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June 1989

SFAS 94 amends consolidation principles to reduce off balance sheet financing. (Accounting)

by Elfrink, John A.

    Abstract- The Financial Accounting Standards Board has implemented Statement of Financial Accounting Standards (SFAS) 94, requiring consolidated financial statements for all majority-owned subsidiaries with their parent firms, in order to eliminate off balance sheet financing. The manufacturing sector of the economy is expected to be heavily affected, with highly leveraged subsidiaries causing an increase in total debt and the debt to equity ratio after consolidation. The likely effects of SFAS 94 on extant debt and management contracting agreements include increased operating costs due to the: negative effects in the securities markets; increased costs inherent in the recontracting of debt covenant restrictions in light of likely violations; and the renegotiation of dividend restrictions, management compensation agreements, and loan agreements.

Firms with significant unconsolidated subsidiaries may find their balance sheets drastically changed as the result of the implementation of SFAS 94. This new pronouncement requires that virtually all majority- owned subsidiaries be consolidated with their parent firms. Although the impact of this change on the income statement is expected to be minimal, the balance sheets, and particularly the corresponding debt ratios of many firms, will be substantially weakened.

SFAS 94 amends ARB 51, ARB 43, and portions of APB 18. The general rule under ARB 51 required consolidation of all majority-owned subsidiaries, however, there were several exceptions to this requirement. Briefly, the three most commonly used non-consolidation exceptions were:

1. Nonhomogeneous operation of parent and subsidiary;

2. Significant minority interest; and,

3. A foreign subsidiary under severe exchange limitations.

In practice, the first exception was the most widely used, with finance, insurance, real estate, and leasing being the operations most often cited as being nonhomogeneous. SFAS 94 narrowed the exceptions to the general rule, most notably eliminating the nonhomogeneous exceptions.

A primary concern of the critics of this pronouncement was the effect of consolidating finance subsidiaries. Finance entities are typically highly leveraged. Merging their balance sheets with non-finance related parents may dramatically change the debt structures of many previously partially consolidated companies.

The AICPA found in a 1986 survey of 600 firms that 423 (70.5%) consolidate all significant subsidiaries, 172 firms (28.7%) consolidate only certain significant subsidiaries, and the remaining five (0.8%) do not present consolidated statements. The total number of subsidiaries not included in the consolidations was 232. Of these, 188 (81%) were finance related, 32 (131.8%) were real estate and 12 (5.2%) were foreign firms. The survey results illustrate the substantial number of highly leveraged finance subsidiaries that will now be consolidated and the potential number of affected firms.

GAAP concerning consolidations had been governed primarily by ARB 51 and APB 16. However, issues concerning unconsolidated subsidiaries, the definition of control, treatment of joint ventures, disclosures of disaggregated data, and consolidations in the not-for-profit area, caused the FASB to reconsider these pronouncements. In 1982, the Board decided on a three-phase approach to revising parent-subsidiary reporting. The first phase is to define the reporting entity. The second is to address disclosure issues, such as joint ventures, less-than- majority-owned subsidiaries and "push-down accounting." The third phase is to examine the problems of consolidated statements in the not-for- profit sector. SFAS 94 is a result of the first phase.

The New Consolidation Principles

The only remaining exceptions to consolidation are temporary majority ownership or control of the corporation by interests unrelated to the parent. Examples of the latter exceptions are subsidiaries in bankruptcy or reorganization or subsidiaries whose operations are severely limited by foreign governments. The FASB has indicated they will consider the issue of control in a future period.

APB 18 required footnote disclosure of certain information or separate statements concerning individual or appropriately grouped unconsolidated subsidiaries. The information should include summarized data for assets, liabilities and operating results. SFAS 94 requires continued reporting of this information for those firms with subsidiaries affected by the new statement. SFAS 94 does not specify any particular format for the continued APB 18 disclosure. Firms may simply continue with the table form disclosure in a separate note, as is common practice under APB 18. Alternatively, inclusion of previously unconsolidated subsidiaries in the segment disclosures note would also appear acceptable under the SFAS 94 guidelines.

APB 18 also required the use of the equity method for unconsolidated subsidiaries. SFAS 94, however, no longer requires the use of the equity method for unconsolidated subsidiaries. In fact, SFAS 94 requires that virtually all unconsolidated subsidiaries be reported using the cost method. The pronouncement emphasizes that neither the equity method nor "parent-company financial statements" are considered acceptable alternatives to consolidated financial statements.

The effective date for SFAS 94 was December 15, 1988. The year of adoption requires restatement of comparative financial statements. Firms will also be required to disclose, in the year of adoption, the change in the reporting entity mandated by SFAS 94.

SFAS 94 and Ford Motor Company

The manufacturing sector of the economy is expected to be profoundly influenced by SFAS 94. To illustrate more specifically the effects of consolidating all majority-owned subsidiaries, pro forma statements were computed under the new statement for Ford Motor Company and contrasted with "as reported" information. The data source is the firm's annual reports, Form 10-K, and additional disclosures by the unconsolidated subsidiaries for 1985 and 1986.

