. This
determines which consolidation approach—voting control or risks and rewards—is used
in evaluating whether the other entity needs to be consolidated. Once an issuer identifies
an entity that is required to be analyzed under the risks and rewards approach, additional
analysis is required to measure the exposure to risks and rewards of the entity. We
discuss Interpretation No. 46(R) in more detail in Section IV of this Report.
b. Unconsolidated Investments
As discussed above, investments in the equity of another entity that do not
provide the issuer with control are accounted for using four different methods. In
general, the Staff believes that the number of potential methods for these investments
should be reduced, as the different methods do not always correspond to investments with
110See SFAS No. 94, paragraph 9 and paragraph C2.a of SFAS No. 144.
111Including: when minority shareholders have significant participatory rights (EITF 96-16, Investor’s
Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority
Shareholder or Shareholders Have Certain Approval or Veto Rights), and where control may exist due to
contractual relationships rather than ownership (EITF 97-2, Application of FASB Statement No. 94 and
APB No. 16 to Physician Practice Management Entities and Certain Other Entities with Contractual
Management Arrangements).
112As noted previously, Interpretation No. 46(R), discussed in detail in Section IV of this Report, addresses
the accounting for Variable Interest Entities, which are generally understood to include the subset of
entities typically referred to as SPEs.
37
differing economics. Some support the equity method by arguing that significant
influence over another entity is a trigger that should change the accounting. Others
suggest that equity method investments should be reported at fair value. Still others
argue that fair value should not be used when that value is not evident from public market
transactions. Although all of these views have merit, the Staff nonetheless believes that
exploring the approach of recording all investments in other entities that do not result in
consolidation at fair value is warranted.
The benefits of reducing the number of alternative accounting treatments for
unconsolidated investments would include: 1) increased transparency for financial
statement users, 2) reduced complexity for financial statement preparers, 3) reduced
likelihood that investments with similar underlying economic characteristics are
presented differently in the financial statements, and 4) reduced incentives to structure
investments in an effort to achieve a particular accounting treatment. For example, an
issuer investing in another entity that is likely to incur losses in the short term may
currently have an incentive to structure its investment to avoid the equity method,113
because it would require the investor to recognize its share of these losses.
3. Empirical Findings from Study of Filings by Issuers
In this section the Staff presents empirical findings from the Study of filings by
issuers related to investments in other entities. The Staff also extrapolates from these
findings to estimate amounts related to the approximate population of active U.S. issuers.
Table III(A)(1) describes the percentage of issuers reporting investments in the
equity of other entities. Almost 96% of the sample issuers present financial reports that
consolidate one or more other entities. As indicated in the table, approximately 50% of
the sample issuers report equity-method investments, and approximately 36% report cost-
method investments. Approximately 58% and 18% of the sample issuers report
investments categorized as “available for sale” and “trading”, respectively.114 An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that approximately 24% of the population of issuers report equity-
method investments, approximately 17% report cost method investments, approximately
37% report available-for-sale investments and approximately 6% report trading
investments.
113See, for example, EITF Issue No. 02-14, Whether an Investor Should Apply the Equity Method of
Accounting to Investments Other Than Common Stock.
114 Two-thirds of those issuers reporting trading investments are large banks, financial institutions,
insurance companies, and the like.
38
TABLE III(A)(1): Issuers Reporting Investments in the Equity of Other Entities
Sub-Samples
Categorized by Accounting
Treatment a Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers presenting consolidated
financial statements b 95.5 100 91 91.1
Issuers reporting equity method
investments c 50.5 78 23 23.5
Issuers reporting cost method
investments c 36 55 17 17.4
Issuers reporting available-for-sale
investments c 58 79 37 37.4
Issuers reporting trading
investments c 17.5 29 6 6.2
a These categories are not mutually exclusive.
b Determined by observation of the face of the balance sheet; issuers presenting consolidated financial statements will
include the term “Consolidated” in the titles of each statement.
c Determined by examining the notes to the financial statements of issuers that report “Investments” to ascertain
whether these investments are accounted for as “trading,” “available for sale,” “cost method,” or “equity method
investments.”
Table III(A)(2) presents reported amounts related to equity method investments,
where such amounts can be determined. As discussed above, the amount presented on
the balance sheet for equity method investments represents the issuer’s interest in the net
assets of the other entity. For our sample of issuers, the total value on the balance sheet
for equity-method investments is reported at approximately $146 billion. A total of
almost $18 billion in income related to equity method investments is reported on the
sample issuers’ income statements.
TABLE III(A)(2): Reported Amounts Related to Equity Method Investments a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Equity method investments reported
on issuer balance sheet a $145,914 $143,318 $2,596 $402,918
Income (loss) from equity method
investments reported on issuer
income statements a $17,664 $17,462 $202 $37,662
a These data were collected from the notes to the financial statements and supplemental exhibits.
It is important to note that disclosure of the amount on the balance sheet related to
equity method investments may not be required, absent other factors that make the
39
information material to investors. For example, if the investment does not meet certain
requirements that designate it as “significant,”115 the amount reported for the investment
may be combined with other items on the balance sheet and presented as “other assets”
with no further breakdown of the other asset categories required. In this case, investors
may not be able to determine the existence of some equity method investments (or other
types of investments) from the issuer’s filing.
If the investment is “significant,” disclosures about the financial position and
operating results of the other entity may be required in the notes to the financial
statements or in supplemental exhibits. The Staff notes that, due to the varying
placement of the disclosures and the different levels of disclosures required, it may
sometimes be difficult for investors to fully comprehend the extent of an issuer’s
involvement with equity method investments and to compare such involvements across
issuers. As a result, the Staff acknowledges that the values reported in Table III(A)(2)
may be understated.
In reviewing the sample data, the Staff notes that fair values of equity method
investments are not disclosed in many cases.116 Where fair values were reported, the
Staff notes that there is little, if any, correlation among the fair values, the value reported
on the issuer’s balance sheet under the equity method, and the underlying equity in the
other entity.
B. Transfers of Financial Assets with Continuing Involvement
1. Nature of Arrangements and Financial Reporting
Requirements
Issuers often transfer financial assets (e.g., customer receivables, notes,
mortgages, bonds) to other parties. In this subsection, we discuss the “derecognition” of
financial assets; that is, when is it appropriate for an issuer to consider financial assets to
be sold, and remove them from the balance sheet. If the transfer is treated as a sale (i.e.,
if it receives “sale accounting”), the issuer would record the receipt of cash, remove (i.e.,
“derecognize”) the assets from its balance sheet, and report any gain or loss in the income
statement. If a transfer of financial assets does not qualify for sale accounting, it is
instead accounted for as a borrowing. In these cases, the issuer transferring the assets
would record the receipt of cash, but would not remove the assets from its balance sheet,
and would not report any gain or loss in the income statement. Further, the issuer
transferring the assets would recognize a liability for the full amount of cash received
from the other party.
In a simple example, consider an issuer selling $1 million in customer receivables
to a finance company without recourse or further obligation on either party’s part. The
issuer receives cash today and its customers’ future payments are sent to the finance
115See Regulation S-X Rules 3-09 and 4-08(g).
116Paragraph 20(b) of APB No. 18 indicates that the “For those investments in common stock for which a
quoted market price is available, aggregate value of each identified investment based on the quoted market
price usually should be disclosed.”
40
company. In this case the finance company bears all the risk and, assuming no fraud or
other irregularities, the issuer is not required to reimburse the finance company if its
customers default. In this case, since the issuer surrenders all rights and retains no
obligations associated with ownership of the receivables, the transfer would typically be
treated as a sale.
In other arrangements, the issuer may continue to be involved with the transferred
assets. For example, an issuer might transfer customer receivables to a finance company
for cash, but accept an obligation to reimburse the finance company in the event that the
issuer’s customers default. Consider a transfer of $1 million in customer receivables
similar to that above, except that the issuer guarantees up to $10,000 of the amounts
transferred. Such a transfer would typically still be treated as a sale, since the continuing
obligation to which the issuer is exposed is relatively small, and does not result in the
issuer continuing to control the transferred assets..
The transaction looks less like a sale as the continuing involvement increases.
Indeed, in some cases, a transfer of financial assets with extensive continuing
involvement might be economically indistinguishable from a borrowing secured by the
“sold” assets. Consider a similar transfer of $1 million in customer receivables where the
issuer guarantees 100% of the amounts transferred, such that the issuer must reimburse
the finance company for any and all customer defaults. This transaction clearly has
economic similarities to a secured borrowing since the issuer has received cash today and
is obligated to remit cash to the finance company in the future, regardless of whether or
not its customers pay.
SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, provides the guidance for determining whether all, or any
portion of, a transfer of financial assets should be accounted for as a sale, in cases where
there is continuing involvement. SFAS No. 140 focuses on the concept of “control” of
the transferred financial assets; if control is deemed to be relinquished, the transaction is
treated as a sale. However, SFAS No. 140 does not impose a “sale” or “no sale”
determination for the entire transaction. Instead, what has been dubbed a “financial
components” approach is taken, such that the issuer continues to record as an asset any
portion of the original asset that it continues to control after the transfer, and removes
from its balance sheet the portion that it no longer controls. Thus, if control over only a
portion of the assets has been given up, an issuer would account for only that portion as
sold. The issuer would continue to include in its financial statements any portion of the
assets it did not sell and recognize any other assets or liabilities related to its continuing
involvement with the portion of the assets sold.
In our example above where the issuer guaranteed up to $10,000 of the amounts
transferred, assuming that sale accounting were appropriate, the issuer would recognize
the receipt of the cash, remove the customer receivables from its balance sheet, and
recognize a liability related to the $10,000 guarantee. If, in addition to the guarantee, the
issuer retained an undivided interest in 20% of the receivables, then the issuer would
recognize the receipt of the cash, remove only 80% of the receivables’ carrying value
41
from its balance sheet, and recognize a liability related to the $10,000 guarantee.117 In
the example above where the issuer guaranteed 100% of the amounts transferred, it is
likely that the transfer of the customer receivables would not receive sale accounting. In
this circumstance, as described above, a liability will be recorded to reflect the issuer’s
obligation to repay the full amount received to the finance company.
It is noteworthy that, under this approach, transfer of control remains the key
criterion (as opposed to, say, some measure of risks and rewards), albeit applied to each
component of the transaction. In this context, transfer of control is generally considered
to have occurred for accounting purposes if:118
• The assets have been “isolated” from the issuer transferring the assets119 (that is,
put presumptively beyond the reach of the issuer or its creditors even in
bankruptcy);
• The purchaser120 is not restricted from selling the assets or using them as
collateral for a loan; and
• The issuer transferring the assets does not continue to maintain effective control
over the assets by keeping a right or obligation to repurchase or redeem the assets
before their maturity.
Transfers of financial assets often take more complex forms than the simple
scenarios discussed above. For example, financial assets are often transferred into a
special purpose entity, which issues securities or commercial paper in order to fund the
purchase of the financial assets. If the SPE issues securities, the transaction is commonly
described as a “securitization” of those financial assets.121 If the transaction involves the
transfer of mortgage loans and a related guarantee (such as one from a government-
sponsored agency), it is referred to as a “guaranteed mortgage securitization.” If the SPE
issues commercial paper, it might be referred to as a commercial paper conduit.
There are several reasons why issuers engage in these more complex transactions,
such as to enhance liquidity, manage risks, and/or to obtain lower-cost funding. In order
to achieve lower-cost funding, issuers generally maintain at least some level of
continuing involvement in the transferred assets that provides protection (i.e., from credit,
interest rate, or other risks) to the purchasers of the securities or commercial paper issued
by the SPE. For example, a seller may provide credit enhancement through over-
collateralization of the assets sold. In a common type of over-collateralization, the seller
117This would assume that all the criteria to qualify for sale accounting in paragraph 9 of SFAS No. 140
have been met.
118See SFAS No. 140, paragraph 9.
119This is a facts and circumstances determination, and often requires the advice of outside attorneys.
120When the purchaser is a QSPE (as is discussed below), this criteria applies to restrictions on the QSPE’s
interest holder.
121Paragraph 364 of SFAS No. 140, defines a securitization as “the process by which financial assets are
transformed into securities.”
42
would sell assets worth, say, $100 for $90, while retaining the right to the last $10
collected on those assets. Other types of continuing involvement include derivative
transactions with the SPE,122 cash reserve accounts,123 guarantees,124 and/or servicing
obligations for the underlying assets. In the context of a securitization, the assets and
liabilities related to an issuer’s continuing involvement in the transferred assets are often
referred to as “retained interests.” Both the economics and the structural forms of these
contracts have evolved rapidly in recent years, in order to take advantage of opportunities
in financial markets and, at times, to achieve specific accounting results.
When an SPE is involved, in addition to determining whether or not sale
accounting is appropriate, there is also a need to determine whether the transferor is
required to consolidate the SPE for accounting purposes. If an issuer transfers financial
assets to an SPE in a transaction qualifying for sale accounting, but the SPE is
consolidated, the sale accounting allowed by SFAS No. 140 would be effectively
negated. That is, the issuer would recognize the outstanding portion of the assets
transferred on its consolidated balance sheet, as well as a liability reflecting the SPE’s
obligation to its debt-holders.
In order to facilitate sale accounting in securitization transactions, the accounting
guidance includes an exception to the consolidation requirements for certain SPE’s
commonly used in securitization transactions. In many cases the SPE in a securitization
transaction can be described as being on “auto-pilot”—i.e., it merely collects cash flows
on the financial assets and pays those cash flows to investors, but does nothing else, such
that, in essence, no one controls or needs to control the operations of the entity. In such
cases, since all decisions are preprogrammed by the legal documents that create the SPE,
it has been argued that there is no need for any party to be deemed to control the entity—
and thus, no justification for consolidation. The FASB denoted this type of SPE as a
“qualifying” SPE or “QSPE” to differentiate it from other SPEs.125
SFAS No. 140 also requires the following disclosures (among others): 126
• Total outstanding amounts of securitized assets, the portion that has been
derecognized, and the portion that continues to be recognized on the balance sheet
(e.g., as retained interests); and
• Amounts of, delinquencies on, and net credit losses related to securitized assets
plus any other assets the issuer manages with them;
122See discussion on derivatives in Section III(F).
123A cash reserve account is a form of credit protection provided by the seller and is typically funded from a
portion of the seller’s proceeds from the securitization transaction. Losses of principal and/or interest in the
entity generally would be borne first by the cash reserve account up to the amount funded in such account,
thus providing a form of credit enhancement to the third-party investors.
124See discussion on guarantees in Section III(E).
125See SFAS No. 140, paragraph 46 and Interpretation No. 46(R), paragraph 4(c).
126See SFAS No. 140, paragraph 17 a complete list of the disclosure requirements.
43
In addition, SFAS No. 140 requires the following disclosures for each
securitization asset type (such as credit card receivables, mortgage loans or automobile
loans):
• The characteristics of the securitization—that is, a description of the issuer’s
continuing involvement with the securitized assets and the amount of gain or loss
on sale;
• Cash flows between the issuer and the SPE;
• The issuer’s accounting policies for initially and subsequently measuring any
retained interests;
• Key assumptions in measuring the fair value of the retained interests; and
• Sensitivity analysis showing the effects of changes in the key measurement
assumptions.
The Commission’s Financial Reporting Release No. 67 (known as FR 67)
mandated by section 401(a) of the Act, also requires additional disclosures in the Off-
Balance Sheet section of MD&A regarding certain off-balance sheet arrangements. FR
67 requires issuers to provide disclosures about securitization transactions that involve
transfers to an unconsolidated entity with the issuer having retained or contingent
interests in the unconsolidated entity. Disclosure is required to the extent necessary to
provide an understanding of the issuer’s material off-balance sheet arrangements as well
as the material effects of those arrangements. For securitization transactions these
disclosures may include:
• Nature and business purpose of the arrangement, including a description of the
retained or contingent interests in assets transferred that serve as credit, liquidity,
or market risk support for the assets;
• Importance of the arrangement to liquidity, capital resources, market risk or credit
risk support, or other benefits;
• The financial impact of the arrangements and the issuer’s exposure to risk as a
result of the arrangements (e.g., retained interests or contingent liabilities); and
• Known events, demands, commitments, trends or uncertainties that affect the
availability or benefits of such arrangements.
2. Off-Balance Sheet Issues in Accounting for Transfers of
Financial Assets
During the development of the guidance related to transfers of financial assets, the
FASB noted that transfers of financial assets in which the seller has some continuing
involvement (either with the transferred assets or with the purchaser) had grown
significantly in volume, variety, and complexity.127 With this in mind, the FASB set out
127See SFAS No. 140, paragraph 116.
44
to develop an approach that would be more responsive to developments in the financial
markets. The financial components approach was designed to be consistent with the way
market participants deal with financial assets, recognizing that the financial marketplace
can contractually separate and repackage the cash flows associated with financial assets
in many ways. The financial components approach was also designed to reflect the
economic consequences of contractual provisions underlying the financial assets and
liabilities, and conform to the FASB’s conceptual framework.
Application of the financial components approach may be challenging, as many of
these transactions (e.g., securitizations) can be complex and highly structured. For
example, it is often necessary to obtain legal opinions from attorneys with specific
expertise in these transactions. Additionally, determining the fair value of the various
components of the transaction, including any retained interests, requires the exercise of
judgment and may also involve subjective estimations, raising questions about the
preciseness of both the fair values and of gains or losses recorded upon the sale of the
financial assets. Nevertheless, the financial components approach, in general, provides a
consistent approach to derecognition, and is a substantial improvement from the
incomplete and sometimes inconsistent guidance that existed before that approach was
adopted. The financial components approach is also more flexible than an “all or
nothing” approach that would look at each instrument only as whole.128
As discussed above, an alternative to using control as a basis for determining
which assets to record is a “risks and rewards” approach. Those who support a risks and
rewards approach to derecognition often suggest that an approach that focuses on control
of the financial assets makes it possible to have economically similar transactions treated
differently for accounting purposes. For example, consider an issuer selling customer
receivables and specifying in the sale agreement that it could, at some later date, select
from among those receivables a small portion to repurchase at a fixed price. Since any
individual receivable could be repurchased under this provision, according to SFAS No.
140 the issuer is deemed to have retained control over the entire pool of assets, even
though the issuer might not participate significantly in the risks and rewards associated
with the asset pool. As a consequence of this retained control, this transfer would not
qualify for sale accounting under SFAS No. 140.
Although there is debate about whether the guidance in SFAS No. 140 is
effective, much of the controversy is caused not by the standards themselves, but by
transaction structuring. Issuers often structure transfers in order to achieve or avoid sale
accounting, trigger or avoid the recognition of losses (or gains), or change the
measurement attribute applied to the recorded assets and liabilities. The Staff believes,
based on its reviews of issuer filings, that the most frequent structuring goal is to achieve
sale treatment without consolidation of any related SPEs. While economic motivations
for most asset transfers exist, some transfers of financial assets appear to be significantly,
primarily, or even solely entered into with accounting motivations in mind.
128In contrast, lease accounting, discussed in Section III.D, takes such an “all or nothing” approach.
45
Some of this structuring has been undertaken by using QSPEs in situations that
appear to the Staff to be beyond those originally contemplated by the FASB. The FASB
originally intended a QSPE to be merely a pass-through entity to essentially serve as
custodian of the underlying financial assets,129 and attempted to define it in such a way as
to ensure that this was the case. There are restrictions on the types of assets that an SPE
can hold while remaining “qualified,” and when it is acceptable for the QSPE to dispose
of certain non-cash financial assets.130 Although the limitations on the activities of
QSPEs do not permit the QSPE to manage the assets on its balance sheet, there are few
explicit limitations on managing the balance sheet liabilities.131 That is, in structures
where the QSPE holds longer term assets and funds the purchase of such assets through
the issuance of shorter term interests to investors, decisions have to be made regarding
the nature of the new interests to be issued when the original short term interests mature.
In practice, these decisions are made by the issuer transferring the financial assets.
Accountants and auditors have concluded that the SPE – despite such management of
liabilities -- is a QSPE under SFAS No. 140, and is therefore exempt from consolidation.
These and other interpretations of the QSPE guidance have expanded the activities of
QSPEs beyond the simple pass-through entities originally envisioned by the FASB.132
Despite persistent work by the FASB133 and the Commission, the Staff considers
the accounting for sales of financial assets to be in need of improvement. Indeed, the
FASB already has several projects on its agenda relating to transfers of financial assets.
However, this area is challenging to standard setters, in large part because financial
structures are virtually limitless and continue to evolve at a rapid pace. However,
because the areas in need of improvement in their accounting stem mainly from
structured transactions that have accounting motivations, improvement in transparency
and comparability across issuers can perhaps most directly and quickly be accomplished
by eliminating the use of such structured transactions.
3. Empirical Findings from Study of Filings by Issuers
In this section the Staff presents empirical findings from the Study of filings by
issuers related to transfers of financial assets. The Staff also extrapolates from these
findings to estimate amounts related to the approximate population of active U.S. issuers.
Table III(B)(1) describes the percentage of issuers reporting transfers of financial
assets. As indicated in the table, approximately 17% of the sample issuers report
129See SFAS No. 140, paragraph 177.
130See SFAS No. 140, paragraph 35.
131The FASB is currently considering these and other issues as part of a project to amend SFAS No. 140.
132In acknowledging these interpretations, the Staff does not intend to signify its agreement with them.
133For example, the FASB previously amended and added to the guidance in SFAS No. 125 through the
issuance of SFAS No. 140. Additionally, the FASB staff addressed 123 interpretive questions in a Special
Report, A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities. More recently, the FASB has undertaken a project to
amend the guidance in SFAS No. 140.
46
transfers of financial assets, mainly via securitizations, and most of these issuers are
members of the large issuer sub-sample. Approximately 13% of issuers report retained
interests related to these transfers and, again, most of these issuers are members of the
large issuer sub-sample. An extrapolation of the findings from the sample to the
approximate population of active U.S. issuers suggests that approximately 4% of the
population of issuers report transfers of financial assets, and approximately 3% report
retained interests from their continuing involvement with these assets.
