The need for transparency in financial reporting

Implications of off-balance-sheet financing and inferences for the future

The Authors

Gerald H. Lander, College of Business, University of South Florida, St. Petersburg, Florida, USA

Kathleen A. Auger, Perzel & Lara Forensic CPAs, P.A., Clearwater, Florida, USA

Abstract

Purpose – The paper's aim is to research and discuss the issue of the lack of transparency in financial reporting and how companies take advantage of accounting rules in ways that inhibit transparency.

Design/methodology/approach – A literature review was carried out to see what had been written and discussed. Various legal cases were studied as well as Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) studies of the impact of off-balance-sheet arrangements allowed by the FASB and SEC.

Findings – There are many ways that companies accomplish off-balance-sheet financing by taking advantage of rules-based accounting. If there is not a rule to prevent an entity from handling a particular transaction a certain way, then it is difficult for the auditor to stop it from happening.

Research limitations/implications – The paper is of descriptive nature. There are many policy implications from the results of the paper for all regulatory agencies. The economic substance of transactions needs to be communicated.

Practical implications – Financial managers and financial consultants need to refocus the structuring of financial transactions so that they comply with generally accepted accounting principles and that the economic substance of financial transactions is communicated. More accountability and ethical awareness needs to be instilled in the individuals who deceitfully structure financial transactions. Regulatory bodies need to ensure more transparency by closing loopholes and better enforcement of accounting standards. Boards of directors, especially the audit committees, need to be sure that a company is communicating the true economic reality of the financial transactions and financial position of the business entity. Off-balance-sheet financing is one of the most significant ways, among others, that the user of financial statements can be misled. It is time for regulatory bodies to eliminate overly rules-based standards, clearly state the economic objective of each standard, and require firms to disclose the economic motivations for the accounting practices they adopt.

Originality/value – The value of the paper is that it studies the problems of the lack of transparency in financial reporting. It then suggests that if what is currently being done, (i.e. rules-based accounting), is not working, then a new approach, principles-based accounting needs to be implemented by the regulatory agencies. This paper provides an overview of the lack of financial statement transparency.

Article Type:

General review

Keyword(s):

Off balance sheet finance; Accounting standards; Financial reporting.

Journal:

Journal of Accounting & Organizational Change

Volume:

Number:

Year:

2008

pp:

27-46

Copyright ©

Emerald Group Publishing Limited

ISSN:

1832-5912

1 Introduction and background

Off-balance-sheet financing arrangements are allowable under generally accepted accounting principles (GAAP) in the USA and have been for more than three decades (Kavanaugh, 2003, p. 3). Companies engage in these transactions to keep certain types of debt off the balance sheet in order to maintain attractive financial ratios and increase borrowing capacity (Kieso et al., 2001a, p. 1191). In addition, they are used to transfer risk, such as from parent to off-balance-sheet subsidiary, which, in turn, influences investors who may not want to invest in the higher-risk parent (Wayman, 2002). There are also tax advantages to certain types of off-balance-sheet arrangements. In addition, off-balance-sheet financing can help to smooth financial figures from one period to another, keeping the volatility that normally accompanies greater risk off the financial statements. Several activities and arrangements may lead to off-balance-sheet transactions:

investments in the equity of other entities;
transfers of financial assets;
retirement arrangements;
leases; and
contingent obligations and guarantees (Report, 2005, pp. i-ii).

These types of transactions attracted relatively minimal scrutiny until the Enron debacle in which the company spun a ludicrously tangled web of fraudulent special-purpose entities in order to hide billions of dollars of debt (Powers et al., 2002, pp. 41-147). Subsequent failures at companies such as WorldCom and Adelphia further indicated a serious breakdown in our system of corporate governance, the audit process, and the financial reporting process as well (Report, 2005, p. 16). In an effort to restore public confidence in corporate America, the stock market, and the accounting profession, the Sarbanes-Oxley Act of 2002 (the Act) was passed by both houses of Congress almost unanimously. The main objective of the Act is to increase transparency in corporate accounting and reporting (Drahuschak, 2006). Section 401(c) of the Act requires the Securities and Exchange Commission (SEC) to conduct an extensive study of the use of off-balance-sheet transactions by corporations, with an emphasis on special-purpose entities, due to the many areas in which they are used and the substantial risks that can be hidden in the absence of proper disclosure (Public Law 107-204, 2002). The study was completed in 2005 and is referred to throughout this paper as “report,” or “study.” Owing to this scrutiny, some companies simply try to avoid off-balance-sheet transactions altogether (Taylor, 2006), unfortunately for firms and investors that could legitimately benefit from their use. But while Enron's abuses were blatant, more subtle misperceptions that corporations project on a regular basis, especially through the use of off-balance-sheet financing, have the potential of being equally devastating. This paper will describe the problems besetting accounting for off-balance-sheet transactions, problems that mirror similar difficulties in other areas, and suggest methods of solving these and similar problems. We will show why off-balance-sheet financing is one of the major reasons that we need to eliminate overly rules-based standards, clearly state the economic objective of each standard, and require firms to disclose the economic motivations for the accounting practices they adopt.

2 Types of off-balance-sheet arrangements and their implications

2.1 Investments in the equity of other entities

According to existing accounting guidelines, equity securities (as opposed to debt securities) must be reported using either the “equity method” or the “consolidation method” of accounting (Ketz, 2003, p. 55). Once a company invests in an entity to a point where it gains “significant influence” over the entity, the investment must be classified as an equity investment and the equity method must be employed. The initial cost of the investment is shown as a one-line balance sheet item and its value is adjusted over time to reflect the investing firm's percentage-share of changes in the investee's net assets (i.e. assets less liabilities), net income or loss, and the investor's receipt of dividends. The Auditing Principles Board's (APB) statement number 18 suggests that “significant influence” can be presumed if a firm “owns more than 20% but no more than 50% of the voting stock of an entity” (Report, 2005, p. 34). However, as the SEC states in its report, “The determination of whether an investor has significant influence often requires judgment” (Report, 2005). The report goes on to explain that significant influence can also be evidenced through “board representation, participation in policy making processes, or even technological dependency” (pp. 34-35).

