2012Cambridge Business & Economics ConferenceISBN : 9780974211428
Two Steps Backward and One Step Forward; The IASB’s response to Off - Balance Sheet Financing through investments in other entities
Mark D. Hughes*
Faculty of Business and Government
University of Canberra
ACT 2601 Australia
Phone: +612 6201 2695
Simon J. Hoy
Faculty of Business and Government
University of Canberra
ACT 2601 Australia
Phone: +612 6201 2680
* corresponding author
22 February 2012
Thanks are due to participants at a session of the 2011 World Accounting Frontiers Series Conference for their insight and constructive comments.
Two Steps Backward and One Step Forward; The IASB’s response to Off - Balance Sheet Financing through investments in other entities
ABSTRACT
In the wake of the Global Financial Crisis, a number of influential stakeholders called on the International Accounting Standards Board to improve the quality of accounting rules that relate to investments in other entities. This paper argues that the Board’s response to those calls has led to an increase in off - balance sheet financing opportunities for reporting entities. This outcome persists, even after taking into account an increase in disclosures and the removal of a loophole which facilitated off - balance sheet financing.
The Board has legitimized off-balance sheet financing opportunities through the use of supermajorities and potential voting rights. It is argued that this has resulted from the Board’s focus on developing a single test for consolidation, rather than primarily considering the issue from the perspective of providing decision useful information.This paper provides evidence of the impact on financial data in general purpose financial reports and shows approximately 25 percent of subjects in a sample of large companies do not consolidate majority-held investees. While it is true that the Board has increased disclosures relating to investments in other entities, these can be easily circumvented.
1. INTRODUCTION
There has been widespread and longstanding criticism that the accounting standard setting process has yet to achieve its stated objective of developing standards which require decision-useful information be provided to users of general purpose financial reports (GPFR). The basis of this criticism relates to rules that fail to discloseinformation, or present it in ways that users are unable to incorporate in their decision-making processes (Clarke, Dean & Oliver, 1997; Financial Accounting Standards Board, 2006; Graham, King & Morrill, 2003; Herz, 2005; Mackintosh, 2006; Penman, 2003; Pozen, 2007; Securities and Exchange Commission, 2007).This criticism became more pronounced in the wake of the Global Financial Crisis (GFC) when a number of influential reports, such as the Turner Review (2009), the Congressional Oversight Panel (2009), and the Financial Stability Forum (2008)warned that accounting rules relating to equity investments in other entities facilitated various forms of off-balance sheet financing (OBF). These reportslink the GFC with OBF becauseregulators and other equity market stakeholders were misled as to the level of risk faced by reporting entities. These reviews had considerable impact and“in April 2008, in response to the GFC and the recommendation of the Financial Stability Forum, the Boarddecided to accelerate the consolidation project and proceed directly to the publication of an exposure draft”(IASB, 2009, p2).
The International Accounting Standards Board (IASB)duly released Exposure Draft 10 Consolidated Financial Statements(ED 10) (IASB, 2008), Staff Draft IFRS XConsolidated Financial Statements(SD) (IASB, 2010), and International Financial Reporting Standard 10 Consolidated Financial Statements (IFRS 10)(IASB, 2011c).All of these documents specify the use of a single control test to determine when an investorshould consolidate investees.In the Basis for Conclusions on IFRS 10,(IASB, 2011a) the Board states that it expects the use of this single test will reduce the potential for opportunistic structuring of transactions. However, the illustrative examples contained in Appendix B – Application Guidance of IFRS 10 demonstrate that the control test will be applied in two ways that expands the potential for entities to engage in OBF.1First, IFRS 10 relaxes the rules relating to potential voting rights and second, itformally recognizes supermajorities. Potential voting rights exist when aninvestor holds financial instruments, such as options or warrants which, if exercised or converted, would increase the number of voting rights of the holder.