TABLE III(B)(1): Issuers Reporting Transfers of Financial Assets
Sub-Samples
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers reporting transfers of
financial assets a 17 30 4 4.3
Issuers reporting retained interests a 13 23 3 3.2
a These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
Table III(B)(2) presents reported amounts related to transferred financial assets.
Our sample of issuers reports approximately $791 billion in financial assets that were
transferred, and moved off issuer balance sheets, but are still outstanding. In addition,
our sample of issuers reported net gains of approximately $10 billion related to the sale of
financial assets during 2003. Our sample issuers report approximately $161 billion in
assets and liabilities related to the issuer’s continuing involvement with these assets. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that financial assets reported by the population as transferred but
still outstanding are close to $1 trillion, and that assets and liabilities reported by the
population as representing their continuing involvement in these transferred assets are
approximately $186 billion.
47
TABLE III(B)(2): Reported Amounts Related to Financial Assets Transferred a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Financial assets transferred off
issuer balance sheets but still
outstanding $790,925 $789,325 $1,600 $949,325
Gain/loss on transfers of financial
assets reported on issuer income
statements $10,287 $10,047 $240 $34,047
Retained interests reported on issuer
balance sheets $161,175 $160,928 $247 $185,628
a These data were collected from the notes to the financial statements.
Table III(B)(3) presents reported amounts for some of the major classes of
retained interests reported by our sample of issuers. Interest-only strips,134 recorded as
assets on the issuer’s balance sheet, total approximately $5.6 billion for the sample. Of
the various types of retained interests, these are typically the most subordinate, and
consequently carry the highest concentration of risk. Servicing assets,135 which carry risk
primarily related to prepayments, total approximately $23 billion for the sample. The
remainder of the retained interests, approximately $133 billion, includes but is not limited
to various types of more senior interests that, by their nature, are apt to carry lower risk
concentrations.
TABLE III(B)(3): Reported Amounts Related to Major Classes of Retained
Interests a
Sub-Samples
Type of Retained Interest Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Interest-only Strip $5,628 $5,540 $88 $14,340
Servicing Assets $22,677 $22,518 $159 $38,418
Other Retained Interests b $132,870 $132,870 $0 $132,870
a These data were collected from the notes to the financial statements.
b These interests would include amounts representing, for example, overcollateralizations, senior or mezzanine bond
interests, and seller’s interests in credit card securitizations.
It appears that some issuers exclude information regarding securitization
transactions from their disclosures if they did not retain a subordinate interest, such as an
134Interest-only strips are instruments that entitle the holder to a portion of the interest payments made on a
pool of loans or debt securities
135Servicing assets involve the right to payments similar to an interest-only strip in return for collecting and
dispersing payments made on the underlying loans.
48
interest-only strip, following the transactions. Further, the Staff notes that the sample
issuers disclosed relatively little information regarding transactions with commercial
paper conduits, such as transfers of trade receivables.
C. Retirement Arrangements
1. Nature of Arrangements and Financial Reporting
Requirements
Many companies provide employees with retirement benefits. Cash payments
under pension plans are the most common, but other benefits, such as health-care
insurance, are also offered. Due in part to the magnitude of the obligations under these
plans, the significance of the unfunded or underfunded status of plans, and the
uncertainty inherent in measuring the obligations, the accounting for certain retirement
benefits has long been controversial. However, with the aging population, concerns over
the future of the social security system, and companies reducing or eliminating retirement
benefits altogether, discussions regarding the accounting for employee retirement benefits
occur at the highest levels within the U.S. government, corporate-America and the
workforce.
There are two primary types of pension benefit plans: defined contribution and
defined benefit. Under a defined contribution plan, the employer provides contributions
to the plan based upon its agreements with employees and its policies, but has no further
obligation to provide benefits under the plan. The future risks and rewards of these plans
rest with employees, not employers. Thus, the accounting for defined contribution plans
is quite straightforward and does not raise significant off-balance sheet questions; as
such, the accounting for these plans is not addressed in this Report.
In contrast, under a defined benefit plan, the employer is at risk and is obligated to
ensure that employees receive the predetermined benefits after retirement. An employer
might simply choose to pay such benefits as they become due. However, most issuers set
up a separate legal entity (usually a type of trust) to hold and manage retirement assets
and make the related payments. Even when a separate entity is established to accumulate
assets to fund pension benefits, the employer’s obligation is not satisfied merely by
making contributions to the plan. Because of its responsibility to ensure there are
sufficient assets to pay plan benefits, the employer retains the risk of underperforming
assets, and receives the benefit when those assets perform better than expected. Subject
to certain limitations in employment law, the employer, or a representative appointed by
the employer, also generally determines the plan’s investments.
Based on our discussions in the previous sections, and in view of the employer’s
continuing involvement and risk, it might seem that a separate legal entity that is
established to hold and manage pension plan assets and that is controlled by the issuer
should be consolidated. If consolidated, plan assets and liabilities would be separately
recognized on the issuer’s balance sheet. However, defined benefit pension plans are
exempt from consolidation.136 Instead, the retirement plan assets and liabilities, to the
136See, for example, Interpretation 46(R), paragraph 4(b), and SFAS No. 87, paragraphs 35-37.
49
extent recognized, are netted against each other, with only the net asset or net liability for
each plan recognized on the issuer’s balance sheet.137
It is generally accepted that any liability for pension-related costs should be
recognized by the employer as its employees perform service. Pension and other
retirement plan costs are determined by developing best estimates of future benefit
payments, taking into account a number of factors, to the extent such factors are relevant,
including the employee’s age, length of service, retirement date, salary, expected trends
in medical costs, expected mortality. These estimated future benefit payments are then
discounted to their present value. Due to the complexities involved in estimating pension
obligations, actuaries are typically involved. Given the long-term nature of pension
plans, changes in the estimates and assumptions over time are expected. The accounting
guidance for these plans does not require adjustments to the pension obligation as a result
of changes in the estimates and assumptions to be recognized immediately.138 Similarly,
differences between expected and actual returns on assets need not be recognized
immediately. All of these items, which are collectively referred to as pension gains and
losses, may be deferred and factored into the pension obligation or asset reported on the
balance sheet over future periods.
The approach to accounting for defined benefit pensions is designed to ensure that
the related pension costs are recorded over the service lives of the employees and that the
recorded obligation is sufficient to reflect all benefit payments obligations before they
become due. However, companies are afforded discretion under the guidance as to when
gains and losses are recorded during the service period, so long as they are recorded by
the time the obligations become due. An issuer that does not elect to defer pension gains
or losses as permitted by the accounting guidance will report a net retirement plan asset
or liability that is determined based on the fair value of the assets in the plan, and the
then-current best estimate of the retirement obligation. That issuer would likely report
significant volatility in its pension expense, as any changes in actuarial estimates and
assumptions would be immediately recognized, as would actual returns on pension plan
assets. On the other hand, an issuer that elects to defer pension gains and losses would
report much smoother pension expense from period to period, but would report a net
retirement plan asset or liability that could be affected as much by deferrals of gains and
losses as by actual changes in assets and obligations.
The FASB attempted to mitigate the effects of smoothing pension expense and
reduce the amount of retirement liability that may be off-balance sheet, by instituting a
“minimum liability rule.”139 If issuers choose to defer pension gains and losses, they
137In part, this acknowledges the fact that under U.S. employment law, there are certain protections of
retirement benefits so long as the company funds its pension plans adequately and meets other
requirements. See Employee Retirement Income Security Act of 1974.
138SFAS No. 87, Employers’ Accounting for Pensions and SFAS No. 106, Employers’ Accounting for
Postretirement Benefits Other Than Pensions, are the primary accounting standards related to accounting
for retirement benefits.
139See SFAS No. 87, paragraph 36. Health-care and other postretirement benefit plans are not subject to the
minimum liability rule.
50
must recognize a liability of at least the amount by which the accumulated benefit
obligation (“ABO”), which is defined as the best estimate of the present value of future
pension payments without taking into account future salary increases, exceeds the fair
value of pension plan assets.140 However, even with recognizing the minimum liability, a
significant amount of an issuer’s pension obligation may remain off-balance sheet, since
the determination of the minimum liability is based on the ABO, rather than the projected
benefit obligation (“PBO”), a projection of benefit obligations which considers the effects
of expected future salary increases.
Extensive disclosures are required for pensions and other postretirement benefit
plans.141 These disclosure requirements are intended to provide financial statement users
a more complete picture of the retirement plans. More particularly, the disclosures are
generally designed to accomplish three tasks. First, they provide consistent information
about benefit plans, no matter what choices have been made regarding balance sheet and
income statement presentation of retirement plan amounts. Second, they provide the
reader with information about certain key assumptions and estimates used in the pension
and postretirement benefit plan calculations. And finally, they explain whether the issuer
has elected to defer any of the gains or losses and provide information about the effect of
deferral.
Required disclosures include:
• A reconciliation of changes in employers’ retirement obligations from period to
period, and a reconciliation of changes in fair values of retirement plan assets
from period to period;
• Funded status of the plan (i.e., the extent to which the retirement obligations ((as
measured by PBO for pensions and ABO for other postretirement benefit plans))
are funded with retirement assets to cover those obligations) and the amounts of
retirement-related obligations that are off-balance sheet;
• Qualitative and quantitative information about how retirement plan assets are
invested;
• Estimates of amounts expected to be contributed to the plan in the subsequent
year and the benefits to be paid to employees in the near term;
• The amount of net periodic benefit cost recognized in earnings; and
140 However, any such increase in liability does not appear on the income statement as a loss. Rather, the
“other side” of the accounting entry is also to the balance sheet, either to an intangible asset or to other
comprehensive income (a component of equity).
141The accounting for other postretirement benefit plans is similar to defined benefit pension plans in that
the issuer is required to estimate and recognize the obligation and related cost of providing such benefits as
the employees perform services. Further, many of the same issues regarding estimation of the obligation,
netting plan assets and liabilities and deferral of certain changes in plan assets and liabilities exist under
other postretirement benefit plan accounting. However, other postretirement benefit plans are often not
funded through the establishment of a separate legal entity.
51
• Key assumptions used in measurement of plan assets, liabilities and retirement
cost, including the dates such measurements were determined.142
2. Off-Balance Sheet Issues in Accounting for Retirement
Arrangements
Some investors have expressed concerns about the transparency of pension and
other postretirement benefit accounting and disclosure. The CFA Institute (formerly the
Association for Investment Management and Research or “AIMR”), a nonprofit
membership organization for investment professionals, recently commented that, because
the pension and other postretirement benefit accounting standard “fails to provide full
recognition in the financial statements of the effects on the firm of the pension and
postretirement benefit contracts, a huge and very costly burden has been shifted to those
for whom the statements are prepared, analysts and other users.”143 Accordingly, some
investors have called for issuers to report actual gains and losses from changes in
expected assumptions versus actual plan results by eliminating the smoothing of gains
and losses currently allowed under GAAP and to separately recognize pension and other
postretirement benefit plan assets and liabilities on the balance sheet. The Staff agrees
that, under the current standards, the balance sheet is often not transparent as to the true
funded status of pension plans and that additional clarity is necessary.
In the deliberations that led to the issuance of the retirement accounting standards
that were in the mid-1980s and early-1990’s, the FASB stated that it would be preferable
conceptually to recognize retirement liabilities and assets with either no delay in
recognition of gains and losses in net income, or with gains and losses reported currently
in other comprehensive income, but not in net income.144 However, it was strongly
argued by issuers that recognizing these short-term gains and losses in the income
statement of the issuer may overwhelm the effects of the issuer’s continuing operations
and thus would not fairly reflect the primary business activities of the issuer.
Furthermore, as noted above, preparers argued that retirement plans are a long-term
commitment, and that the accounting should take a similar long-term view that avoids
excessive short-term volatility, so long as the obligation is recognized by the time it
becomes due. Ultimately, the FASB acknowledged that not permitting the deferral of
certain gains or losses would be “too great of a change from past practice” and was
satisfied that the standards “as a whole represented an improvement in financial
reporting.” However, the FASB also acknowledged that the issuance of such guidance
was only one step toward gradual, evolutionary change.145
142See paragraph 5 et. seq. of SFAS No. 132 Revised.
143See the CFA Institute (formerly AIMR) Comment Letter to the FASB: Re: File Reference No. 1025-200-
Proposed Statement of Financial Accounting Standards: Employers’ Disclosures about Pensions and Other
Postretirement Benefits, Oct. 27, 2003. See also CFA Institute (formerly AIMR) letter to the IASB: Re:
Improvement of IAS 19, Employee Benefits, June 16, 2002, in which CFA Institute states that they are not
in favor of smoothing pension losses and gains.
144SFAS 87, paragraph 107.
145SFAS No. 87, paragraph 107.
52
While the merits of the various positions can be debated, it is true that retirement
plan accounting is at times inconsistent with the accounting for similar assets and
liabilities. For example, there are many liabilities whose ultimate payment amount
depends on future events. When the estimate of the amount to be paid changes, those
other liabilities are adjusted to reflect the change in estimate. However, when estimates
of the amounts of retirement benefits to be paid change, the related liability is not
required to be adjusted immediately, as gains and losses may be deferred. Also, as noted
previously, assets held in retirement plans are not accounted for using the guidance that
would apply to such assets if not held in retirement plans. In addition, the existence of so
many optional treatments is itself a difference between retirement plan accounting and
the accounting for other significant assets and liabilities.
Application of the current pension and other postretirement benefit accounting
guidance has raised other questions. As noted above, estimation of retirement plan
liabilities depends upon multiple actuarial and other estimates and assumptions. Because
of the size of retirement obligations and their sensitivity to certain assumptions, even
relatively small changes in those assumptions or estimates can significantly change the
estimated obligation or pension expense. The Staff has therefore focused on retirement
plan assumptions in its reviews of issuer filings in the past. For example, pension plan
assumptions were identified as a significant issue in the “Summary by the Division of
Corporation Finance of Significant Issues Addressed in the Review of the Periodic
Reports of the Fortune 500 Companies” issued in 2003. That report noted that several
topics which merit improved MD&A disclosures, including information about the
significant assumptions used and how they were determined, sensitivity of the financial
statements to changes in assumptions, and the impact of any planned changes in
assumptions. The selection of appropriate assumptions and the use of judgment in
making estimates of retirement obligations would likely be as important even if the
accounting guidance were changed.
3. Empirical Findings from Study of Filings by Issuers
In this section the Staff presents empirical findings from the Study of filings by
issuers related to retirement plans. The Staff also extrapolates from these findings to
estimate amounts related to the approximate population of active U.S. issuers.
Table III(C)(1) describes the percentage of issuers reporting defined-benefit
retirement plans. Approximately 48% of the sample issuers report defined-benefit
pension plans, while approximately 44% report other postretirement benefit plans.146 The
large issuer sub-sample reports a higher incidence of these plans in that 81% (74%) of
these issuers report defined-benefit pension (other postretirement benefit) plans. In
contrast, in the random issuer sub-sample, only 15% (14%) of the issuers report
information about defined-benefit pension (other postretirement benefit) plans. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that approximately 16% of the total population of issuers report
146Issuers may have many individual plans, but often report information on an aggregate basis.
53
sponsoring defined-benefit pension plans, and 15% report sponsoring other defined-
benefit postretirement plans.147
TABLE III(C)(1): Issuers Reporting Defined-Benefit Retirement Plans a
Sub-Samples
Categorized by Type of Plan b Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers reporting defined-benefit
pension plan(s) 48 81 15 15.7
Issuers reporting other post-
retirement benefit plan(s) 44 74 14 14.6
a These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
b These categories are not mutually exclusive.
Table III(C)(2) presents the reported obligations, plan assets, and funded status
related to defined-benefit pension plans. These issuers report pension benefit obligations
(“PBOs”) of approximately $764 billion and plan assets set aside for pension plans of
approximately $678 billion. Defined-benefit pension plans for our sample of issuers are
thus underfunded, based on this set of measurements, by approximately $86 billion
(approximately 11% of total PBO), which means that the assets set aside for the plan(s)
are less than the estimated obligations related to the plan(s). In an economic sense, this
“underfundedness” represents the net economic liability of an issuer related to pension
plans.
147Ciesielski, J.T., “Ugly OPEBs: Surveying the S&P 500,” The Analyst’s Accounting Observer, November
24, 2004, reports that 14.7% of the 9,852 companies reviewed from S&P’s Research Insight database have
other post-employment benefit plans (which includes other postretirement benefit plans).
54
TABLE III(C)(2): Amounts Reported Related to Funded Status of Defined-benefit
Pension Plans a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Reported PBOs $764,497 $758,882 $5,615 $1,320,382
Reported ABOs $537,522 $533,498 $4,024 $935,898
Reported values of plan assets $678,019 $673,564 $4,455 $1,119,064
Funded Status b
$86,478
(underfunded)
$85,318
(underfunded)
$1,160
(underfunded)
$201,318
(underfunded)
a These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
b The funded status is calculated as the value of reported plan assets less the reported PBO.
These amounts for the sample as a whole are dominated by the large issuer sub-
sample, which reports 99% of both the total reported obligation and the total value of
plan assets for the sample. An extrapolation of the findings from the sample to the
approximate population of active U.S. issuers suggests that defined-benefit pension plan
obligations and assets reported by the population approximate $1.320 trillion and $1.119
trillion, respectively. This extrapolation suggests that pension plans for the population
may be underfunded by approximately $201 billion on a net basis.
Table III(C)(3) presents amounts that are reported on issuer balance sheets related
to defined-benefit pension plans. The sample issuers report pension assets on the balance
sheet of approximately $181 billion and pension liabilities on the balance sheet of almost
$90 billion. Thus, issuers in the Study report a net asset position on the balance sheet for
defined benefit pension plans of approximately $91 billion. The $177 billion difference
between the liability implied by the $86 billion underfundedness (as shown in Table
III(C)(2)) and the $91 billion net asset recognized on the balance sheet is the portion of
the net pension liability that remains off-balance sheet for the sample of issuers in the
Study due to the smoothing allowed by current pension accounting standards.
55
TABLE III(C)(3): Amounts Reported on Issuer Balance Sheets Related to Defined-
benefit Pension Plans a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Pension asset reported on issuer
balance sheets b $181,045 $179,544 $1,501 $329,644
Pension liability reported on issuer
balance sheets $89,960 $89,682 $278 $117,482
Other comprehensive income
reported in equity section of issuer
balance sheets $50,181 $50,134 $47 $54,834
a These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
These items are presented on the balance sheets of issuers, but since balance sheet items are often aggregated, the
detailed data can often only be obtained from the notes.
b This total includes reported prepaid pension benefits of $172,248 (representing those retirement plans in a net asset
positions and intangible assets of $8,797. The intangible assets relate to prior service costs and exist only to offset part
of the additional minimum pension liability.
An extrapolation of the findings from the sample to the approximate population of
active U.S. issuers suggests that net pension assets and net pension liabilities reported on
issuer balance sheets approximate $330 billion and $117 billion, respectively, which nets
to approximately a $213 billion asset position. The underfundedness estimated for the
population and presented in Table III(C)(2) suggests that there may be a net economic
liability related to defined benefit pension plans of approximately $201 billion. Thus,
these extrapolations suggest that a total of approximately $414 billion in net pension
liability may remain off-balance sheet for the approximate population of active U.S.
issuers.
Table III(C)(4) presents the reported obligations, plan assets, and funded status
related to other postretirement benefit plans, as well as any associated amounts reported
on issuer balance sheets. The issuers in our sample report total obligations, denoted as
accumulated postretirement benefit obligations (“APBOs”),148 of almost $260 billion, but
they report total plan assets set aside for other postretirement benefit plans of only
approximately $42 billion (i.e., 16% funded). As a result, other postretirement benefit
plans for our sample of issuers are underfunded by approximately $217 billion
(approximately 84% of the total APBO), which represents the net economic liability for
these issuers related to other postretirement benefit plans. Note that other postretirement
benefit plans are substantially more underfunded than defined-benefit pension plans—in
fact, other postretirement benefit plans are often not funded at all. An extrapolation of
the findings from the sample to the approximate population of active U.S. issuers
suggests that other postretirement benefit obligations and assets reported by the
population approximate $389 billion and $52 billion, respectively. This extrapolation
148Note that GAAP does not require the calculation of a PBO for other postretirement benefit plans; in
general, such benefits are not affected by future salary increases.
56 suggests that other postretirement benefit plans may be underfunded by approximately
$337 billion for the population.149
TABLE III(C)(4): Amounts Reported Related to Funded Status of Other
Postretirement Benefit Plans and Amounts on Issuer Balance Sheets Related to
Other Postretirement Benefit Plans a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Reported APBOs $259,865 $258,560 $1,305 $389,060
Reported Values of plan assets $42,406 $42,306 $100 $52,306
Funded status b $217,459
(underfunded)
$216,254
(underfunded)
$1,205
(underfunded)
$336,754
(underfunded)
Other postretirement benefit plan
assets reported on issuer balance
sheets $693 $693 $0 $693
Other postretirement benefit plan
liabilities reported on issuer balance
sheets $146,741 $146,034 $707 $216,734
a These data were collected from the financial statements in the filings of issuers selected for the Study
b The funded status is defined as the reported value of plan assets less the reported APBO. However, not all issuers
reported the funded status directly—some simply reported the value of plan assets and the APBO. Issuers directly
reported total underfundedness of $210,056 for the sample as a whole, $208,929 for the large issuer sub-sample, and
$1,127 for the random issuer sub-sample.
Table III(C)(4) also presents amounts that are reported on issuer balance sheets
related to other postretirement benefit plans. The sample issuers report net liabilities on
the balance sheet related to other postretirement benefit plans of almost $147 billion, as
compared to net assets of less than $1 billion (i.e., $693 million). The underfundedness
presented in Table III(C)(4) implies that there is a net economic liability related to other
postretirement benefit plans of $217 billion. The difference between the
underfundedness of $217 billion and the $146 billion net liability recognized on the
balance sheet is approximately $71 billion. This $71 billion net other postretirement
benefit liability remains off-balance sheet for the sample of issuers in the Study.