When a firm's financial investment in an entity directly or indirectly represents 51 percent or more of that entity's voting interest, it is assumed that the investing firm now has significant “control” over the investee. In most cases, the investing firm then becomes the “parent” and the investee becomes the “subsidiary,” according to Financial Accounting Standards Board's (FASB's) Statement of Financial Accounting Standards (SFAS) No. 94, which also states that, when this condition occurs, the parent firm shall present consolidated financial statements (FASB, 1987, par. 13). This requires that the assets and liabilities of the subsidiary be combined with or added to those of the parent firm. Revenues and expenses are combined as well (Report, 2005, p. 36).

In most cases, net assets and net income would be the same for the investing firm under either the equity method or the consolidation method. However, there are two major implications in using the consolidated method. The first is that, by consolidating, a firm cannot transfer underperforming assets or liabilities from its balance sheet to the investee's balance sheet simply for appearance purposes. Second, where the equity method nets assets and liabilities, the consolidated method provides much better detail as to the exact makeup of-balance-sheet items, thereby providing financial statement users with more useful information (Report, 2005).

Ketz (2003) explains how some firms tried to skirt the 20 and 51 percent criteria by not having actual voting interest in a particular entity while still maintaining the “option” to convert the entity's debt obligations or the investing firm's small equity interest into “large and often majority ownership positions at any given time” (pp. 57, 63-70). To circumvent these types of misinterpretations and to keep up with changes in business and financial environments, FASB issued Financial Interpretation (FIN) No. 46 and, subsequently, FIN No. 46 (Revised) Consolidation of Variable Interest Entities, which are interpretations of Accounting Research Bulletin 51, Consolidated Financial Statements (Reinstein et al., 2006, p. 28). FIN No. 46(R) provides guidance as to when an entity (typically, at this point, referred to as a special purpose entity or SPE) should be consolidated as a “variable interest entity” (VIE) of the parent or “beneficiary” (p. 30). Specifically, as noted by Reinstein, et al., FIN No. 46(R) adds a “risk-and-rewards” model to the historic “voting-interest model” that expands the concepts of influence and control. Besides, clearly defining under which circumstances an SPE should be categorized as a VIE and thus be subject to FIN No. 46(R) requirements, the interpretation explains that a “controlling interest” is represented through a firm's “absorption of more than half of a VIE's losses or risks or its entitlement to a majority of a VIE's rewards” (Reinstein et al., 2006). FIN No. 46(R) is lengthy and intricately worded and emphasizes repeatedly that significant or reasonable judgment is often necessary to determine its application (FASB, 2003). However, even before its revision, the interpretation had some impact. Ketz (2003) notes that after the issuance of FIN No. 46, big corporations, such as the former FleetBoston Financial and Boeing, consolidated billions of dollars of debt that was previously off their books (p. 142).

The SEC study estimates that about 91 percent of all financial statement issuers present consolidated financial statements and 23.5 percent report equity method investments, which are estimated to be worth a total of nearly $403 billion (Report, 2005, p. 39). The SEC also notes that review of their sample data reveals that the:

… fair values of equity method investments are either not disclosed or, when they are, there is little correlation among the fair values reported in disclosures and the values reported on the issuer's balance sheet (p. 40).

2.2 Transfers of financial assets

Transactions that fall under the heading of transfers of financial assets and have off-balance-sheet implications tend, like those already discussed, to be complex and frequently involve the transfer of assets to an SPE (Report, 2005, p. 42). Historically, the most common types of asset transfers involved customer receivables, notes, mortgages, and bonds (p. 40). More recently, however, the use of more complex transactions involving “derivatives, cash reserve accounts, guarantees, and servicing obligations for underlying assets” has become more frequent. The SEC explains that this is a result of firms wanting “to take advantage of opportunities in financial markets and, at times, to achieve specific accounting results” (p. 43). Increasingly, firms structure transactions in order to “enhance liquidity, manage risks, and obtain low-cost funding” (p. 42). SPE's are frequently created for these purposes. Securitization is a common type of transaction between a firm and an SPE where assets are transferred to the SPE, which then issues securities to investors to fund the purchase of the assets. The SPE then transfers cash raised from the sale of securities back to the firm, thereby increasing the firm's liquidity. Obligations to investors are then borne by the SPE as opposed to the firm (Kavanaugh, 2003, pp. 3-4).

Many times, the issuing firm retains some type of interest in the transferred assets, which raises the issue of “control” or “continuing involvement” and prompts the need to determine whether consolidation of the SPE is necessary (Report, 2005, p. 45). In efforts to avoid consolidation, many have argued that since the purpose and activities of this type of SPE are set forth at its inception by the legal documents that create it, there is no need for any particular entity to “control” it and, thus, no need for consolidation. In light of this argument, and “to facilitate sale accounting in securitization transactions,” the FASB allows an exception for this type of SPE, describing it as a “qualifying SPE” or “QSPE” (p. 43). Both the FASB and the SEC require several disclosures within the transferring firm's financial statements regarding any QSPEs that the firm is involved with (pp. 43-44). As stated in the SEC report, “Disclosure is required to the extent necessary to provide an understanding of the issuer's material off-balance-sheet arrangements as well as the material effects of those arrangements” (p. 44).

