Peeling away financial reporting issues one layer at a time

APB 18: SEC Disclosures Paper Over Decades-Old Bad Accounting

Every three months, the SEC Regulations Committee  of the AICPA takes SEC staff members to lunch, and discuss emerging issues relating to SEC financial reporting rules and regulations.  Sometimes the SEC will use the Regs Committee as a conduit to express its views on issues they will be focusing on in the future.  (I will be reporting in a later post on their remarks concerning executive compensation disclosures.)  The Committee also uses the meeting opportunity to raise ‘technical’ questions of application of SEC regulations.  A recent question concerned the disclosures accompanying intercorporate investments accounted for by the ‘equity method.’ 

The equity method became rule in 1971 via APB 18, and it has been a crown jewel of off-balance sheet financing ever since.  APB 18 somewhat distinctive because off-balance sheet financing is most often accomplished via artful recognition and measurement loopholes.  But, the recognition and measurement rules of APB 18 are actually well-reasoned; thus, the window dressing results from dodgy financial statement presentation–the netting of unrelated financial statement components.  APB 18 could require the investor to separately report its proportionate share of assets, liabilities, revenues and expenses–and it should. But instead, APB 18 requires that proportionate shares in assets be netted with liabilities and revenues be netted with expenses.  The result is to hide from view high debt/asset ratios, low asset turnover and profit margins.  You can’t tell if debt/assets is 10% or 90%; if profit margin is 10% or one-tenth of 1%. 

Somewhere along the line, the SEC acknowledged the great potential of the equity method to distort financial statements, but evidently it was reluctant to start an accounting war by overriding the Accounting Principles Board.  To paper over its dilemma, the SEC added a rule to Regulation S-X (Rule 4-08(g)) to require disclosure in the notes to the financial statements of a company’s proportionate share of total assets, liabilities, revenues and expenses (i.e., "summarized financial information") in ‘significant’ investees accounted for by the equity method. At least savvy investors could now peer into the opague box wherein a variety of ills might be stuffed.  But alas, everyone else is still pretty much left to grope blindly. 

Now comes an anonymous constituent of the AICPA to whiningly ask through the Regs Committee if it can circumvent Rule 4-08(g), the aforementioned SEC’s paltry sop to investors, based on what it sees as a technicality.  To wit, must the significance of an investee be evaluated for each year in which financial statements are presented in a filing, or just for the most recent year?  To its credit, the SEC staff’s position holds the line.  If equity method investees are significant in any year, the Rule 4-08(g) disclosures have to be made for each year in which financial statements are presented.

 

While the complexity of arrangements involving non-controlling intercorporate investsments have expanded, APB 18 reigns as a prince of opacity.  Take, for example, the prevalence of joint ventures, in which no party can exercise influence without collaborating with other venturers.  International accounting standards address joint ventures, and calls for proportionate consolidation in those cases.  U.S. GAAP is supposed to be more detailed than international standards, right?  But ‘we’ don’t have a standard (much less a definition) for joint venutres, and ‘they’ do.  Why?  To consider joint ventures would mean that the FASB must consider proportionate consolidation–and concoct another ridiculous rationale to reject it.  In this post-SOX era where Congress has directed the SEC to take a closer look at off-balance sheet arrangements, even the FASB doesn’t have the chutzpah to formally expand the scope of the equity method.   Instead, in the exalted name of convergence, they are spending their time and our money figuring out how to move international standards to the dark side–away from proportionate consolidation to the equity method. 

So, if you think the equity method has more to do with politics than principles or transparent accounting, you think like I do.

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