Loading.

PPT Off Balance Sheet Financing, Variable Interest Entities, and Synthetic Leases PowerPoint presentation | free to view

Off Balance Sheet Financing, Variable Interest Entities, and Synthetic Leases

Leverage, debt/equity ratios, return on assets (higher net income, smaller asset. Pacific Gas and Electric, Goldman Sachs, Microsoft, AOL Time Warner, Sears. PowerPoint PPT presentation

3

• Leverage, debt/equity ratios, return on assets

(higher net income, smaller asset baseas we

leave off debt, we also leave off the related

asset)

And how are assets removed from the balance

Who is using Off-Balance Sheet Financing?

Krispy Kreme, Continental Airlines, Cisco,

Pacific Gas and Electric, Goldman Sachs,

6

Robert Willens, of Lehman Brothers states, Well

Three ways to keep debt off the Balance Sheet

leasing property or equipment instead of buying

it the equipment may be owned by a third party

or by a Variable Interest Entity, which is a form

of joint venture.

selling less valuable assets such as accounts

So what is a Variable Interest Entity?

VIEs are business entities formed for the purpose

of conducting a well-specified activity, such as

the construction of a gas pipeline, collection of

a specific group of accounts receivable, etc.

Because VIEs are usually designated to conduct

just one pre-specified activity, the cash flows

and risk of the venture are normally clearly

specified.

9

• By contrast, in a normal corporation the

corporate management can take on a variety of

transactions and activities the investor did not

expect.

What does this mean from an investors viewpoint?

Or a creditors viewpoint?

Example

• A company needs 1 billion to finance building

a gas pipeline in central Asia. Investors may

want their risk/reward exposure limited to the

pipeline. They might also want the pipeline to be

a self-supported, independent entity with no fear

that the sponsoring company would sell it. These

objectives can be achieved by forming a VIE with

a charter that specifies these limited operating

activities.

13

• So the VIE could be a joint venture between a

sponsoring company and a group of investors. The

disposition of net cash flows from the venture

may be restricted to payments to the investors.

14

• VIEs can be structured to preclude bankruptcy

filings. One way of doing this would be to

create 2 VIEs. The first would be the primary

investment vehicle to raise capital from outside

investors and would be designed to be completely

protected from bankruptcy filing. It might be an

all-equity entity (with no debt, it cant be

forced into bankruptcy)

15

• The VIE doesnt have to be LARGE, so it might not

need a large equity investment to create the

initial VIE.

16

• VIE1 would then invest in VIE2, which would buy

assets (either from a 3rd party or from the

sponsoring organization) hold the debt associated

with the purchase of those assets, and conduct

the specified activities of the project.

VIE1 would have to invest equity equal to 10 or

more of the assets of VIE2, which would equal

100 of the voting shares of VIE2.

17

• The 2-part VIE also makes it easier to keep debt

off of the sponsoring corporations balance sheet

18

• Not only are corporations pleased with the

financial statement impact of using off-balance

sheet financing and VIEs, lenders might REQUIRE

the use this structure as they perceive that it

19

• As we will see, everyone attempts to limit their

risk exposure, and different parties in the

transaction may believe that their risk exposure

is essentially zero. However, there is not

adequate court precedent to validate this

belief(SOMEBODY has to be responsible for risk

of defaultdont they. )

Synthetic Leases

• Leasing property or equipment instead of buying

it may involve the use of a synthetic lease. A

synthetic lease allows a company to have the

benefits of ownership without having to put the

asset or the liability on the balance sheet

21

• (and how do assets get removed from the balance

sheet? When the are expensed to the income

statement.they have limited the expenses they

need to recognize on the income statement to just

the rent expense, no depreciation)

22

• VIEs are the structure used to implement a

synthetic lease.

23

• In a synthetic lease, the asset is held by the

VIE, and the VIE takes out loans to finance the

purchase of the asset. The asset is then leased

to the sponsoring corporation.

24

• What do we remember about leases?
• Capital leasethe value of the leased asset is

recognized, as is a liability equal to the

present value of the future lease payments.

25

• In a capital lease, the asset and liability are

on the balance sheet, and the income statement

recognizes both the interest expense and

depreciation expense.