As is typical with many of the “exceptions” that accounting standards have allowed for, the SEC finds that firms are increasingly structuring finance through the use of QSPEs and that the transactions passing through them are becoming more complex and are “beyond those originally contemplated by the FASB” (Report, 2005, p. 46). Additionally, based on its study, the SEC states, “The most frequent structuring goal is to achieve sale treatment without consolidation of any related SPEs and, while economic motivations … exist, some transfers of … assets appear to be significantly, primarily, or even solely entered into with accounting motivations in mind” (p. 45).

The SEC study estimates that about 4 percent of US financial statement issuers report transfers of assets with three percent reporting retained interests in those assets. Assets reported as transferred but still outstanding amount to $1 trillion and issuers' continuing involvement in those assets is valued at $186 billion (Report, 2005, p. 47).

2.3 Retirement arrangements

The two types of pension plans that companies generally offer to employees are the “defined contribution” plan or the “defined benefit” plan. Accounting for defined contribution plans is straightforward and does not have off-balance-sheet implications. Once the employer contributes a predetermined amount to the plan, any future risk or reward generated by the plan rests with the employee (Report, 2005, p. 49).

In contrast, accounting for defined benefit plans is quite complex and involves considerable amounts of estimations and assumptions, besides offering firms several different options in satisfying accounting requirements. Additionally, the employer has a future obligation to ensure that the employees receive their predetermined benefits after retirement. In order to ensure this, companies frequently set up separate legal entities, such as trusts, to manage and invest pension funds. This does not negate the employer's obligation to fund benefits. The employer still bears the risk should the trust's assets underperform but likewise reaps the rewards when generated returns are better than expected (Report, 2005, p. 49). Even though the employer retains the risks and rewards and has considerable control over the trust, FIN No. 46(R) reiterates several previous accounting standards, specifically stating that “an employer shall not consolidate an employee benefit plan” (FASB, p. 3, par. 4b). Therefore, a considerable amount of defined benefit pension accounting takes place off the balance sheet.

However, since the SEC reported on its study, the FASB issued SFAS No. 158, “Employers' accounting for defined benefit pension and other post-retirement benefits plans,” amending several previous statements on pension accounting. The new standard, effective after December 15, 2006 (FASB, 2006), will significantly reduce amounts previously reported off the balance sheet. Currently what is shown on the employer's balance sheet is either a net “recognized” (versus “unrecognized” items as discussed below) accumulated plan asset or liability (Report, 2005, pp. 49-50). The word “accumulated” refers to the amount required to fund benefits based on an employee's time with the employer to date. SFAS No. 158 now requires employers to show on the balance sheet a projected net asset or liability – “projected” meaning the amount required to fully fund its pension obligation into the future (FASB, 2006; Kieso et al., 2001b, p. 1124).

Some of the factors that determine the cost of funding future benefit payments include the “employee's age, length of service, salary, retirement date, expected mortality, expected trends in medical costs,” and expected interest and inflation rates (Report, 2005, p. 50). Once assumptions are made about these factors, the estimated cost of future payments is then discounted to the present value and used as a starting point. Obviously, there will be fluctuations in these assumptions and estimates over an employee's years of service with the company. However, accounting guidance such as that offered by SFAS No. 87, “Employers' accounting for pensions,” does not require an employer to recognize changes in pension obligation estimates on the balance sheet or through the income statement until the obligation becomes due. Thus, the employer may have “unrecognized” gains and losses from its pension obligations. The main reason for not requiring immediate recognition of gains and losses is that it would likely cause “significant volatility” in an employer's financial statements. Therefore, companies have been able to smooth earnings by being able to decide, for the most part, when to recognize gains and losses (Report, 2005). Again, SFAS No. 158 addresses the issue of changes in estimates and assumptions and boldly ignores the concern over volatility by now requiring employers to report periodic changes (gains and losses) in the value of their benefit obligations or plan assets in the “other comprehensive income” section of the financial statement (FASB, 2006, par. B34).

Many investors have wanted employers to report actual gains and losses due to changes in assumptions on the balance sheet. The CFA Institute states that failure to fully recognize the effects of such changes in the financial statements presents a “huge and very costly burden … to those for whom the statements are prepared” (Report, 2005, p. 52). The FASB has taken these concerns a step further by now requiring full balance sheet disclosure of pension obligations. However, FASB's rules change does not mean that all pension problems will disappear. Once the new rules take effect, many corporations will have to show huge liabilities on their balance sheets, giving them even more incentive to hide liabilities elsewhere. Corporations will be struggling with how to meet debt covenants with the extra liability now in plain view (Beck, 2006). Another effect that Beck points out might be that some companies will choose to end their pension programs altogether, or they may switch to defined contribution programs instead. Additionally, companies may consider underestimating plan assumptions to keep the future estimated liability lower. However, they should think twice about this ploy because the SEC is already familiar with this tactic (Taub, 2004).

The SEC study estimates that 16 percent of US financial statement issuers sponsor defined benefit pension plans having plan assets of approximately $1.119 trillion and plan obligations of $1.320 trillion, which suggests that the pension plans of US issuers are underfunded by a net amount of about $201 billion (p. 55).

2.4 Leases

This section will focus on the lessee of an asset rather than the lessor, as the lessee is more likely to engage in lease transactions that are not reflected on the balance sheet.