Supermajorities arise through anagreement between a majority shareholder and other shareholders stipulating that votes in relation to the operating or financing activities of an investee require more than a simple majority.Supermajorities and potential voting rights provide managers with considerable flexibility in selecting the desired level of disclosure to apply to various investments. That is, managers can choose whether an investment will be consolidated, equity accounted or accounted as financial instruments. Amajor advantage of accounting for equity investments in other entities as financial instruments is that an investor can inflate earnings in a number of ways, such as reflecting revaluations of the investment in the Statement of Comprehensive Income (SCI) and by not having toeliminate intra-entity transactions. Previously, this would not have been of concern, as investors generally held small equity interests in these investees and would have found it difficult to impose their will on other equity holders. However OBF, through supermajorities and potential voting rights, can greatly facilitate this type of activity.
At the same time as releasing IFRS 10, the Board released International Financial Reporting Standard 12 Disclosure of Interests in Other Entities (IFRS 12) (IASB, 2011d), whichsets out the minimum disclosures required for investments in subsidiaries, joint arrangements, associates and unconsolidated structured entities, with considerable emphasis on structured entities. This rule requires more rigorous disclosures than previously required, but still has substantial gaps which facilitate OBF.
The potential for an increase in OBF following the implementation of IFRS 10 and IFRS 12is a critical issue, as considerable evidence indicates managers actively seek to design transactions that result in reduced disclosures through a range of OBF techniques (Bens & Monahan, 2008; Mills & Newberry, 2005; Mulford & Cominskey, 2002; Partnoy, 2003; Schilit, 2002). Further, there is substantial evidence indicating that the decision-making ability of users is impaired when accounting rules result in opaque disclosures (Harper, Mister, & Strawser, 1991; Hopkins, 1996; Hirst & Hopkins, 1998; Hopkins, Houston, & Peters, 2000; Hirst, Hopkins, & Wahlen, 2004).
This paper adds to the literature by demonstrating how IFRS 10 facilitates OBF through structuring transactions using potential voting rights and supermajorities.An analysis of the notes to the financial reports of a sample of companies from the ASX100 (Top 100 Australian companies)is conducted in order to ascertain how frequently entities do not consolidate a majority-owned investee due to a supermajority agreement. The paper also uses a case study to illustrate the impact a supermajority agreement can have on the GPFR of a reporting entity.
The remainder of the paper is arranged as follows. Section 2 comprises the literature review and discusses the pressures facing the IASB with respect to improving the quality of accounting rules related to equity investments in other entities. It also describes the key elements of IFRS 10 and presents evidence in relation to the impact certain OBF techniques can have on GPFR and specifically examines the impact of supermajority agreements and potential voting rights on GPFR. Section 3 describes the methods employed and provides details with respect to data collection and analysis. Section 4presents the results relating to the prevalence of supermajorities and examines, through the use of a case study,the impact supermajorities can have on GPFR. The final section presents conclusions and offers suggestions for future research.
2.LITERATURE REVIEW
2.1 Perceived inadequacies of accounting rules
The GFC triggered a number of calls for improvement in the rules relating to equity investments in entities. For example, the President’s Working Group (2008, p6) states that “authorities should encourage the FASB and IASB to achieve more rapid convergence of accounting standards for consolidation of ... off-balance sheet vehicles.” A much stronger demand for change was made by the Financial Stability Forum (2008, p26) which suggested that the IASB and FASB truncate their due process procedures to produce a revised rule for investments in other entities to meet an “urgent need for improved standards.”
Standard setters have been working on a range of projects aimed at reducing deficiencies in rules which facilitate OBF through equity investments in other entities. However, the effectiveness of these efforts has been questioned in a number of recent reports and inquiries thatlinkthis variant of OBF to the GFC. For example, the Congressional Oversight Panel claims “the proliferation of off-balance-sheet entities….undermined clarity and understanding in the marketplace” (Congressional Oversight Panel, 2009, p14). Similarly, the Financial Stability Forum (2008, p25) states “the build-up and subsequent revelation of significant off-balance sheet exposures has highlighted the need for clarity about the treatment of off-balance sheet entities and about the risks they pose to financial institutions. The use of off-balance sheet entities created a belief that risk did not lie with arrangers and led market participants to underestimate firms’ risk exposures.”
