About $1.2 Trillion of assets to be back on balance sheets of banks

With new accounting rules on off-balance-sheet transactions coming into effect in January, approx 53 large companies have already estimated that they will have put back an aggregate $515 billion in assets to their balance sheets during the first quarter, according to a new study of S&P 500 companies released by Credit Suisse.

The rules that force companies to put such assets back on their balance sheets were issued in 2008 and went into effect at the beginning of this year. They are Topic 860 (formerly FAS 166), which deals with transfers and servicing of financial assets and liabilities, and Topic 810 (formerly FAS 167), the rule governing the consolidation of off-balance-sheet entities in their controlling companies' financial reports.

Predictably, most of the asset increases belong to companies in the financial sector, where off-balance-sheet transactions such as securitization, factoring, and repurchase agreements are popular.

Assets are returning to balance sheets for several reasons, most notably the Financial Accounting Standards Board's elimination of QSPEs, or "Qs," in 2008, when it became apparent that the structures were being abused. Indeed, Qs were permitted to remain off bank balance sheets if they took a "passive" role in managing the structures' finances. But when the subprime crisis hit, and the mortgages being held in Qs began to fail, banks — with the blessing of regulators — took a more active role, reworking the terms of the entities' mortgage investments. At the time, FASB chairman Robert Herz called Qs "ticking time bombs" that started to "explode" during the credit crunch.

Since their enactment, the accounting rules have affected their industry big time. Of the companies reporting an impact, nine purely financial-sector outfits plus General Electric account for 96% of the $515 billion being consolidated during the first quarter, says Credit Suisse. Of that group, which includes Bank of America, JP Morgan Chase, and Capital One, Citigroup tops the list with an estimated $129 billion in assets being brought back on the books in the first quarter — which represents 7% of its existing total assets. The newly consolidated assets come in all shapes and sizes, says the report: $86.3 billion in credit-card loans, $28.3 billion in asset-backed commercial paper, $13.6 billion in student loans, and $4.4 billion in consumer mortgages, for example ($5 trillion of the $5.7 trillion held in VIEs and Qs is mortgage related). Citigroup also disclosed a $13.4 billion charge for setting up additional loan loss reserves and eliminating interest lost from consolidating the assets.

Operating the lease - a discussion paper

The FASB is looking to overhaul its 35 year old standard on Leases - FASB 13. This overhaul looks to have been directed with the convergence of the FASB and the IASB.

Both the bodies have recently issued a discussion paper on changing the way we account for operating leases. The discussion paper higlights the rationale to change the way we account for a "right to use assets" as described in EITF 01-08 or my earlier blog on embedded leases.

Under the current rule, Companies record finance lease obligations on the balance sheet while disclosing the operating lease obligations in the notes to accounts.

Under the discussion paper, the new rule will require companies to record operating lease obligations on the balance sheet as a liability and capitalise the right to use the asset as an asset, thereby making Companies look highly leveraged.

Broadly the implications of such a rule will have a bearing on the following

1. Balance sheets look highly leveraged (an estimate pegs the operating lease obligations for SEC listed companies at $1.25 trillion
2. Financial reporters will have to test for impairment on the capitalized operating lease assets in case of non-cancellable lease obligations
3. Operating lease obligations will be required to be recorded at fair values
4. In case of contingent rentals for operating lease assets, computing the value of the assets and obligations will be a nightmare
5. Periodic reassessment of the lease classifcation in case of constant renewal options/modifications coming in the agreement
6. Rental expenses now will be broken into rental expenses and interest costs (for the imputed value of the lease obligation)
7. A nightmare of companies who outsource work say for a period of 2 years under a non-cancellable lease - splicing the agreement into services and assets would take some doing

I welcome FASB's stance on recording the obligations and recording the assets on the balance sheet. This will make reporting more structured by ensuring stakeholders get to know as to whether an asset taken on an operating lease is impaired or not and the leverage of the balance sheet.

For instance financials of Airlines companies who lease planes on operating leases do not have any planes as assets on their balance sheets nor any liabilities. This is strange considering that from a going concern perspective airline companies cannot live without these planes. The new rule will reflect a clearer picture of the financial position of such companies.

The real problem will come to accountants when they address issues on contingent rentals, renewal clauses etc. These will be highly subjective from one company to the other and will render the purpose of meaningful comparasions among different companies baseless.

Well the proposed change is in mid 2011, hopefully by then we will have a lot more brightlines to easily account for the new OPERATING LEASE REGIME.

FASB issues statements 166 and 167

The FASB recently published Financial Accounting Statements No. 166, Accounting for Transfers of Financial Assets, and No. 167,Amendments to FASB Interpretation No. 46(R), which change the way entities account for securitizations and special-purpose entities. The new standards will impact financial institution balance sheets beginning in 2010. The impact of both new standards has been taken into account by regulators in the recent “stress tests.”

These projects were initiated at the request of investors, the SEC, and The President’s Working Group on Financial Markets. Copies of the new standards are available at theFASB’s website, along with a concise briefing document.

Statement 166 is a revision to Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and will require more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets, and requires additional disclosures.

Statement 167 is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance.

Robert Herz, chairman of the FASB, said:

“These changes were proposed and considered to improve existing standards and to address concerns about companies who were stretching the use of off-balance sheet entities to the detriment of investors. The new standards eliminate existing exceptions, strengthen the standards relating to securitizations and special-purpose entities, and enhance disclosure requirements. They’ll provide better transparency for investors about a company’s activities and risks in these areas.”

Both new standards will require a number of new disclosures. Statement 167 will require a company to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A company will be required to disclose how its involvement with a variable interest entity affects the company’s financial statements. Statement 166 enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and a company’s continuing involvement in transferred financial assets.

Both Statements 166 and 167 will be effective at the start of a company’s first fiscal year beginning after November 15, 2009, or January 1, 2010 for companies reporting earnings on a calendar-year basis.