All leases receive either of two types of treatment. Either a lease is treated as a sale and is termed a “capital lease,” or it is treated as a rental and is termed an “operating lease.” The appropriate treatment is determined by whether “most of the risks and rewards of ownership are transferred to the lessee.” If so, the lease is capitalized on the lessee's balance sheet by recording the asset and the related liability. If not, the lessee simply records periodic lease payments as an operating expense (Report, 2005, pp. 60-61). SFAS No. 13, “Accounting for leases,” lists four tests used to determine whether to account for a lease as a capital lease. Only one criterion needs to be met in order for a lease to be classified as a capital lease. They are:

the lease transfers ownership to the lessee using the asset by the end of the lease term;
the lease contains an option whereby the lessee can purchase the leased property at a price sufficiently lower than the expected fair value of the leased property at the end of the lease term;
the term of the lease is equal to or greater than 75 percent of the estimated economic life of the leased property; and
the present value of the minimum lease payments to be made by the lessee is equal to or greater than 90 percent of the fair value of the leased property (FASB, 1976).

However, by issuing clear guidelines in terms of percentages, more and more firms have been able to structure lease agreements to achieve whatever accounting treatment is sought to achieve their presentational goals. In fact, as the SEC recognizes, “Lease structuring to meet various accounting, tax, and other goals, has become an industry unto itself in the last 30 years” (p. 63). Although extensive disclosure is required for lease arrangements, as with pension accounting, the burden of making sense of it all lies with the financial statement users (pp. 61-62). Table I illustrates why firms have an incentive to avoid capital leases. Information taken from Starbucks' September 2005 financial statements was adjusted to estimate the effects on Starbucks' balance sheet should they choose to account for their various locations under capital leasing versus under the operating method. Most notably, long-term liabilities increase 1,118 percent under capital leasing, as Starbucks is able to keep about $2 billion in debt off its balance sheet.

FASB's guidance on lease accounting has long been criticized for its complexities and inconsistency with the FASB's conceptual framework (Ketz, 2006a, b). Just recently, the board voted to work on revamping the current guidelines to be more in line with international standards. However, it may take as many as three years before an updated rule is issued (Leone, 2006). Currently, the International Accounting Standards Board (IASB), which follows a principles-based approach to setting standards, addresses leases in six IASB pronouncements and one interpretation. Under US GAAP, lease accounting is addressed in 20 FASB statements, nine interpretations, ten technical bulletins, and 39 emerging issues task force abstracts (Shortridge and Myring, 2004).

The SEC study estimates that 63 percent of US financial statement issuers report operating leases having an undiscounted sum of future cash flow commitments of $206 billion and 22 percent report capital leases having an undiscounted sum of future cash flows of $16 billion (p. 65).

2.5 Contingent obligations and guarantees

Contingent obligations and guarantees involve uncertainties as to whether a firm will incur an obligation to transfer cash or other assets in the future and, if so, in what amounts. Examples include payments contingent upon the outcome of a lawsuit or court proceeding that the firm may be involved in, warranty payments for a firm's defective products, and default payments on loans guaranteed by the firm. SFAS No. 5, “Accounting for contingencies” requires that these uncertainties be accounted for in one of three ways after an initial determination as to whether the occurrence of a loss is deemed “probable” and, if so, whether the amount of loss is estimable (Report, 2005, p. 65).

If a loss is deemed “probable” and estimable, the loss amount with the highest probability of occurrence must be recognized on the balance sheet. If the potential loss is “probable” but not estimable, or if the loss is deemed “reasonably possible” but not “probable,” the existence of the potential loss must be disclosed but no liability is recorded on the balance sheet. If the loss is deemed “remote,” no disclosure or recognition of a liability is required. Probability and loss amounts are matters of judgment, given all known facts and circumstances, and weighted averages are generally used to determine the “probability-weighted amount to be paid” under SFAS No. 5. However, as noted by the SEC, SFAS No. 5 does not provide a clear threshold “in determining whether a liability should be recognized and for how much,” but “by all accounts,” it appears that likelihood of occurrence is deemed “probable” at a “substantially higher” threshold than “50%+” (pp. 65-66).

More recently, guidance under FIN No. 45, “Guarantor's accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others,” requires a fair value approach to recognizing on the balance sheet certain guarantees, where the degree of uncertainty is reflected in the measurement of the liability, as opposed to determining whether the liability should be recognized at all. One method used to estimate the fair value of the contingent obligation is based on probability-weighted discounted cash flows that produce an “expected value.” This expected value would then be recognized as a liability on the balance sheet even though, under the SFAS No. 5 approach, the occurrence of the loss might not be “probable” and thus not recognizable on the financial statement, as illustrated in Table II (Report, 2005, p. 66). Numerous disclosures are required for contingent obligations and guarantees as outlined in various accounting standards and interpretations and in the Sarbanes-Oxley Act (pp. 67-68).

Many arguments exist for and against each of the approaches to measuring contingent obligations, but the main objective is to provide financial statement users with the most useful information. Under SFAS No. 5, determining whether a loss is “probable” and in what amount can be subjective, based on management's judgment, which is also difficult to verify independently. Similarly, under FIN No. 45, the recorded liability may not be representative of the actual “probable” cost of resolution of the contingency, which could be misleading. Some argue that, under FIN No. 45, at least contingencies are acknowledged where with the SFAS No. 5 approach, they may “go entirely unrecognized” (Report, 2005, p. 69).

The SEC found in its study that “disclosures about contingent obligations vary widely in terms of format and location in the filing,” making “data difficult to collect in a consistent manner” (Report, 2005, p. 69). The SEC estimates, based on notes to the financial statements, that 46.3 percent of US issuers report legal contingent obligations, 10.2 percent report environmental contingencies, and 35.4 percent report guarantees. Liabilities reported on the balance sheet for the various contingencies are 5.1 percent for legal contingencies, 5.1 percent for environmental contingencies, and 10.2 percent for guarantees (p. 70). Estimates of the amounts reported as liabilities on the balance sheet versus exposures reported only in notes to the financial statement can be seen in the following Table III.