2.2IFRS 10
The IASB reacted to pressure emanating from the GFC and the Financial Stability Forum by accelerating its work on the consolidation project (IASB, 2009), leading to ED 10, SD and IFRS 10.These documents adopt the control test as the only criterion by which an investing entity will assess whether to consolidate an investee. In the Basis of Conclusions on IFRS 10 (IASB, 2011a, para BC35(d)) the Board stated that it retained the control model as this would reduce the potential for “structuring opportunities.” Paragraph 7 of IFRS 10 states that an investor controls an investee if, and only if, all of the following three elements are present: The investor has to show it has power over the investee, it has exposure or rights to variable returns from its involvement with the investee, and the investor has the ability to use its power over the investee to affect the amount of the investor’s returns.
Prior to the introduction of IFRS 10, reporting entities had to work out whether they should apply International Accounting Standard 27 Consolidated and Separate Financial Statements (IAS 27) (IASB, 2003) or SIC-12 Consolidation—Special Purpose Entities(IASB, 1998) when assessing whether they controlled an investee. In the development of IFRS 10, the Board felt that permitting different interpretations of control for different types of investees would lead to inconsistencies and “potential arbitrage by varying investee-specific characteristics” (IASB, 2011a para BC74), so the decision was made to combine the guidance on the control test in IAS 27 and SIC-12in a single rule (IASB, 2011a para BC75).
More significantly, the Board adopted the concepts of substantive and protective rights from EITF 96-16 Investor’s Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or shareholders Have Certain Approval or Veto Rights (FASB, 1996). Protective rights are defined in paragraph B26 of IFRS 10 as being those rights that “relate to fundamental changes in the activities of an investee or apply only in exceptional circumstances.” Examples of protective rights include restrictive loan covenants and the rights of non-controlling interests to approve the issue of debt or equity instruments, as well as the right to approve significant capital expenditures (para B28).
Appendix B, paragraph B9of IFRS 10states that “for the purpose of assessing power, only substantive rights and rights that are not protective shall be considered.” Paragraph B22 states that for “a right to be substantive, the holder must have the practical ability to exercise that right.”When determining whether an entity has this ability, entities must consider a range of factors, including whether there are any barriers, (legal, financial, contractual, operational) or incentives which would result in the entity not exercising that right (IFRS 10, para B23). If it is likely that the right will not be exercised, it cannot be a substantive right.It would be expected that some kind of boundary would be set in relation to the application of the control test. However, it appears that the Board’s interpretation of substantive rights will facilitate OBF in a number of guises.
2.2.1Potential voting rights
Under IAS 27, an investor assessing whether it controlled another entity would include potential voting rights held under instruments such as options or warrants, if these instruments are currently exercisable (IAS 27, para 14). Paragraph 15 of IAS 27 states that when considering potential voting rights, an investor is to ignore whether its management has the intention or the financial capacity to convert the rights into actual votes. Paragraph B47 of IFRS 10restricts the application of this test,as potential voting rights are only to be included in an analysis of control if they are substantive.In this context, the instruments have to be currently exercisable and it has to make ‘economic sense’ for the investor to exercise or convert the instruments into actual voting rights.
For example, assume an investor holds currently exercisable, but out of the money, options to buy additional shares in an investee. Under IAS 27, the investor would include the voting rights represented by those options, when assessing whether it should consolidate the investee (IAS 27, IG8), as they are currently exercisable. Under IAS 27, the financial capacity of an entity and the intention of management to exercise the options are ignored, as these could be arranged so as to keep certain investments off the balance sheet. However, Application Examples 9 and 10 of IFRS 10indicate voting rights attaching to such options maybe excluded from the analysis, depending on how far they are out of the money. If these instruments are “deeply” out of the money, the associated potential voting rights may not be deemed to be substantive. However, if they are not “deeply” out of the money, the potential voting rights may be deemed to be substantive.