Capital Lease Criteria

• Meeting any ONE of the following 4 criteria

causes the leasing corporation to recognize a

capital lease

PV of the lease payments 90 of FMV of asset

Lease life is 75 of total life

Title transfers at end of lease

Lease contains a bargain purchase option

27

• Operating leaseno asset on the books, no

liability on the bookseach cash payment under

the lease is rent expense

If a lease can be structured as an operating

lease, the asset and related liability are kept

OFF the balance sheet.

28

• Synthetic leases are structured so that the

sponsoring corporation accounts for them as

operating leases.

The lease term is less than 75 of the expected

useful life, and the payments are close to the

payments the SPE makes on the debt. At the end

of the lease term, the lessee usually has the

option to purchase the asset at its original

purchase price.

29

• Instead of the company owning the asset, the VIE

owns the asset.

But the VIE is dependent on the sponsoring

company for cash flows, so has the sponsoring

company has not really given up control of the

asset?

The question of economic control, legal control,

and accounting control needs to be answered.

30

• As long as the VIE does not have to be

consolidated with the financial statements of the

sponsoring corporation, the debt and asset are

both kept off the books.

Consolidations.

• What do we know about consolidations?
• The corporation must own 50 or LESS of the

voting interest of the SPE

At least one additional stockholder must own at

least 10 of the total assets of the VIE

(But remember, A-L OE, and OE may be very

small)

32

• Also, for a VIE to remain unconsolidated, the

independent 3rd party owner(s) must possess the

substantive risks and rewards of the investment

in the VIE (FIN 46)—the owners investment and

return are at risk and not guaranteed by

another party (ENE).

33

• The relation of the sponsoring company to the VIE

should be disclosed in the footnotes. This

should include guarantees or contingent

obligations. (The sponsoring corporation can

guarantee the debt of the VIE, but not the return

to the equity stockholders.)

34

• The VIE is dependent on the sponsoring company

for its cash inflows, which are primarily the

rent charged for the asset.

These cash flows are then used to pay the debt

obligation.

35

• Benefits of a synthetic lease include
• Favorable interest ratesi.e. 4 vs. 15
• Favorable tax treatment. Congress passed a law

that allows depreciation expense as an expense on

the tax return even though the corporation does

not own the asset.

Stronger balance sheet, with lower leverage

ratios risk has been parceled out

Added protection from violating debt covenants

for sponsoring corporation.

36

• Increased flexibility and lower cost of capital
• And..the company is also directly benefiting

investors by conserving cash (taxes, interest)

Example

• ABC Company wants the use of a building for its

corporate offices for he next 20 years. The land

and building would cost 100 million to buy.

A VIE is formed to buy the land and building. A

financial institution loans the VIE up to 90 of

the fmv of the real estate.

The loan is backed by the building.

38

• The remaining 10 of the cost is put up by an

outside equity investor(s). The outside investor

owns 100 of the shareholder equity in the VIE

(Remember, Assets Liabilities Owners Equity.

This is what the 10 rule that is discussed is

all about.)

39

• So, should the VIE be consolidated?
• All of the outside equity is owned by someone

other than the sponsoring corporation.

(Normally, we consolidate when a corporation owns

more than 50 of the equity in a subsidiary.)

40

• The VIE leases the land and building to ABC

Corporation at a lease cost adequate to cover the

lease payments.

At the end of the lease, the VIE sells the asset

at fmv (possibly to ABC) OR at original cost

(depending on the VIE terms and how the loan was

structured) and transfers any gain on sale to the

outside investors.

41

• IF ABC had originally owned the building, they

could have sold it to the VIE, booked the gain on

sale, and leased it back.

They get the double benefit of booking the gain

on sale and of getting both the asset and the

liability off the balance sheet.

42

• Estimates of the size of the synthetic lease

market vary (there is no required reporting for

the VIE as it is not publicly held) but some

claim that as much as 600 billion of real

estate, equipment, and other assets in the US may

be financed by synthetic leases.

43

• GECC reports equipment leased to others of

36.5 billion, and an additional 29.4 billion in

direct financing leases

44

• Example of dormitories on college campuses.

Risks.

• Interest rate risk. The interest rate on the

debt acquired by the VIE is often a variable rate

debt, tied to a rate such as LIBOR (London

Interbank Offered Rate)

This risk can be managed with a derivative such

as an interest rate swap.

46

• Residual Value Guarantees
• At the end of the lease, the property is either

purchased by the company at its original cost (it

may have gone up or done since then), its fmv,

or rolled into a new lease, or sold to an

unrelated 3rd party to pay off the debt.