An extrapolation of the findings from the sample to the approximate population of
active U.S. issuers suggests that the liability for other postretirement benefit plans
reported on the balance sheet may be approximately $216 billion. The underfundedness
estimated for the population and presented in Table III(C)(4) suggests that there may be a
net economic liability related to other postretirement benefit plans of $337 billion. Thus,
149 Ciesielski, J.T., (2004), (cited previously) reports APBO of approximately $382 billion and plan assets
of approximately $65 billion from S&P 500 issuers with have other post-employment benefit plans (which
includes other postretirement benefit plans).
57
these extrapolations suggest that approximately $121 billion in other postretirement
benefit liability may remain off-balance sheet for the population.150 For retirement plans
overall (i.e., including pension and other postretirement benefit plans), the extrapolations
from the sample data suggest that liabilities of approximately $535 billion may remain
off-balance sheet.
The values reported above are all based on the amounts reported in financial
statements. However, given the sensitivity of retirement obligations to various estimates
and assumptions, it is important to also discuss some of these assumptions. For example,
one of the most critical assumptions is the choice of discount rate used to calculate the
present value of future benefit payments. Current accounting guidance specifies that
issuers should select discount rates that reflect the yield on high quality bonds of duration
similar to that of their projected annual benefit payments.151
Table III(C)(5) presents information about discount rates used by issuers to
calculate the obligations for defined-benefit pension plans. The rates used by our sample
of issuers range from approximately 5.10% to 6.75% and the average is 6.18%. The
average discount rate is slightly higher for the random issuer sub-sample (at 6.26%) than
for the large issuer sub-sample (at 6.18%). By way of comparison, using the Bloomberg
fair value index bond yields for maturities of 10 years to 30 years, AA bond rates as of
December 31, 2003 ranged from 4.7% to 5.7%.152 As another point of comparison,
S&P’s Creditweek Corporate Industrial AA Bond Yields for maturities of 10 years to 25
years, ranged from 5.09% to 6.0%. The Staff understands that there are a variety of other
indices that issuers rely on when selecting discount rates for pension calculations.
However, it appears that on average issuers may be using discount rates that are at the
high end.153
150It is important to note that a portion of the amount of liability that remains off the balance sheet likely
results from issuer’s elections to recognize the effects of applying the new accounting guidance under
SFAS No. 106, which became effective in the early 1990s, over long periods of time.
151SFAS No. 87, SFAS No. 106 as well as EITF Topic D-36 Selection of Discount Rate Used for
Measuring Defined Benefit Pension Obligations and Obligations of PostRetirement Benefit Plans Other
Than Pensions provide explicit instructions on how issuers should select the discount rate used to calculate
their obligations.
152The Staff notes that this index is based on coupon-bearing bonds. To match maturities with precision
would theoretically require rates equivalent to those of zero-coupon bonds, which rates would likely be
slightly higher.
153 One of the principal subjects of comment by the Division of Corporation Finance in their reviews of the
annual reports filed by the Fortune 500 in 2002 was pension accounting and disclosure. One of the
requested disclosures was of the assumptions, estimates, and data source used to determine the discount
rate. See the Staff document Summary by the Division of Corporation Finance of Significant Issues
Addressed in the Review of the Periodic Reports of the Fortune 500 Companies at
http://www.sec.gov/divisions/corpfin/fortune500rep.htm. In addition, the Division Staff provides
information and guidance to registrants on accounting and disclosure issues in various ways. For example,
see the Staff document Current Accounting and Disclosure Issues in the Division of Corporation Finance at
http://www.sec.gov/divisions/corpfin/acctdis030405.pdf, as well as the Staff document Frequently
Requested Accounting and Financial Reporting Interpretations and Guidance at
http://www.sec.gov/divisions/corpfin/guidance/cfactfaq.htm, which contain information on the selection of
discount rates for pension and post retirement benefit plans.
58
TABLE III(C)(5): Reported Discount Rates used in Defined-benefit Pension
Calculations a
Sub-Samples
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Minimum 5.10c 5.10c 6.00 NA
Average b 6.18 6.18 6.26 NA
Maximum 6.75d 6.75d 6.75 NA
a These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
These items are presented on the balance sheets of issuers, but since balance sheet items are often aggregated, the
detailed data can often only be obtained from the notes.
b The average is weighted by PBO and is calculated only for issuers reporting discount rates in the notes to the financial
statements.
c This is the minimum reported for a U.S. defined benefit pension plan. The actual minimum of the reported discount
rates for a defined benefit pension plan of 3.7% relates to a non-U.S. plan.
d This is the maximum reported for a U.S. pension plan. The actual maximum of the reported discount rates of 6.8%
relates to a non-U.S. plan.
For illustrative purposes, the Staff notes that a ½% increase (e.g., from 5.5% to
6%) in the discount rate applied to a stream of annual cash flows of equal amounts for 20
years (compounded daily) would reduce the present value of that stream of cash flows by
approximately 4%. While it is not possible to illustrate the effect on PBOs because the
timing of payments is unknown, the Staff’s estimate of pension underfundedness may
itself be understated due to the interest rates selected by issuers for discounting.
Further, the accounting measure of underfundedness represents only one method
of calculating this measure. For example, the Pension Benefit Guaranty Corporation
(“PBGC”) measures retirement liabilities based on the estimated cost of purchasing
annuities to settle pension obligations when a company no longer can afford to maintain
its plan. Thus, the discount rate used by the PBGC is based on periodical surveys of
insurance companies which, in combination with a mandated mortality table, results in a
present value representative of group annuity purchase prices. The 20 year select
discount rate used by the PBGC as included in its fiscal year 2003 annual report was
4.40%. On the other hand, discount rates used to determine minimum funding of plan
liabilities are calculated using rates either selected by a company’s actuary (ERISA
Liability) based on how pension assets are invested or the current liability which is based
on a statutory range of rates. The statutory range at December 31, 2003 approximated
5.90% to 6.60%.
59
D. Leases
1. Nature of Arrangements and Financial Reporting
Requirements
A lease is a contractual obligation that allows assets owned by one party to be
used by another party, for specified periods of time, in return for a payment or series of
payments. Assets that are commonly leased include automobiles, airplanes, buildings
and other real estate, machinery, computer equipment, and many other tangible assets.
An issuer may be motivated to lease, rather than purchase, an asset for many reasons,
including economies of scale or scope, increased flexibility, tax advantages, improved
access to capital, reduced costs of upgrading equipment, and improved risk sharing.154
SFAS No. 13, Accounting for Leases (issued in 1976), provides the basic
guidance for leases.155 Leases that transfer most of the benefits and responsibilities of
ownership to the party using the asset may be economically similar to sales with attached
financing agreements. This is recognized in SFAS No. 13, which states that “a lease that
transfers substantially all of the benefits and risks incident to the ownership of property
should be accounted for as the acquisition of an asset and the incurrence of an obligation
by the lessee and as a sale or financing by the lessor.”156 Otherwise, the lease should be
accounted for as a rental contract. We concentrate on the case where an issuer is the
lessee, that is, where the issuer is the party using the asset, as this is the scenario most
likely to result in no elements of the lease or leased asset being on the balance sheet.
Leases can transfer control of the asset from the lessor to the lessee for as much of
the asset’s life as desired, and can also transfer as many of the risks and rewards of
ownership as desired. Leasing transactions can take many forms and include many
different terms. Yet, despite this diversity in leasing arrangements, all leases receive one
of two opposing accounting treatments; either the lease is treated as if it were a sale or as
if it were a rental.
If “most” of the risks and rewards of ownership are transferred to an issuer leasing
an asset, the lease is treated as a sale of the entire asset by the owner (i.e., the lessor) and
a purchase of an asset financed with debt by the issuer using the asset (referred to as the
‘whole-of-the-asset’ approach). This kind of lease is called a “capital lease.”157 In these
cases, the lessor removes the cost of the asset from its balance sheet and reports a sale of
the asset for proceeds equal to the present value of the required lease payments, plus the
expected remaining value of the leased asset at the end of the lease term. The issuer
154The Equipment Leasing Association indicates that of the $668 billion of productive assets acquired by
businesses in 2003, $208 billion, or 31 percent, was acquired through leasing. See the Equipment Leasing
Association’s website: http://www.elaonline.com/industrydata/overview.cfm.
155Leases are defined as the right to use property, plant, or equipment for stated periods of time and can
include agreements that are not nominally identified as leases. See paragraph 1 of SFAS 13, Accounting
for Leases. Also see EITF Issue 01-8, Determining Whether an Arrangement Contains a Lease, which
describes other arrangements than are not nominally identified as leases but may contain a lease.
156See SFAS No. 13, paragraph 60.
157Such a lease would be referred to as either a “sales-type” or “direct financing” lease for lessors.
60
using the asset records the asset and a related liability for the present value of the required
lease payments on its balance sheet.
If the lease does not transfer sufficient risks and rewards to the lessee to be treated
as a sale and purchase, it is instead treated like a rental contract. This kind of lease is
called an “operating lease.” In this case, the owner of the asset retains the asset on its
balance sheet and records lease rental revenue (as well as depreciation, property taxes,
etc.) in its income statement on a period-by-period basis. The issuer using the asset does
not record the asset, or a related liability for the future contractual rental payments, on its
balance sheet, but records leasing expense in its income statement, also on a period-by-
period basis.
SFAS No. 13 specifies that a lease is a capital lease if:
• The lease transfers ownership to the issuer (i.e., the lessee) using the asset by the
end of the lease term; or
• The lease contains an option whereby the issuer can purchase the leased property
at a price sufficiently lower than the expected fair value of the leased property at
the end of the lease term; or
• The term of the lease is equal to or greater than 75% of the estimated economic
life of the leased property; or
• The present value of the minimum lease payments to be made by the issuer is
equal to or greater than 90% of the fair value of the leased property.158
While in the majority of cases the evaluation of whether these criteria have been
met is straightforward, in certain circumstances it can be challenging, as leases
sometimes contain contingent or variable payment requirements, optional term
extensions, and other clauses that affect the calculations under one or more of the tests
described above. However, such determinations are very important, as they can
completely change the accounting for the lease.
The identification of which agreements should be accounted for as leases, and
thus subject to the tests listed above, is also challenging in some situations. In order to
reduce the chances of like arrangements being accounted for differently, the accounting
guidance defines leases by their characteristics, not by their label. Thus, any contract, or
portion of a contract, that meets the definition of a lease must be accounted for as one.159
While most leases are indeed explicitly identified as such, some are not.
The accounting guidance also includes extensive disclosure requirements for
leases. These requirements vary based upon the type of lease and whether the issuer is
the lessor or lessee. These disclosure requirements provide investors with the following
information:
158In addition, lessors must also consider the following additional criteria: collectibility of the minimum
lease payments is reasonably predictable and no important uncertainties surround the amount of
unreimbursable costs yet to be incurred by the lessor under the lease. See SFAS 13, paragraphs 7 and 8.
159See, for example, EITF Issuer No. 01-8, Determining Whether an Arrangement Contains a Lease.
61
• General description of the nature of leasing arrangements;
• The nature, timing and amount of cash inflows and outflows associated with
leases;
• The amount of lease revenues and expenses reported in the income statement each
period;
• Description and amounts of leased assets by major balance sheet classification
and related liabilities; and
• Amounts receivable and unearned revenues under lease agreements.160
In addition, FR 67 requires presentation of both capital and operating lease
obligations in the contractual obligations table in MD&A.
2. Off-Balance Sheet Issues in Accounting for Leases
A lease is a particular kind of contractual obligation. As discussed in Section
III.G, the most significant accounting issue with respect to most contractual obligations is
whether to record the rights and obligations inherent in the contracts as assets and
liabilities when neither party to the contract has performed. With respect to leases,
however, the question is really how to assess whether performance has occurred. As
noted above, the current lease accounting standards focus on a determination as to which
party to a lease agreement has the risks and rewards of ownership of the leased asset.
This, in turn, determines whether the owner is deemed to have sold the asset and whether
the issuer using the asset is deemed to have purchased the asset.
As a consequence of this approach, the issuer leasing the asset will either
recognize the entire leased asset on its books and a liability for all of its contractually
required payments, or it will recognize no asset and no liability. The lease accounting
guidance either treats the contract as if all of the performance occurs at the beginning of
the lease, or as if none of it does. The intention is to treat those leases that are
economically equivalent to sales as sales, and to treat other leases similar to service
contracts. This approach, while a significant improvement from previous lease
accounting, which rarely if ever required recognition of a capital lease, does not allow the
balance sheet to show the fact that, in just about every lease, both parties have some
interest in the asset, as well as some interest in one or more financial receivables or
payables.161
The “all-or-nothing” nature of the guidance means that economically similar
arrangements may receive different accounting—if they are just to one side or the other
of the bright line test. For example, most would agree that there is little economic
160See SFAS 13, as amended for detailed lists of disclosure requirements.
161In contrast, the model used for transfers of financial assets with continuing involvement, discussed in
Section III.B, does attempt to recognize this fact, by requiring the transferor to continue to recognize those
components that it continues to control, while requiring it to derecognize the components it no longer
controls.
62
difference between a lease that commits an issuer to payments equaling 89% of an asset’s
fair value vs. 90% of an asset’s fair value. Nonetheless, because of the bright-line nature
of the lease classification tests, this small difference in economics can completely change
the accounting. Conversely, economically different transactions may be treated
similarly.162 For example, most would agree that there is a significant economic
difference between a one-month lease of a building and a 10-year lease of that building.
However, if both leases qualified for operating lease treatment, they would likely both
have little to no effect on the balance sheet. The extensive disclosures required for leases
do provide some information about the rights and obligations inherent in operating leases.
Problems with the all-or-nothing character of the accounting have been magnified
because many issuers involved in leases, taking advantage of the bright-line nature of the
lease classification guidance, structure their lease arrangements to achieve whatever
accounting (sales-type/capital or operating) is desired. These issuers have been aided in
these endeavors by a large number of attorneys, lenders, investment banks, accountants,
insurers, industry advocates, and other advisers. Indeed, lease structuring to meet various
accounting, tax, and other goals, has become an industry unto itself in the last 30 years.
The significant amount of structuring of leases also makes analyzing potential
changes to the lease guidance very difficult. Indeed, the current accounting guidance,
which is criticized by many, would likely be held in much higher regard were it being
applied to the lease arrangements that existed when it was debated and created. Changes
in lease terms in response to the accounting guidance have caused undue focus on the
weaknesses of the guidance. The fact that lease structuring based on the accounting
guidance has become so prevalent will likely mean that there will be strong resistance to
significant changes to the leasing guidance, both from preparers who have become
accustomed to designing leases that achieve various reporting goals, and from other
parties that assist those preparers.
3. Empirical Findings from Study of Filings by Issuers
In this section, the Staff presents empirical findings from the Study of filings by
issuers related to leases. The Staff also extrapolates from these findings to estimate
amounts related to the approximate population of active U.S. issuers.
Table III(D)(1) describes the percentage of issuers reporting cash flows
committed under operating and capital leases. Approximately 77% of issuers in the
sample report information about operating leases, while approximately 31% report
information about capital leases. An extrapolation of the findings from the sample to the
approximate population of active U.S. issuers suggests that approximately 63% of the
total population of issuers report operating leases, and 22% report capital leases.
162See paragraph 119 of SFAC 2 which states “Greater comparability of accounting information, which
most people agree is a worthwhile aim, is not to be attained by making unlike things look alike any more
than by making like things look different. The moral is that in seeking comparability accountants must not
disguise real differences nor create false differences.”
63
TABLE III(D)(1): Issuers Reporting Future Cash Flows Committed under
Operating and Capital Leases a
Sub-Samples
Categorized by Type of Lease Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers Reporting Operating Leases 77 91 63 63.3
Issuers Reporting Capital Leases 30.5 39 22 22.2
a These data were collected from the contractual obligations table in the MD&A of the filings of issuers selected for the
Study.
b These categories are not mutually exclusive.
Table III(D)(2) presents the total future cash flows committed under operating
and capital leases, as reported in the contractual obligation table in MD&A. Assets and
liabilities related to capital leases are recorded on issuer balance sheets, but assets and
liabilities related to operating leases are not.
TABLE III(D)(2): Reported Future Cash Flows Committed under Operating and
Capital Leases a
Sub-Samples
Categorized by Type of Lease Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Undiscounted cash flows committed
under operating leases $205,971 $195,506 $10,465 $1,252,006
Undiscounted cash flows committed
under capital leases $16,095 $15,802 $293 $45,102
a These data were collected from the contractual obligations table in the off-balance sheet arrangements section of the
MD&A (required by FR67) for the filings of issuers selected for the Staff Study. It is important to note that the data
include only non-cancelable leases. It is also important to note that these amounts are not discounted
The undiscounted sum of the future committed cash flows related to non-
cancelable operating leases for our sample issuers is approximately $206 billion. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that total (undiscounted) cash flows associated with these off-
balance sheet operating leases for the population may approach $1.25 trillion.
If these lease obligations had been reported on issuer balance sheets, the related
assets and liabilities would have been required to be recognized at their present (i.e.,
discounted) values.163 The Staff did not attempt to determine the appropriate discount
rates that would be used to estimate these amounts. For illustrative purposes, the
163However, if the present value exceeds the fair value, issuers would be required to measure the lease
obligation using the fair value of the related asset.
64
discounted value of a series of five (ten) equal annual cash flows, using a discount rate of
8%, would be approximately 80% (67%) of the total undiscounted cash flows.
For comparison purposes, Table III(D)(2) also presents the total dollar amounts of
cash flows committed under capital leases for the 200 issuers in the sample. As noted
earlier, these leases are presented on issuer balance sheets. The undiscounted sum of the
cash flows related to capital leases for our sample issuers is approximately $16 billion.
The Staff notes that the ratio of the total cash flows related to non-cancelable operating
leases to capital leases is more than 12 to 1 within the sample and is estimated to be more
than 25 to 1 for the population.
E. Contingent Obligations and Guarantees
1. Nature of Arrangements and Financial Reporting
Requirements
Issuers are often involved in situations where uncertainty exists about whether an
obligation to transfer cash or other assets has arisen and/or the amount that will be
required to settle such obligation. Examples include:
• Where an issuer is a defendant in a lawsuit and any payment is contingent
upon the outcome of a settlement or an administrative or court proceeding;
• Where an issuer provides a warranty for a product it sells and any payment is
contingent on the number of products that actually become defective and
qualify for benefits under the warranty; and
• Where an issuer acts as a guarantor on a loan for another entity and any
payment is contingent on whether the other entity defaults.
Broadly, these kinds of situations are referred to as contingent obligations.164 The
difficult accounting question is what, if any, liability should be recognized before such
contingencies are resolved. SFAS No. 5, Accounting for Contingencies, provides general
guidance regarding the accounting for contingent obligations, although certain contingent
obligations are specifically addressed in other standards.165 Under SFAS No. 5,
contingent obligations are treated in one of three ways depending on the circumstances.
In order to conclude which treatment is applicable, an initial two-fold determination is
made as to whether the loss itself is deemed “probable” to occur and whether the amount
of the loss is estimable.
Recognition of a liability is required if the loss is deemed “probable” and
estimable; the amount to be recognized is the most likely outcome—i.e., the individual
loss amount with the highest probability. No liability is recognized on the balance sheet,
but disclosures are required to inform users of the existence of the potential loss if a) the
164Although contingencies may represent either potential assets or liabilities, the Staff focuses here on
contingent obligations, as these tend to result in more reporting questions.
165For example, guidance related to the accounting for insurance is provided by SFAS No. 60 and other
standards, and guidance related to the accounting for derivatives is provided by SFAS No. 133.
65
loss is deemed “probable,” but an amount cannot be reasonably estimated, or b) the loss
is deemed “reasonably possible,” but not “probable.” Neither recognition of a liability
nor disclosure is required if the probability of loss is deemed “remote.”
Consider an example where an issuer is a defendant in a lawsuit. Assume the
following three possible outcomes and related probabilities of occurrence:
Outcome
Probability
(A)
Amount to be Paid
(B)
Probability-Weighted
Amount to be Paid
(A x B)
Issuer is found liable 5 % $500,000 $ 25,000
Issuer settles 90 % $ 50,000 $ 45,000
Issuer wins lawsuit 5 % $ 0 $ 0
Total 100 % $70,000
Under SFAS No. 5, the loss would be deemed “probable,” given the 95%
likelihood of a loss occurring. A liability would be recognized in the amount of $50,000,
because this amount is the most likely loss amount.
Required disclosures under SFAS No. 5 include the nature of the contingency, the
range of the reasonably possible losses, and the amount recognized on the balance sheet,
if any.166
SFAS No. 5 addresses uncertainty by using the probability of loss as a threshold
in determining whether a liability should be recognized and for how much. In the context
of SFAS No. 5, there appear to be some range of interpretations as to how high the
likelihood of occurrence must be to be deemed “probable,” but by all accounts this
likelihood is substantially higher than a 50%+ threshold that common parlance might
assign to the term. If a liability is recognized, that liability is measured as the amount
that constitutes the most likely outcome.
In contrast to the SFAS No. 5 approach, some recent accounting guidance
requires that certain obligations that include contingencies be recognized at fair value.
Under a fair value approach, the degree of uncertainty associated with a contingent
liability is reflected in the measurement of the liability, rather than in the determination of
whether a liability is recognized.
Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others, issued in 2002 in
light of the then-recent corporate scandals and passage of the Sarbanes-Oxley Act,
requires certain guarantees to be initially recognized on the balance sheet at fair value.167
166Additional disclosures regarding loss contingencies may be required by Staff Accounting Bulletin Topic
5Y, Accounting and Disclosures Relating to Loss Contingencies, Statement of Position No. 94-6,
Disclosure of Certain Significant Risks and Uncertainties, and Statement of Position No. 96-1,
Environmental Remediation Liabilities, among others. In addition, Item 103 of Regulation S-K requires
certain descriptive information to be disclosed regarding legal proceedings.
167In developing the fair value model, FASB indicated that, over the life of a guarantee, a guarantor takes
the obligation to “stand ready” to honor the guarantee, and that the stand-ready obligation is not itself
66
One method used by issuers in determining the fair value of contingent obligations is
presented by SFAC No. 7, Using Cash Flow Information and Present Value in
Accounting Measurements. This method of estimating fair value is based on probability-
weighted discounted cash flows consistent with the economic concept known as
“expected value”.
