fin 46 new rule

8/6/2019 FIN 46 New Rule

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Equity Research

24 June 2003Americas/United States

Accounting & Tax

FIN 46New Rule Could Surprise Investors

Anticipating the impact of the FASBs new rule on off-balance-sheet activity,FIN 46, Consolidation of Variable Interest Entities (VIEs) is difficult. The newrule, which goes into effect for most companies on July 1, is complex, vague,involves significant amounts of management and auditor judgment and must beapplied to countless transactions.

Consolidating what was once off balance sheet could affect almost every linein the financial statements. Credit ratings, loan covenants, and regulatorycapital could all feel the influence of FIN 46.

In theory, FIN 46 should not have an impact on valuation. However, if investorslearn that a company bears more risk than was known before, that could havean impact on estimates of future cash flows and the return that investors woulddemand, which could affect valuation.

We estimate that close to $400 billion of off-balance-sheet assets and $400billion of off-balance-sheet liabilities will move on balance sheet for thecompanies in the S&P 500 when FIN 46 goes into effect, unless transactionscan be restructured to get around the new rule. Almost two-thirds of the assetsand liabilities that could come on balance sheet are concentrated within tencompanies. No real surprises there.

Looking for surprises? We would keep an eye on the 57 companies listed inAppendix F. These companies have either discussed some type of exposure toVIEs or are still evaluating FIN 46 and have not yet provided an estimate of itsimpact.

FOR IMPORTANT DISCLOSURE INFORMATION relating to analyst certification, please refer to the Disclosure Section at theend of the report. For important disclosure regarding the Firm's investment banking relationships, if any, with companiesmentioned in this report and regarding the Firm's rating system, valuation methods, and potential conflicts of interest,please visit the website at www.csfb.com/researchdisclosures or call +1 (877) 291-2683.

research team

David Zion, CFA, CPA212 538 [email protected]

Bill Carcache, CPA212 325 [email protected]


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Table of Contents

Executive Summary ..........................................................................................................3

Conclusion.....................................................................................................................5

Key Findings .....................................................................................................................6

The FIN 46 Two Step........................................................................................................7

How did the Old Rules Work? .......................................................................................8

Step One: Is the Entity a VIE?.......................................................................................9

Step Two: Who Controls the VIE?.................................................................................9

Auditors and Companies, Confused............................................................................10

In Search of VIEsThe S&P 500 ...................................................................................12

Our Methodology .........................................................................................................12

VIE Exposure for the S&P 500 ....................................................................................12

Magnitude of VIE Impact .............................................................................................13

Industry Report Card ...................................................................................................15

Wide Variety of Impacts ..................................................................................................19

Moving Target..............................................................................................................19Financial Statement Impact.........................................................................................20

Economic Impact.........................................................................................................25

Debt/Loan Covenants..................................................................................................28

Regulatory Capital .......................................................................................................29

Credit Ratings..............................................................................................................29

Coming Soon to a Balance Sheet Near You ..................................................................30

Industry Exposure........................................................................................................30

VIE Examples ..............................................................................................................32

Staying Off Balance Sheet..............................................................................................47

Finding the Skeletons in the Closet ................................................................................51

New Disclosures to the Rescue ..................................................................................52

Principles-Based Approach.............................................................................................55

Who Needs Rules? How about Principles Instead?....................................................56

Appendix A: FIN 46 in Detail...........................................................................................58

Step One: Is the Entity a VIE?.....................................................................................58

Step Two: Who controls the VIE? ...............................................................................60

Initial Measurement .....................................................................................................63

Consolidation Procedures Ignored ..............................................................................63

Transition.....................................................................................................................63

Appendix B: ABCP Conduit Example .............................................................................64

Appendix C: Synthetic Lease Example...........................................................................69

Appendix D: 138 Companies Expecting No Impact from FIN 46....................................73

Appendix E: 128 Companies Making No Mention of FIN 46 ..........................................74

Appendix F: 57 Companies That FIN 46 Could Impact - No Estimate.............................75

Appendix G: 92 Companies That FIN 46 Could Impact - Gives Estimate........................77