There is a danger that the property value will

47

A rollover into a new lease may not be possible

if the lender has developed concerns about the

companys ability to payand if the company cant

pay, they may have to sell the asset to a third

party. If the asset is sold at a loss, the VIE

is liable for the difference, and that may have

to be paid by the sponsoring corporation as the

only source of VIE assets is the corporate rent

payment.

48

• Synthetic leases are expensive in terms of legal,

tax accounting, securities registration, and

other similar costs.

49

• Another major risk for VIE investor is that the

assets of the VIE, while seemingly completely

isolated from the transferor, may be rolled back

into the transferors balance sheet by a

bankruptcy judge. There is not adequate case

precedent to determine when this might happen.

• The examples weve just seen consider the use of

VIEs to facilitate transactions with tangible

assetsreal estate, inventory, etc.

VIEs are also used for financial assets.

51

• VIEs are used to increase liquidity by allowing a

company to bundle assets like accounts receivable

or mortgage-backed securities and to obtain cash

for these securities before the maturity date.

52

• For example, Bank A might have loans with a face

value of 100 million. Because interest rates

have changed, the loans may have a fmv of 110

million. The Bank can transfer the loans to a

VIE. IF the transfer qualifies as a sale, the

bank may book a gain on sale immediately.

53

• There have been questions about aggressive use of

the gain on sale accounting with respect to VIEs

of several financial institutions. For example,

Conseco, Inc. acquired a financing arm, Green

Tree Financial Corporation, in mid-1998. Prior

to the acquisition by Conseco, Green Tree had

made have use of gain-on-sale accounting for

several asset transfers.

54

• The income recognized in these transactions had

to be later written down by Conseco when the

collections on receivables proved to be far less

than initially assumed. In early 2000, Conseco

took a 350 million write-off.

55

• There is concern that VIEs can be motivated

either by a genuine business purpose, such as

risk sharing among investors and isolation of

project risk from company risk, or by a specific

financial disclosure goal, such as off-balance

sheet financing.

56

• The financial accounting and disclosure effects

obtained by the use of VIEs differ substantially

in character and complexity from what we have

traditionally understood to be accounting

manipulations. Some refer to these effects as

financial engineering effects rather than

accounting manipulation.

57

• VIE transactions are inherently complex,

requiring the formation of legal entities, and

the creation of financing arrangements between

the company, its lenders, and new outside

investors. These financial arrangements are

sometimes referred to as structured finance.

58

• According to Dharan (Rice University, Houston),

an important characteristic of financial

engineering is an organizational commitment to

59

• By contrast, achieving the desired accounting

effects from the use of VIEs requires significant

legal planning, including the proper creation of

legal entities, as well as the use of investment

bankers for raising the necessary loans and

external capital.

60

• Financial engineering thus also requires the

involvement of senior management and the company

board of directors in the decisions to create the

needed financial structures.

61

• This means that a corporation where financial

engineering of financial statements is conducted

may well be characterized by a large-scale

break-down of internal controls to prevent

62

• The lack of disclosure transparency is another

characteristic of financial engineering decisions

and structured finance arrangements.

There are limited tools of financial analysis

Execution of transactions at fictitious prices

and on demand

By selling a portion of an investment to an VIE,

a market price is determined that may then be

used to value the retained asset to market. The

McKinsey Company

Lay hired McKinsey Company, management

consultants, to help develop a new business

strategy.

Jeffrey Skilling was one of the consultants who

began to work with Enron.

Skilling proposed a radical plan. Enron would

price. In doing so, ENE created a new product

and a new paradigm for the industrythe energy

derivative.

73

• Skillings plan was successful, and Lay hired him

from McKinsey to work for Enron.

It is claimed that Skilling changed the corporate

culture at Enron.

Skilling

• Skilling adopted an employee ranking system,

Performance Review Committee.

The PRC gained the reputation of having been the

harshest employee-ranking system in the country.

The Performance Review Committee ranked everyone

against their peers.

75

• There was no limit on the bonuses paid to the top

performers.

Up to 15 of the bottom performers were fired

each year.

Fierce internal competition prevailed and

immediate gratification was prized above

long-term potential.

Secrecy became the order of the day.

76

• The Performance Review process created incentives

to do the deal at all costs.

