Exposure Draft Of Financial Accounting Standards; Consolidated Financial Statement
Contributor
On February 23, 1999, the Financial Accounting Standards Board (“FASB”) issued an exposure draft of a new statement of financial accounting standards relating to consolidation 1. The deadline for comments on the exposure draft is May 24, 1999. The new standard is proposed to become effective for financial statements for annual periods beginning after December 15, 1999. Consolidation policy is relevant to securitizations in two primary ways:
- First, when a securitization is intended to achieve off balance sheet treatment, the transferor and the ultimate transferee must not be part of the same consolidated group. Otherwise, the effect of any sale between the transferor and the transferee will be wiped out in the group’s consolidated financial statements.
- Second, many securitization vehicles, including most multi-seller asset-backed commercial paper conduits, are established as “orphan” special purpose entities, meaning that their equity is owned by someone other than the entities that arrange and administer transactions for the vehicles. The exposure draft could be read as possibly requiring some orphan vehicles to be consolidated on the financial statements of their arrangers, administrators or certain other service providers (such as credit enhancers).
Interaction With EITF 96-20/SFAS 125
For many securitizations, the new consolidation standard probably will not contain the pertinent rule on consolidation. This is because many securitizations make use of special purpose entities that satisfy the requirements to be treated as a “qualifying special purpose entity” (or “QSPE”), as defined in Statement of Financial Accounting Standards (“SFAS”) 125.
Shortly after the adoption of SFAS 125, the Emerging Issues Task Force (“EITF”) decided, in EITF Issue No. 96-20, that an entity that transfers financial assets to a QSPE should not consolidate the QSPE in the transferor’s financial statements, even if the transferor owned a majority (or even 100%) of the voting equity of the QSPE 2. The standards for QSPE status are stringent, including strict limits on the types of assets the SPE may hold and the activities of the SPE (particularly on transfers of financial assets by a QSPE). However, many vehicles used in securitization transactions satisfy those standards.
FASB is currently working on an amendment to SFAS 125 that, among other things, modifies the definition of QSPE and incorporates into the body of SFAS 125 the non-consolidation rule established by EITF 96-20. Neither the consolidation exposure draft nor the most recent draft of the SFAS 125 amendment specifically address the relationship between the special rule for QSPEs and the general consolidation policy set out in the exposure draft. However, it seems virtually certain that the special rule for QSPEs will be preserved.
Consequently, the consolidation exposure draft is most important for securitization vehicles that, at least currently, cannot qualify as QSPEs. These are primarily single seller SPEs that hold non-financial assets that QSPEs are prohibited to hold (such as residual values of equipment subject to leases that are securitized) and multi-seller commercial paper conduits.
Current Consolidation Rules For SPEs That Are Not QSPEs
The main existing standard for consolidation of financial statements requires each reporting entity to consolidate in its financial statements each entity in which it owns a majority voting interest, unless control is likely to be temporary or control does not rest with the majority owner 3.
With respect to SPEs, that standard has been supplemented by a series of pronouncements by the Emerging Issues Task Force, beginning with Appendix Topic D-14 and EITF Issue 90- 15 4. Topic D-14 reported comments made by a representative of the Securities and Exchange Commission (“SEC”) at a February 1989 meeting of the EITF, to the effect that the SEC’s staff was becoming concerned about certain receivables, leasing and other transactions involving SPEs. The representative stated that the SEC staff believed that the sponsor of or transferor to an SPE should consolidate the SPE if:
- the majority owner makes only a nominal capital investment,
- the activities of the SPE are virtually all on the sponsor’s or transferor’s behalf and
- the substantive risks and rewards of the assets or debts of the SPE rest directly with the sponsor or transferor.
EITF Issue 90-15, which considers whether a lessee should consolidate an SPE lessor, sets forth a similar standard. Many accountants have applied the guidance in Issue 90-15 by analogy to receivables securitization transactions prior to the creation of the special rule for QSPEs in EITF Issue 96-20 and thereafter with respect to SPEs that are not QSPEs.
In practice, the most important factor under either Topic D-14 or Issue 90-15 for single seller SPEs has been the presence of adequate third-party equity. Independent equity in an amount equal to at least 3% of an SPE’s assets (and representing a controlling equity interest) has evolved among market participants and their accountants as a benchmark to determine if the capital contributed by a third party is adequate and therefore precludes consolidation. However, multi-seller asset-backed commercial paper conduits generally have not been required to satisfy the 3% test, either because they satisfied other requirements for non-consolidation or because Topic D-14 and Issue 90-15 were deemed to be inapplicable.
The Exposure Draft
The new consolidation standard proposed in the exposure draft would continue to focus on control but would define control in a way that goes beyond the existing standard. Under the new standard, each reporting entity would be required to consolidate each entity that it “controls” in its financial statements, unless the control is temporary at the date that it is obtained. Control is defined as:
the ability of an entity to direct policies and management that guide the ongoing activities of another entity so as to increase its benefits and limit its losses from that other entity’s activities. For purposes of consolidated financial statements, control involves decision- making ability that is not shared with others 5.
