STATE OF THE
OFF-BALANCE SHEET MARKET
Suzanne H. McElyea
42 North Structured Finance
Phone: (972) 242-8909
smcelyea@airmail.net
AMERICAN COLLEGE OF REAL ESTATE LAWYERS
MARCH 20, 2004
TABLE OF CONTENTS
Page
A.
Challenges to Off-Balance Sheet Financing .............................................. 1
B.
Financial Reporting Constituencies ........................................................... 1
C.
New Ground Rules..................................................................................... 1
D.
Corporate Governance Issues .................................................................... 1
E.
Consolidation Accounting Background..................................................... 2
F.
Consolidation Anxiety 2003 ...................................................................... 2
G.
Top Myths about FIN 46............................................................................ 2
H.
FIN 45 - Guarantees................................................................................... 2
I.
Synthetic Leases – What Did Companies Do? .......................................... 3
J.
What Happened?........................................................................................ 3
K.
Restructuring Issues ................................................................................... 3
L.
Use of Off-Balance Sheet Financing Going Forward................................ 3
M.
Continuing Accounting Changes ............................................................... 4
N.
Continued Refinement of FIN 46 .............................................................. 4
O.
EITF Issue No. 01-08................................................................................. 4
P.
Revenue Recognition Project / SFAS 13 ................................................... 4
Q.
The Economy ............................................................................................. 5
R.
Industry Overcapacity................................................................................ 5
S.
Capital Spending........................................................................................ 5
T.
Manufacturing Changes ............................................................................. 5
U.
Outlook for Off-Balance Sheet Financing ................................................. 5
-i-
STATE OF THE OFF-BALANCE SHEET MARKET
By Suzanne H. McElyea
© Copyright 2004. All rights reserved.
A.
B.
C.
D.
Challenges to Off-Balance Sheet Financing
1.
Accounting Changes and Disclosures
2.
Corporate Governance Issues
3.
Economic Conditions
Financial Reporting Constituencies
1.
Securities and Exchange Commission
2.
Financial Accounting Standards Board
3.
Big Four public accounting firms
4.
U.S. Congress
5.
Public Company Accounting Oversight Board ("PCAOB")
6.
SEC registrants
New Ground Rules
1.
FASB Interpretation No. ("FIN") 46 – Consolidation of Variable
Interest Entities
2.
FIN 45 – Guarantees
3.
Sarbanes – Oxley Act
4.
SEC Disclosures on Off-Balance Sheet Arrangements
5.
Corporate Controls and Oversight
Corporate Governance Issues
1.
Sarbanes – Oxley
2.
Directors and officer liability
3.
Anti-avoidance climate
4.
Tax shelters
5.
Accounting schemes
6.
Arranger issues
E.
F.
G.
H.
Consolidation Accounting Background
1.
1982 - Consolidation project initiated
2.
1995, 1999 - Exposure drafts
3.
Fall 2001 - Enron collapses
4.
January 2002 - Consolidation project reactivated
5.
November 2002 - FIN 45 issued
6.
January 2003 - FIN 46 issued
7.
June 30, 2003 - Transition date for most public companies
Consolidation Anxiety 2003
1.
January 2003 - Waiting for rules (i.e., FIN 46)
2.
First quarter 2003 - Waiting to interpret rules
3.
Second quarter 2003 - Inconsistencies in interpretations
4.
July 2003 - FASB Staff Positions ("FSPs")
5.
Summer 2003 - More interpretation of rules and unintended
consequences
6.
More to come…
Top Myths about FIN 46
1.
Synthetic leases are dead
2.
FIN 46 doesn’t apply to sale/leasebacks or true leases
3.
Deals will require 10% equity in the future
4.
Special purpose entities ("SPEs") are variable interest entities
("VIEs")
5.
"I’m okay if someone else consolidates"
6.
Everyone’s going to get together and decide who the primary
beneficiary is
7.
FIN 46 creates greater financial transparency
FIN 45 - Guarantees
1.