82

• Enron used accepted practices for reducing risk,

including transference of high risk assets off

its books. The company also transferred debt to

separate entities, off its books.

This improved the balance sheet and ENEs

apparent return on investments.

ENRON

• Testimony of Frank Partnoy, Professor of Law,

University of San Diego School of Law, Hearings

before the United States Senate Committee On

Governmental Affairs, January 24, 2002

www.senate.gov/gov)affairs/0212402partnoy.htm

84

• Enron was at its core a derivatives trading firm.
• Many people didnt understand that, thinking that

ENE was primarily an energy company.

But it had transformed into a new economy

company with a primary business of trading in

derivative securities.

85

• From numbers in ENEs 2000 Income Statement,

using the assumption that other revenues is a

gain or loss from derivatives transactions

2000 1999 1998

Non derivatives revenue 93,557 34,744

27,215

Non derivatives expenses 94,517 34,761

26,381

Non derivatives gross margin (960)

13 834

Gain (loss) from derivatives 7,232

5,338 4,045

Other Expenses 4,319 4,549 3,501

Operating Income 1,953 802 1,378

86

• The increase in non-derivatives revenue was

offset by an increase in non-derivatives

expenses.

ENEs non-derivatives businesses were not

performing well in 1998 and were deteriorating

through 2000, as indicated by the negative trend

in gross margin.

ENEs positive operating income was primarily

from gains from derivatives.

87

• There appear to be two answers to the question of

why ENE collapsed. One relates to the use of

derivatives outside ENE, in transactions with

some no-infamous Special Purpose Entities.

The other relates to the use of derivatives

inside ENE.

88

• Derivatives can be traded two ways on regulated

exchanges or in unregulated OTC markets. ENEs

activities involved the OTC derivatives markets.

89

• The size of derivatives markets typically is

measured in terms of the notional values of

contracts. Recent estimates of the size of the

exchange-traded derivatives market are in the

range of 13 to 14 trillion in notional amount.

By contrast, the estimated notional amount of

outstanding OTC derivatives as of year-end 2002

was 95.2 trillion.

90

• The OTC derivatives markets, which for the most

part did not exist twenty (or in some cases 10)

years ago, now comprise about 90 percent of the

increased more than five-fold during 2000 alone.

Derivatives outside ENE

• ENE had over 3,000 off-balance sheet subsidiaries

and partnerships.

93

• ENE entered into derivatives transactions with

these entities to shield volatile assets from

quarterly financial reporting and to inflate

artificially the value of certain ENE assets.

94

• ENE used derivatives and SPEs to manipulate

its financial statements in three ways

It hid losses it suffered on technology stocks

It hid huge debts incurred to finance

Using Derivatives to Hide Losses on Technology

Stocks

• ENE invested hundreds of millions of dollars in

speculative technology stocks. As the market

began to deteriorate, they hid the losses.

An oft-cited example is Rhythms Net Connections,

97

Rhythms went public on April 6, 1999. ENEs

stake was suddenly worth hundreds of millions of

98

ENE was prohibited from selling its stock for 6

months after the IPO.

99

• ENE entered into a series of transactions with an

SPE, in this case, Raptor, which was owned by

another SPE, LJM1.

ENE gave Raptor the shares of stock in exchange

for a loan.

Raptor issued its own securities to investors and

use the cash from this stock transaction to lend

money to ENE.

100

• ENE entered into a price swap derivative

contract with Raptor. ENE committed to give ENE

stock to Raptor if Raptors assets declined in

value. In other words, as long as Rhythms Net

Connections stock price remained high, ENE had

no problems. And as long as ENE stock price

remained high, problems would be relatively minor.

101

• ENE had committed to maintain Raptors value at

1.2 billion. If ENE stock price declined in

value, ENE would need to give Raptor more shares

to maintain this value.

This ENE transaction carried the risk of diluting

Using Derivatives to Hide Debt

Because the securities Raptor issued were backed

by ENEs promise to deliver more ENE shares,

investors in Raptor essentially were buying ENE

103

Essentially, ENE was using stock as collateral

for debt, disguised as share ownership.

104

• ENE recognized the gain on the technology stocks

and avoided recognizing, at least on an interim

basis, any future losses on the technology stocks

they owned.

