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April 1992

SFAS 94: did it produce its intended effect? (Statement of Financial Accounting Standards) (Accounting)

by Clark, Stan J.

    Abstract- Statement of Financial Accounting Standards (SFAS) 94 provides a clear example of how the revision of an accounting standard can lead to unintended consequences as corporate management adjusts its activities to limit the impact of the revision. SFAS 94 was originally intended to improve the accounting of unconsolidated subsidiaries by removing the non-homogeneity clause. The issuance of SFAS 94 led to almost a fifth of the firms covered by the standard to divest themselves of unconsolidated subsidiaries. Contrary to expectations, however, debt-to-equity ratios were subsequently increased, when the expected effect of the revision was supposed to have been a decline in debt-to-equity ratios.

Did corporate managers react to the mandated change in accounting for previously unconsolidated subsidiaries? Divesting of these subsidiaries constitutes one possible management reaction that was predicted to occur by some analysts in the financial press.

Homogeneity No Longer A


The FASB eliminated the "non-homogeneity exception" used in accounting for unconsolidated subsidiaries in consolidated financial statements when it issued SFAS 94 in late 1987. This change had no effect on reported income, but the standard met with strong opposition during the comment period. There was speculation in the financial press that the balance sheet impact of this standard could be substantial due to its detrimental effects on rates of return on assets and debt-to-equity (DE) ratios. The companies thought to be most likely affected by the standard were heavy equipment manufacturers and merchandise retailers, because both types of firms made extensive use of unconsolidated finance subsidiaries.

By reporting a subsidiary using the equity method, a parent company was able to add the net income and equity of the subsidiary to its own without having to reflect the subsidiary's debt on its consolidated balance sheet. Companies that appeared to have conservative balance sheets would look much more leveraged if a consolidated position was shown. However, the difference would be in appearance only. The debt carried by the subsidiaries would become more highly visible as opposed to being buried in footnote disclosures. Nevertheless, the effect of consolidation could change ratios used in debt covenant agreements.

Managers of companies with DE ratios near the maximum allowed by debt covenant agreements prior to consolidation, might take action to offset the effects of full consolidation on the ratios rather than having to renegotiate the loan covenants. Another possible action to offset the consolidation effects would be to dispose of the subsidiary entirely or to divest to an ownership percentage of 50% or less. Many members of the investment community, including Lee J. Seidler then of Bear, Stearns & Company, predicted that significant divestment would occur as a result of SFAS 94.

Measuring the Impact of SFAS 94

To determine the extent of divestment of unconsolidated subsidiaries, a search was conducted of various firms' 1985 fiscal year financial statements to identify those firms with unconsolidated finance, leasing, insurance, or real estate subsidiaries; 164 such firms were located. These are the firms that would be most affected by SFAS 94. If a significant number of divestitures were to occur as a result of SFAS 94, they would occur within this group.

Although a certain number of divestitures will occur due to random chance, the assumption was made that numerous divestitures of unconsolidated subsidiaries occurring close to the effective date (1988) of SFAS 94 provides strong evidence of managements' reactions to this statement. The financial statements of the firms with previously unconsolidated subsidiaries were examined for fiscal years 1987, 1988, and 1989. Of the 157 firms examined (note that data for seven of the original 164 firms were unavailable), 30 (19.11%) of the firms divested unconsolidated subsidiaries by either selling them outright or reducing their ownership to 50% or less.

Is 30 a significant number of divestitures or would this number have occurred even without SFAS 94? Short of reading managements' minds, there is no definitive answer. However, given the difficulty and cost of divesting a major subsidiary, it is assumed that almost one in five firms divesting was not due to random chance but rather to a significant event (i.e., SFAS 94).

Searching for More Answers

One method of determining whether SFAS 94 played an important role in the divestitures of the 30 firms is to examine the DE ratios of both the divesting and non-divesting firms. If SFAS 94 was an important factor in the divestiture decision, the the divesting firms would be expected to have either DE ratios after an consolidation than would the non- divesting firms. To test this theory, 1986 fiscal year-end DE ratios for the 30 divesting firms and a random sample of 30 non-divesting firms were obtained. The ratios were computed on a non-consolidation (as is) basis and a consolidation basis (as if the subsidiaries were consolidated). The mean ratios for the two groups appear in Figure 1.

The DE ratios in Figure 1 lend a great deal of credibility to the notion that the divesting firms did so because of SFAS 94. On a before- consolidation basis, the mean DE ratios for the two groups are quite comparable (i.e., 2.35 for divesting firms versus 2.03 for non-divesting


firms). On an after-consolidation basis, the non-divesting firms' mean DE ratios increased by only .58 (28.6%); whereas, the divesting firms' mean DE ratios increased by 1.72 (73.2 percent). By divesting of their unconsolidated subsidiaries prior to the implementation of SFAS 94, the divesting firms were able to avoid significant and potentially damaging increases in their reported leverage.

These results point out the irony created by SFAS 94. The statement was aimed primarily at firms using significant off-balance-sheet financing (i.e., heavily debt-ladened unconsolidated subsidiaries). If SAS 94 had been applied by these firms, their financial statements would have provided more realistic images of their leverage positions. Instead, the very firms at which SFAS 94 was apparently aimed were the firms that avoided the effects of its implementation.

Circumventing the Standards

The FASB's primary goal in developing accounting standards is to improve financial reporting. This goal is evidenced in SFAS 94 in its attempt to eliminate the potentially misleading effect of off-balance- sheet financing created by unconsolidated subsidiaries. Sometimes, however, accounting standards produce economic consequences as corporate management engages in activities devised primarily to circumvent these standards. Such actions by management may result in the misallocation or inefficient use of resources.

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