The SEC also notes that, “for liabilities recognized on the balance sheet, issuers, for the most part, include no other disclosures concerning any additional potential losses.” Further, many times issuers “disclose the existence of a contingent obligation, but recognize no liability and disclose no range of loss” (p. 72).

3 Discussion

Looking at the numbers above, one can see that off-balance-sheet amounts are in the trillions of dollars and this does not even include all transactions with off-balance-sheet implications. Additionally, these are only estimates. It is an attempt to highlight, within the scope of this paper, many of the issues, difficulties, shortcomings, and grey areas that must be dealt with in order to increase transparency and comprehension in financial statement reporting. Off-balance-sheet transactions are by no means new and neither are the concerns over their uses and implications (Morrison, 1993). PCAOB member Charles Niemeler states, “Off-balance sheet reporting was not a problem that ultimately evaporated, but rather festered and imploded with Enron” (Shaw, 2006). Unfortunately, it took that quake and its aftershocks to make us take notice and spur us to quicker, decisive, meaningful action. However, it is increasingly evident that critical decisions must be made and bold steps taken.

3.1 Standards-setters

Everyone suffers in some way when financial markets collapse and confidence erodes. However, a few specific groups should be most concerned with transparent financial reporting and the abundance of risk being kept off-balance-sheets. Naturally, the first group to consider is the standard setters. The SEC finds fault with current accounting standards, citing the existence of “bright lines,” such as the 75 and 90 percent tests for lease accounting that cause the standards to be too rules-based (Report, p. 67). The SEC feels that “rules-based standards can provide a roadmap to avoidance of the accounting objectives inherent in the standards” (p. 102). Graham Ward, president of the International Federation of Accountants states that US accounting standards “are only conducive to promotion of dishonesty” and favors a universal set of international principles-based standards (Gopalakrishnan, 2006).

Ironically, US GAAP is a principles-based system – or at least it starts out that way (Shortridge and Myring, 2004). According to Shortridge and Myring, when standards are proposed, they are generally principles-based. The problem arises when, “in an effort to increase comparability and consistency in financial reporting, a principles-based standard often becomes a rules-based standard.” It is evident from the above discussion of the various off-balance-sheet arrangements that firms do attempt to structure financial transactions to circumvent accounting rules and guidelines and/or in order to reach or maintain an accounting objective versus an economic objective. In light of this, it seems that it would make sense to restructure accounting rules and guidelines so they are less precise, which is an underlying concept of principles-based standards that generally tend to be “broad guidelines that can be applied to numerous situations” (Shortridge and Myring, 2004). However, there are drawbacks to this approach as well. Consider, for example, how companies would determine fair value. Without specific guidelines, any number of interpretations of fair value might be used, which would reduce comparability of and consistency in the financial reports of various entities (Shortridge and Myring, 2004). Considering this, a mix of principles- and rules-based standards might best meet the needs of all involved. Most would probably agree that current US standards already represent this mix to some degree, although some rules, such as those pointed to by the SEC, could probably be eliminated or revised. An “objectives-oriented approach,” as mentioned by the SEC and agreed upon by the FASB, could be incorporated into the mix as well by clearly incorporating into accounting standards the economic objective that the standard is intended to fulfill (Report, 2005, p. 101).

In a statement regarding lease accounting, Ketz (2006a, b) suggests that the FASB should “follow its own conceptual framework” by sticking to its definitions of “assets” and “liabilities” that should be placed on the balance sheet. It does seem to simplify matters when we think in terms of an asset providing for “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events” and a liability as allowing for:

… probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events (Kieso et al., 2001b, p. 40).

Interestingly, FIN No. 46(R) applies a “new” “risk and rewards” model in determining when to consolidate a VIE (Reinstein et al., 2006, p. 2). However, closer examination reveals that the “risk and rewards” model is simply one of the most basic accounting concepts – that is, the concept of assets (rewards) and liabilities (risks). The same type of risk and rewards concept found in FIN No. 46(R) is also articulated in SFAS No. 13, “Accounting for leases,” and it seems this should suffice without having to include four tests for capital leases (FASB, 1976).

An important aspect of the standard-setting process is that the FASB does not act alone. Standards and interpretations are formulated based on input and concerns from various stakeholders, such as big corporations and accounting professionals (FASB Facts, 2005). In fact, standard-setting follows a “due process that is open to public observation and participation” (FASB Facts, 2005). Perhaps, changes to this due process should be considered in order to keep pace with rapidly changing financial markets. As stated in the FASB's literature, “A major project on a proposed standard generally includes dozens of board meetings over several years,” and this is before the first exposure draft is ever written, if it gets to the point of being written. In the end, the process could take twice as long (FASB Facts, 2005). This seems ludicrous in today's fast-paced business environment. In addition, the FASB not only receives “opinions and comments” from interested parties, but it also receives downright pressure. This can be evidenced by the fact that off-balance-sheet accounting has been around for 30 years and it has been a constant concern, as has the accounting for leases and pensions. However, only recently has action been taken. Not surprisingly, the decision to finally put pensions on the balance sheet was met with much opposition (Beck, 2006). The FASB should be concerned about this opposition because the organization received its funding from big businesses and accounting professionals in the past. In the past, if big business did not support what the FASB was promoting, they would not contribute to its existence. However, there will always be opposition to certain positions of the FASB, it is less likely to affect the funding as a result of the Sarbanes-Oxley Act. It is funded as provided in Section 109 of the Sarbanes-Oxley Act. It is supported by an accounting support fee collected from all publicly traded companies, based on market capitalization, and by sales of publications, as long as those sales do not impair the actual and perceived independence of the standards-setting body. The SEC will approve FASB's annual budget, prohibit contributions, and require an annual audit (Williams, 2004).