105

• According to Sherron Watkins, ENE recognized over

550 million of fair value gains on stocks via

swaps with Raptor. Yet much of the stock

declined significantlyAvici by 98 from 178

million to 5 million, New Power Company by 80

percent from 40 per share to 6 per share.

106

• Enron had to issue stock to offset these losses.
• In all, ENE had derivative instruments of 54.9

million shares of ENE common stock at an average

price of 57.92, or about 3.7 billion. At the

start of these deals, over 7 of ENE shares were

potentially committed, and the number rose as the

value of the shares declined.

107

• Further, because the SPEs were not consolidated,

the decline in value was not reflected on the

quarterly financial statements.

108

• This appears to be the type of guarantee that

110

• The form of the transactions between ENE, JEDI,

and Chewco were similar to the transactions with

Raptor, guaranteeing repayment to Chewcos

outside investor.

111

• From 1993 through 1996, ENE and the California

Public Employees Retirement System (CalPERS)

were partners in a 500 million joint venture

investment partnership called JEDI.

112

• Because ENE and CalPERS had joint control of the

partnership, ENE did not consolidate JEDI. ENE

would therefore record its contractual share of

gains and losses from JEDI on its income

statement and would disclose the gain or loss

separately in its financial footnotes, but would

NOT show JEDIs debt on its balance sheet.

113

• In November, 1997, ENE wanted CalPERs to invest

in another, larger partnership. CalPERS was

willing, but only if their interest in JEDI was

bought out first.

ENE needed to find a new partner for JEDI to

avoid consolidation of its financial statements.

114

• Chewco was formed to purchase CalPERs interest.

They needed to find an independent investor to

put up 3 of the total assets in Chewco as an

equity investment.

They were unable to do so.

115

• Notwithstanding the shortfall in required equity

capital, ENE did not consolidate Chewco (or JEDI)

into its consolidated financial statements.

When ENE and Andersen reviewed the transaction

closely in 2001, they concluded that Chewco did

not satisfy the SPE accounting rules.

116

• Because JEDIs non-consolidation depended on

Chewcos statusneither did JEDI.

In November 2001, ENE announced that it would

consolidate Chewco and JEDO retroactive to 1997.

This retroactive consolidation resulted in a

massive reduction in ENEs reported net income

and a massive increase in its reported debt.

117

• For entities do not have to be consolidated, they

are considered related parties, and under FAS 57,

companies have to disclose the nature of the

Using Derivatives to Inflate the Value of

Troubled Businesses

• It appears that Enron inflated the value of

certain assets it held by selling a small portion

of those assets to a special purpose entity at an

inflated price, and then revaluing the remaining

assets held on their balance sheet at the new

inflated price.

120

• From the 2000 annual report, page 49 In 2000,

Enron sold a portion of its dark fiber inventory

to the Related Party in exchange for 30 million

cash and 70 million note receivable that was

subsequently repaid. Enron recognized gross

margin of 67 million on the sale.

121

• The related party was LJM2, an SPE run by Andrew

Fastow, the CFO of Enron.

Enron sold fiber with a cost bases of 33 million

for three times that value. LJM2 issued

securities to investors to obtain the cash to pay

122

• So Enron retained the economic risk associated

with the dark fiber. And even as the value of

123

• Enrons sale of dark fiber to LJM2 magically

generated an inflated price which Enron then

could use in valuing any remaining dark fiber it

Mismarking Forward Curves

• A forward curve is a list of forward rates for a

range of maturities for derivative contracts.

For example, natural gas contracts trade on the

New York Mercantile Exchange. A trader can

commit to buy a particular type of natural gas to

be delivered in weeks, months, or years.

126

• The rate at which a trader can buy natural gas

today with in payment and delivery in one year is

the one year forward rate. The forward curve for

a particular natural gas contract is simply the

list of forward rates for all maturities.

127

• Forward curves are used to determine the value of

a derivatives contract today, and are used to

mark the contract to market as required by GAAP

128

• It appears that traders would deliberately

mismark their forward curves to create artificial

values for contracts (and artificial income as

well.)

A trader can also develop valuation models for

complex contracts that arent routinely traded.

Tweaking the assumptions can change the value

significantly.

129

• Certain derivative contracts are more susceptible

to mismarking than othersfor example it is

difficult to mismark contracts that were publicly

traded. However, the NYMEX forward curve has a

maturity of only six years a trader could

mismark a ten-year natural gas forward rate.