For example, consider a simple example in which an issuer who writes a
guarantee covering the default on a third-party’s debt with the following three outcomes
and probabilities:
Outcome
Probability
(A)
Amount to be Paid
(B)
Probability Weighted
Amount to be Paid
(A x B)
Third party defaults entirely 5 % $100,000 $ 5,000
Third party defaults on ¾ of debt 10 % $ 75,000 $ 7,500
Third party does not default 85 % $ 0 $ 0
Total 100 % $12,500
If a contingency accounted for under the SFAS No. 5 approach had the above
potential outcomes, no liability would be recognized, since the occurrence of a loss is not
“probable” (i.e., a loss occurs with only 15% probability). However, under the
accounting specified by Interpretation No. 45, the writer of this guarantee would
recognize a liability of $12,500, which constitutes the fair value168 of the guarantee.
Notably, all types of guarantees are not included in the scope of Interpretation No.
45. Further, the requirement of Interpretation No. 45 to recognize guarantees on the
balance sheet at fair value only applied to those issued or modified after December 31,
2002. However, Interpretation No. 45 introduced new disclosure requirements, which
were applicable regardless of the date of the guarantee’s issuance or modification. The
disclosures required in the notes to the financial statements include, but are not limited to,
the following:169
• Nature of the guarantee;
• Maximum potential future payments;
• Current amount of liability on the balance sheet; and
• Certain product warranty information, including a reconciliation of changes in
the liability.
The Commission’s Financial Reporting Release No. 67, mandated by section
401(a) of the Act, also requires additional disclosures in the Off-Balance Sheet section of
MD&A regarding certain guarantee contracts. Disclosure is required to the extent
contingent. The liability for the stand-ready obligation is reduced over time as the guarantee performs (that
is, as it fulfills its obligation to stand ready over the life of the contract).
168The time value of money is ignored in this example.
169The required disclosures are presented in paragraphs 13-16 of Interpretation No. 45.
67
necessary to provide an understanding of the issuer’s material off-balance sheet
arrangements as well as the material effects of those arrangements. For guarantee
contracts these disclosures may include:
• Nature and business purpose of the guarantee contracts;
• Importance of the guarantee contracts to liquidity, capital resources, market
risk or credit risk support, or other benefits;
• The financial impact of the guarantee contracts and the issuer’s exposure to
risk as a result of the guarantees; and
• Known events, demands, commitments, trends or uncertainties that affect the
availability or benefits of the guarantee contracts.
2. Off-Balance Sheet Issues in Accounting for Contingent
Obligations and Guarantees
In accounting for contingent liabilities, how uncertainty is taken into account will
affect which items are reflected on the balance sheet. Although both approaches appear
to generate information that would be useful to users of financial statements, differing
views exist as to which treatment provides the most relevant information.
If uncertainty is taken into account in the recognition of liabilities, as is the case
for contingencies accounted for under SFAS No. 5, the balance sheet will report those
liabilities that are highly likely to reduce cash or other assets available for distribution to
shareholders. In addition, the items on the balance sheet would be reported at the amount
most likely to be paid or received. However, several issues arise from this treatment.
First, while the SFAS No. 5 accounting results in the recording of a liability that reflects
the most likely payment, the balance sheet reflects information about only that outcome.
Information about the other potential outcomes is ignored for the purpose of recording
the liability. While disclosures in the notes to the financial statements might help to
provide this information, in practice those disclosures are rarely detailed enough to allow
an investor to take into account multiple possible loss outcomes.
Difficulties in applying the SFAS No. 5 approach also arise because that approach
requires an analysis of whether a loss is probable. Although accountants generally agree,
in practice, on the percentage likelihood that is necessary to conclude that a loss is
probable, determining whether the loss in a particular situation exceeds that threshold can
be subjective. In addition, it may be difficult for others to independently verify
management’s judgments in these areas. Application issues have also arisen in regards to
determining the most likely amount of a loss when a range of possible losses exists. If
one amount within the range is a better estimate than any other amount, that amount
should be recognized. If no amount is considered a better estimate than any other
amount, the minimum amount in the range is recognized.170 In practice, zero may
arguably be the low point of the range in many cases, resulting in no liability being
170FASB Interpretation No. 14, “Reasonable Estimate of the Amount of Loss”.
68
reflected. The Staff has long believed that the application of SFAS No. 5 by issuers
should be improved, and has commented on this numerous times in speeches and other
venues. The needed improvements include better application of both the recognition and
disclosure criteria of SFAS No. 5.
Some of the difficulties in accounting for contingencies under SFAS No. 5 are not
faced in accounting for contingencies under pronouncements in which uncertainty is
reflected in measurement, rather than recognition, of a liability. If uncertainty is taken
into account in measuring the contingent liability, the value reflected on the balance sheet
represents the value the market would assign to the contingent liability in assessing the
value of the issuer; thus, information that a market participant would consider relevant is
not ignored. However, the liability recorded in these situations may not actually
represent a possible outcome upon ultimate resolution of the contingency.171
Reflecting uncertainty in the measurement of the liability also removes some of
the pressure on the “probable” determination, and on the identification of the particular
outcome that is most likely. In addition, this approach would rarely, if ever, omit a
contingent obligation from the balance sheet entirely. However, if determining the
probability of loss and the most likely amount of that loss, as required under SFAS No. 5,
is difficult and subject to judgment, determining the probabilities of multiple potential
outcomes, as required under Interpretation No. 45, may be even more difficult. Some
argue that a fair value approach could result in less reliable financial statements and make
auditing those statements even more challenging. Others, however, note that the fair
value approach ensures that contingencies relevant to assessing an issuer’s value are at
least acknowledged in a fair value approach, in contrast to the SFAS No. 5 approach,
which could allow many of those contingencies to go entirely unrecognized.
3. Empirical Findings from Study of Filings by Issuers
In this section, the Staff presents empirical findings from the Study of filings by
issuers related to contingent obligations, including guarantees. The Staff also
extrapolates from these findings to estimate amounts for the approximate population of
active U.S. issuers.
Table III(E)(1) describes the percentage of issuers reporting certain contingent
liabilities. As indicated in the table, approximately 64% of the sample issuers report
information about some litigation contingencies in their notes to the financial statements
and approximately 55% report information about guarantees. Substantially fewer, 21%,
report information about environmental contingent obligations. The Staff noted during
its analysis of the filings that disclosures about contingent obligations vary widely in
terms of format and location in the filing. As a result, the data for contingent obligations
was difficult to collect in a consistent manner across issuers.
171In the example used previously, the three possible outcomes are losses of zero, $75,000, and $100,000,
yet the fair value that would be recorded is $12,500.
69
TABLE III(E)(1): Issuers Reporting Certain Contingent Obligations a
Sub-Samples
Categorized by Type of Contingent
Obligation b Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers reporting legal contingent
obligations 63.5 81 46 46.3
Issuers reporting environmental
contingent obligations 20.5 31 10 10.2
Issuers reporting guarantees 54.5 74 35 35.4
a These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
b These categories are not mutually exclusive.
Table III(E)(2) describes the percentage of issuers reporting recognition of
liabilities on their balance sheets for certain contingent liabilities. Less than 10% of the
sample issuers report that they have recognized any amount of liability on their balance
sheets for any legal contingent obligation, even though approximately 64% of the sample
issuers report general information regarding legal contingent obligations. Approximately
23% of the sample issuers report that they have recognized a liability for guarantees, less
than half of the 55% of issuers reporting information about the existence of guarantees.
Before the implementation of Interpretation No. 45 in 2002, the Staff suspects that few of
these guarantees would have been recognized as liabilities on issuer balance sheets.
TABLE III(E)(2): Issuers Reporting Liabilities for Certain Contingent Obligations
on their Balance Sheets a
Sub-Samples
Categorized by Type of Contingent
Obligation b Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers recognizing liabilities for legal
contingent obligations 9.5 14 5 5.1
Issuers recognizing liabilities for
environmental contingent obligations 10 15 5 5.1
Issuers recognizing liabilities for
guarantees 22.5 35 10 10.2
a These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
b These categories are not mutually exclusive.
The analysis of this topic so far has focused on the proportion of issuers reporting
information about various types of contingent obligations. We now turn to an analysis of
the amount of liabilities recognized on issuer balance sheets and the exposures reported
in the notes to the financial statements.
70
Table III(E)(3) presents reported amounts of contingent obligations recognized as
liabilities on issuer balance sheets, to the extent they are reported as such in the notes to
the financial statements.172 Issuers in the sample report that they had recognized
liabilities on their balance sheets of approximately $10 billion related to legal contingent
liabilities, approximately $9 billion related to environmental contingent liabilities, and
almost $86 billion related to liabilities related to guarantees. In each of these three
categories, at least 98% of the total liability recognized was recognized by the large
issuer sub-sample.173 An extrapolation of the findings from the sample to the
approximate population of active U.S. issuers suggests that legal contingent liabilities
reported by the total population are approximately $12 billion, environmental contingent
liabilities are approximately $19 billion, and guarantees are approximately $124 billion.
TABLE III(E)(3): Amounts Reported as Liabilities on Issuer Balance Sheet Related
to Certain Contingent Obligations a
Sub-Samples
Categorized by Type of Contingent
Obligation Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Legal contingent liabilities $10,725 $10,714 $11 $11,814
Environmental contingent liabilities $9,219 $9,123 $96 $18,723
Guarantee liabilities $85,834 $85,449 $385 $123,949
a These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
As discussed earlier, SFAS No. 5 and Interpretation No. 45 require disclosures
about exposure to “possible loss or range of loss” in the notes to financial statements.174
Table III(E)(4) presents amounts related to these exposures reported by issuers. Issuers
in the sample report almost $32 billion in possible exposures related to legal
contingencies, only approximately $5 billion related to environmental contingencies, and
approximately $4 trillion related to guarantees. An extrapolation of the findings from the
sample to the approximate population of active U.S. issuers suggests that potential losses
reported by the population are approximately $52 billion potential losses for legal
contingent obligations, approximately $23 billion for environmental contingent
obligations, and more than $46 trillion for guarantees.
172Many such contingencies may not be reported as a separate line item on the balance sheet. Thus, users
of financial statements must usually rely on disclosures to indicate the magnitude of the contingent
obligations recognized.
173This represents a disproportionate difference between the large issuer sub-sample and the random issuer
sub-sample in that the ratio of total liabilities of the random issuer sub-sample to the large issuer sub-
sample is approximately 1:100; the difference in contingent liabilities recognized by the two groups is
1:1000.
174See SFAS No. 5, paragraph 10.
71
TABLE III(E)(4): Reported Exposures for Certain Contingent Obligations a
Sub-Samples
Categorized by Type of Contingent
Obligation Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Legal contingent obligations $31,762 $31,554 $208 $52,354
Environmental contingent
obligations $4,604 $4,414 $190 $23,414
Guarantees $4,053,499 $3,624,389 $429,110 $46,535,389
a These data were collected from the notes to the financial statements in the filings of issuers selected for the Study.
The Staff notes that the amounts of possible losses disclosed by the sample of issuers
are largely unrelated to the liabilities recognized by issuers as reported in Table III(E)(3).
For the most part, issuers seem to have concluded that they need not disclose quantitative
information concerning additional potential losses related to those contingent losses
recognized as liabilities on the balance sheet.175 The Staff further notes that in many
cases, issuers disclose the existence of the contingent legal obligation, but recognize no
liability and disclose no maximum loss or range of loss.
F. Derivatives
1. Nature of Arrangements and Financial Reporting
Requirements
A derivative is “simply a financial instrument (or even more simply, an agreement
between two people) which has a value determined by the price of something else.”176
For example, a stock option contract derives its value, at least in part, from the price of
the underlying stock;177 similarly, a gold futures contract derives its value from the price
175For example, of the $10.328 billion in legal contingent liabilities recognized (see Table III(E)(3)), only
approximately $717 million are disclosed in conjunction with quantitative information about additional
potential losses. Indeed, approximately 97% of the $23,761 billion of potential legal contingent losses
disclosed for the entire sample relate to instances where no liability was reported as being recognized on
the balance sheet. In some cases, where liabilities are recognized, issuers may not deem additional losses
to meet the “reasonably possible” criteria in SFAS No. 5.
176McDonald, Robert L., Derivatives Markets (2003), at 1.
177A stock option may be defined as a “right to purchase or sell a stock at a specified price within a stated
period.” Barron’s Dictionary of Finance and Investment Terms, 5th ed. (1998).
72
of the underlying gold;178 an interest rate swap derives its value from the underlying
interest rates.179
Derivatives permit issuers to mitigate and take on risk, and also to select which
risks they want to retain and manage, and which they want to shift to others willing to
bear them. For example, a manufacturer that requires oil as an input to production is
exposed to the risk of an oil price increase. If oil prices do increase, cost of production
increases and the manufacturer’s profitability may suffer. Such an issuer may choose to
contract with another party to effectively fix the price it will pay for oil at some future
date through a “forward” contract.180 In this case, the issuer has “hedged” its exposure,
and is protected from the negative economic effects of an adverse change in oil prices.
Of course, locking in a price through such a forward contract also precludes any cost
savings the issuer might have experienced from a beneficial change in oil prices. If,
instead, the issuer wished to limit its exposure to price increases while still retaining the
benefits of price decreases, it could enter into an option contract to purchase oil at a fixed
price; if the price goes above the exercise price of the option, the issuer would gain upon
exercise of the option, while if the price fell, the issuer would allow the option to expire
while making its purchases through the spot market. Of course, entering into an option
may be more costly than entering into a forward or futures contract.
a. Accounting for Derivatives
The current accounting guidance for derivatives has only been in effect since
2001.181 Prior to that, many believed that accounting standards had not kept pace with
changes in global financial markets and related financial innovations. As a result, the
Commission, members of Congress, the General Accounting Office, and others urged the
FASB to deal with reporting problems regarding derivatives.182 During the almost 10
year period that this guidance was under development, there were several notable
derivatives issues that captured the attention of the public, various regulators, and the
178A futures contract may be defined as an “agreement to buy or sell a specific amount of a commodity or
financial instrument at a particular price on a stipulated future date … [where] [t]he price is established …
on the floor of a commodity exchange …” Barron’s Dictionary of Finance and Investment Terms, 5th ed.
(1998).
179A swap may be defined as “[a] contract calling for the exchange of payments over time. Often one
payment is fixed in advance and the other is floating, based upon the realization of a price or interest rate.”
McDonald, Robert L., Derivatives Markets (2003), at 851.
180Such a contract promises the delivery of a certain amount of oil at a certain date in the future, for a
certain price.
181SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (as amended), was
originally effective for fiscal years beginning after June 15, 1999. The effective date was subsequently
delayed by SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities-Deferral of
Effective Date of FASB Statement No. 133 to fiscal years beginning after June 15, 2000, or for the year
ended December 31, 2001 for calendar year end issuers.
182SFAS No. 133, paragraph 212.
73
accounting standard setters.183 These events influenced the deliberations that would
ultimately address the actual accounting for derivatives.
Financial reporting for derivatives centers around three main issues. The first is
whether derivative contracts should be recognized on issuer balance sheets. The second
is whether changes in the value of derivative contracts should be recognized in the
income statement. The third is how to convey the overall sensitivity of the issuer to
changes in important variables—for example, say, oil prices for an issuer that uses large
quantities of oil—in light of the derivative positions the issuer may have taken.
In general SFAS No. 133 requires that derivatives be recorded as assets or
liabilities on the balance sheet at fair value, and re-measured each period with changes in
fair value reflected in earnings. In part, the rationale for this approach was FASB’s view
that recognizing derivatives on the balance sheet based on measurements other than fair
value was generally less relevant and understandable.184 For example, if historical cost
were used to measure derivatives, many would be reported at a value of zero because no
payment is made at the inception of the contract (e.g., most forward contracts). In
addition, under a historical cost measurement principle, changes that may have a
significant effect on the issuer’s value would not be reflected in its financial statements.
While this is true for all assets and liabilities measured at historical cost, derivatives have
a potential for substantial variability in value typically exceeding that of more traditional
assets such as plant and equipment. Other methods proposed, such as intrinsic value and
lower of cost or market, were also considered inappropriate because they ignored
significant items that factor into the fair value of the derivative. In the end, the FASB
concluded that fair value was the only relevant measurement for derivatives.185
Although the core principle in SFAS No. 133 of recording all derivatives on the
balance sheet at fair value is simply stated, many complexities become apparent with
further analysis. First is the issue of defining “derivative” for purposes of applying the
principle. As discussed below, the FASB started with a definition that looks to certain
characteristics of a contract to identify derivatives. However, various exceptions were
made to this definition in order to ease implementation of the standard or to acknowledge
that certain instruments that meet the characteristics-based definition were previously
addressed as insurance contracts or in some other manner in the existing accounting
guidance. In addition, the guidance includes a requirement that certain derivatives
embedded in other non-derivative financial instruments or other contracts be separated
out or “bifurcated” from those instruments and separately recognized in issuer financial
statements. This provision prevents an issuer from avoiding the recognition and
183In particular, during 1994 there were some well-publicized incidents related to derivatives. The largest
was the bankruptcy of Orange County, California, which was partially attributed to what was considered
the imprudent use of derivatives. In addition, there were several significant corporate losses from
derivative transactions, including losses at The Proctor and Gamble Company, MG Corp. (a unit of
Germany's Metallgesellschaft AG) and Gibson Greetings Inc.
184SFAS No. 133, paragraphs 221 and 223.
185Paragraph 3(b) of SFAS 133 states: “Fair value is the most relevant measure for financial instruments
and the only relevant measure for derivative instruments.”
74
measurement requirements of SFAS No. 133 merely by embedding a derivative
instrument in a non-derivative financial instrument or other contract.186
b. Hedge Accounting
Many issuers utilize derivative instruments to hedge their exposure to certain
economic risks. When a derivative is used to hedge an exposure, the value of the
derivative should have an inverse relation to the value of the exposure it is hedging.
While the core principle under SFAS No. 133 is to recognize changes in the value of
derivatives in the income statement, SFAS No. 133 provides for an exception to this
principle known as “hedge accounting,” to address potential timing differences in
recognizing offsetting gains and losses. These timing differences occur in part because
GAAP utilizes a “mixed-attribute” approach where some items are recognized at
historical cost, others at the lower of cost or market, and still others at fair value. As a
consequence, changes in the value of a derivative may not be reflected in earnings at the
same time as changes in the value of the hedged exposure unless hedge accounting is
used.
For example, consider an issuer that has a mortgage obligation with a term of 30
years at a fixed interest rate of 9% per year. The issuer enters into a contract designed to
have the same effect as if the fixed rate of interest in the mortgage were changed to a
variable rate of interest. The terms of the contract require the issuer to pay a variable rate
based on the current rate on U.S. Treasury securities in exchange for payments based on
the 9% rate in the mortgage. Economically, the issuer is in approximately the same
position as if its 9% fixed-rate mortgage obligation were instead a variable rate mortgage
obligation. Such a derivative contract is called an interest rate swap. If interest rates
drop below 9%, the swap contract will have a positive value to the issuer; that is, it is an
asset. If interest rates rise above 9%, the swap will have a negative value to the issuer
and is a liability.
If changes in interest rates were recognized in the measurement of the mortgage,
then the accounting for this would be relatively straightforward. For example, suppose
interest rates dropped below 9%. Other things being equal, the recorded value of the
mortgage liability would increase, but by approximately the same amount that the
derivative asset (i.e., the swap) increases in value. Thus, the changes in fair value would
approximately offset each other, mirroring the economics of such contracts. However,
changes in the fair value of the mortgage liability associated with changes in interest rates
are not recognized in current earnings. Instead, debt, such as the mortgage liability, is
recognized at its historical cost.
The FASB addressed the inconsistency resulting from recognizing the derivative
at fair value and the instrument the derivative is designed to work with at historical cost
by creating an exception to the general historical cost measurement for some
assets/liabilities that are hedged with derivative contracts. If an asset (liability) is
typically measured using historical cost and its fair value is hedged with a derivative,
then the asset (liability) can be reflected on the balance sheet at its fair value for the
186Paragraph 293 of SFAS No. 133.
75
portion of the risk that is being hedged. This accounting treatment—known as a “fair
value hedge”—results in recognizing in the income statement both the change in fair
value of the mortgage liability (due to changes in interest rates), and the offsetting change
in fair value of the swap. Thus, this treatment reflects both sides of the economic story in
the financial statements.
While fair value hedge accounting resolves certain issues caused by the mixed-
attribute approach, another type of hedge accounting addresses situations where the issuer
has hedged its exposure to variability in expected future cash flows. For example,
consider an issuer that expects to purchase oil in the future and is thus exposed to market
variability in oil prices. The issuer enters into a forward contract to purchase oil in the
future at the current “spot” price of $25 per barrel in order to hedge this exposure. A
subsequent increase in the price of oil to $27 would have no net economic effect on the
issuer, because the forward contract would offset the effects of the price increase. That
is, while the value of the oil being purchased has increased $2 per barrel, the value of the
forward contract would offset such a price increase by approximately the same
amount.187 Once the price of oil has risen above $25, the forward contract clearly
constitutes an asset, as it entitles the issuer to buy oil at less than the current market price.
However, the issuer’s balance sheet does not recognize an obligation (or liability) related
to the expected future purchase of oil—the item being hedged.
Such an accounting treatment introduces volatility into earnings that some believe
does not represent the underlying economics of such transactions. Thus, the FASB
developed an approach—known as a “cash flow hedge”—that allows the issuer to hold
changes in value of derivatives (to the extent these offset changes in value of the hedged
item) that hedge expected variability in future cash flows in a section of equity called
“accumulated other comprehensive income” until the transaction being hedged occurs.188
When the future transaction that was designated as being hedged actually occurs and is
recognized in income, the amount initially recorded in equity is then also recognized in
income to reflect the offsetting effect of the hedge.
