Sarbanes Oxley Research Project

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Web Editor's Note

We are in the preliminary pilot testing stage of a negotiation simulation involving Variable Interest Entities. The following material forms the core of a seminar that has been conducted on several occasions for the capstone accounting class at Suffolk University. You are welcome to view the seminar slides while reviewing this material.

Introduction

Many firms prefer to establish “special” business subsidiaries to perform “special” tasks. For instance, a firm may incorporate a new business entity in China to qualify for trading rights and preferences that are only available to local firms there. Or a firm may establish a new partnership with other organizations to share the costs of developing a trade association or government lobbying function. Firms may also create special entities for developing and managing real estate investments, maintaining pension plans, and leasing or financing capital equipment.

If a parent company owns a special entity, is responsible for its obligations, and controls its destiny through board-level voting power, then it is required to consolidate the entity's financial statements with its own financial statements. A minority ownership interest that falls shortly of total ownership and control must likewise be recorded on the parent company's books.

Regrettably, some companies have taken advantage of these accounting practices by intentionally establishing special entities that: (a) are not legally owned by them, and (b) only exist to “hide” losses, liabilities, and other detrimental information from the readers of their financial statements. Enron, for instance, established hundreds of special purpose entities in off-shore nations, transferred their corporate liabilities to these entities, and then omitted the entities from their consolidated financial statements with the rationale that their corporate officers (i.e. not Enron itself) owned the special entities as private individuals.

In 2003, the Financial Accounting Standards Board tightened GAAP by issuing Interpretation 46(R). Because of this interpretation, a parent company must now recognize a special entity within its financial statements (even if it does not legally own the entity) if it reasonably expects to absorb the majority of the losses of the special entity in the future. One implication of this interpretation is that auditors must now assess the business plans of each special entity in order to compute its expected future profits and losses and then estimate the extent to which any losses might be absorbed by the parent company.

Impact on Education

As accounting students, you are learning that some financial accounting and audit decisions should be based on rules and others should be based on principles. For instance, when FASB Interpretation 46(R) states that a firm “issuing guarantees on behalf of an entity” or “providing financing to an entity” is holding a reportable variable interest in the entity, we might consider that to be a rule. And when it states that a reportable variable interest may not exist if the auditor makes a “diligent effort” that leads to a “reasonable conclusion” that a special entity can “finance its activities without additional (outside) financial support,” we might consider that to be a principle.

There is often no clear right or wrong answer regarding the appropriate accounting treatment for special entities; reasonable people can (and often do) disagree about such decisions. Nevertheless, because we must train you to make such decisions in a professional and ethical manner, we are seeking your feedback about the approach that you might prefer to adopt when analyzing such situations.

Your Task

FASB Interpretation 46(R) is posted online at http://www.fasb.org/st/#int47. It is summarized in the June 2005 CPA Journal article titled FASB Interpretation 46(R): Consolidation Required in Unexpected Situations by James Schmutte and James R. Duncan; the article is also posted online at http://www.nysscpa.org/cpajournal/2005/605/essentials/p42.htm.

Please begin by selecting a classmate and deciding on roles for purposes of completing this exercise. One of you should assume the role of “parent company CFO” throughout this exercise, and the other should assume the role of “audit partner.”

Then, working together, please read the 7 page NYSSCPA article and skim the original Interpretation document. Let me know if you have any questions or comments about the topic.

We are going to use the fictional companies that are mentioned in the NYSSCPA article as the basis of this exercise. Custom Designs Inc. is a parent company that rents space from a special entity called Facilities Inc.; the two firms are owned by the same individuals but do not own each other. The authors note that the parent would, nevertheless, hold a reportable variable interest in the special entity if: (a) it guarantees the debt of the special entity, (b) it leases assets from the special entity, (c) the special entity relies on it for future financial support, (d) the special entity would not be considered financially viable without such support, and/or (d) it expects to absorb the future expected losses of the entity. The first three points might be considered rule based determinants, whereas the last two points might be considered principle based determinants.

We would like you and your classmate to play your roles and work through the following scenarios. You should refer to the documents noted above, and may refer to any other sources of information that you may consider relevant.

1. In the NYSSCPA article, the parent company explicitly guarantees the debt of the special entity, which clearly makes the special entity a reportable one. Now let's assume that the CFO contacts the bank and convinces them to eliminate the parent company's guarantee as long as the individual owners of the two companies continue to maintain their personal guarantees of the entity's debt.

(a) Did you reach an agreement about whether the special entity is still a reportable one?

(b) On a scale of 1 to 10, where 1 means “CFO's position strengthened enormously” and 10 means “auditor's position strengthened enormously,” to what extent did this new development change the relative strength of the positions? It is quite possible that you and your classmate might have somewhat different opinions, so please feel free to report your individual scores in response to this question.

(c) On a scale of 1 to 10, where 1 means “enormously more of a rule based approach” and 10 means “enormously more of a principle based approach,” to what extent did this new development change the extent to which you relied on rules or principles when making your decision? Again, please feel free to report your individual scores.

(d) On a scale of 1 to 10, where 1 means “enormously comfortable” and 10 means “enormously uncomfortable,” to what extent do you feel your position is consistent with FASB Interpretation 46 (R)? Again, please feel free to report individual scores.

2. Now let's assume that the CFO, having already eliminated the parent company's guarantee, now arranges for the individual owners of the two companies to place their voting stock of the special entity into a “blind trust” for their children, with full voting and management control over the entity placed in the hands of their personal attorney. Please go back and answer questions (a) through (d) above.

3. On a scale of 1 to 10, where 1 means “strongly prefer a rule based approach” and 10 means “strongly prefer a principle based approach,” what do you prefer to use when making this type of decision? You may step out of your role and think about your personal preferences when answering this question ... and again, individual scores are welcome!

Thank you for your time and assistance!