130

• Because many of Enrons derivatives had long

maturities..up to 29 yearsthere were often not

prices from liquid markets to use as benchmarks.

It is possible that some contracts were valued

based on transfer rates between different

nonconsolidated SPEs.

131

• Enron Online was founded in the fall of 1999.
• During 2000, Enrons derivatives-related assets

increased from 2.2 billion to 12 billion, and

Enrons derivatives-related liabilities increased

from 1.8 billion to 10.5 billion.

132

• Much of this change was related to EnronOnline.

But EnronOnlines assets and revenues were

qualitatively different from Enrons other

derivatives trading.

133

• Whereas Enrons derivatives operations included

speculative positions in various contracts,

EnronOnlines operations simply matched buyers

and sellers. The revenues associated with

EnronOnline arguably do not belong in Enrons

financial statements.

Risk Management At Enron

• Enrons risk management manual stated, Reported

earnings follow the rules and principles of

accounting. The results do not always create

measures consistent with the underlying

economics. However, corporate managements

performance is generally measured by accounting

income, not underlying economics. Risk management

strategies are therefore directed at accounting

rather than economic performance.

So where are we with

• Special Purpose Entities
• Variable Interest Entities

136

• In 1990, the EITF, with the implicit concurrence

of the SEC, issued guidance in EITF 90-15. This

guidance and the related EITF publication called

Topic D-14, Transactions Involving Special

Purpose Entities, were the primary sources for

the acceptance of the infamous three percent rule

for SPE non-consolidation.

137

• The 3 rule stated that an SPE need not be

consolidated if at least three percent of the

total assets was owned by the outside equity

holders who bear ownership risk.

The rule was formalized in FAS 125 (June 1996)

which was replaced with FAS 140 (September 2000).

138

• Motivation for the EITF is found in the SEC

Observer cited in D-14

The SEC staff is becoming increasingly concerned

about certain receivables, leasing, and other

transactions involving SPEs. Certain

characteristics of those transactions raise

questions about whether SPEs should be

consolidated, notwithstanding lack of majority

139

• ownership, and whether transfers of assets to the

SPE should be recognized as sales. Generally the

SEC staff believes that for nonconsolidation and

sales recognition by the sponsor to be

appropriate, the majority owner(s) of the SPE

must be an independent third party who has made a

substantive capital investment in the SPE, and

140

• of the SPE, and has substantive risks and rewards

of ownership of the assets of the SPE, including

substantive risks and rewards of ownership of the

assets of the SPE (including residuals).

Conversely, the SEC staff believes that

nonconsolidation and sales recognition are not

appropriate by the sponsor when the majority

owner of the SPE makes only a nominal capital

investment,

141

• the activities of the SPE are virtually all on

the sponsors behalf, and the substantive risks

and rewards of the assets or the debt of the SPE

rest directly or indirectly with the sponsor.

142

• In EITF 90-15 discussion, however, the following

statement was made

The initial substantive residual equity

investment should be comparable to that expected

for a substantive business involved in similar

leasing transactions with similar risks and

rewards. The SEC staff understands from

discussions with the Working Group members that

those

143

• members believe that the 3 percent is the minimum

acceptable investment. The SEC staff believes a

greater investment may be necessary depending on

the facts and circumstances.

144

• It appears that the 3 rule was an ad hoc

solution to a specific issue faced by the EITF

and was intended as guidance.

Somehow that guidance became the industry

standardand professional judgment about fair

presentation was been left behind.

FIN 46

• Because of the problems with SPEs brought to

light with ENE, the FASB issued Interpretation

46, Consolidation of Variable Interest Entities.

FIN 46

• In general, a variable interest entity is a

corporation, partnership, trust, or any other

legal structure used for business purposes that

either (a) does not have equity investors with

voting rights or (b) has equity investors that do

not provide sufficient financial resources for

the entity to support its activities.

149

• Fin 46 increases the minimum outside equity

investment in a VIE to 10 from 3. Those that

fail the new standard can no longer be kept off a

balance sheet. Companies have until the end of

the third quarter to either comply with the new

10 requirement, or to consolidate the VIE.

150

• A variable interest entity often holds financial

assets, including loans or receivables, real

estate or other property. A variable interest

entity may be essentially passive or it may

engage in research and development or other

activities on behalf of another company.

