RSS feedsFor a few years it seemed possible that off-balance sheet accounting had finally been vanquished. That view now seems naive. While it is clear that, in general, the quality and transparency of corporate reporting steadily improved in the 1990s and in the early part of the 21st century, the lure of off-balance sheet transactions never quite lost their shine. Maybe that statement needs one qualification: while it seems non-financials have lessened their dependence on off-balance sheet vehicles, the banking sector remains fiercely loyal.
By its very nature, it is impossible to define the size of off-balance sheet assets and liabilities, the number of organisations involved in the various schemes and, most importantly, the size and nature of the risks created by the practice. Talk to European standard setters and they will claim the US has more of a problem with the small matter of up to $5 trillion in special purpose entities which the Financial Accounting Standards Board is seeking to deal with.
What we do know is that those charged with having to clear up after the credit crisis believe that off-balance sheet financing was a material contributory factor.
In April this year, the global Financial Stability Forum (FSF) urged accounting standard setters to work together to improve the accounting and disclosure standards for off-balance sheet vehicles on an accelerated basis and move toward international convergence.
Willing as always, that is what the International Accounting Standards Board (IASB) is trying to do. It has started a project aimed at sharpening up the current requirements for the derecognition of financial assets and liabilities. The proposals, which would amend IAS39 and IFRS7, seek to improve the assessment of when a financial asset should be derecognised. The proposals are tying to improve the disclosures so that financial statement users are provided with more and better information about an entity's risk exposure. Trying to deal with o ff-balance sheet financing is no stroll in the park. This time last year, the UK's Accounting Standards Board's (ASB) Urgent Issues Task Force (UITF) decided that as the Companies Act 2006 failed to define an off-balance sheet arrangement so companies would not be clear over the amount and type of off-balance sheet disclosures they should make, there was nothing it could do.
The IASB is not cowed by such problems and is in a hurry to act – it is under pressure to move fast on this issue and to come up with the right answer. To help with its search for clamping down on off-balance sheet vehicles and transactions it held a series of public roundtables across the world, before the time for comment closes at the end of July. It wants to issue final amendments in the first half of 2010.
The banks are concerned that the proposals would have a material impact on the way they are required to present their financial statements and it is clear the banking industry will work hard to block any moves which they would see as detrimental. Banks are particularly concerned that their securitisation and repo (repurchase agreement) businesses, worth trillions of dollars, could be hit. You could argue that the more banks squirm, the sounder the IASB's suggestions become.
The crux of this question is simple: when should a bank remove a financial instrument from its financial statements? The answer is complicated when the bank has an ongoing involvement with the asset it has transferred. One example used by the IASB is when an asset is transferred in return for cash and a call option. How, asks the IASB, does the transferor account for the transaction: is it a sale or borrowing secured by the asset?
Under existing IASB provisions there are several derecognition concepts – risk and reward, control and continuing involvement – whereas under the new proposal derecognition would be based on a single concept of control. This would mean a company should derecognise financial assets when the contractual right to the cashflow expires and upon transfer, it has no continuing involvement. Or, the company maintains a continuing involvement but the entity that buys the asset has the 'practical ability' to transfer the financial asset for its own benefit.
The alternative approach suggested by the IASB is that a financial asset could be derecognised by a company if it no longer had access for its own benefit to all of the cashflows or other economic benefits of the asset.
In terms of disclosure, the IASB wants to see corporates commentating on the nature of the continuing involvement and the related risks of off-balance sheet components. It is convinced that enhancing the disclosure requirements would allow users to assess the risk exposure of a company resulting from its continuing involvement in derecognised assets. It was the failure to understand and communicate the risks involved that poured petrol on the flames of the credit crunch.
It is fair to say that the IASB had off-balance sheet finance, the banks' special structures and other complex financial arrangements on its radar pre-crunch. The financial meltdown has since strengthened the IASB in terms of what it can push through and when. Depressingly, though, banks are still lobbying against changes designed to improve corporate reporting.
