Hold on to your bottom-line hat: An accounting rule change is rapidly shifting hundreds of billions of dollars in assets and liabilities - much of it in real estate - back onto corporate balance sheets.
        The catalyst: the Financial Accounting Standards Board's (FASB) 56-page "Interpretation No. 46" (FIN 46).

FIN 46 is "a great way to ruin your summer if you invest in, develop, own or use real estate," said Ernst & Young's Paul Griesmer (pictured).

        That single, complex accounting change is already triggering major fallout. FIN 46 took effect on July 1 for companies beginning their new fiscal years. Ultimately, the interpretation's impact will register in cash flow, earnings per share, debt-to-equity ratios and credit ratings.
        And FIN 46's sting is particularly acute for real estate financing.
        "It's a great way to ruin your summer if you invest in, develop, own or use real estate," said Paul Griesmer, the Boston-area leader for Ernst & Young's Real Estate Advisory Services practice (www.ey.com/us/realestate).
        FIN 46 basically sounds the death knell for numerous off-balance-sheet financing schemes. And that bell will toll for a very long list. For the S&P 500 alone, FIN 46 will move some US$379 billion of assets and $377 billion in liabilities onto third-quarter balance sheets, according to projections in a newly released Credit Suisse First Boston (CSFB at www.csfb.com) study.

Broad Ruling, Broad Industry Impact

Initially, business didn't expect such a drastic regulatory change.
        Post-Enron, FASB was certain to take action to plug the "creative financing" schemes used by shady companies that hid debt - and duped investors - by moving it off their books. Given that scenario, almost every analyst anticipated only a narrow accounting-standard change applying to "special-purpose entities." But FIN 46 has a far broader sweep.
        That broadness is particularly evident in the real estate industry, Griesmer explained.
        "FIN 46," he said, "impacts anyone involved in a complicated lease, a real estate partnership, a limited liability company, a joint venture, or a management or services contract, as well as anyone who provides real estate mortgages or participating debt or who invests directly in commercial real estate."
        That's one heck of a range. FIN 46, however, isn't readily digestible stuff. Indeed, FASB rulings can be mind-numbingly impenetrable to anyone save accounting or law-school grads. But there's no ducking out on the major balance-sheet shifts the new change will trigger.
        FIN 46, for example, may move about $55 billion of Citigroup assets and $43.6 billion of General Electric assets onto those firms' balance sheets, according to CSFB's study.
        "The combination of weak disclosures and a vague new accounting rule leads us to believe we may be in for a few surprises over the coming weeks and months as companies announce and investors digest [FIN 46's] impact," said David Zion, the accounting analyst who authored CSFB's report.
        One of those possible "surprises": falling stock prices, Zion noted, "if investors learn that a company bears more risk than was known before."

Process 'Like an Appraisal on Steroids'

Figuring out which assets go on which balance sheets, however, promises to boost Excedrin's stock.
        At issue are real estate "variable interest entities" (VIEs). Essentially, a VIE is a cooperative deal or contract dependent on other players' support.
        Rich Jeanneret, leader of Ernst & Young's Mid-Atlantic Real Estate Industry and Private Equity groups, describes VIEs' parameters in more specific, FASB-friendly lingo: "An entity is considered a VIE if the entity's total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties." But those other parties with equity interest at risk, Jeanneret added, must "lack the characteristics of a controlling financial interest."
        That may seem clear enough to those whose daily bread depends on plumbing contractual intricacies. But the process of deciding if, and where, a VIE should be consolidated, is a dicey task that Griesmer likened to "an appraisal on steroids."
        With the new FASB interpretation, risk and reward - not voting clout - is what counts with VIEs, Jeanneret explained.
        "Under the existing rule," he said, "one company generally includes another entity in its consolidated financial statements only if it controls the entity by owning a majority of the entity's voting interests.
        "FIN 46 changes that," he continued, "by requiring a company to consolidate a VIE if that company absorbs a majority of the risk of loss from the VIE's activities or is entitled to receive a majority of the VIE's residual returns as evidenced by the variable interest."

Whose building is it anyway? Whether a project's value increases or decreases may determine whether the "variable interest entity" will have to be consolidated on the developer's or the lender's balance sheet.

        FIN 46 further creates a pivotal new concept: the notion of "variability of cash flow," or variable interest (VI). For supporters of stringent accounting reform, VI represents the end of the abuse of structured-finance vehicles and the start of a principle-based standard based on ownership control.

Project Value Change Could
Alter Which Party Has to Consolidate

Jeanneret offers a concrete example to cut through the complexities: Consider a VIE project in which a real estate developer invests $40 million in equity and a commercial bank provides a $60-million fixed-rate loan. That loan, Jeanneret explained, wouldn't be a VIE, as it's "not expected to change in value."
        But the project's performance could determine which party consolidates the VIE - and it could make lenders more wary.
        If the project does well, for example, increasing in value to $130 million, then the developer's equity would rise to $70 million. "Because the developer bears the risks and enjoys the rewards at the outset, it is the primary beneficiary of the project and is required to consolidate the VIE," Jeanneret said.
        The order flips, though, if the project loses value to, say, $50 million, and debt restructuring changes the original contractual arrangements.
        "The developer's equity interest in that case would be wiped out, but the lender's interest is still $60 million," Jeanneret noted. "As a result, the lender may become the primary beneficiary and be required to consolidate the project because it has a variable interest and bears all the VIE's risk."
        Likewise, real estate management firms could face changed circumstances. As an example, Jeanneret describes a hotel management company that provides an owner with equity capital or financing to land an incentive-laden contract.
        "If the contract is with a VIE and the contract gives the management company more of a financial interest - including its incentive fee - in the hotel than the owner," Jeanneret explained, "then the management company would be required to consolidate the hotel."

CSFB: Many Firms Still Quantifying Exposure

FIN 46's real-world impact remains a work in progress. Many firms, Zion said, are still evaluating the accounting change and quantifying their financial exposure.
        "To avoid consolidation," Jeanneret advised, "a company generally must have equity at risk equal to 10 percent of its assets." But a VIE can still avoid consolidation if it meets certain other requirements - for instance, if it demonstrates that it "can finance its activities without additional subordinated financial support," he said.
        FIN 46 essentially adds up to the proverbial tangled web. Companies trying to unravel that web, Jeanneret advised, should:
        • Establish a controlled process "for identifying entities currently being consolidated and those in which they have variable interests;"
        • Evaluate their corporate entities "to determine whether they are VIEs and whether the company is the primary beneficiary," and
        • Decide whether to consolidate.
        For some companies, though, the upshot may still largely be business as usual. But even reaching that pleasing pass may be a thorny process.
        "Variability in cash flow is a new concept that will present many challenges for companies and other entities in implementing FIN 46," Jeanneret said. "At present, there is limited guidance on how to apply the concept."
        Editor's Note: For insights into how FASB changes have affected synthetics leases, see "Synthetic Becomes Transparent" from the January 2003 issue of  Site Selection.