151

• Until FIN 46 was released, one company generally

has included another entity in its consolidated

financial statements only if it controlled the

entity through voting interests.

FIN 46

• In contrast to the original exposure draft, which

applied only to special-purpose entities (any

entity that did not meet the accounting

definition of a business), the final

Interpretation is far broader in scope and

potentially applies to any legal entity, such as

real estate partnerships and joint ventures.

155

• FIN 46 is complex. Judgment is called for in

analyzing entities with which a company has

business arrangements to determine if those

entities are Variable Interest Entities (VIEs)

and, if so, whether consolidation is required.

156

• In applying FIN 46, an enterprise and its related

parties must first determine whether they have a

variable interest in another entity.

157

• If the enterprise and its related parties have a

variable interest in an entity, they next need to

determine if the entity is a VIE. An entity is a

VIE if

the equity in the entity is not sufficient to

absorb the entitys expected losses

the equity investors do not have the ability to

control the activities of the entity or

the investors are not obligated to absorb losses,

if they occur, or receive the entitys residual

returns, if they occur.

158

• If an entity is a VIE, the enterprise and its

related parties need to determine if they or

another investor are exposed to a majority of

the entitys expected losses. If so, that party

is required to consolidate the VIE.

159

• If no investor is exposed to a majority of

expected losses, then the enterprise and its

related parties would need to determine if they

are entitled to a majority of the entitys

residual rewards. If so, they would be required

to consolidate the entity.

160

• So the three main accounting issues are
• Whether or not the VIE should be consolidated

(FIN 46)

When the transfer of assets to a VIE should be

treated as a sale

How the related-party transactions are defined

and reported. Can transfers of assets to related

parties be reported as revenue?

Consolidating VIEs

• Consolidation rules for VIEs have been

Harvey Pitt

• Corporate governance needs to be improved. Recent

events underscore the need to craft responsible

guidance for directors and senior officers to

follow.

164

• There are a number of ways current corporate

governance standards can be improved to

strengthen the resolve of honest managers and

the directors who oversee management’s actions

and make them more responsive to the public’s

expectations and interests.

165

• We think the best way to do that is a two-fold

approach first, make certain that officers and

directors have a clear understanding of what

their roles are, and second, apply serious

consequences to those who do not live up to their

fiduciary obligations.

166

• Corporate governance should establish policies

and procedures that encourage corporate leaders

be faithful to the interests of shareholders and

act with both ability and integrity. The most

important challenge to corporate governance today

is to restore the preeminence of these values

Business Roundtable on Corporate Governance

• Principles
• Select CEO AND oversee the SEE and other senior

management in the competent and ethical

operations of the company on a day to day basis.

Management has the responsibility to act in an

effective and ethical manner to produce value for

168

Management has the responsibility to produce

fair financial statements and timely disclosure

vigilant to ensure that the company or its

171

• Good governance structure is a system for

172

• Audit committee, compensation committee, and

governance committee functions are CENTRAL to

effective governance.

The Audit Committee should be comprised of

independent directors

Audit committee members must understand the

business and risk profile, be financially

literate, and have at least one financial expert

Greenspan, 3/26/02

• In a further endeavor to align boards of

directors with shareholders, rather than

management, considerable attention has been

placed on filling board seats with so-called

independent directors.

174

• However, in my experience, few directors in

modern times have seen their interests as

separate from those of the CEO, who effectively

appointed them and, presumably, could remove them

from future slates of directors submitted to

shareholders.

175

• After considerable soul-searching and many

congressional hearings, the current CEO-dominant

paradigm, with all its faults, will likely

continue to be viewed as the most viable form of

corporate governance for todays world.

176

• The only credible alternative is for

large—primarily institutional—shareholders to

exert far more control over corporate affairs

than they appear to be willing to exercise.

177

• Fortunately, it seems clear that, if the CEO

chooses to govern in the interests of

shareholders, he or she can, by example and

through oversight, induce corporate colleagues

and outside auditors to behave in ways that

produce de facto governance that matches the de

jure shareholder-led model.

178

• Such CEO leadership is critical for achieving the

optimum allocation of the nations corporate

capital

179

• I do not deny that laws could be passed to force

selection of slates of directors who are patently

independent of CEO influence and thereby

significantly diminish the role of the CEO.