In the exposure draft, an entity that “controls” another entity is called a “parent,” and the controlled entity is called a “subsidiary.” Under the proposed standard, control could be found to exist (and consolidation required) even for entities that do not issue voting shares, and control may be found to be held by someone who does not own a majority voting interest. Control may be based upon a direct, single source such as stock ownership or from multiple, indirect sources such as governing documents, voting agreements or other legal devices.
It is possible that, under this new standard, “sponsors” of some orphan SPEs (that are not QSPEs) will be deemed to “control” the SPE and therefore be required to consolidate the financial statements of the SPE with the sponsor’s own financial statements. Given the limited activities of SPEs and other features of securitizations, it is reasonable to hope that all or most such sponsors will be able to demonstrate that they do not “control” SPEs. However, this is a fact intensive determination that will have to be carried out individually for each SPE, and it is impossible to say at this time how the “control” test will be interpreted in various circumstances. We summarize very briefly below some considerations that may be relevant in those determinations.
Since a parent’s “decision-making ability” must be exclusive, “control” should not be found to exist if the putative controlling party must obtain the consent of another party to implement its decisions. However, the exposure draft states that “control” can exist even if the decision-making ability of the parent is limited to some extent by law or contractual obligations (such as debt covenants). The FASB refers to limitations of this sort as “protective rights” 6 and concludes that control can still exist in such circumstances if the “parent” has the ability to increase its benefits, and limit its losses, from the activities of the “subsidiary” in ways not prohibited by the protective rights or by eliminating the protective rights (for instance by causing a subsidiary to retire debt which benefits from protective rights in the form of negative covenants) 7.
In the exposure draft, the traditional indicia of control in corporations, partnerships and trusts are reiterated and applied to the new standard. Thus, in corporations, ownership and the ability to elect officers and directors are indicative of control 8. In general partnerships, control is usually shared among the partners, so no one has to consolidate (so long as there are at least two unaffiliated partners). In limited partnerships, control usually resides in the general partner(s), which creates a presumption of control if there is only one general partner 9. In trusts, although the trustee usually controls the use or investment of trust assets, fiduciary standards prohibit a trustee to exercise such power for its own benefit 10. Therefore, a trustee will not normally be deemed to “control” a trust. Similarly, a beneficiary will not have decision-making authority for the trust and therefore will not normally “control” the trust 11.
Where such traditional factors are lacking, the exposure draft sets forth additional factors to be considered in determining whether or not consolidation is appropriate. For corporations and similar entities, these include:
- whether an entity provides significant funding and has or shares decision- making powers and duties typical of a board of directors, especially as to use and regulation of access to the corporation’s assets and the “selection, retention, and composition of its management”;
- whether the entity has the power to change the articles of incorporation of the other entity; and
- whether the entity holds “significant risks and rewards of ownership” in the corporation 12. Finally, whether or not traditional indicia of control are present, the preparer of financial statements is required to decide whether or not “control” exists based upon an assessment of all of the relevant facts and circumstances. To illustrate the decisions that will need to be made, the exposure draft contains 10 examples in an appendix. The examples do not provide a definitive standard for securitization SPEs, but examples 5-8 provide examples of the analysis of particular SPEs (none of which are engaged in securitizations) which may be seen as relevant by analogy.
Example 5 discusses a corporation formed for the purpose of research and development.
Example 6 discusses the creation of an athletic foundation to benefit a particular university.
Examples 7 and 8 discuss and contrast two special-purpose entities used for real estate leasing transactions.
Conclusion
If adopted in its current form, the new consolidation standard proposed in the exposure draft will require significant analysis to determine whether effective control is present and consolidation required by entities that deal with SPEs that are not QSPEs. To the extent that market participants are concerned that the proposed standard could be interpreted as requiring consolidation in inappropriate circumstances, we encourage you to submit comments to the FASB by the May 24 deadline.
Footnotes
1 Exposure Draft of Financial Accounting Standards; Consolidated Financial Statements: Purpose and Policy; February 23, 1999 (No. 194-B).
2 A partial draft of a proposed amendment to SFAS 125 that was recently circulated suggests that this rule may be extended to also clearly avoid consolidation with servicers and sponsors.
3 See Accounting Research Bulletin No. 51, as amended by SFAS 94.
4 See also EITF Issue Nos. 96-21 and 97-1, which provide additional guidance. The exposure draft is silent as to its effect on these EITF pronouncements.
5 Paragraph 6(a). This and other citations to “paragraphs” in this memorandum refer to paragraphs of the exposure draft.
6 Paragraph 12.
7 Paragraphs 42 and 43.
8 Paragraphs 18-19.
9 Paragraphs 20-21.
10 Paragraph 22.
11 Id.
12 Paragraph 19.
Disclaimer: Please note that Mayer, Brown & Platt is a law firm and not licensed to practice accounting. The above analysis does not purport to provide accounting advice but merely raises certain issues that should be discussed with an entity’s accountants.