The Financial Impact of Changes to On Balance Sheet and Off Balance Sh…

As a consequence of the financial crisis and in a bid to enhance transparency, the International Accounting Standards Board (IASB) recently issued new standards to enhance guidance on Off Balance Sheet activities. If material, these may impact the examination of company risk, lending and investment decisions.

The changes average that whilst an entity may keep the same in name, its accounting composition could differ. Assets and limitations that were before off balance sheet may be brought on balance sheet while other interests that used to be consolidated may now only be shown as a net investment if they do not meet new criteria. Changed levels of debt would average that covenant calculations and test levels may need to be reviewed and forecasts redrawn. consequently, regular review of borrowers, clients and investments remains meaningful.

Standards must be implemented at the latest for periods starting on or after 1 January 2013 but as they can be applied now a clear understanding is imperative. A summary is detailed below:

IFRS 10 Consolidated Financial Statements states that control is the meaningful factor in calculating consolidation. Control is essentially strength over an entity and most particularly the strength to change any amounts received in returns from that entity. Factors impacting strength include the size of holding, spread of holdings, whether other shareholders are passive and whether the entity is controlled by rights other than voting rights. consequently, already if ownership is less than 50%, an entity could nevertheless be controlled if a shareholder can come to an agreement with other shareholders or has possible voting rights.

The new standard provides a much clearer definition of control (than past standards) and provides more guidance in circumstances when control is difficult to estimate. It also states that if there is no clear conclusion of control then it is deemed that no control exists.

This standard is likely to affect specific sectors such as private equity funds, asset managers and financial sets including insurance companies which may need to consolidate the funds/assets they manage if they are deemed to be principals as opposed to agents despite any special purpose means.

IFRS 11 Joint Arrangements – A joint arrangement exists where two or more parties contractually agree to proportion control but the new standard focuses on the rights/obligations of an arrangement instead of its legal form.

Joint arrangements can either be joint operations or joint ventures. In a joint operation a company has direct rights to the individual assets, limitations and revenue of the operation and recognises these directly in its accounts. A joint venturer, however, only has rights to the net assets/profit/loss of the venture and consequently, these keep off balance sheet with its interest shown as an investment by a single line in the Profit and Loss and Balance Sheet.

Proportionate consolidation is no longer an option for JVs which should reduce inconsistencies – historically most French and Spanish companies opted for proportionate consolidation while UK and German companies generally showed JV interests as an investment.

So who is likely to be affected? Sectors where joint arrangements are shared such as real estate, construction, mining and extraction and those using joint arrangements to mitigate risk as they expandtheir market offering and geographic reach. The indirect impact of this may be that deal structures may be modificated.

In conclusion, as the accounting composition of entities may change going forward risk may also change impacting lending and investment decisions. consequently, current review remains meaningful.