It is important to note that SFAS No 133 strictly limits the kinds of situations that
qualify for hedge accounting.189 In addition, in order to qualify for hedge accounting, the
issuer has to meet specific documentation requirements. This is to avoid an opportunity
for an issuer, using hindsight, to freely pick the approach that presents the best results. It
is also important to note that the risks that are eligible for hedging are market-related
risks (changes in fair value and variability in cash flows), and not accounting risks, such
as variability in reported net income. Finally, except in very rare situations,190 the
effectiveness of the derivative at offsetting the changes in value of the hedged item must
187This is an oversimplification for expository purposes. It assumes that cash wasn’t paid upon the signing
of the contract. Also, it does not take into consideration the time value of money.
188See SFAS No. 133, paragraph 30 for a discussion of the amounts to be deferred into accumulated other
comprehensive income in the case of cash flow hedges.
189In addition to fair value and cash flow hedges, SFAS No. 133 provides for hedging the foreign currency
risk related to an issuer’s net investment in foreign operations.
190See SFAS No. 133, paragraphs 65 and 68.
76 be periodically measured, and any ineffectiveness must be recognized in the income
statement, even when the relationship does qualify for hedge accounting.191
c. Disclosures
SFAS No. 133 also provides disclosure guidance, intended to help investors and
creditors understand what an entity is attempting to accomplish through the use of
derivatives. These disclosures are required to facilitate the understanding of the nature of
an entity’s derivative activities and evaluation of the success of those activities, their
importance to the entity, and their effect on the entity’s financial statements. As a result,
SFAS No. 133 requires numerous qualitative disclosures about an entity’s use of
derivatives including, but not limited to:192
• Its objectives for holding or issuing derivative instruments, the context needed to
understand those objectives, and its strategies for achieving those objectives;
• A description distinguishing between derivative instruments designated as fair
value, cash flow, and foreign currency hedging instruments, and all other
derivatives. The description shall also indicate the entity’s risk management
policy for each of those types of hedges, including a description of the items or
transactions for which risks are hedged. For derivative instruments not designated
as hedging instruments, the description shall indicate the purpose of the derivative
activity; and
• Certain quantitative information related to cash flow and foreign currency hedges.
In addition to the SFAS No. 133 required disclosures about derivatives and
hedging activities, Item 305 of Commission Regulation S-K requires certain additional
disclosures about market risks and how those risks are managed, including the use of
derivatives. In particular, Item 305 requires both quantitative and qualitative disclosures
about each type of market risk including interest rate, foreign currency, commodity price
and other relevant risks, such as equity price risk. In preparing the quantitative
disclosures, the issuer can choose from three alternatives:
• Tabular presentation of fair value information and contract terms relevant to
determining future cash flows – categorized by expected maturity dates;
• Sensitivity analysis assessing the potential loss in future earnings, fair values or
cash flows of market sensitive instruments resulting from hypothetical changes in
various market indices; or
191Ibid, paragraphs 20, 22, 26, 28 and 30.
192See SFAS No. 133, paragraphs 44 to 47 for a complete list of the disclosure requirements for derivatives
and hedging activities.
77
• Value at risk analysis estimating the potential loss in future earnings, fair values
or cash flows from market movements with a specified likelihood of
occurrence.193
2. Off-Balance Sheet Issues in Accounting for Derivatives
As can be seen from the above discussion, derivatives are, in fact, on the balance
sheet. We include them in this Report, however, because derivatives are often an integral
part of arrangements that are considered off-balance sheet, such as the Enron prepay
transactions discussed in Section I.C. While many have criticized SFAS No. 133 (and its
related interpretive guidance) for its complexity, and its “rules-based” guidance, it must
be recognized that prior to the issuance of SFAS No. 133, many derivatives were indeed
“off-balance sheet,” and issuers’ exposures to related risks and changes in financial
condition was therefore entirely unreported. Furthermore, much of the complexity in
SFAS No. 133 relates to hedge accounting, which is optional. In fact, hedge accounting
is a modification or exception to the core principles of the standard. For the reasons
already discussed, the FASB felt that hedge accounting was an appropriate part of SFAS
No. 133. Nonetheless, it should be noted that, as is often the case with exceptions to
basic principles, the hedge accounting guidance is complex and relies on a substantial
number of rules.
There are over 850 pages of authoritative guidance on accounting for derivatives,
generated primarily by four related accounting standards194 and over 180 implementation
and interpretive issues. What started out with a simple principle—“Record all derivatives
at fair value”—became very rules-based through a proliferation of scope exceptions and
extensive implementation and interpretive guidance, as preparers and auditors requested
more detailed guidance. Many issues contribute to the complexity and challenges of the
current approach to derivative accounting, but there appear to be four primary issues:
i.) The scope of the guidance, including the definition of and identification of a
derivative;
ii.) The application of hedge accounting;
iii.) The “bifurcation” requirements for embedded derivatives; and
iv.) The valuation methodologies used.
In defining the scope of SFAS No. 133, the FASB avoided simply listing the
instruments and contracts to which the standard would apply (for example, options,
forward contracts, interest rate swaps, etc). If the scope of an accounting standard were
defined in such a way, the definition would need to be revised regularly to deal with new
193See Release Nos. 33-7386 and 34-38223 for full text of the rule.
194SFAS No. 133, as well as SFAS No. 137, Accounting for Derivative Instruments and Hedging
Activities–Deferral of the Effective Date of FASB Statement No. 133, SFAS No. 138, Accounting for
Certain Derivatives and Certain Hedging Activities, and SFAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities.
78
instruments. Instead, SFAS No. 133 employed a characteristics-based definition195 so
that any instrument or contract reflecting those characteristics would be covered by the
derivatives guidance. Further, to prevent issuers from avoiding the recognition and
measurement guidance in SFAS No. 133, the standard requires that derivatives embedded
in non-derivative financial instruments or other contracts be “bifurcated” from the host
instrument and separately valued.196
Although FASB attempted to take an inclusive approach in developing SFAS No.
133, the Board also included a number of exceptions to the standard’s definition of a
derivative. These exceptions served to exclude certain contracts that otherwise would be
accounted for as derivatives. In some cases, the exceptions were included because other
accounting pronouncements already covered certain instruments. For example, from an
economic perspective, many insurance contracts are derivatives, but other guidance197
already addressed such contracts. In addition, some contracts that would meet the
definition of a derivative, but are deemed to be “normal purchase and sale” contracts,
were excluded simply to be consistent with the current accounting for similar contracts
that would not qualify as derivatives under SFAS No. 133.198 Finally, derivatives on an
issuer’s own equity are excluded because of questions surrounding whether such
instruments represent assets or liabilities, as opposed to equity.199
While the scope issues present challenges, many more interpretive issues concern
hedge accounting. The underpinnings for allowing hedge accounting, as described
previously, are not all that difficult to understand. The principal idea is to avoid
recognizing volatility in earnings that does not represent true economic volatility.
However, because hedge accounting is optional, and results in changes in the way assets,
195Those characteristics are discussed in paragraphs 6-9, and 57 of SFAS No. 133 (as amended), and in
over 20 interpretative issues addressed by the DIG (“Derivatives Implementation Group”). Those
characteristics generally are that a derivative has:
One or more underlyings and one or more notional amounts or payment provisions or both. Those
terms determine the amount of the settlement or settlements, and, in some cases, whether or not a
settlement is required;
No initial net investment or an initial net investment that is smaller than would be required for
other types of contracts that would be expected to have a similar response to changes in market
factors; and
Terms that require or permit net settlement, it can readily be settled net by a means outside the
contract, or it provides for delivery of an asset that puts the recipient in a position not substantially
different from net settlement.
196This guidance is found in paragraphs 12-16, 60-61, and 176-200 of SFAS No. 133 (as amended) and in
36 interpretative issues addressed by the DIG.
197See, for example, SFAS No. 60. Also note that the FASB has taken up a project to provide additional
guidance on determining when an insurance contract that limits the amount of risk taken on by the insurer
should be accounted for as insurance, and when it should instead be accounted for as an investment by the
insured and a loan by the insurer.
198See SFAS No. 133, paragraphs 271 and 272.
199See SFAS No. 133, paragraph 11(a), EITF Issue No. 00-19, and SFAS No. 150.
79
liabilities, gains, and losses are reflected in the financial statements, the FASB felt it
necessary to limit its use to situations in which the effectiveness of the derivatives at
offsetting the risks being hedged were demonstrable. As such, to qualify for hedge
accounting, an issuer must meet a number of requirements relating to identification of the
hedging relationship and measurement of the effectiveness of that relationship – that is,
measurement of the extent to which the changes in the fair value of the derivative can be
expected to and in fact do offset changes in the value of the hedged item.200
Although the accounting for derivatives attempts to appropriately reflect the
economics of hedged transactions, it is nonetheless true that an issuer engaged in
derivative transactions is economically different from an issuer that is not, all other things
being equal. Thus, it is important for disclosures to communicate the economic risks
involved. The disclosures required by the accounting guidance and by the Item 305 of
Regulation S-K are meant to provide the user with information that goes beyond the
current value of the derivatives. Although fair value may reflect an important aspect of
the “economics” of the derivative at a point in time, it nonetheless 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. For example, a gold
mining company that has entered into fixed price forward contracts to sell its gold has a
very different risk profile than one that has not entered into such contracts, other things
being equal. It is important for investors to understand what risk profile the issuer has
selected—specifically, whether or not the issuer will benefit from an increase in the price
of gold.
Despite the disclosures required by the accounting standards and the
Commission’s rules, there is still 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 issuers could do a better job in the notes to the financial
statements, MD&A, and item 305 disclosures of providing disclosures on market risk
exposures, hedge strategies, and the results of those strategies.
3. Empirical Findings from Study of Filings by Issuers
In this section the Staff presents empirical findings from the Study of filings by
issuers related to derivatives. The Staff also extrapolates from these findings to estimate
amounts related to the approximate population of active U.S. issuers.
As noted previously, instruments that meet the definition of a derivative pursuant
to SFAS No. 133 are reported on the balance sheet at fair value. However, also as noted
above, the scope exceptions in SFAS No. 133 allow certain arrangements having the
economic characteristics of derivatives to remain off-balance sheet. As there are no
required disclosures for these latter arrangements, the Staff cannot reach any conclusions
regarding the extent of these arrangements based on public filings.
200There have been many interpretive issues that address whether hedge accounting can be applied to
certain situations. Indeed, over 180 issues have been addressed to date by the DIG, many of which
interpret the hedge accounting guidance in SFAS No. 133. The requirements further manifest themselves
in the level of documentation necessary to maintain hedge accounting.
80
Since derivatives subject to SFAS No. 133 are reported on the balance sheet at
fair value, the Staff did not make it a priority to report their extent in the Study of filings
by issuers. However, as a result of conducting the Study of filings by issuers, the Staff
notes that it is often difficult to determine the total dollar amounts that are on the balance
sheet related to derivatives. This difficulty stems from the fact that derivatives may be
presented as separate line items on the balance sheet, or alternatively, included as a
component of some broader category (e.g., other assets).201 This latter treatment occurs
predominantly for derivatives whose current values are not considered material to the
balance sheet presentation. Moreover, derivatives disclosures may be presented in
different places in an issuer’s 10-K filing.
Table III(F)(1) describes the percentage of issuers reporting derivatives for
trading and non-trading purposes. Although only approximately 10% of the sample
issuers report derivative transactions for trading purposes, approximately 63% of the
sample issuers report using derivatives for non-trading purposes. Note fully 95% of the
large issuer sub-sample report derivatives for non-trading (i.e., hedging) purposes. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that approximately 3% of the population of issuers report that they
use derivatives for trading purposes, while more than 30% report the use of derivatives
for non-trading purposes.
TABLE III(F)(1): Issuers Reporting Purpose of Using Derivatives a
Sub-Samples
Categorized by Purpose b Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
For trading purposes 10.5 18 3 3.1
For non-trading purposes 62.5 95 30 30.6
a These data were collected from the notes to the financial statements and the market risk disclosures in the filings of
issuers selected for the Study.
b These categories are not mutually exclusive.
Table III(F)(2) describes the percentage of issuers reporting the use of different
types of derivative instruments. The largest percentages of issuers report the use of
forwards and swaps, while few report using credit derivatives and combinations of
derivatives. Again, these results are largely driven by the large issuer sub-sample.
201SFAS No. 133 does not require separate disclosure of the fair value of derivatives in the notes to the
financial statements. Accordingly, many issuers do not provide this information, and the Staff noted that
the disclosures by those who do may appear in many different places in the notes.
81
TABLE III(F)(2): Issuers Reporting Types of Derivative Instruments Used a
Sub-Samples
Categorized by Type of Derivative
Instrument b Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Options 25.5 47 4 4.4
Futures 15 25 5 5.2
Forwards 39 66 12 12.5
Swaps 48 78 18 18.6
Credit derivatives 5.5 10 1 1.1
Combinations 4.5 8 1 1.1
a These data were collected from the notes to the financial statements and the market risk disclosures in the filings of
issuers selected for the Study.
b These categories are not mutually exclusive.
It is important to note, however, that even though the fair value of certain
derivatives is on the balance sheet, the risks inherent in these instruments are not, and can
not be, adequately presented on the balance sheet. Although it is true that the balance
sheet is also unable to capture the risks associated with owning, say, equipment, or
inventory, for the most part, investors understand the risks and rewards of such
“ownership” arrangements. The difference between these more familiar arrangements
and derivatives is the latter’s potential volatility, the low level of investment that may be
required, and the flexibility available in structuring the agreements. As a consequence,
supplemental disclosures are even more important for derivatives in understanding risk.
Thus, the Staff believed it was important in evaluating balance sheet transparency to
examine the disclosures related to derivatives in the Study of filings by issuers.
As described in Section III(F)(1)(c), disclosures about derivatives are presented in
the notes to the financial statements and in a section of the filing that reports on the
issuer’s exposure to market risks. The information in the notes to the financial statements
includes both qualitative and quantitative information about the issuer’s involvement with
derivatives. The issuer is required to report qualitative information about, among other
things, “its objectives for holding or issuing those instruments, the context needed to
understand those objectives, and its strategies for achieving those objectives.”202 The
issuer is also required to report quantitative information, but most of this information
relates to hedge accounting, such as the amount of gain or loss temporarily deferred in
accumulated other comprehensive income (a component of shareholders’ equity), and the
amount of any ineffectiveness recognized in the income statement, resulting from the
hedging arrangements.
Table III(F)(3) describes the percentage of issuers reporting the use of certain
forms of hedge accounting. Approximately 46% of the sample issuers report using cash
flow hedges and 42% report using fair value hedges. However, as these results are
202SFAS No. 133, paragraph 44.
82
largely driven by the large issuer sub-sample. An extrapolation of the findings from the
sample to the approximate population of active U.S. issuers suggests that only
approximately 17% of the population reports the use of cash flow hedges and
approximately 8% report the use of fair value hedges.
TABLE III(F)(3): Issuers Reporting Use of Hedge Accounting a
Sub-Samples
Categorized by Type of Accounting
Hedge b Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers reporting cash flow hedges 45.5 75 16 16.6
Issuers reporting fair value hedges 42 77 7 7.7
a These data were collected from the notes to the financial statements and the market risk disclosures in the filings of
issuers selected for the Study.
b These categories are not mutually exclusive.
As noted above, issuers are required to disclose information about market risks in
their filings; these issuers may or may not use derivatives to hedge such market risks.
These disclosures are both qualitative and quantitative in nature. The qualitative
information includes disclosures regarding the issuer’s primary market risk exposures,
how those risks are managed, and actual or expected material changes in the issuer’s
exposures. The quantitative information is intended to provide investors with
information to assess the potential impact of market risks on the issuer.
Table III(F)(4) describes the percentage of issuers reporting different types of
market risks. A total of 60% of the sample issuers report some type of exposure to
market risk. Note that the largest number of issuers report interest rate risk and currency
price risk—almost 50% and 43%, respectively—while fewer issuers report commodity
price risk or equity price risk. In the large issuer sub-sample, 82% of the issuers report
exposure to interest rate risk and 76% report currency price risk; but in the random issuer
sub-sample only 17% of issuers report interest rate risk and only 9% report currency price
risk.
83
TABLE III(F)(4): Issuers Reporting Market Risks a
Sub-Samples
Categorized by Type of Market
Risk b Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Any market risk 60 91 29 29.6
Commodity price risk 15 24 6 6.2
Interest rate risk 49.5 82 17 17.6
Currency price risk 42.5 76 9 9.7
Equity price risk 15.5 31 0 0c
a These data were collected from the notes to the financial statements and the market risk disclosures in the filings of
issuers selected for the Study.
b These categories are not mutually exclusive.
c Less than 1%
The Staff notes that one barrier to achieving transparency is that the disclosures
related to market risk are usually organized by type of market risk (e.g., commodity price
risk, interest rate risk, etc.), but the SFAS No. 133 disclosures in the notes to the financial
statements are usually organized by type of accounting hedge (e.g., cash flow hedges, fair
value hedges, etc.). Thus, it may be difficult for issuers and investors to effectively
integrate the disclosures.
Further, there is no one generally accepted method for characterizing and
communicating information about risk. As a result, Commission rules allow issuers to
choose among three types of quantitative disclosures. Issuers may simply disclose the
terms of any outstanding derivative contracts in a tabular format, including information
about fair values and contract terms relevant to determining future cash flows,
categorized by expected maturity dates. Alternatively, issuers may disclose sensitivity
analysis assessing the potential for loss (e.g., in terms of net income) resulting from
hypothetical changes in various market factors (e.g., oil prices). Issuers may also present
the results of a value-at-risk (“VaR”) analysis, which quantifies the potential loss in fair
values, earnings or cash flows, from market movements with a selected likelihood of
occurrence.
Table III(F)(5) describes the percentage of issuers using different types of
disclosures in reporting market risks. As noted above, 60% of sample issuers report some
type of exposure to market risk (see Table III(F)(4)). More than half of this group (i.e.,
more than half of those disclosing information about market risks) present sensitivity
analysis in their disclosures; 12% present value-at-risk disclosures and another 9%
present tabular disclosures.203 As a result, comparing the risk disclosures across issuers
can be difficult, due to lack of comparability. As is the case with regard to the earlier
results, these percentages are driven by the predominance of derivative use in the large
issuer sub-sample.
203Issuers may use different methods to disclose information about different market risks.
84
TABLE III(F)(5): Issuers Reporting Risk Disclosures for Non-trading Derivatives a
Sub-Samples
Categorized by Type of Risk
Disclosure b Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Tabular 9 14 4 4.1
Sensitivity analysis 32 52 12 12.4
Value-at-risk 12 21 3 3.2
a These data were collected from the market risk disclosures in the filings of issuers selected for the Study.
b These categories are not mutually exclusive.
However, even if two issuers use the same type of disclosure about derivatives,
direct comparisons between issuers still may not be possible. Consider two issuers that
both use sensitivity analysis to communicate information about their risk exposure to
interest rate risk. These disclosures require that an issuer estimate the change in some
component of issuer value (the numerator) as a result of a change in some component of
market risk (the denominator). One issuer may report the change in net income (this
particular issuer’s choice of numerator) as a result of a 1% increase in LIBOR rates (this
issuer’s choice of denominator). Another issuer may report the change in a different
numerator as a result of a change in a different denominator. Both of these disclosures
may meet the requirements set up by the Commission, but investors may not be able to
effectively compare these two issuers based upon public filings.
As an example, Table III(F)(6) reports the numerators and denominators for the
sensitivity analyses related to interest rate risk for a set of pharmaceutical issuers (i.e.,
SIC=2834). The disclosures identified in this table are for illustrative purposes only and
are not highlighted as being in any way insufficient or inconsistent with the disclosure
requirements under Item 305 of Regulation S-K, but were simply selected to show the
range of potential disclosures under Item 305 and the resulting difficulty of comparing
the disclosures of different companies.
85
TABLE III(F)(6) Empirical Findings Regarding Comparability of Sensitivity
Analysis Disclosures Related to Interest Rate Risk for Pharmaceutical Industry
(SIC=2834) a,b
Numerator Denominator
Company A b
Cash flows, income, or market
values
100 basis point change in interest
rates
Company B b
Financial position, results of
operations, or cash flows
10% change in interest rate
structure
Company C
Fair value of derivative and other
interest rate sensitive instruments
10 basis point change in interest
rates
Company D Fair value of debt and investments
1 basis point change in interest
rates
Company E
Net income related to financial
instruments
10% adverse change in interest
rates
Company F
Fair value of outstanding long term
debt outstanding 10% decrease in interest rates
Company G Fair value of outstanding debt 1% point increase in interest rates
a These data were collected from the market risk disclosures in the filings of issuers selected for the Study.
c The sensitivity is reported to be immaterial for these issuers.
Overall, based on information available in public filings, not only is it difficult to
ascertain the magnitude of the fair values of derivatives that are reported on the balance
sheet, it is also difficult to ascertain the extent of the underlying market risk exposures, as
well as the effects of derivative transactions intended to hedge these risks. Although the
tradeoff between comparability and representational faithfulness presents significant
challenges, the Staff believes improvements can and should be made to enhance the
transparency of reporting issuer activities related to derivatives and risk management.
The Staff notes the FASB’s recently announced project to consider enhancing the
existing disclosure requirements of SFAS No. 133. The FASB has stated that it will also
consider whether to expand the scope of any disclosure enhancements to include financial
instruments outside the scope of SFAS No. 133.
G. Other Contractual Obligations
1. Nature of Arrangements and Financial Reporting
Requirements
Issuers are involved in any number of contractual obligations, including debt
obligations, retirement obligations, compensation agreements, leases, guarantees,
derivatives, and obligations to purchase goods and services. In many cases, liabilities are
recognized on the balance sheet at the inception of the contract, because one party has
performed. For example, if an issuer borrows money, it recognizes a liability upon
receipt of the funds. In other cases, liabilities are recognized as time passes, as in the
case of interest related to the borrowed funds. In still other cases, contractual obligations
remain off the balance sheet. Examples of these obligations may include operating
86
leases, portions of obligations related to retirement plans, certain guarantees, and certain
derivatives, all of which have been discussed above. Although the discussion generally
applies to other types of contractual obligations, this section will primarily focus on one
major class of contractual obligations that remain off issuer balance sheets—purchase
obligations.204
A purchase obligation could be as simple as a standard one-time purchase order.
