How Should Accounting Cope with Structured Finance?
by Stephen G. Ryan
October 2002 The recent accounting travails of Enron and other users of structured financial transactions have caused legislators and policymakers to question the adequacy of current financial reporting rules for these transactions.
Feeling the political heat, the Financial Accounting Standards Board (FASB) has recently issued proposals to tighten the rules for the consolidation of the special-purpose entities (SPEs) used in structured finance transactions and to account initially at fair value for guarantees commonly present in these transactions.
The billion-dollar question is whether these proposals will allow users of financial reports to better understand these transactions. This article explains the distinct roles of the consolidation of SPEs and fair value accounting for contracts in improving the accounting for structured financial transactions. It also describes the importance of expanded estimation sensitivity and risk disclosures for these transactions.
What is an SPE? While there is no precise definition either in the law or accounting rules, the basic idea is that an SPE is an entity with a limited purpose that is expressed in its charter or in the contracts in which it engages. Unlike normal firms, SPEs do not have significant ongoing control issues, because their decision-making follows a predetermined path. SPEs often have no or tiny equity claims, with the owners of record bearing little risk and return. Instead, the main bearers of the risk and return on an SPE’s assets are often its (potentially numerous) contractual conterparties. In such cases, it is better to think of an SPE as the conduit for a set of contracts rather than as a firm in the usual sense.
The Securities and Exchange Commission (SEC) and FASB historically have focused on consolidation as the primary solution to the problem of accounting for SPEs. This focus is reasonable when a single firm directly or indirectly holds most or all of the contractual rights and obligations of the SPE. This focus is usually misguided, however, because in most cases SPEs are used to disperse risks and returns of underlying assets across various counterparties, with no one counterparty holding most of the contractual rights and obligations of the SPE. In these cases, the only good way to account for SPE is for each counterparty to account well for each of the contracts it has with the SPE.
The real problem is that current accounting rules do not account well for many of the contracts in which SPEs commonly are involved, such as:
Better accounting for such contracts is the real solution to the SPE problem, and this requires fair value accounting. Fair value accounting values contractual rights and obligations at the discounted expected value of the current expected net cash flows using rates that reflect current market factors. While, in the absence of observable market prices, fair value accounting entails judgment to apply, and judgment can be misapplied, the alternative of accounting for contractual rights and obligations at zero or amortized cost is surely worse. The judgmental nature of fair value accounting can be mitigated through disclosures of estimation methods and sensitivity. Moreover, a desirable attribute of fair value accounting is it self-corrects over time, that is, fair values must be reestimated each period using revised estimates of cash flows and market factors.
Even fair value accounting cannot describe many structured financial transactions fully, however, because these transactions often partition fair value differently from risk across the counterparties in the transaction. For example, issuers in risky asset securitizations often transfer most of the fair value of the underlying financial assets to purchasers of the asset-backed securities while retaining disproportionately risky subordinated or residual interests in those assets. Thus fair value accounting must be supplemented with good risk disclosures.
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STEPHEN G. RYAN is an Associate Professor of Accounting and Robert Stovall Faculty Fellow Stern School of Business, New York University, and author of Financial Instruments and Institutions: Accounting and Disclosure Rules John Wiley & Sons, 2002.2002 SmartPros Ltd. All Rights Reserved.