3.2 Accounting professionals

It would seem that accountants and auditors are best trained in determining when and how firms might attempt to skirt rules and regulations and manipulate numbers and words for appearance purposes. Continuing professional education should require more courses in fraud detection and financial statement fraud, and universities should require such courses of their finance, business, and accounting majors. Accountants and auditors should have the knowledge, capability, and willingness to afford corporations transparency in financial reporting and comprehension of accounting standards, instead of trying to help firms maneuver around them. Shortridge and Myring (2004) state that an advantage of principles-based accounting over a rules-based system is that it “allow[s] accountants to apply professional judgment in assessing the substance of a transaction” and they contrast this approach with the “‘box-ticking’ approach common in rules-based accounting standards.” They paraphrase FASB Chair Robert Herz as stating, “He believes the professionalism of financial statements would be enhanced if accountants are required to utilize their judgment instead of relying on detailed rules.”

Herz's position is debatable. The accounting profession, by its own standards, already requires the use of professional judgment (AICPA, 2003, p. 173, par. 11). Furthermore, accounting professionals are demonstrably not brainless “box-tickers” whose hands are tied by strict rules and guidelines. KPMG partners obviously felt quite uninhibited in fashioning fraudulent tax shelters for wealthy clients. Instead of trying to lay blame on existing standards, accounting professionals should be more actively participating in identifying where problems lie and facilitating changes for the better. If accountants wish to regain the public's confidence in their profession, they must check their own ethical convictions and ability to consistently act professionally and hold themselves to the highest standards that the profession dictates and that the public demands.

The SEC's newly appointed deputy chief accountant, Zoe-Vonna Palmrose, may push to shield auditors from liability in corporate fraud lawsuits (Westbrook, 2006). Although auditor concerns are understandable, it seems that shielding them from liability will take away at least some of their incentive to look for fraud. Since, as Westbrook (2006) points out, the government now regulates auditors by way of the Public Company Accounting Oversight Board (PCAOB), perhaps the time is right for the SEC to set up a pool whereby money is collected from particular corporations and the SEC pays for and assigns auditors to engagements from that pool. This sort of arrangement might solve both the issues of liability and auditor independence.

If we truly are about transparency in financial reporting, why do not these kinds of initiatives take place? They does not take place because businesses do not want them to take place. Businesses like the game of one-up-manship. They have the money to lobby to keep the game going.

3.3 Boards of directors

Some company boards of directors have been reminded by the Sarbanes-Oxley Act of the need for them to act “reasonably and in good faith” should they wish to be shielded from liability in the event of corporate misdealing (Skinner, 2006, p. 38). These are the people who hire the outside auditors for the firm and to whom the firm's audit committee reports. Additionally, they are held responsible by securities laws to oversee their companies' disclosures (Grienenberger and Lee, 1998). If transactions are taking place that are less than above-board, these individuals may find it difficult to prove they have acted “reasonably and in good faith” unless they specifically inquire about such things as the existence and nature of off-balance sheet arrangements, reasons for certain accounting treatments, quality of financial statement disclosures, and the like.

Enron's board of directors was well aware that the company was involved in many questionable arrangements, including “misleading accounting.” They were the gatekeepers that should have saved the investing public from catastrophe and yet they failed to act (Levin, 2002).

3.4 Investors

Above all, investors should be paying close attention to the rules and regulations governing corporate reporting because they play an enormous role in the corporate accounting and reporting process, as Daniel et al. (2002) so well document in their work based on behavioral finance. In brief, Daniel et al., found in their study that investors generally tend to be biased in judgment and decision, naïve, credulous, overconfident, lacking in skepticism and information and have limited attention spans and processing capacity (pp. 139, 142-3, 145, 177). These attributes affect how investors perceive and process information about a particular stock. As it applies to this paper, Daniel et al., conclude, “Financial reporting rules and mandated disclosures are necessary to protect credulous investors” (p. 183). They go on to explain that, due to their biases, investors do not possess enough skepticism to rationally interpret accounting numbers, especially footnotes, or even corporate events such as news releases, in ways that will lead them to rational investment decisions (pp. 169-70, 185). As an example of investor irrationality, Teoh and Wong (Daniel et al., 2002) found that “stock prices react more strongly to earnings that are attested to by a major auditor than by a less-well-known auditor” (p. 170).

Further, evidence confirms that “presentation of financial information and accounting method choice influence the perceptions of investors.” They hypothesize that firms are aware of this and fashion financial reports and information according to which information they want noticed versus what they prefer to have overlooked (Daniel et al., 2002, pp. 185-86). For these reasons, Daniel et al. suggest that “important information that is hard for investors to process should be recognized within the financial statements and less important and easily processed information footnoted” (p. 187). Overall, Daniel et al. state, “Fully rational investor skepticism should force voluntary revelation of substantive information” (p. 186).

Adding to investor irrationality is Wall Street's focus on short-term earnings, which has led to the tendency of corporate boards to compensate top management based on quarterly earnings, which are relatively unreliable to begin with. However, managers are then given incentives to inflate those earnings (Ketz, 2006a, b). Unfortunately, as Daniel et al. explain, investors normally only discount for “the ordinary level of manipulation” and may fail to discount appropriately when a firm's incentive to manage earnings upward is greater (p. 188). It would behoove investors to become more educated in accounting and finance, humble themselves, and take a healthy dose of skepticism to avoid being led astray by appearances.