Alternatively, the purchase obligation may be attributable to the purchase of goods or
services to be delivered over an extended period of time. Generally, the accounting
question is whether or not a party to a contract should reflect the rights and obligations
inherent in the contract upon signing the contract, and, if so, in what way.
Consider a contract to purchase one million units of inventory per year for the
next three years.205 Upon signing the contract, the purchaser could record an asset (e.g.,
“Inventory Receivable”) and a liability (e.g., “Purchase Obligation”). The seller could
also record an asset for the cash to be received and a liability reflecting its obligation to
deliver the inventory. However, at this point in time, nothing has been delivered and no
payment has been made. Nonetheless, one could argue that, even though no performance
has occurred, the issuers have many of the same risks and rewards as if the exchange had
already been completed, and thus should recognize the related assets and liabilities.
Under this view, it could be argued that binding contracts give rise to assets and liabilities
in advance of any performance under the contract.
The contrary view is that assets and liabilities should only be recognized to the
extent performance has occurred—that is, to the extent that one or both parties have
carried out the actions (duties) agreed to in the contract, such as delivering or paying for
the goods. Under this view, until some amount of performance has occurred on a
contract, the buyer does not have an asset for the goods or services to be received nor a
liability (i.e., a present obligation) to pay for them, and the seller does not have a
recognizable asset for the right to collect the contractual payments. Thus, no asset or
liability would be recorded until some performance has occurred. For example, if the
purchaser of the inventory paid for it in advance, the purchaser’s obligation to pay would
be considered performed, and the purchaser would at that time record an asset to
recognize its right to receive inventory.
The latter view underlies the more common financial reporting treatment. Thus,
signing a contract for the sale/purchase of goods generally does not result in the
recognition of an asset or liability by either party. However, there are exceptions to this
general treatment. Two of the major exceptions are addressed in separate sections of this
204The Staff does not address loan commitments, lines of credit, and other similar arrangements in the
Study, due to their specialized industry-specific nature and the fact that these obligations to provide funding
under certain terms and conditions themselves constitute a financial service, which is arguably more similar
to an obligation to sell than an obligation to purchase.
205The motivation to enter into such contractual commitments is straightforward. An issuer that uses
certain raw materials in its production may wish to secure its supply of those materials—and possibly the
price, as well—by entering into long-term purchase contracts. The provider of raw materials may also
benefit from knowing how much to produce.
87
report: leases and derivatives. In yet other cases, while the assets and liabilities related to
an unperformed contract are not separately recognized, losses embedded in those
contracts are recognized. This so called “loss contract” accounting is required when an
issuer has committed to purchase inventory at prices that ensure a loss on resale of that
inventory,206 and when a long-term construction contract is expected to result in a loss.207
In January 2002, the Commission released FR-61, “Commission Statement about
Management's Discussion and Analysis of Financial Condition and Results of
Operations,” which described the views of the Commission regarding certain disclosures
that should be considered by issuers, including disclosures about contractual obligations
and commercial commitments. This guidance was updated in the 2003 revision by the
Commission of Item 303(A)(4) of Regulation S-K. Item 303(A)(4) requires disclosures
about certain off-balance sheet arrangements, including certain contractual obligations.
Specifically, these new rules require tabular disclosure in MD&A of contractual
obligations, including open purchase orders, that will result in future cash payments.
This disclosure is intended to provide financial statement users with information about
unrecognized (as well as recognized) obligations. While the disclosures do not provide
information about the related assets to be received as a result of those cash payments, the
disclosures are an attempt to portray contractual obligations broadly.
2. Off-Balance Sheet Issues in Accounting for Contractual
Obligations
Conceptually, the accounting for unperformed contractual obligations could be
done in a variety of ways. For example, all contractual rights and obligations could be
recognized as assets and liabilities.208 This would recognize the fact that once an entity
enters into a firm contract to buy or sell something, the entity is generally subject to many
of the same risks and rewards as if the transaction had already been completed. For
example, once an issuer has entered into a firm fixed-price contract to purchase
inventory, future declines in the value of that inventory affect the issuer. Similarly, once
an issuer has agreed to sell inventory for a particular price, future decreases in the value
of that inventory do not affect the issuer.
However, to the extent neither party to a contract has performed, each party’s
rights and obligations are, at least implicitly, contingent upon the other party’s. As such,
some assert the rights and obligations in the contract do not qualify as assets and
liabilities because they do not result from past transactions. Others believe that, because
the rights and obligations are contingent upon one another, they should be accounted for
only as a group—that is, the “unit of account” would be the contract as a whole, rather
than the assets and liabilities individually. In this analysis, the assets and liabilities would
be offset against one another. Assuming the contract represents an exchange of equal
206See ARB 43, Chapter 4, Statement 10.
207See SOP 81-1, paragraphs 85-89.
208The CFA Institute (formerly AIMR) has called upon standard setters to treat all executory contracts with
terms greater than one year as assets and liabilities. See Financial Reporting in the 1990s and Beyond,
AIMR (1993), page 86.
88
values, the values of the assets and liabilities would likely net to zero, thus effectively
resulting in no impact on the balance sheet.
Although standard-setters have almost invariably determined that such
unperformed contracts should not result in the recording of assets and liabilities, the basis
for these decisions is not always stated.209 For example, as mentioned above, losses on
certain contractual commitments, such as inventory purchases and construction contracts,
are required to be recognized before performance occurs. Conceptually, the loss in these
contracts might be viewed as akin to an asset impairment loss, even though the rights in
these contracts have not previously been reported as assets.
Another potentially confusing aspect of accounting for loss contracts is that the
accounting is applied far beyond the situations specifically addressed in the accounting
guidance. Although this guidance specifically applies to very narrow classes of
transactions, issuers and auditors have often applied it by analogy to other unperformed
contractual obligations. These analogies have been applied sporadically, meaning that
losses inherent in some unperformed contracts are recorded, while others are not. This
diversity led the EITF to consider two issues related to losses on unperformed contracts.
Neither, however, resulted in a consensus.210
3. Empirical Findings from Filings by Issuers
In this section the Staff presents empirical findings from the Study of filings by
issuers related to purchase obligations, a subset of contractual obligations. Other major
categories of contractual obligations, such as leases, guarantees, and derivatives, have
been addressed in other sections of this Report. The Staff also extrapolates from these
findings to estimate amounts for the approximate population of active U.S. issuers.
Table III(G)(1) describes the percentage of issuers reporting purchase obligations.
Approximately 54% of issuers in the sample report cash flows committed under purchase
obligations. An extrapolation of the findings from the sample to the approximate
population of active U.S. issuers suggests that approximately 30% of the total population
of issuers report cash flows committed under purchase obligations.
209Neither the FASB’s actual, or proposed, Statements of Financial Accounting Concepts clarifies, one way
or the other, whether recognition of contractual commitments fits within the current conceptual framework.
By commissioning a research report on Recognition of Contractual Rights and Obligations, the FASB gave
some recognition, in 1980, to the need to consider the conceptual framework in relation to executory
contracts. That research report was written by Yuji Ijiri, Recognition of Contractual Rights and Obligations
(Stamford, CT: FASB, December, 1980).
210See EITF 99-14 and EITF 00-26.
89
TABLE III(G)(1): Issuers Reporting Future Cash Flows Committed under
Purchase Obligations a
Sub-Samples
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers Reporting Purchase
Obligations 54 78 30 30.5
a These data were collected from the contractual obligations table in the MD&A of the filings of issuers selected for the
Study.
Table III(G)(2) presents the total future cash flows committed under purchase
obligations for the 200 issuers in the sample, which are not recorded on the balance
sheets of issuer. The undiscounted sum of the future committed cash flows related to
purchase obligations for our sample of issuers is approximately $434 billion. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that the total (undiscounted) cash flows associated with purchase
commitments reported by the population is approximately $725 billion.
TABLE III(G)(2): Reported Future Cash Flows Committed under Purchase
Commitments a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
Total undiscounted cash flows $433,661 $430,713 $2,948 $725,513
a These data were collected from the contractual obligations table in the off-balance sheet arrangements section of the
MD&A (required by FR67) for the filings of issuers selected for the Staff Study. It is important to note that these
amounts are not discounted.
Issuers reported other types of contractual obligations in the Contractual
Commitments table in MD&A. In many cases, it is obvious whether the commitment in
question is, indeed, on the issuer’s balance sheet (e.g., debt). However, in some cases,
the Staff notes that whether the item is on or off the balance sheet remains unclear.
90
IV. EMPIRICAL FINDINGS ON CERTAIN POST-SARBANES-
OXLEY IMPROVEMENTS IN FINANCIAL REPORTING ON
OFF-BALANCE SHEET ARRANGEMENTS
A. Consolidation of Variable Interest Entities
1. Discussion
After the downfall of Enron, attention became focused on special purpose entities,
a vehicle frequently used by Enron as a means to get assets and liabilities off the balance
sheet. In response to the attention on previous SPE accounting,211 the FASB developed a
new accounting interpretation that targets what are now referred to as variable interest
entities (“VIEs”). FASB Interpretation No. 46, Consolidation of Variable Interest
Entities—an interpretation of ARB No. 51, was issued in January 2003, with a revision—
Interpretation No. 46(R), Consolidation of Variable Interest Entities (revised December
2003)—an interpretation of ARB No. 51—issued in December 2003.212
Variable interest entities include SPEs and can be generally described as entities
in which the equity investment at risk does not provide its holders with the characteristics
of a controlling financial interest or is not sufficient for the entity to finance its activities
without additional subordinated financial support.213 These characteristics are meant to
identify arrangements in which control of the entity would not be achieved through
voting stock ownership, but through some other method.
FASB Interpretation No. 46(R) requires consolidation of a variable interest entity
by a party that has a majority of the risks and rewards (i.e., greater than 50%) associated
with the entity. Interpretation No. 46(R) also establishes a methodology for determining
which party associated with a VIE should consolidate the VIE. Essentially, the
requirement is that the party exposed to a majority of the variations in the outcome of the
performance of a VIE, both positive and negative, should consolidate the VIE, because
such exposure is likely to be indicative of control. Interpretation No. 46(R) refers to
such a party as the primary beneficiary of the VIE.
An issuer’s involvement with a VIE can manifest itself in debt instruments,
guarantees, service contracts, written put options, total return swaps, etc. These
arrangements with a VIE can put the issuer in a position akin to an equity holder in that
the issuer bears the same risks and rewards of the VIE as an equity holder would. For
example, consider an issuer that owns 50% of the voting stock of another entity and is the
sole guarantor of debt of the entity. Before Interpretation No. 46(R), such an issuer may
211See EITF Topic D-14, Transactions involving Special-Purpose Entities; EITF 96-21, Implementation
Issues in Accounting for Leasing Transactions involving Special-Purpose Entities; EITF 90-15, Impact of
Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions.
212As has been the convention in the rest of this document, the Staff will generally refer to the revised
version of the interpretation (i.e., Interpretation No. 46(R)). However, there are some cases in this section
that require reference to the original version of the interpretation (i.e., Interpretation No. 46).
213See Interpretation No. 46(R), paragraph D2.
91
not have been required to consolidate the other entity based upon voting control.
However, subsequent to the promulgation of Interpretation No. 46(R), if this same entity
is deemed to be a VIE, then the issuer would likely be required to consolidate, due to the
issuer’s additional risk of loss from the outstanding guarantee.
In anticipation of the implementation of Interpretation No. 46 and Interpretation
No. 46(R), a number of entities restructured arrangements with potential VIEs such that
they would not require consolidation. Disclosures of such restructurings were noted in
the sample companies. The Staff also is aware anecdotally that many arrangements with
potential VIEs were restructured such that the entity either would not be considered a
VIE or such that no party would be required to consolidate the VIE. The effect of such
changes is difficult to measure. However, in some cases, it appears that the changes
made involved substantive changes to the economics of the variable interests or to the
decision-making capabilities of the investors, while in other cases, the changes may have
been less substantive.
Although Interpretation No. 46(R) constitutes an improvement over the
previously existing consolidation guidance, a number of interpretive questions remain.
Many users of Interpretation No. 46R find it theoretically and practically challenging to
apply. Currently, the FASB is considering ways to resolve an issue originally discussed
by the EITF in issue 04-07, Determining Whether an Interest Is a Variable Interest in a
Potential Variable Interest Entity. A consensus on this EITF issue may change how some
issuers apply Interpretation No. 46(R).
The Staff has noted that Interpretation No. 46(R) has resulted in a number of non-
SPE type entities being consolidated such as joint ventures and jointly owned entities
such as LLCs. However, it is unclear to the Staff whether Interpretation No. 46(R) has
significantly increased the number of SPE entities that are consolidated. In part, this may
be a result of practice being ahead of the standard setters, effectively restructuring
arrangements in advance of the effective date of standards in order to achieve desired
financial reporting results. Even so, if the changes made to SPEs in order to avoid
consolidation do indeed represent substantive changes, such that the issuers in question
no longer control the SPE, Interpretation No. 46(R) will have improved financial
reporting even if there is not a significant increase in the frequency of consolidation of
SPEs. The Staff believes more time is needed to fully evaluate the effects of
Interpretation No. 46(R).
2. Empirical Findings from Study of Filings by Issuers
This section summarizes the empirical findings from the Study of filings by
issuers related to VIEs. The Staff also extrapolates from these findings to estimate
amounts related to the approximate population of active U.S. issuers.
The Staff examined the disclosures related to Interpretation No. 46 and
Interpretation No. 46(R) in the annual 10-K filings used for the remainder of the Study.
However, as of that point in time, many of the sample issuers had not yet fully adopted
Interpretation No. 46(R), so the available data was primarily limited to disclosures about
92
the expected impact of adopting Interpretation No. 46(R).214 In light of these limitations,
the Staff supplemented the data by collecting additional information regarding issuers’
implementations of Interpretation No. 46(R) from selected quarterly 10-Q filings.
Table IV(A)(1) describes the percentage of issuers reporting different levels of
actual or anticipated effects of implementing Interpretation No. 46 (and to some extent,
of Interpretation No. 46(R)) as of the date of our sample issuers’ annual 10-K or 10KSB
filings.
Table IV(A)(1): Anticipated Effects of Adoption of Interpretation No. 46 Presented
in Annual 10-K Filings a
Sub-Samples
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers with no Interpretation No. 46
disclosures 18.5 7 30 29.8
Issuers reporting no VIEs b 13 6 20 19.9
Issuers reporting no material VIEs b 8.5 11 6 6.0
Issuers reporting that the effect of
adopting Interpretation No. 46 was not
material or not expected to be material
38 48c 28 28.2
Issuers reporting no statement about
materiality for any VIEs 12 14 10 10.0
Issuers reporting they are still
evaluating for some VIEs 6.5 7 6 6.0
Issuers reporting that the impact of
adopting Interpretation No. 46(R) was
material or was expected to be
material for any VIEs
3.5 7 0 0.0d
a These data were collected from the notes to the financial statements in the 10-K filings of issuers selected for the
Study. In some cases, issuers had fully or partially implemented Interpretation No. 46(R) as well.
b Issuers included in this category are not counted in the categories below, even though some of these issuers also stated
that the effects were not material.
c Approximately 16% of the issuers in this group reported the existence of VIEs other than those for which they
considered impact of Interpretation No. 46(R) to be immaterial, but these issuers did not make any statement about
materiality for these other VIEs.
d Less than 0.5%.
214As of the 10-K filing dates for the sample, most issuers had either not adopted or had only partially
adopted Interpretation No. 46(R), because Interpretation No. 46(R) replaced Interpretation No. 46, but only
after the effective date of Interpretation No. 46. The effective date for Interpretation No. 46(R) was after
the balance sheet date for most 10-K filings in the sample. In addition, public small business issuers (i.e.,
issuers that file a 10KSB) were not required to adopt Interpretation No. 46(R) until 9 months after other
public issuers.
93
The information gathered for this table mainly relies on disclosures under Staff
Accounting Bulletin No. 74, Disclosure of the impact that recently issued accounting
standards will have on the financial statements of the registrant when adopted in a future
period (“SAB 74”). As can be seen, less than 4% of the sample issuers reported that the
impact of the interpretations either was material or was expected to be material, and all of
these issuers were members of the large issuer sub-sample. An extrapolation of the
findings from the sample to the approximate population of active U.S. issuers suggests
that less than 1% of the issuers in the population would expect the effect of the
interpretations to be material.
In addition, as mentioned above, the Staff believes that some arrangements with
potential VIEs were restructured such that the entity would not be consolidated under
Interpretation No. 46 or 46(R). In fact, seven issuers in the large issuer sub-sample made
reference in their filings to restructurings that occurred in anticipation of or coincident
with the implementation of Interpretation No. 46 and 46(R).
The Staff supplemented its analysis of the annual 10-K filings by collecting
additional information about the application of Interpretation No. 46 and 46(R) from
selected quarterly 10-Q filings, which is presented in Tables IV(A)(2) and IV(A)(3).215
Table IV(A)(2) describes the percentage of issuers reporting adoption of
Interpretation No. 46(R) and the percentage of issuers that are affected. Approximately
77% of the sample issuers report that they have adopted Interpretation No. 46(R).216
Approximately 12% of the sample issuers report in their quarterly 10-Qs that they have
no VIEs, which is a similar proportion of those who reported no VIEs in their SAB 74
disclosures (i.e., 13%). Issuers reporting the existence of VIEs in their quarterly 10-Qs
amounted to approximately 32%. Finally, approximately 23% of the sample issuers
report the existence of VIEs that are consolidated.
215The Staff selected the quarterly 10-Q filing for each issuer in the sample for the period in which
Interpretation No. 46(R) should have been fully adopted. Public small business issuers (i.e., issuers that file
a 10KSB) were not required to adopt Interpretation No. 46(R) until 9 months after other public issuers. As
a result, the Staff cannot comment on the effects of Interpretation No. 46(R) for many of the issuers in this
category.
216Some sample issuers may not have reported adoption if they had no arrangements that were in the scope
of Interpretation No. 46(R) and thus concluded that no disclosure was necessary.
94
Table IV(A)(2): Effects of Adoption of Interpretation No. 46(R) Presented in
Quarterly 10-Q Filings a
Sub-Samples
Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Issuers Reporting Full Adoption of
Interpretation No. 46(R)b 76.5 88 65c 65
Issuers Reporting No VIEs 11.5 5 18 17.9
Issuers Reporting Existence of
VIEs a 32 50 14 14.4
Issuers Reporting VIEs that are
Consolidated b 22.5 39 6 6.3
a These data were collected from the notes to the financial statements in the 10-Q filings of issuers selected for the
Study.
b In many cases, filings did not clearly indicate whether the consolidations occurred as a result of adopting
Interpretation No. 46(R).
c Includes 8 of the 26 small business issuers in the sample.
The findings for the sub-samples present a different picture. Only 5% of the large
issuer sub-sample report that they have no VIEs, compared to 18% of the random issuer
sub-sample. Approximately 50% of the large issuer sub-sample reports the existence of
VIEs, and 39% of this sub-sample reports consolidating at least some of these VIEs. In
contrast, only 14% of the random issuer sub-sample report the existence of VIEs, and
only 6% report any consolidation.
Table IV(A)(3) presents the reported amounts of assets and liabilities consolidated
under Interpretation No. 46(R). The sample issuers consolidated approximately $208
billion in assets and almost $170 billion in liabilities, the vast majority of which reflects
consolidations in the large issuer sub-sample. These assets and liabilities represent
approximately 2% of the total assets and 2% of the total liabilities for the sample (as
shown in Table II(A)(2)), and are proportionate for each of the sub-samples. An
extrapolation of the findings from the sample to the approximate population of active
U.S. issuers suggests that VIEs with approximately $516 billion in assets and $444
billion in liabilities are consolidated by the population.
95
TABLE IV(A)(3): Reported Amounts Related to Consolidated Assets and
Liabilities of Variable Interest Entities a
Sub-Samples
Full Sample
(n=200)
(millions)
Large
Issuers
(n=100)
(millions)
Random
Issuers
(n=100)
(millions)
Estimate for
Population
(N=10,100)
(millions)
VIEs Consolidated by Issuers:
Assets $208,312 $205,206 $3,106 $515,806
Liabilities $169,706 $166,938 $2,768 $443,738
a These data were collected from the notes to the financial statements in the 10-K and 10-Q filings of issuers selected
for the Study. In most cases, filings did not clearly indicate whether the consolidations occurred as a result of adopting
Interpretation No. 46(R).
B. Disclosure in Management's Discussion and Analysis about Off-
Balance Sheet Arrangements and Aggregate Contractual
Obligations
1. Discussion
As directed by Section 401(a) of the Act, the Commission adopted amendments to
its rules to require each annual and quarterly financial report required to be filed with the
Commission to disclose “all material off-balance sheet transactions, arrangements,
obligations (including contingent obligations), and other relationships of the issuer with
unconsolidated entities or other persons, that may have a material current or future effect
on financial condition, changes in financial condition, results of operations, liquidity,
capital expenditures, capital resources, or significant components of revenues or
expenses.”217 The rule requires an issuer to provide an explanation of its off-balance
sheet arrangements in a separately captioned subsection of the Management's Discussion
and Analysis section of the issuer’s disclosure documents. It also requires issuers (other
than small business issuers) to provide an overview of certain known contractual
obligations in a tabular format.
FR 67 requires disclosure for any contractual arrangement to which an
unconsolidated entity is a party, and under which a registrant has:
• Any obligation under certain guarantee contracts;
• A retained or contingent interest in assets transferred to an unconsolidated entity;
• Any obligation under certain derivative instruments; or
• Any obligation under a variable interest held by the issuer in an unconsolidated
entity.218
217Final Rule: Disclosure in Management's Discussion and Analysis about Off-Balance Sheet Arrangements
and Aggregate Contractual Obligations, Release No. 34-47264, also codified in FR 67
218See FR 67 for a more detailed description of these categories.