180

• I suspect, however, that such an initiative,

Audit Committee

• Pitt In an environment where the quality of

financial information is more critical than ever

before, the audit committee stands to protect and

preserve the integrity of Americas financial

reporting process.

182

• Given their importance, there is no reason why

the right things, and asking the right questions

an audit committee that meets several times a

year where every member has a understanding of

the basic principles of financial reporting,

183

• Where there are no personal ties to the company

where, ultimately, the investor interest is being

served.

Blue Ribbon Panel on Best Practices

• Audit Committees oversee both internal and

external audits

Ensure independent communications with auditors

Engage in robust, candid and probing discussions

OMalley Panel

Audit Committees should obtain annual reports

from management assessing the companys internal

controls, and should pre-approve non-audit

quality—not just the acceptability—of a

companys financial statements, we recognize the

systemic importance of justifying decisions that

directly affect a companys financial reporting

process.

187

• This seems intended to encourage the Audit

Committee and the auditor to discuss gray areas

of accounting.

FEI Survey of Corporate Governance Best Practices

• May, 2002
• 328 responses 101 from NASDAQ-listed companies

Code of Conduct

• 83 have a Code of Conduct and 69 of those

companies ask employees to sign a Code of

Conduct. For those that do have a Code of

Conduct, 85 had their Code approved by their

Board of Directors.

190

• For those that do have a Code of Conduct, 80

Board of Directors

• 62 say that their Board has an independent

nominating committee.

194

• 70 do NOT have a Lead Outside Director
• 57 do NOT have a designated officer in charge of

corporate governance

195

• All publicly traded companies are required to

have at least one financial expert as aboard

member, serving on the audit committee.

196

• 39 of companies describe their financial

expert as a current or former CEO

32 say it is a current or former CFO

197

• The average number of directors on a BOD is 10.
• The number that qualify as independent is 7.

198

• The average number of directors on a BOD is 10.
• The number that qualify as independent is 7.

199

• 86 do NOT provide a program for educating board

members on a continuing basis

The Audit Committee

• When asked whether the audit committee must

authorize all non-audit services provided to the

company by the independent auditors, 60 said no.

However, 62 said that the Audit Committee was

required to approve the overall level of nonaudit

201

• Statement It is hard to find qualified and

interested members to serve on the audit

committee

Strongly agree 12

Agree 28

No opinion 35

Disagree 20

Strongly disagree 5

202

• Question Does the internal audit function

report directly, or jointly with another officer,

to the audit committee?

28 Direct

49 Joint

23 Does not report to the audit committee

NYSE

• Listed companies must have a majority of outside

directors.

No director qualifies as independent unless the

BOD affirmatively determines that the director

has no material relationship with the listed

company (either directly or as a shareholder,

partner, or officer of an organization that has a

relationship with the company. Companies must

disclose this determination.

204

• No director who is a former employee can be

independent until 5 years after their

employment ended

No director who is, or in the past 5 has been,

affiliated with or employed by a present or

former auditor of the company or an affiliate of

the company can be independent until 5 years

after the end of the affiliation or the auditing

relationship.

205

• No director can be independent if in the last 5

years he or she is or has been part of an

interlocking directorate in which an executive

officer of the listed company serves on the

compensation committee of another company that

concurrently employs the director.

Nominating/Corporate Governance Committee

• Listed companies must have a nominating/corporate

governance committee composed entirely of

independent directors.

209

• The nominating/corporate governance committee

must have a written charter that addresses

The committees purpose, which must at the

minimum be to identify individuals qualified to

be board members, and to select, or to recommend

Compensation Committee

• Listed companies must have a compensation

committee composed entirely of independent

directors.

The compensation committee must have a charter

that addresses the committees purpose, which

must, at the minimum, be to discharge the boards

responsibilities with regard to compensation of

the companys executives, and to include an

annual report on executive compensation to be

included in the companys proxy statement,

212

• Detail the committees responsibilities and

duties, which at a minimum must be to review and

approve corporate goals and objectives relevant

to CEO compensation, evaluate the CEOs

performance in light of these goals and

Audit Committee

• The audit committee has the sole authority to

hire or fire the auditor, and to approve any

significant nonaudit relationship with the

independent auditor.

217

• The audit committee must have a written charter

that addresses the committees purpose, which at

a minimum must be to assist board oversight of

the integrity of the companys financial

statements, the companys compliance with legal

and regulatory requirements, the independent