In a Cato Institute Policy Analysis, Barbara Kavanaugh (2003) explains:

The first structured transactions (i.e. securitizations through an SPE) were built with the aid of Wall Street financial engineers who were attempting to satisfy investors looking for specific attributes in their investments.

In other words, financial transactions were structured to make financial statements look like what it was perceived that investors wanted, versus reporting what was the economic reality of a company. This leads to a lack of transparency and deception on the part of the structuring of financial transactions. The lack of good ethical behavior in the structuring of financial transactions is where the manipulation starts. Financial managers and consultants make a living coming up with new ways to circumvent accounting principles and rules. Jeff Skilling, of the former Enron, admitted in front of the US congress that their derivative transactions were so sophisticated that even they did not understand them. If they did not understand them, how are auditors and ultimately the users of financial statements going to understand them? Ethical values need to be instilled in these people in the education process and the continuing education process. There also needs to be some type of legal accountability for intentionally structuring transactions to deceive the users of financial statements. The audit committee has to be held to a higher level of accountability for the types of transactions that a company is using and insure that transparency of the substance of economic reality is being communicated to the investors, not some illusion.

Although, Daniel and his colleagues do not differentiate between the average investor and the more sophisticated investor, it can be argued that their analysis is pointed more toward the average individual investor who may be more apt to take financial information at face value. Institutional investors, money managers, and analysts understand the calculations involved in bringing some off-balance-sheet items, such as operating leases, onto the balance sheet to gain a better financial picture and, if off-balance sheet items are properly disclosed, they are able to make better financial decisions than the average individual can in most cases. However, it seems that where the average and sophisticated investors meet is in their failure to account for management's incentives to manipulate the numbers. In Enron's case, the incentive was sheer greed and Enron's story is a classic example of how even the most sophisticated investors can lack skepticism and become biased, credulous, and overconfident. While Enron filed for bankruptcy on December 2, 2001, 11 out of 16 Wall Street analysts still rated Enron stock as a “buy” or “strong buy” as late as November 8, 2001. Four of the 11 analysts testified in front of a Senate investigative panel, admitting that, “they had been misled by Enron's false financial reporting” (Analysts, 2002). However, an independent analyst testified in front of the same panel, stating that, “in just one hour of scrutinizing Enron regulatory filings he had filled three pages with examples of questionable disclosures” (Analysts, 2002). One reason for the bias of the 11 analysts might be that they were being paid from the revenues of Enron investments and, therefore, were not independent of the organization (Analysts, 2002). They had become greedy as well.

Besides, lack of proper disclosure of Enron's off-balance-sheet arrangements and related party transactions, Dharan and Dufkin (2003, p. 3) illustrate how Enron's financial statements and ratios simply did not add up “according to common profitability and valuation measures,” and suggest that “the business press and financial analysts must have been in denial over Enron.” Even simpler, Enron's unprecedented 65 percent+ average annual growth in the typically slow-growing energy and utility industries should have created greater skepticism and increased scrutiny (p. 2). Instead, it simply created awe. Further evidence of investor overconfidence is illustrated in subsequent crises such as WorldCom and Adelphia. In all, the average investor and sophisticated investor alike are probably harmed more by inadequate or misleading disclosures of off-balance-sheet transactions than by the transactions themselves. It is impossible to protect ones' self from something that is simply not known.

A study done by Chandra et al. (2006), that evaluates the quality of disclosures by firms pre- and post-Enron illustrates how firms have little incentive to disclose any more than the minimum required by GAAP standards or SEC regulations. Beyond regulatory requirements, disclosure of additional information can reduce a firm's competitive advantage if, for example, competitors decide to also sponsor off-balance-sheet entities (p. 234). After Enron's collapse, the SEC issued Financial Release No. 61 (FR-61) to “remind” managers of their disclosure obligations regarding liquidity and capital resources, which would include SPE's and other off-balance-sheet items. Although guidelines were already in place prior to Enron, Chandra et al. find that many firms either did not disclose their off-balance-sheet entities or those that did provided very little useful information (p. 231).

This study also found that when guidance is more objectives- or principles-based, such as is the guidance on disclosure requirements, “reminders” such as FR-61 prove helpful and serve to improve disclosures at least to some extent (p. 231). This is something to bear in mind if US GAAP is going to become more principles-based.

3.5 Regulators

The Sarbanes-Oxley Act of 2002 passed both houses of congress with nearly unanimous votes. It was designed to increase investor protection by “making corporate accounting more transparent” (Drahuschak, 2006). Recently, former Federal Reserve Chairman Alan Greenspan (as quoted in Drahuschak, 2006) commented that the act passed “with the vast, vast majority of the House and Senate not having read the bill,” and also noted, “Any bill that goes through Congress with that sort of vote cannot be good.” The Act applies to all issuers of securities that are registered or have filed a registration statement with the SEC or are required to file reports with the SEC, including non-US issuers (White collar, 2005).

Since, its enactment, companies have increasingly complained about the costs of compliance and difficulties in implementation. In addition, there has been considerable speculation that the Act has caused some companies to go private and some private companies not to go public (Drahuschak, 2006). However, there is tangible evidence that more companies are going public on foreign exchanges instead of in the USA and the number of foreign firms listing their shares in the USA has “fallen substantially in the past five years” (Drahuschak, 2006; Special report, 2006). Furthermore, the Economist Newspaper reports, “More of corporate America was taken out of public ownership by private-equity firms in the first ten months of this year than in the previous five years combined” (Special report, 2006). Again, one can only speculate as to the cause of this activity.

Nonetheless, lawmakers are growing increasingly concerned about America's capital markets, their competitiveness, and their ability to help businesses grow. They are recognizing the Sarbanes-Oxley Act as a big part of the problem and the SEC has plans in the very near future to unveil reforms to the Act aimed at easing compliance (Special report, 2006).

