FASB May Tighten Special-Purpose Entity Rules

by Mike Godfrey, Tax-News.com, New York

02 April 2002

The Financial Accounting Standards Board is likely to introduce tighter regulations covering 'special-purpose entities' in the wake of the Enron debacle, for instance requiring a public company to move the assets and liabilities of a special-purpose entity to its balance sheet if there is less than 10% outside equity investment in the entity.

Last week the Financial Accounting Standards Advisory Council met to discuss retailers' use of special-purpose entities in particular, focusing on the securitization of accounts-receivable for inventory purchases, and the securitization of real estate to finance store growth and other operations.

There are tax aspects of the use of special purpose entities, for instance in Enron's case by placing the entity offshore, and in other cases because the entity can charge tax-deductible operating costs to the parent company, while itself taking advantage of separate financial status. This is the principle on which leasing works, and some retailers have indulged in so-called 'synthetic' leases.

In a synthetic lease, the property owner takes out a lease from its own special-purpose entity, thus removing the debt involved in acquisition of the property from its balance sheet while being able to deduct leasing payments for tax purposes. Krispy Kreme Doughnuts Inc and Dollar General Corp both recently took criticism for their use of synthetic leases. Krispy Kreme later said it would no longer use synthetic leases and Dollar General restated its earnings as a result of the criticism.

The impact of the new rules on retailers won't be clear until they are finally agreed, although it seems likely that they will come into effect in August. Richard Hastings, an analyst at Cyber Business Credit LLC, a New York consultant to retailers and manufacturers, told the Wall Street Journal that investors can expect to see some balance sheets burdened with added debt and risk, adding that while the proliferation of special-purpose entities at Enron was probably unique in its vastness, it is likely that there are plenty of companies that have created networks of "structured finance" partnerships that are difficult for investors to understand.

"The reforms could lead to an improvement in transparency and a decrease in credit quality," Mr. Hastings said. "The question is: Are companies doing sufficient risk management of their peripheral entities so that on the day the transparency opens up, the risks are under control?"

The Financial Accounting Standards Board is said to be considering a requirement that retailers financially guarantee their portfolios of store leases with credit derivatives or other types of insurance instruments. If this happens alongside a major tightening-up of the use of special-purpose entities, the post-tax earnings of many retailers will take a hit not just from the additional costs but also from higher tax bills. And the increase in transparency, while having long-term benefits, will reduce perceived creditworthiness in the short term, adding to downwards pressure on stock prices.

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