In the development process for IFRS 10, the Board has consistently stated that it prefers the principle-based control test to other metrics, such as risk and returns, which require quantification, as these could lead to structuring opportunities (IASB 2011(a), BC 35(c), BC36). It is therefore surprising that the Board has introduced a test (how deep an instrument is out of the money) which implicitly requires a quantitative assessment before it can be answered. For example, is 10 percent deeply out of the money; or does this only apply from 20 percent? This test facilitates structuring opportunities through the interpretation of “deeply”. For example, assume an investor owned 70 percent of the shares of an investee and sold 30 percent of these to a hedge fund or some other entity. As part of the transaction, the investor also bought a call option on these shares, exercisable at 10 percent above whatever the market price is on the day the options are exercised. The investor would now own less than 50 percent of the votes but it is unclear whether or not the investee needs to be consolidated. The ambiguity arises because it is not clear whether the 10 percent premium would represent an instrument that is “deeply” out of the money.
In paragraph 94 of the Basis for Conclusions of the Staff Draft(IASB, 2010), the Board states that “the holder of potential voting rights …has to take steps to obtain its voting rights. In each case, the question is whether those steps are so significant that they act as a barrier to prevent the investor from having the current ability to direct the activities of an investee.” While this seems a reasonable argument to preserve the internal consistency of the substantive rights test, it ignores evidence that indicatesinvestors are prepared to manufacture these barriers in order to avoid consolidating an investment. For example, Bens and Monahan (2008) show North American banks were prepared to pay investors returns of 25 percent for providing a “consolidation service”. The service these investors provided was the purchase of certain instruments which allowed banks to keep asset-backed commercial paper off their balance sheets. Subramaniam and Mark (2010) cite similar adaptive behaviour in responses to a Standard and Poor’s survey on the introduction of FIN 46R.2
2.2.2 Supermajorities
In paragraph B36 of IFRS 10, the Board explicitly recognizes that having a majority of voting rights may not constitute control, if these rights are not substantive. The Board suggests this situation may arise in those cases where an entity is “subject to direction by a government, court, administrator, liquidator or regulator”(IASB, 2011c B37). It should not be inferred from this list of examples that rights can only be deemed non-substantive due to regulatory reasons. The Board also recognizes that an entity is able to enter into agreements with other parties which may result in the entity not having substantive rights.
Paragraph B25 of IFRS 10 states that substantive rights “exercisable by other parties can prevent an investor from controlling the investee to which those rights relate …. even if [those rights] only give the holders the current ability to approve or block decisions that relate to the relevant activities.” This echoes paragraph 25 of Exposure Draft 10 (IASB, 2008) which states that a “reporting entity can have a majority of the voting rights of an entity but not control that entity. This will occur if legal requirements, the founding documents or other contractual arrangements of the other entity restrict the power of the reporting entity to the extent that it cannot direct the activities of the entity.” The Board’s argument that a regulatory restriction on the exercise of power results in a loss of control of an investee would seem reasonable. However, the Board is formalizing an OBF opportunity by extending this argument to situations where an investing entity can structure transactions so that it has the majority of voting rights, yet have these classified as non-substantive.
2.3. IFRS 12
In 2011 the IASB released IFRS 12 in response to the GFC and requests from users for improved disclosures regarding an investing entity’s investments in other entities (IASB, 2011b).In developing IFRS 12, the Board was particularly focused on redressing a lack of transparency regarding the risks an entity faced when it had invested in structured entities (IASB, 2011b, BC4). As a result, a considerable proportion of this rule is concerned with improving disclosures relating to this kind of investment. Structured entities are defined as “an entity that has been designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements”(IASB, 2011d, Appendix A). The Board should be applauded for improving the disclosure requirements for this type of investment. However, IFRS 12 provides other opportunities for managers seeking to engage in OBF.