96 Disclosure is required to the extent necessary to provide an understanding of the
issuer’s material off-balance sheet arrangements as well as the material effects of those
arrangements on financial condition, changes in financial condition, revenues or
expenses, results of operations, liquidity, capital expenditures or capital resources. As the
Commission noted in the release accompanying the final rule, management has the
responsibility to identify and address the key variables and other qualitative and
quantitative factors that are peculiar to, and necessary for, an understanding and
evaluation of the issuer. More specifically, to the extent necessary for an understanding
of the issuer’s off-balance sheet arrangements, an issuer must provide the following four
items:
• The nature and business purpose of the issuer’s off-balance sheet arrangements;
• The importance of the off-balance sheet arrangements to the issuer for liquidity,
capital resources, market risk or credit risk support or other benefits;
• The financial impact of the arrangements on the issuer (e.g., revenues, expenses,
cash flows or securities issued) and the issuer’s exposure to risk as a result of the
arrangements (e.g., retained interests or contingent liabilities); and
• Known events, demands, commitments, trends or uncertainties that affect the
availability or benefits to the issuer of material off-balance sheet arrangements.
2. Empirical Findings from Study of Filings by Issuers
This section summarizes the empirical findings of the Staff Study of filings by
issuers related to off-balance sheet arrangements reported in the section of MD&A, as
required by FR 67. The Staff also extrapolates from these findings to estimate amounts
related to the approximate population of active U.S. issuers.
Table IV(B)(1) describes the percentage of issuers reporting different types of
arrangements in the off-balance sheet section of MD&A. Approximately 23% of issuers
report information about guarantees in the off-balance sheet section of their MD&A.
Only approximately 8% report information about variable interests held in
unconsolidated VIEs. Approximately 13% also report information about retained
interests in financial assets transferred to an unconsolidated entity. Even fewer issuers—
approximately 1% of the sample—report the existence of the derivatives required to be
disclosed under FR 67 (e.g., equity-linked derivatives).
97
TABLE IV(B)(1): Issuers Reporting Arrangements in MD&A Off-Balance Sheet
Section a
Sub-Samples
Categorized by Type of
Arrangement b Full Sample
(n=200)
(%)
Large
Issuers
(n=100)
(%)
Random
Issuers
(n=100)
(%)
Estimate for
Population
(N=10,100)
(%)
Variable Interest Entities 7.5 14 1 1.1
Retained Interests 13 25 1 1.2
Guarantees 22.5 39 6 6.3
Equity-linked Derivatives 1 2 0 0c
a These data were collected from the section on off-balance sheet arrangements in the MD&A of the filings of issuers
selected for the Study.
b These categories are not mutually exclusive.
c Less than 0.5%.
In many cases, the Staff notes that a greater proportion of issuers report OBS
arrangements in the notes to the financial statements, as compared to the off-balance
sheet section of the MD&A. For example, more than twice as many issuers report
information on guarantees in the notes to the financial statements as in the off-balance
sheet section. One possible explanation for this is that FR 67 requires disclosures for
only a subset of the guarantees encompassed by the disclosure requirements under
Interpretation No. 45.219 Specifically, FR 67 only requires disclosures for the types of
guarantees that are required to be recognized as liabilities on the balance sheet under
Interpretation No. 45, while Interpretation No. 45 also requires disclosures for certain
arrangements, such as product warranties, that are not required to be recognized on the
balance sheet.
Nevertheless, it appears that issuers may not have identified all of the off-balance
sheet arrangements that are required to be discussed in the OBS section of MD&A.
Further, the Staff believes—based in part on the difficulties faced in gathering the data
necessary for the Study and Report—that the quality of the issuer disclosures provided in
the off-balance sheet section of MD&A can and should be improved. To some extent,
this is not surprising, given that this was the first year for such disclosures. The Staff
expects to focus on these areas in its reviews of issuer filings.
V. Initiatives to Improve Financial Reporting Transparency
This Report has presented analyses and discussion on various types of
transactions and arrangements that may give rise to questions regarding the content of the
balance sheet. The Staff does not, however, view these issues as totally separable from
certain other issues that arise in financial reporting. In the course of the Staff’s day-to-
day work, which includes working with issuers on accounting questions as well as
overseeing the work of the FASB in the development of accounting standards, the Staff
often develops views as to how financial reporting might be improved. While that
219Recall that Interpretation No. 45 governs disclosures in the footnotes.
98
cumulative knowledge informs this Report, the work to produce this Report has also
reinforced some of the Staff’s prior views on several broad goals that it believes are key
to raising the level of quality of financial reporting. We present these items below.
Readers will note that the goals do not speak to particular improvements in
accounting standards. While we do provide specific recommendations related to
accounting standards in Section VI, it is the broad goals that we believe should guide the
work of the standard-setters, and, more importantly, that should be in the minds of
preparers, auditors, regulators, and others who affect financial reporting. The Staff
believes that discussions on improvements in financial reporting too often focus
inappropriately and singularly on standard-setting activities. The Staff believes that
improvement will best be achieved when all parties in the financial reporting process are
working towards the same goals. Indeed, the Staff believes that significant improvement
in the transparency of the balance sheet and of financial reporting in general is possible
without any changes in standards.
A. Eliminate (or at least Reduce) Accounting-Motivated Structured
Transactions
As noted in the introduction to this Report, we have not limited the scope of our
consideration of off-balance sheet transactions to only those transactions that involve
deliberate manipulation on the part of the issuer. Nonetheless, it is true that most of the
scandals that provided a catalyst to the passage of the Act did indeed involve transactions
that were structured so as to present information in a manner inconsistent with the
underlying economics. In fact, deliberate attempts to work around the intent of the
standards have contributed to many of the largest financial reporting failures. These
attempts normally involve transactions that are structured in an attempt to achieve
accounting results that do not mirror the economics of the transaction. With regard to
certain of Enron’s structured transactions, Neal Batson concluded that:
broad concepts have given way to rules-based, bright-line tests under
which the financial accounting for a transaction often depends on the
form of the transaction rather than its economic substance. In fact, in
many cases the very purpose of designing a structured finance
transaction to comply with the literal GAAP rules is to report the
transaction in accordance with its form rather than its economic
substance.220
In addition, transparency and the degree to which accounting and disclosure
standards achieve their goals can be greatly diminished by the use of structuring, even
when that structuring appears to comply with the standards. Examples of this abound in
financial reporting, and touch on several of the topics that are addressed in this Report.
Leasing is a prime example of this. The guidance that currently exists was developed
with regard to the transactions that were commonplace at the time that guidance was
issued. And, indeed, it might have produced results that would have reflected the
220See Second Interim Batson Report, pages 51 and 52.
99
economics of those transactions, if not for the fact that lease transactions changed in
response to the guidance. Interpretation No. 46(R), which addresses the consolidation of
variable interest entities (including SPEs), could well suffer a similar fate. In some cases,
securitizations and derivatives have been used in accounting-motivated transactions.
When we refer to accounting-motivated structured transactions, we are speaking
of those transactions that are structured in an attempt to achieve reporting results that are
not consistent with the economics of the transaction, and thereby impair the transparency
of financial reports.221 Further, we include not only those transactions that would not
have been undertaken but for the perceived “benefits” of the resultant financial reporting,
but also those that adopt a more complex form than would otherwise be the case, in order
to achieve an accounting result. For example, an issuer might contemplate a secured
borrowing transaction because it needs capital—a true business purpose. However, if
that issuer transfers the assets to an SPE, which then borrows the funds and transfers
them to the issuer in a transaction that keeps the debt off the balance sheet while exposing
the issuer to virtually the identical risks and rewards as if the simple secured borrowing
had been undertaken, the Staff considers the transaction to be accounting-motivated.
It is tempting to blame the use of accounting-motivated transactions on
accounting standards that can be exploited. However, while the fact that accounting
standards may be vulnerable to exploitation may be thought of as representing a failure of
the standard-setter, it is the creation and use of a structured transaction undertaken with
purpose and intent to obfuscate, conceal and/or deceive that reduces transparency, not the
standards themselves. Issuers, auditors, and advisors who work to implement
transactions that are structured in ways that attempt to portray the transactions differently
from their substance do not operate in the interests of investors, and may be in violation
of the securities laws.222 Underscoring the seriousness of the problems caused by
accounting-motivated transaction structures, the Commission has recently entered into
settlements with several entities that engaged in the development or facilitation of
transaction structures.223
The Staff believes that the significant use of accounting-motivated transactions
has contributed to a reduction in the transparency and credibility of financial statements.
221Thus, we do not mean to include situations where, for example, an issuer increases its sales efforts at the
end of a period to generate revenue. In that situation, the reporting of revenue would generally mirror the
economics if additional sales are generated. Such situations may, however, result in the need for
explanatory disclosures, particularly in MD&A.
222See Release No. 34-49695, Policy Statement: Interagency Statement on Sound Practices Concerning
Complex Structured Finance Activities
223See Commission Press Releases SEC Charges Merrill Lynch, Four Merrill Lynch Executives with
Aiding and Abetting Enron Accounting Fraud (where Merrill Lynch simultaneously settles charges for
permanent anti-fraud injunction and payment of $80 million in disgorgement, penalties and interest) (2003-
32); SEC Settles Enforcement Proceedings against J.P. Morgan Chase and Citigroup (where J.P. Morgan
Chase agrees to pay $135 million to settle Commission allegations that it helped Enron commit fraud and
Citigroup agrees to pay $120 million to settle Commission allegations that it helped Enron and Dynegy
commit fraud) (2003-87); see also American International Group, Inc. Agrees to Pay $126 Million to Settle
Fraud Charges Arising Out of Its Offer and Sale of An Earnings Management Product (2004-163).
100
In addition, transaction structuring has substantially contributed to the complexity of
accounting and reporting standards in certain areas, a point we address immediately
below.
B. Continue Implementation of Objectives-Oriented Approach to
Standard Setting
In many areas of accounting, including several of the areas discussed in Section
III, the accounting and reporting standards are complex. While complexity is not in-and-
of-itself a bad thing, and in some cases may be necessary, it nevertheless typically entails
added cost. On July 25, 2003, the Commission released a Staff study on the adoption by
the U.S. financial reporting system of a principles-based accounting system.224 The Staff
recommended therein that FASB more consistently develop accounting standards on a
principles-based or “objectives-oriented” basis, as defined in the study. The FASB has
indicated that it “agrees with the recommendations” of the study.225 The results of the
current Study of off-balance sheet arrangements have only served to reinforce the Staff’s
previous conclusion of the importance of taking an objectives-oriented approach to
standard setting.
As noted in Section I above, the Objectives-Oriented Accounting Standards Study
recommended that accounting standards should be developed using an objectives-
oriented approach and that such standards should have the following characteristics:
• Clearly state the accounting objective of the standard with the objective
incorporated in the standard;
• Minimize the use of exceptions from the standard;
• Avoid use of percentage tests (“bright-lines”) that allow financial engineers to
achieve technical compliance with the standard while evading the intent of the
standard;
• Be based on an improved and consistently applied conceptual framework; and
• Provide sufficient detail and structure so that the standard can be operationalized
and applied on a consistent basis.
Objectives-oriented standards would clearly establish the objectives for a class of
transactions—and incorporate those objectives as an integral part of the standard itself.
Under an objectives-oriented approach, preparers would be held responsible to present
financial statements that are in accordance with the substantive accounting objectives
built into the pertinent standards. Moreover, under an objectives-oriented approach, the
cost to investors and analysts of comprehending the standards themselves should be
lower. Indeed, ideally, an investor or analyst could obtain a reasoned conceptual
understanding of the meaning of reported numbers by simply studying the stated
224The study was conducted pursuant to the provisions of Section of the Sarbanes-Oxley Act. See
Objectives-Oriented Accounting Standards Study.
225FASB Response to SEC Study on the Adoption of a Principles-Based Accounting System, July 2004.
101
objectives of the pertinent standards. That is, under an objectives-oriented regime, each
standard’s stated objective assists the user in comprehending how the standard is
constructed, how it is to be applied to a class of transactions or events, and how those
transactions or events should be reflected in the financial statements. This intuitive
coherence serves to enhance transparency.
As noted in the previous study, rules-based standards “further a need and demand
for voluminously detailed implementation guidance on the application of the standard,
creating complexity in and uncertainty about the application of the standard.” For
example, the derivatives accounting guidance is often criticized as being excessively long
and overly complex, but much of that guidance is devoted to determining whether an
instrument qualifies for one of the exceptions from the definition of derivative, or one of
the exceptions in the application of hedge accounting. Objectives-oriented standards that
rely on a coherent and consistent conceptual framework with less bright lines and fewer
exceptions may allow a significant reduction in complexity of the accounting guidance.
Moreover, rules-based standards can provide a roadmap to avoidance of the
accounting objectives inherent in the standards. Internal inconsistencies, exceptions and
bright-line tests reward those willing to engineer their way around the intent of standards.
This can result in financial reporting that is inconsistent and not representationally
faithful to the underlying economic substance of transactions and events.226 For example,
with respect to securitizations, current standards allow issuers to structure transactions to
achieve desired accounting results—that is, either sale or borrowing treatment for the
items being securitized—for what are economically similar transactions. Other examples
of accounting-motivated structured finance transactions are discussed throughout this
Report.
Again, it is tempting to look to the accounting standard-setter for progress
towards objective oriented standards. However, while the FASB must be a driver of
greater use of objectives-oriented standards and the accompanying reduction in
complexity of the guidance, they cannot do it alone. Other parties must also be
committed to these goals in order to make them a reality. As noted in the previous study,
the complexity in current standards exist in large part due to requests for guidance from
preparers and auditors, due to exceptions to basic principles that were requested by
preparers or others in the financial reporting process, and due to concerns about litigation
that might stem from standards that require a greater use of judgment on the part of
management and auditors. It is important that all participants in the financial reporting
process do their part to reduce complexity in financial reporting by being willing to apply
(and accept) reasonable judgments.
226For example, as indicated in Batson’s Second Interim Report, “Enron’s intimate knowledge and carefully
calculated application and manipulation of the GAAP rules … provided a leading example of how abuse of
the rules-based approach to GAAP standard setting can result in reported financial results materially
different from the underlying substance of the transactions reported.” Batson’s Second Interim Report,
Appendix B (Accounting Standards), page 12.
102
C. Improve the Consistency and Relevance of Disclosures
As discussed in Section II above, the basic financial statements themselves cannot
convey all of the relevant information about an issuer’s rights, obligations, and
transactions. Disclosures outside of the basic financial statements are necessary to
complement that information in order to enhance the decision-usefulness of financial
reporting. In the process of conducting this Study, including the gathering of empirical
data, the Staff observed that the quality of the information presented in some areas varies
greatly from issuer to issuer, and among topical areas. Some of these issues are
mentioned in the subsections of Section III dealing with empirical data, as the Staff noted
that it was not able to comprehensively compile data in certain areas.
In addition, the Staff observed that disclosures sometimes appear haphazard, with
the disclosures required by each rule or standard developed independent of other
disclosures. While it was observed that disclosures made by issuers did in fact often
provide information about the potential variability of estimates, alternate measurement
attributes, assumptions used by management, and detail of summarized financial
statement captions, it was not always clear why particular disclosures were included in
various situations, or, in some cases, what the purpose of the disclosures was.
Indeed, both users and preparers in various industries have stated that they believe
that disclosures in the area of financial instruments, among others, do not provide a
complete or meaningful picture for investors. The Staff believes that it is important that
issuers take the time and make the effort to prepare disclosures in a meaningful way and
to provide sufficient disclosures to allow investors to understand the substance of the
issuer’s situation and activities.227
D. Improve Communication Focus in Financial Reporting
An unfortunate effect of the large volume and complexity of financial reporting
requirements is that many accountants, lawyers, and others seem to view the goal of
financial reporting as achieving technical compliance with the rules without regard to
communicating effectively to investors. As we have noted, the Staff believes the goal is
to communicate effectively to investors while complying with the rules.
The Commission has previously noted the importance of clear communication in
financial reports. Perhaps most notable were the efforts to achieve greater use of “plain
English” in filings. The Commission issued rules in this area in 1998, noting in the
release that:228
Full and fair disclosure is one of the cornerstones of investor protection
under the federal securities laws. If a prospectus fails to communicate
227Cf. Exchange Act Rule 12b-20 which states that “In addition to the information expressly required to be
included in a statement or report, there shall be added such further material information, if any, as may be
necessary to make the required statements, in the light of the circumstances under which they are made not
misleading.”
228See Release No. 33-7497, Plain English Disclosure (January 28, 1998)
103
information clearly, investors do not receive that basic protection…A
major challenge facing the securities industry and its regulators is assuring
that financial and business information reaches investors in a form they
can read and understand.
The plain English rules require the use of short sentences, everyday language, and
tabular presentation of complex information, amongst other things. Despite these and
other efforts to encourage better communication, the Staff believes that a substantial
number of issuers continue to focus the bulk of their efforts on technical compliance with
the rules, rather than true communication.
While this mindset is certainly not limited to off-balance sheet issues or the types
of transactions discussed in this Report, it does manifest itself in the volume of
accounting motivated transaction structures and in disclosures that may provide certain
required data, but remain insufficient to permit a true understanding of the issuer’s
activities or position. No matter how many improvements are made to accounting
standards, financial reporting will continue to suffer if it remains an accepted premise by
some practitioners that efforts to avoid the intent of standards while maintaining seeming
technical, minimal compliance with the letter of those standards are acceptable.229
A stronger focus on communication with readers should also have the effect of
making financial reports easier to understand and digest. Turning again to the example of
financial instrument disclosures, the Staff noted during its work on the Study and Report
that even where significant information was available in filings, it was often spread in
several places, and there was little explanation of how the various disclosures related to
each other or to the amounts reported in the financial statements.
If all participants in the process came at financial reporting with a view of
complying with the objectives of the guidance and clearly and transparently
communicating material information to investors, significant improvements would occur
even if none of the other recommendations in this Report were to be adopted.
Conversely, the focus on seeming technical compliance results in a tendency to only
make improvements when new rules or standards require those improvements. This
burdens the standard-setters with the responsibility for driving all improvements, and
investors with the responsibility for deciphering reports that are not written clearly.
Changing this situation will not be a short-term proposition. However,
opportunities to improve exist, and most of the opportunities depend on the actions and
intentions of issuers. The Commission and the Staff will continue to attempt to assist.
For example, recent Commission rules that require auditors to make audit committees
aware of situations where management has chosen a less preferable method of accounting
may help preparers and auditors identify opportunities to improve.230 The recent
229Notably, proof of compliance with GAAP does not imply that an issuer or auditor acted in good faith and
that the “facts as certified were not materially false or misleading.” See U.S. v. Simon 425 F.2d 796.
230Release No. 33-8183, Strengthening the Commission’s Requirements Regarding Auditor Independence;
Section 210.2-07 Communication with audit committees
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interpretive release on MD&A information also provides various suggestions to improve
the quality and transparency of these disclosures.231
The Staff is also exploring the ways that technology can help to provide
information to investors that is easier to use and understand, and that increases the ability
to make comparisons across companies. Among other things, the Commission is
implementing a voluntary program to allow issuers to file certain information using
XBRL, which may facilitate the analysis of financial information by users.232 It is hoped
that preparers and users will take advantage of this program to identify the most useful
information to provide in this format, including information relating to the arrangements
discussed in this Report. The Staff will continue to explore ways to encourage better and
more useful disclosures. However, efforts in this area will have a much greater chance of
success with the commitment of preparers to communicate with investors in the most
effective ways possible.
VI. Recommendations Related to Accounting Standards
The recommendations below represent suggestions for changes in accounting and
reporting standards that we believe have the greatest potential to result in improved
transparency. It is important to note that all of the standards that currently exist were
actively debated and discussed when they were set, and were subject to an open and
deliberative process. The Staff believes that this process has worked well, and is the
appropriate process by which improvements to the existing standards should be
considered and developed. Furthermore, by including these recommendations, the Staff
does not mean to suggest the primary responsibility for improvements in reporting rests
solely with the FASB. Rather, the recommendations are meant in part to make clear to
readers of this Report the kinds of changes which would likely flow from attempts by the
FASB to help achieve the goals discussed in Section V. In each case, the
recommendations speak directly to issues of transparency the Staff identified during its
work in preparing this Report.
A. Standards on Accounting for Leases
Lease accounting has been identified repeatedly as an area that should be
reexamined by the FASB.233 The current “all or nothing” lease accounting guidance is
not designed to reflect the wide continuum of lease arrangements that are used, and
231Release Nos. 33-8350; 34-48960 Interpretation: Commission Guidance Regarding Management’s
Discussion and Analysis of Financial Condition and Results of Operations FR 72.
232Release Nos. 33-8529, 34-51129, 25-27944, 39-2432, IC-26747 XBRL Voluntary Financial Reporting
Program on the EDGAR System
233See, for example, AICPA’s Special Committee on Financial Reporting, Improving Business Reporting—
A Customer Focus (Dec. 1994) (discussion of users’ concerns with accounting and disclosures on long
term leases); Robert C. Lipe “Lease Accounting Research and the G4+1 Proposal” Accounting Horizons
(Sept. 2001); Dennis W. Monson “The Conceptual Framework and Accounting for Leases” Accounting
Horizons (Sept. 2001) (Notes that “there is virtually universal agreement that SFAS No. 13 fails to achieve
its stated objectives and needs to be reconsidered.”)
105
therefore, it cannot transparently and consistently reflect the varying economics of the
underlying arrangements. In addition, the Staff is aware that sophisticated users, such as
credit-rating agencies, often adjust balance sheets in their work so they can analyze
companies as if all leases were reflected on the balance sheet. A project on lease
accounting would be consistent with several of the goals described above in Section V.
The lease accounting standards rely extensively on bright lines, greatly increasing
the potential for similar arrangements to be portrayed very differently. Indeed, for a
lessee, the accounting can flip between recording no assets and liabilities at lease
inception to recording the entire leased asset and entire loan price with only a very small
change in economics. As discussed previously, the bright line tests have served to
facilitate significant structuring of leases to obtain particular financial reporting goals.
The extensive structuring further erodes the effectiveness of the standards.
Some have suggested that lease accounting should focus on contractual cash
inflows and outflows234 in determining the amount of assets and liabilities to record on
entities’ balance sheets. Lease accounting methods based on cash flows would generally
require both parties in lease agreements to report their economic interests in the leased
assets as well as assets and/or liabilities related to payments mandated by the lease
agreement. The FASB, as part of a group of standard setters known as the G4+1,235 has
considered, in some depth, such approaches in the past.236 The Staff believes that these
approaches, among others, remain worthy of further consideration.