Although not specifically related to off-balance-sheet financing, this reaction is an illustration of how accounting regulation can affect financial markets. Hopefully, any new or revised legislation will be more carefully reviewed before it is put into practice. The reaction to Sarbanes-Oxley should serve as a signal to the SEC and other government officials that all the costs and benefits need to be weighed carefully before imposing undue requirements on businesses.

4 Conclusion

US GAAP has served firms, investors, and the public relatively well for more than seventy years. But markets were expanding and evolving rapidly and competition was getting tougher. Red flags abounded at Enron but virtually everyone from board members to accountants to auditors to investors to the media and beyond were so in awe of the company that no one questioned its performance – and the first one to be blamed after its collapse was the FASB (Wee, 2001). However, had the FASB attempted to introduce tough regulations on SPEs during Enron's glory days, it would have been met with insurmountable opposition from all who were making money off of Enron stock.

We have the tools required and the systems in place to bring financial reporting to a point where it provides a higher level of assurance. We need to eliminate overly rules-based standards, clearly state the economic objective of each standard, and require firms to disclose the economic motivations for the accounting practices they adopt. The FASB together with the IASB are currently working together “to develop a common conceptual framework” that will “provide a sound foundation for developing future principles-based accounting standards” (Conceptual, 2006). The FASB's bold move on pension accounting, which has been a controversial topic for decades, is a strong signal that the board is less willing to be influenced by big corporations in setting standards that best serve investors and other stakeholders (Pension, 2006). In addition, the SEC and the FASB have agreed to work together on developing a disclosure framework to enhance the quality and transparency of corporate reporting (Report, 2005, p. 115). A disclosure framework will make disclosures more comparable across firms, as well. Decreasing the time it takes to establish new standards or revise old ones seems imperative, given the rapid pace that business is keeping. However, with leasing on its agenda, pensions on the balance sheet, and its new interpretation on consolidation of VIE's, the FASB has at least begun to pull in the reins on off-balance-sheet accounting.

Financial managers and financial consultants need to refocus the structuring of financial transactions so that they comply with GAAP and communicate the economic substance of transactions to users of financial statements. More accountability and ethical awareness needs to be instilled in the individuals who deceitfully structure financial transactions. In addition, the investment banking industry should have controls in place to ensure the maximum possible level of independence between analysts and the firms whose stocks they trade.

4.1 Recommendations for the future

Adopt more principles- and objectives-based accounting standards.
Follow up with “reminders” and suggestions for application and disclosure, such as is included in FR-61.
Adopt a set of international accounting standards (especially in light of an ever-increasing global business environment).
Require firms to clearly disclose the economic objective for the accounting treatments that they adopt.
Develop a uniform (possibly industry-specific) disclosure framework to be used by all firms to simplify location of pertinent information and comparison amongst firms.
Include fraud and ethics education and awareness in all undergraduate accounting, finance, and business courses.
Require fraud and ethics continuing education of accounting professionals. (Why not require it of CFOs and CEOs as well?).
Require and ensure independence of every company board member.
Institute better controls (to ensure independence) over the investment banking industry.
Increase independence between investment analysts and firms whose stock they trade.
Have an agency, possibly the SEC, assign and pay auditors from a pool that collects fees from various businesses, thereby assuring auditor independence.
Provide funding for the FASB that is totally independent of big business. Possibly higher fees from publicly traded companies based on company assets and less reliance on market capitalization and the sales of publications.

We have discussed the need for more transparency in financial reporting. Some may argue that these kinds of off-balance-sheet activities do not really hurt sophisticated investors, such as large institutional investors and money managers. Capital market valuation research argues that sophisticated analysts will make adjustments to the financial statements for off-balance-sheet items. However, if an item or items are not disclosed such as debt guarantees, contingent losses or SPEs, how is the analyst going to adjust the financial statements? We argue on the side of positive accounting research that management has incentives to avoid certain financial activities on the balance sheet. If not, why do companies lobby so hard against financial transparency if there is not some major advantage for spending the resources to do so? In the mid-1990s, when the FASB tried to move toward expensing stock options and to make firms consolidate special purpose entities, why was there so much opposition and why did not it happen? The US Congress, at one point, was going to regulate stock options for they did not like the expensing direction that the FASB was taking. Many powerful leaders were against expensing stock options such as Senators and Congressmen. As we have pointed out previously, 11 out of 16, Wall Street Analysts still rated Enron stock as a “buy” or “strong buy” as late as November 8, 2001. On December 2, 2001 Enron was Bankrupt. Had there been more transparency in the financial reporting of Enron, it is possible that these analysts would not have been able to have gotten away with pumping the company up so that they could unload their holdings. Had Enron's financial statements been more transparent, possibly fewer investors, including many pension plans, may not have been hurt to the extent that they were for they and the markets could have been more aware of what was really the state of Enron. Most recently, there has been much powerful opposition to FASB's efforts to make pension accounting more transparent. The new requirements still net the pension assets and liabilities as a compromise to get the standard passed. Whether sophisticated or not, the investor has a right to fair and transparent reporting by business entities. We need to assure the investors that the “critical events” of the business entity are being communicated. As a profession, we need to set the proper tone at the top. We need to stop the politics of game playing and do the right thing.

Table I

Table IIAccounting for a loan guarantee under FIN No. 45 vs SFAS No. 5

Table IIIContingencies on vs off balance sheet

References

AICPA (2003), AICPA Professional Standards, American Institute of Certified Public Accountants – AICPA, Inc., New York, NY, June, Vol. Vol. 1.