How can the investor accurately diagnose financial health if part of a companies heart (i.e. the balance sheet) is concealed from view?

By using off-balance-sheet schemes a company can bring inert assets back to life, gain access to cheap financing, and disperse shareholder risk. However, the benefits of off-balance-sheet dealings can be overshadowed by the pitfalls -- namely Enron.

Some, namely the Fed, would argue that Enron is an isolated blow up that arrived not necessarily because of the company's off-balance-sheet dealings but because of blatant fraud. However, this argument is akin to saying that since banks will inevitably be robbed they shouldn't keep their doors locked. To be sure, Enron's shady off-balance-sheet practices would not have been allowed grow so large if not for GAAP allowing them to. As former SEC Chief Accountant, Lynn Turner, previously pointed out, the issue of consolidation has been festering for some time.

"In 1982, the FASB undertook a project on consolidation. One of my sons who was born that year has since graduated from high school. In the meantime, investors are still waiting for an answer, especially for structures, such as special purpose entities (SPEs) that have been specifically designed with the aid of the accounting profession to reduce transparency to investors." Senate Banking Committee ~ February 26, 2002.

Following Enron's collapse the spotlight shined directly on off-balance-sheet financings, and - for a moment - it seemed like progress was finally going to be made. However, FASB's FIN 46 (and revision last December) came and went in 2003 and companies have not been rushing to consolidate. Rather, Post-Enron, Structured Finance Addiction Hasn't Ebbed

Companies Complained, But Planned Ahead

When FASB reintroduced the idea of consolidation following Enron companies and accountants went on the attack arguing that the changes would kill the structured finance market. However, companies also - openly flouting FASB's authority - planned to circumvent what seemed like the inevitable. A one liner from Citigroup says it all:

"The Company is considering restructuring alternatives that would enable certain VIEs to meet the criteria for non-consolidation as presently understood." Citigroup (10K) March 3, 2003

With Citigroup and countless others scurrying to avoid consolidating their off-balance-sheet interests a loophole was eventually found. In fact, this loophole may be what is helping to spark the increase in off balance sheet activity this year. One of the first documented mentions of this loophole - called 'expected loss note' - is found in TD's September 2003" Canadian ABS & MBS Market Report (pg. 6)".

"This is the solution [to FIN 46] predominately being explored in the US, which involves selling an expected loss note that provides loss protection to the Commercial Paper (CP) holders and effectively absorbs the majority of the expected losses of the conduit."

Not surprisingly, the slow moving FASB - which thinks about issues for decades not months - didn't even touch on the subject of 'expected loss notes' in its Fin 46 revisions made in December 2003. Despite the lack of press coverage, the 'expected loss note' has, reportedly, caught on; enabling companies like Citigroup to cleverly avoid consolidating some of their off-balance-sheet interests.

Waiting For The Next Enron

After waiting more than 20-years to tackle the issue of consolidation FASB has failed to introduce standards rigid enough to make off-balance-sheet activities more transparent to investors. Accordingly, all that can be hoped for is that new standards - which are focused on trying to unmask "primary beneficiaries" and raising the minimum outside equity investment in an SPE to 10% from 3% - are enough to deter companies from recklessly concealing large risks.

For its part, the SEC is not impressed. Rather, the SEC is already looking into why companies "appear to be ignoring accounting rules designed to prevent Enron-style hiding of debt." As for the Fed, it is obvious that Greenspan and company are looking the other way. After all, remember that LTCM wasn't enough for Greenspan to back hedge fund and/or OTC regulation, and Enron barely made the Fed flinch (as a CFO article suggested earlier this year, the mandate of the Fed is starkly different than that of the SEC).

Lastly, there is the investor - who should be aware of any and all disclosures on SPEs, VIEs, and Conduits in companies that they own. These disclosures are not found in the balance sheet, but in a labyrinth of footnotes. Each footnote should be studied, and potential cash obligations - if applicable - should be calculated. While doing this research the investor looking at companies like Citigroup and General Electric will undoubtedly discover that off-balance-sheet financing activities (gain on sale) have been used, from time to time, to boost/smooth over earnings - *this is one of the other main reasons why corporate America wants to be able to throw assets off the balance sheet.

It is difficult for the investor to accurately gauge corporate health given that the quality of off-balance-sheet assets are not as transparent (in most cases) as those assets on the balance sheet. In the end, after another Enron occurs, FASB may get it right.

Citigroup ~ 10Q: "The implementation of FIN 46 encompassed a review of thousands of entities to determine the impact of adoption and considerable judgment was used in evaluating whether or not a VIE should be consolidated&Our credit card receivable and mortgage loan securitizations are organized as QSPEs and are, therefore, not VIEs subject to FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46). SPEs may be QSPEs or VIEs or neither. When an entity is deemed a variable interest entity (VIE) under FIN 46, the entity in question must be consolidated by the primary beneficiary; however, we are not the primary beneficiary of most of these entities and as such do not consolidate most of them."