Effective January 1, 2003, but existing guarantees grandfathered
2.
Disclosures are biggest impact
3.
Valuation of new guarantees just starting
2
4.
I.
Practice mixed, but not stopping deals
Synthetic Leases – What Did Companies Do?
1.
FIN 46 brought synthetics back to life with voting interest entities from a technical standpoint
2.
From a practical standpoint, only a small percentage of SPE deals
were restructured
3.
Many factors limited transaction opportunities
a.
b.
c.
d.
e.
J.
K.
L.
Board of Directors
Corporate governance
Wall St. Journal effect
Cost to restructure
Increased borrowing cost
What Happened?
1.
Deals in existing voting interest entities okay as is
2.
Some deals paid off altogether
3.
Most deals consolidated with financing outstanding
4.
Some SPE deals restructured
5.
FIN 45 didn’t scare anyone away, but some lessees restructured
prior to effective date
Restructuring Issues
1.
What lessors qualify as voting interest entities?
2.
Big Four interpretation of FIN 46
3.
FASB Staff Positions
4.
Lessor information letters
5.
Lessor accounting issues
6.
Equity method vs. leveraged lease
7.
Direct finance lease
8.
Existing entities promoted their availability
9.
One or two new entities organized
Use of Off-Balance Sheet Financing Going Forward
1.
Continuing Accounting Changes
3
M.
N.
O.
2.
Capital Spending
3.
Corporate Balance Sheets and Ratings
Continuing Accounting Changes
1.
Continued Refinement of FIN 46
2.
Emerging issues Task Force ("EITF") 01-08 – Service Contracts
3.
Revenue Recognition Project
4.
Statement of Financial Accounting Standard ("SFAS") No. 13 –
Lease Accounting
Continued Refinement of FIN 46
1.
Five FSPs issued
2.
Five FSPs exposed for comment
3.
Ongoing development and refinements of interpretation and
application
EITF Issue No. 01-08
1.
Effective May 2003
2.
Affects “off credit” service or supply arrangements
3.
Arrangements may contain a “lease” to be recognized by purchaser
if:
a.
b.
c.
4.
P.
Specific property, plant or equipment ("PP&E") is
explicitly or implicitly identified
No right or economically infeasible to use other PP&E
Right to use controlled by purchaser
If applicable, lease component separated out of contract and
classified under SFAS 13 as capital or operating lease
Revenue Recognition Project / SFAS 13
1.
Joint project of the Financial Accounting Standards Board
("FASB") and the International Accounting Standards Board
("IASB")
2.
Project will be the foundation for changes in SFAS 13
3.
Implications for lessor accounting
4
Q.
R.
S.
T.
U.
4.
IASB expecting to expose new lease standards in 2007 and to
finalize in 2008
5.
Will FASB follow suit?
The Economy
1.
Industry overcapacity
2.
Capital spending
3.
Manufacturing changes
Industry Overcapacity
1.
Factory utilization rates at 75% in 2002 after growing by more
than a third from 1995 to 2000
2.
Smokestack industry capacity growth back to where it was 5 years
ago due to plant closings
3.
Corporate earnings will improve as capacity utilization increases
Capital Spending
1.
$1.1 trillion investment spending/year
2.
Declined 13% in 2002 after declines in prior 2 years
3.
25% of capital expenditures for real estate and plants; 3 years of
double digit declines
4.
75% of capital expenditures for equipment and software; most
spending has been for replacement or maintenance items
Manufacturing Changes
1.
Investment spending in U.S. manufacturing to diminish in future as
production moves offshore
2.
Productivity improvements occurring through replacement and
upgrade of plant and equipment
3.
“Jobless” recovery
Outlook for Off-Balance Sheet Financing
1.
Corporate governance will predominate in short run
2.
Concerns about balance sheets and leverage will grow as
expansionary capital spending grows
5
3.
Off-balance sheet products will become more acceptable but not
with the same fervor as before
6