Financial Statement Impact. Ford Motor Company's consolidation policy in 1986 excluded several subsidiaries from consolidation and reported these affiliates under the equity method. Ford made additional disclosures of summarized operating results, assets, and liabilities for these subsidiaries in the notes to financial statements, as required by APB 18. Ford provided three sets of additional information: 1) Ford Motor Credit Company and Consolidated Subsidiaries; 2) First Nationwide Financial Corporation; and 3) a summary for Other Unconsolidated Subsidiaries and Affiliates.

Summary information from "as reported" and pro forma statements is presented in Exhibit 1. Summarized balance sheet and income statement information is presented, based on Ford's annual report and on a SFAS 94 pro forma basis, for years ended December 31, 1985 and 1986, respectively. The "as reported" and pro forma debt-to-equity ratios are also illustrated. The Exhibit also presents net change and percentage changes resulting from consolidation of the previously unconsolidated subsidiaries.

Since Ford currently accounts for these finance subsidiaries under the equity method, net income and stockholders' equity amounts in the Exhibit are unchanged by consolidation. However, details of assets, liabilities, revenues and expenses radically change. Total assets are significantly increased (135.7% in 1985 and 147% in 1986) by including the assets of the unconsolidated subsidiaries. The highly leveraged nature of Ford's subsidiaries, likewise, results in substantial increases in total debt (221.7% in 1985 and 241.2% in 1986).

The income statement effects observed in the Exhibit are less severe. Net sales for 1985 and 1986 are increased by 9.2% and 11.4%, respectively, but these are offset by equal increases in operating expenses. Net income is unchanged by the consolidation of subsidiaries formerly carried under the equity method.

Ford, like many other firms in the AICPA survey, is primarily a large manufacturing firm. In the past, subsidiaries have been excluded from consolidation under the ARB 51 non-homogeneity assumption. Current reporting practices in the manufacturing industry differ substantially from those in the finance and insurance industries. In balance sheet presentations manufacturers typically present classified balance sheets, while finance and insurance firms do not.

This illustrates a reporting problem caused by SFAS 94. How should a firm combine previously classified and unclassified balance sheets into a single acceptable format? Manufacturers may have to abandon the classified balance sheet format. Ford Motor Credit and First Nationwide Financial are Ford's largest unconsolidated subsidiaries. Both firms are finance related subsidiaries and the balance sheet information available is in an unclassified format. Consequently, the authors were unable to separate the finance receivables into current and non-current classifications. The dollar amount of these receivables is substantial ($50,797,300,000).

The balance sheet changes may adversely impact Ford's operations through their effect on existing debt or management contracting agreements. Ford's debt-to-equity ratio increased upon consolidation of all the majority-owned subsidiaries for both 1985 and 1986 (221.71% in 1985 and 242.6% in 1986). Debt covenants often prohibit issuance of additional debt when this ratio exceeds limits specified in bond indenture agreements. Automakers and similar firms having captive finance subsidiaries may face substantial costs for renegotiating existing debt covenants to adjust for the effects of these changes.

Ernst and Whinney (1987) examined the financial statements of the 50 largest industrial companies and found that the average debt-to-equity ratio will increase from .74 before consolidation of nonhomogeneous subsidiaries to 1.18 after following the new pronouncement. This equates to a 59.5% increase in this ratio.

Similar adverse effects can be expected from consolidating insurance, real estate and leasing subsidiaries which also tend to be highly leveraged. If investors fail to consider the effects of the accounting method change, then firms may face adverse consequences in the securities markets. Many other ratios may also change unfavorably, further increasing recontracting costs in response to debt covenants violations, dividend restrictions, or management and executive compensation agreements. Clearly the Ford Motor Company will have to adjust to dramatically altered balance sheets.

Early Reactions. Early indications are that the format to be used by firms effected by SFAS 94 will be somewhat different than anticipated. CPAs are recommending alternative disclosures to the normal consolidation presentation. They are proposing that the information from these previously unconsolidated subsidiaries be reported in separate sections or in disaggregated columns on the financial statements proper. The normal consolidation process would merge the financial statement items of the affiliated firms in a singular set of reports.

For example, Ford Motor Company will present the assets, liabilities, revenues and expenses of their financial subsidiaries in separate sections following the assets, liabilities, revenue and expenses of the parent and other subsidiaries. The assets and liabilities will not be classified. Likewise, two net income figures will appear on the income statement.

Whether or not such presentation is in the spirit of SFAS 94, is questionable. Separate sections or columns might be confusing. Failure to classify items would make financial statement analysis more difficult.

Conclusion. The accounting profession must consider the cost benefit trade-off of any new pronouncement. The major cost of SFAS 94 will be the potential expenses of renegotiating numerous loan agreements and management compensation packages. The benefits that will accrue to users of consolidated financial statements are difficult to determine. Nevertheless, SFAS 94 will eliminate "off balance sheet financing."

However, users may be disadvantaged by implementation of the new standard. The balance sheet classification problem, discussed previously, provides an example. If firms choose the expedient solution of abandoning the classified balance sheet, then investors must bear the burden of lost information concerning the current-noncurrent classification of asset and liability data. Exhibit 1 Omitted

Joseph H. Anthony, PhD Michigan State University East Lansing, MI John A. Elfrink, PhD, CPA Southeast Missouri State University Cape Girardeau, MO

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