Off-Balance Sheet Financing Curbs Are Double-Trouble

Depending on how you look at it, two federal regulations passed in 2003 are giving accountants – particularly real estate specialists – some real headaches … or some real job security.

The Financial Accounting Standards Board and the Securities and Exchange Commission enacted two regulations, called FIN 46R and EITF 04-05, to curb the use of off-balance sheeting financing, which allowed many companies to hide massive debts from creditors, investors and regulators.

Prior to the enactment of the regulations, companies were allowed to own up to 97 percent of a “special purpose entity,” without reflecting either the assets or liabilities of that entity on a firm’s balance sheet. Many accountants say the creation of such entities by Enron Corp. and Adelphia Communications Inc., among others, was frequently used to hide corporate liabilities.

“Everyone has credit cards and loans, and you would not be able to exclude those loans on a balance sheet,” said Ernest Miranda, a partner at Squar Milner Miranda & Williamson LLP. “But that’s effectively what was happening, and it was pretty egregious.”

Accounting firms are now being called upon to interpret the complex and occasionally ambiguous provisions of these regulations and advise their clients accordingly. The job typically falls to actuaries with 20 to 25 years of experience.

Accountants who specialize in real estate are the most affected. In recent years, real estate has become an accepted asset class for institutional investors. As a result, L.A. County real estate companies – usually comprised of several entities and occasionally with as many as 25 limited partners – have an unprecedented amount of capital available to them. Amid the growth, private equity firms have purchased some of the companies and others have gone public. All of them, however, are now required to list all of their entities – no matter how limited a partner – on their balance sheets.

“From 25,000 feet, these rules have changed the landscape for the real estate industry,” said Christopher Tower, director of real estate services for the Western Region at BDO Seidman LLP.

Rick Smetanka, a partner at Haskell & White LLP, said the industry has spent years debating the issue of consolidation accounting. Smetanka said it was seen as more straightforward when it was based on the rule that if a general partner or limited partner owned 51 percent of an entity, it had to consolidate the assets and liabilities on its balance sheet.

He said the new rules would trip up many real estate firms because it’s common for real estate developers to own office buildings and then lease the building back to their operating company.

“It’s making for some very difficult conversations when we have to sit down with a client and tell them they have to consolidate an LLC with a building and mortgage, even if they don’t own it,” he said. He added that some clients are going so far as to accept a qualified audit report from their auditor, despite its negative implications, because they don’t want the liabilities on their balance sheet.

While putting a significant burden on L.A. accounting firms, they have also made the accounting companies essential for the major real estate players.