In suggesting that the FASB should undertake a project to reconsider the
standards for accounting for leases, the Staff does not mean to suggest that such a project
would be simple. Leases can have many different terms, including contingent rents,
optional extensions, penalty clauses, purchase options, and others that each will require
consideration in any project. The challenges in developing an approach that considers
each of these terms in a conceptually consistent way are not insignificant. Furthermore, it
is likely that a project on lease accounting would generate significant controversy; many
issuers see leasing as an attractive form of financing asset acquisition in part because
leases can be structured so as to avoid recording debt. For these reasons, a project on
lease accounting would also likely take a significant amount of time as well as necessitate
a substantial commitment of FASB staff resources. Nonetheless, the Staff believes that
the potential benefits in terms of increased transparency of financial reporting would be
substantial enough to justify the time and effort required.
The project to reconsider the accounting for leases may be most effective if
conducted as a joint project with the International Accounting Standards Board (“IASB”).
234See SFAC No. 1, paragraph 37.
235Members of the G4+1 included the Australian Accounting Standards Board, the Canadian Accounting
Standards Board, the International Accounting Standards Committee, the New Zealand Accounting
Standards Review Board, the New Zealand Financial Reporting Standards Board, the United Kingdom
Accounting Standards Board and the United States Financial Accounting Standards Board.
236See Financial Accounting Series Special Report: Accounting for Leases: A New Approach, July 1996
and Financial Accounting Series Special Report: Leases: Implementation of a New Approach, February
2000.
106
The IASB’s standards are widely used outside of the United States. In an area as
pervasive as leasing, it would be beneficial to have similar accounting standards be used
around the world to the greatest extent possible.
B. Standards on Accounting for Defined-Benefit Retirement
Arrangements
The accounting for defined-benefit retirement arrangements provides a good
example of a situation in which different accounting is achieved solely due to the form of
arrangement used. An issuer could meet its pension obligations by paying them out as
they become due, and funding those payments from assets held by the issuer. If it did so,
the assets would be accounted for like any other assets held by the issuer, and the
obligation would be estimated and accrued like any other long-term compensation
arrangements. As discussed above, most U.S. companies choose instead to fund their
retirement arrangements by setting up separate entities for their pension plans and
funding those plans. Although the company generally has almost the same risks and
rewards and much of the same level of control over the assets and obligations whether
they are in a separate plan or not, the accounting changes completely if a plan is used.
The FASB itself questioned whether the accounting guidance that addresses defined-
benefit pension plans is sufficiently transparent, as pointed out in SFAS No. 87:
The Board believes that it would be conceptually appropriate and
preferable to recognize a net pension liability or asset measured as the
difference between the projected benefit obligation and plan assets, either
with no delay in recognition of gains and losses, or perhaps with gains and
losses reported currently in comprehensive income but not in earnings.
The Staff believes that a project that would reconsider the accounting for defined-
benefit pension plans is warranted.
The Staff believes that such an effort would further several of the initiatives
discussed previously in Section V. First, the accounting for defined-benefit pension plans
deviates from the accounting required for other business and compensation arrangements,
even when the economics are similar. While issues such as how to most appropriately
measure the pension obligation and report pension items in the income statement should
be considered, the Staff believes that work on the accounting for defined-benefit plans
should also focus on those areas that are inconsistent with the accounting for similar
items in other areas, including:
• Consolidation—Given the fact that the plan sponsor generally controls and is
subject to the vast majority of the risks and rewards of the pension plan, there
is not an obvious conceptual reason why the plan should not be consolidated,
especially since other trusts used to fund liabilities typically are consolidated.
In addition, the consolidation exemption results in a very different financial
statement presentation based on whether a separate entity is used to manage
the retirement benefits. While separate plans are common in the U.S. because
of employment and tax laws, laws in other jurisdictions vary, again raising the
possibility of different accounting for similar transactions.
107
• Deferral of Actuarial Gains and Losses—It is not clear why changes in
estimates related to retirement obligations should not be treated in the balance
sheet the same way as changes in estimates related to other obligations.
Changes in estimated amounts to be paid on obligations other than retirement
obligations almost invariably are recognized immediately as an adjustment to
the recorded liability, while such changes are permitted to be deferred and
recognized over time when they relate to defined-benefit pension plans.
• Valuation of Assets—The guidance for valuing assets of retirement plans and
recognizing related gains and losses is not consistent with the guidance that
applies to other entities. As the sponsor of a defined-benefit plan is affected
by the gains and losses on pension plan assets in almost the same way as it is
affected by gains and losses on other investments, this distinction appears
questionable.237
The Staff also believes that the complex series of smoothing mechanisms, and the
disclosures to explain them, render financial statements more difficult to understand and
reduce transparency. SFAS No. 87 does require certain disclosures that help explain the
effect of SFAS No. 87’s many netting and smoothing provisions. In this case, however,
the disclosures seem designed to compensate for less than desirable accounting. A recent
FASB project revised the disclosure requirements to provide even more information.238
While the disclosures are quite detailed, the Staff notes that it has long been accepted that
“good disclosure doesn’t cure bad accounting.”239 The combination of the accounting
and disclosure provisions contribute to the length and complexity of financial statements,
a common complaint among users and preparers alike. Revisions to the guidance that
eliminate optional smoothing mechanisms would allow significant reduction in
disclosures without a loss of important information.
Much like the recommendation to undertake a project on lease accounting, it is
likely that a project on pension accounting would generate significant controversy.
Indeed, it was such controversy that caused the FASB to deviate from its preferred
accounting when it promulgated SFAS No. 87. Nevertheless, the Staff believes that a
project on pension accounting should be undertaken when resources permit. Like lease
237This does not necessarily suggest that all assets of retirement plans should be recorded at fair value, as
this is not always the treatment that applies outside of retirement plans. See SFAS No. 115 and APB No.
18.
238See Statement of Financial Accounting Standard No. 132 (revised 2003): Employers’ Disclosures about
Pension and Other Postretirement Benefits—an amendment of FASB Statement No. 87, 88, and 106
(issued 12/2003). According to the FASB, the “Statement was developed in response to concerns
expressed by users of financial statements about their need for more information about pension plan assets,
obligations, benefit payments, contributions, and net benefit cost.” See FASB Summary of Statement No.
132 (revised 2003) at FASB.org web site.
239Remarks by Michael H. Sutton, Chief Accountant, U.S. Securities and Exchange Commission, to
American Institute of Certified Public Accountants 1996 Twenty-Fourth Annual National Conference on
Current SEC Developments, December 10, 1996.
108
accounting, the Staff believes that a pension accounting project may be most effective if
conducted as a joint project with the IASB, for similar reasons.
C. Continue Work on Consolidation Policy
Individual decisions relating to which entities should be reflected in the
consolidated financial statements of an issuer—that is, decisions relating to determining
the “reporting entity”—can create much more significant differences than individual
decisions about how to report particular transactions. This is because the consolidation
decision determines whether all of the assets and liabilities of another entity should be
included in the financial statements instead of one asset representing the issuer’s
investment in the other entity. As noted in Section III above, the consolidation decision
is typically based on whether or not control exists, with the determination of control
generally based on legal ability to control the entity. However, it is possible to
effectively control an entity without having legal control. An issuer that owns 49% of the
voting shares of an entity whose shares are otherwise widely distributed would almost
certainly be able to set policy for that other entity, but currently would not be deemed to
control that other entity for accounting purposes.
The FASB previously considered replacing legal control as the trigger for
consolidation with standards that focus on what has been called “effective control.”240 A
consolidation standard based on effective control would seek to identify characteristics of
control other than a majority voting interest, in order to ensure that all entities for which
the issuer can direct policy and make decisions are included in the issuer’s consolidated
financial statements.
While the FASB discontinued its broad project on effective control,
Interpretation No. 46(R) is an attempt to deal with SPEs by creating a consolidation test
for those entities that is meant to identify which entity has the majority of the exposure to
variations in performance and in turn effective control. However, because that test is so
different from the test used to determine consolidation of other entities, a new series of
structures that straddle the lines between consolidation approaches has sprung up, and
various structures have been designed to work around the guidance in Interpretation No.
46(R). The Staff believes that more time should be taken to evaluate the results of
Interpretation No. 46(R) and to allow the development of interpretive guidance that may
assist in its application. Several projects currently being undertaken by the EITF and the
FASB staff may provide such guidance.
Clearly, the current consolidation guidance is complicated, despite the consistent
objective of requiring consolidation when an investor controls another entity. The Staff
believes additional standard setting efforts related to consolidation should be focused on
whether there are ways to achieve the objectives with less complex guidance. In
addition, once the questions regarding Interpretation No. 46(R) have been more fully
addressed, the FASB may also wish to consider whether it should again explore the use
of effective, rather than legal, control to guide all consolidation decisions. Finally,
240See Exposure Draft, Proposed Statement of Standards: Consolidated Financial Statements: Policy and
Procedures, (1996).
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additional work holds the promise of promoting further convergence between of
consolidation guidance in US GAAP and the consolidation guidance in the IASB’s
standards.
D. Continue to Explore the Feasibility of Reporting All
Financial Instruments at Fair Value
Whether financial instruments are reported at fair value or not is obviously not a
question of whether they are on or off the balance sheet. However, the Staff believes that
the issue of whether particular financial instruments are reported at fair value is related to
a number of the topics discussed in this Report, and is directly related to a number of the
goals discussed in Section V.
Questions of whether to record assets and liabilities based on their historical costs
or their current market values (“fair value”) have long been high profile issues in the
financial reporting world. Supporters of greater use of fair values in the balance sheet
argue that the most useful information is that which reflects the current value of the
issuer’s assets and obligations, as this represents the “opportunity cost” of the resources
being used by the issuer. As previously discussed, GAAP requires a mix of historical
costs and fair values on the balance sheet—what is often termed a “mixed-attribute
model.” Derivative assets and liabilities are generally recorded at their fair values.
Financial assets are often reflected at fair value, although there are significant exceptions.
Non-financial assets are generally reflected at historical cost, but are also generally
subject to an impairment test that is based in part on fair value. Both financial and non-
financial liabilities are generally recorded based on their historical basis, with accretion
over time to their final settlement values. For certain instruments, the accounting is
dependent upon the issuer’s intent or policy elections. In an extreme example, an issuer
could conceivably own three of the exact same corporate debt instruments, and account
for each in a different manner. This mixed-attribute model has developed in part because
of concerns as to whether fair value information is reliable enough to be included in the
balance sheet and income statement, and in part because of disagreements regarding the
relevance of fair value information.
The mixed-attribute model has prompted a significant amount of accounting-
motivated transaction structures. For example, as noted above, some sales of financial
assets seem motivated primarily by a desire to recognize gains that could not otherwise
be recognized, by selling (at least for accounting purposes) receivables, available-for-sale
securities, cost method investments, or other financial assets that are not recognized at
fair value with changes recorded in earnings. Others seem designed to change the assets’
form into assets with a different measurement basis in order to minimize income
statement volatility, match the measurement basis of assets with that of liabilities, or for
other reasons. Similarly, investments in the stock of other entities are often designed to
either achieve or avoid use of the equity method of accounting. In many of the
accounting-motivated transactions noted above, the motivation for the transaction or the
structuring could be essentially eliminated if all financial instruments were recorded at
fair value.
In addition, fair value accounting for all financial instruments would reduce the
complexity of financial reporting. Investors would not have to study the accounting
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guidance or the choices made by management to determine what basis of accounting is
used for particular instruments. Further, fair value hedge accounting would no longer be
needed if all financial instruments were recorded at fair value, as the gains and losses
would naturally offset each other to the extent the hedges were effective. This would
eliminate the related documentation, record keeping, and other associated issues. In
addition, fair value accounting for all financial instruments would eliminate the need to
bifurcate and separately value derivatives embedded in financial instruments, as the
accounting would be the same for both the host instruments and the derivative. Users of
financial statements would be spared from having to comprehend a complicated set of
rules regarding which financial instruments are at fair value and which are at historical
cost.
As discussed above, fair value accounting for all financial instruments would
appear to have benefits in terms of reduced complexity, more understandability, and less
motivation to structure transactions to meet accounting goals. In addition, many believe
that fair value is simply the most relevant measure for financial instruments.241 There
are, however, significant concerns with requiring fair value accounting for all financial
instruments including:
• Relevance—Some supporters of historical cost measurements “believe that
amortized cost provides relevant information because it focuses on the
decision to acquire the asset, the earning effects of that decision that will be
realized over time, and the ultimate recoverable value of the asset. Among
other things, many argue that this is particularly valuable information in
monitoring the performance of management. They argue that fair value
ignores those concepts and focuses instead on the effects of transactions and
events that do not involve the enterprise, reflecting opportunity gains and
losses, whose recognition in the financial statements is, in their view, not
appropriate until they are realized.”242
• Reliability—“Opponents of fair value reporting also challenge the subjectivity
that may be necessary in estimating fair values and question the usefulness of
reporting fair values for securities if they are not readily marketable.”243
• Manipulability—When applied to instruments without readily available
markets, some are concerned that management may be able to use fair value
estimates to manage earnings, inflate reported equity, or otherwise deceive
users as to the value of the company.244
241For example, paragraphs 39 – 50 of SFAS No. 107 discuss the relevance of fair value information. It
states in part in paragraph 41, “Information about fair value better enables investors, creditors, and other
users to assess the consequences of an entity’s investment and financing strategies, that is, to assess its
performance.”
242SFAS 115, paragraph 42.
243SFAS 115, paragraph 43.
244As Paton and Littleton (1940, 65) write: “The process of measuring periodic income involves the
division of the stream of costs incurred between the present and the future.” They also write: “In general,
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The Staff appreciates these concerns, and acknowledges, in particular, the concern
about the potential manipulation of fair value measurements, which has been a part of
some of the recent financial reporting scandals. However, in light of the potential
benefits, the Staff believes that exploration of ways to eliminate the obstacles to fair
value accounting for financial instruments is warranted.
Of course, the broad issue of the reliability of fair value measurements will
continue to be a concern. The Staff notes, however, that it is now possible to reliably
value many instruments that could not be reliably valued in the past. The continued
development of financial markets should further expand the types of instruments for
which reliable information on fair value is available. In addition, the FASB plans soon to
issue a document that includes better guidance on fair value measurement than previously
existed.245 This should help to encourage convergence of practices in this area.
One of the other significant obstacles to reporting financial instruments at their
fair values in the balance sheet is their treatment in the income statement. Many believe
that income statements become too difficult to understand if changes in the value of
reported assets and liabilities attributable to market fluctuations are combined with
changes in assets and liabilities related to business transactions. Some believe that
holding gains and losses are simply of a different character than transactional gains and
losses. Others believe that investing and financing activities should not be combined
with operating activities. Still others believe that unrealized and realized gains and losses
are different in character and should not be combined. There are also those who would
prefer that gains and losses related to highly subjective estimates be reported separately
from those related to measurements that are more certain.
Indeed, the ability to differentiate changes in equity that have these various
characteristics in different combinations could be useful to users in understanding the
results of operations and in evaluating the company’s ability to generate cash flows in the
future. The FASB and IASB currently have a joint project on Reporting Financial
Performance that could address this issue.246 The Staff has encouraged the two Boards to
the only definite facts available to represent exchange transactions objectively and to express them
homogenously are the price-aggregates involved in the exchanges; hence such data constitute the basic
subject matter of accounting.” Paton, W. A. and A.C. Littleton, 1940, at 7, An Introduction to Corporate
Accounting Standards, American Accounting Association, Sarasota, FL. Ijiri (1975) emphasizes that
historical cost is consistent with accountability, because it is both hard (difficult to manipulate) and tracks
managements’ actual decisions rather than would-be decisions tracked by fair values. (On the other hand,
one might argue that to choose to not enter into a transaction that would serve to convert an asset into its
fair value also constitutes a decision. To wit, a decision to incur that opportunity cost. Such a decision,
and its measurement by means of fair value, might be of interest to investors.)
245The FASB issued an Exposure Draft of a proposed statement, Fair Value Measurements, on June 23,
2004. The comment period ended on September 7, 2004 and on September 21, 2004, the FASB held a
public roundtable meeting. The FASB is currently deliberating both the results of the comment letters
received and the roundtable discussions. A final pronouncement is currently expected to be released during
the second quarter of 2005.
246The first meeting of the joint international group on performance reporting took place on January 13-14,
2005. The FASB and IASB anticipate that an initial public discussion document in the form of a
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focus on this project, consider the various views discussed, and devise ways to report
changes in values of assets and liabilities that are consistent and transparent and best
facilitate appropriate analysis of reported results.247
Another important, and related, issue is to determine whether changes in an
issuer’s own credit risk should be reflected in the reported value of that issuer’s financial
instruments. This possibility raises concern because the effect of an increase in the
issuer’s credit risk would be to reduce the value of liabilities reported, resulting in an
increase in equity (and, potentially, income). This result seems counterintuitive to many.
The FASB has recently decided to specifically consider this issue.248
The Staff hopes to promote further discussions regarding the use of fair value in
the coming year.
E. Develop a Disclosure Framework
The disclosures in the notes to the financial statements are a critically important
complement to the financial statements and are necessary to achieve transparency in
financial reporting. Based on this Study, as well as experience with issuer filings, the
Staff believes that disclosures can be improved. First, as discussed above, the Staff
believes that disclosures could be improved if issuers were to seek to achieve the goal of
communicating with investors, rather than focusing principally on technical compliance
with rules and regulations.
The Staff also believes that more useful and consistent disclosure requirements
for the notes to the financial statements could be achieved if a disclosure framework were
developed that set forth the objectives to be used in these disclosures. Currently, the
FASB’s conceptual framework does not contain a substantial amount of guidance related
to the notes to the financial statements. As a consequence, disclosure guidance tends to
vary from standard to standard. A project directed at developing a framework for use in
determining the content of notes to the financial statements might consider, for example,
whether (and if so, when) the following goals—each of which is evident in certain
currently required disclosures—are appropriate:249
• Provide information about alternative measurement attributes;
Preliminary Views will be issued in late 2005. For more information about the project status see the
Project Updates section at www.fasb.org
247For example, the IASB has considered a matrix format income statement that includes rows organized
into categories of: “business”, “financing”, “tax” and “discontinued operations”. The columns include:
“total,” “before re-measurements,” and “re-measurements.” International Accounting Standards Board,
2003, IASB Project Summary: Reporting Comprehensive Income.
248The FASB is currently considering adding a project to its agenda that would amend SFAS No. 133
addressing whether an issuer’s own credit risk should be considered when measuring derivative liabilities
at fair value. While this proposed project is narrow in that it relates only to derivative liabilities, the same
issue would also apply to other issuer liabilities that are measured at fair value. Accordingly, the Staff
believes that the FASB will likely consider this issue in other projects where fair value is the measurement
attribute for the liability
249The list is not intended to be all-inclusive.
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• Explain the nature and extent of uncertainty in the reported figures;
• Allow users to recompute certain items using different assumptions than those
used by management;
• Make it more difficult for management to engage in financial fraud;
• Allow comparisons between issuers that have chosen different accounting
policies;
• Explain the sensitivity of the issuer’s results to various risks;
• Provide detailed breakdowns of certain financial statement captions;
• Explain the issuer’s future cash requirements;
• Highlight the impact of unusual or non-recurring events;
• Disaggregate the issuer’s results;
• Explain how management’s intentions affected the reported financial position and
results of operations; and
• Confirm compliance with GAAP.
Disclosure relating to financial instruments, including derivatives, in particular,
could be improved through consistent objectives and principles. Changing the disclosure
requirements for financial instruments would not require changes in recognition and
measurement. Indeed, assets and liabilities could be carried on the books under the same
principles as before. Disclosures about fair values will be informative to users, even in
cases where there is variation inherent in the valuation (so long as it is disclosed that
there is variation in the valuation). The Staff notes that the IASB has recently
proposed/promulgated guidance in this area that could be used as a starting point for
work in this area in the U.S.250
In order to stimulate thought and discussion, we identify below some possibilities
for financial instrument disclosures that arose from the Staff’s work in preparing this
Report, as well as its work reviewing filing and following the IASB’s project on financial
instrument disclosures that is referred to above:
• Carrying value as of balance sheet date;
• Explanation of changes in carrying value since last balance sheet date;
• Fair market value as of balance sheet date (include range as well as point
estimate);
• Changes in fair market value since last balance sheet date;
250See International Accounting Standards Board Exposure Draft ED 7 Financial Instruments: Disclosures
July 2004.
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• Description of valuation methods, including what proportions were valued based
on the different types of inputs, as well as description of significant assumptions
(and possibly access to example/actual valuation models);
• Related derivative positions as of balance sheet date;
• Fair value of related derivative positions as of balance sheet date;
• Description of income statement impact;
• Sensitivity of fair value and income to changes in significant underlying
variable(s) without considering related derivative positions; and
• Sensitivity of fair value and income to changes in significant underlying
variable(s) net of related derivative positions.
By highlighting potential objectives for disclosures in the notes to the financial
statements and explaining what factors might influence the decision as to which
objectives should drive disclosure requirements in a particular standard, the addition of
disclosure guidance to the FASB’s conceptual framework could drive more consistent
disclosures across various accounting issues, while helping users to understand why
certain disclosures are included in financial statements. The Staff has suggested to the
FASB that adding disclosures to its conceptual framework would be helpful.
Of course, insights generated by the development of such a disclosure framework
might also lead to recommendations from the Staff regarding the Commission’s
regulatory disclosure requirements. Indeed, some of the objectives noted above, each of
which is evident in the disclosure requirements for notes to the financial statements in
some areas, are also objectives of MD&A or other regulatory disclosure requirements.
As such, the Staff would be willing to work closely with the FASB in its development of
a disclosure framework, in order to consider whether complementary changes to the
Commission’s disclosure requirements would generate further improvement as well as to
ensure that disclosure is provided in the most appropriate location, whether it be in notes
to the financial statements, MD&A or in some other location.
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