Appendix H: 85 Companies That FIN 46 Could Impact - Immaterial ...............................79


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Executive Summary

Much of the discussion about the crisis in confidence among investors and the intense

scrutiny on corporate accounting has revolved around the mysterious use of off-

balance-sheet activity. Sparked by the myriad off-balance-sheet arrangements used by

Enron, the FASB was poked and prodded by Congress, the SEC, and investors to fix

this problem as quickly as possible. The FASB responded in January by issuing

Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an

Interpretation of ARB No. 51. The new rule is intended to provide guidance on whether

or not a company should put its off-balance-sheet activity on balance sheet.

The list of possible names for these off-balance-sheet arrangements is certainly long:

special purpose entities or SPEs, special purpose vehicles or SPVs, shell companies,

conduits, off-balance-sheet vehicles, bankruptcy-remote entities, and those-things-I-

never-heard-about-until-the-Enron-mess are just some examples. Now, we have yet

another term provided to us by the FASB in FIN 46: variable interest entities, or VIEs.

Countless different types of entities must be reviewed and potentially accounted for

under FIN 46 before it goes into effect for most companies on July 1. The companies

applying the rule are having difficulty estimating its impact. For example, in General

Electrics (GE, $30.01, NEUTRAL, Target $30, MARKET WEIGHT) March 31, 2003,

10Q, it claims that the very complexity of the new consolidation rules and their evolving

clarification make forecasting that July 1 effect impracticable.

If you think the companies are frustrated, the auditors are pulling their hair out and

smashing their pocket protectors. In a recent comment letter to the FASB, one of the

Final Four accounting firms, KPMG, stated its experience to date indicates that the FIN

46 accounting model is severely non-operational.

With a July 1 implementation date, we expect companies to provide further detail on the

impact of FIN 46 when they announce second quarter results in a few weeks or at some

time during the third quarter. For calendar year companies, investors can expect to see

the full impact of FIN 46 reflected for the first time in the September 30, 2003 10-Qs.

Whats an Investor to Do?

If the companies and their auditors are having trouble with the standard, just think about

the poor investor (you) trying to make heads or tails of this new rule. Whats an investor

to do? Pray, head for the hills, or peer into a crystal ball? The countless different types

of entities (almost no two are alikeeach has its own bells and whistles), a general lack

of information, and a vague new accounting rule make forecasting the impact of FIN 46

virtually impossible.

In this report, we set out to accomplish four goals as the FIN 46 implementation datedraws near:

1. Walk through FIN 46.

2. Lay out FIN 46s potential impacts.

3. Identify the companies and industries that appear to have the most exposure to FIN

46, based on disclosures to date.

4. Describe the different types of off-balance-sheet activity that are affected by FIN 46.


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Walking through FIN 46

FIN 46 can be broken down into two steps. The first step is for companies to figure out if

the entities in which they have contractual, ownership, or other interests are VIEs. The

second step is to determine who controls the VIE. The company that controls a VIE is

the lucky one that gets to consolidate it, bringing the VIE on balance sheet. Each step

involves a significant amount of management and auditor judgment, potentially resulting

in inconsistencies among companies when the rule is applied in practice.

We briefly walk through the new rule in the The FIN 46 Two Step section of this report,

and then for those brave enough, we dig a little deeper into FIN 46 in Appendix A.

What Impacts Will FIN 46 Have?

Consolidating what was once off balance sheet could have an impact on almost every

line in the financial statements, affecting performance measures such as EPS, EBITDA,

and free cash flow, along with many financial ratiosparticularly leverage ratios. Credit

ratings, loan covenants, and regulatory capital may all feel the influence of FIN 46. In

theory, a new accounting rule should not have an impact on valuation, as the cash flows

dont change. That is true as long as no new information about risk is conveyed. If

investors learn that a company actually bears more risk than was known before, that

could have an impact on the estimates of future cash flows and the return that investors

would demand, which could affect valuation. The actual economics could also change if

a company were to restructure its off-balance-sheet activity in an attempt to keep it off

balance sheet.

In the Wide Variety of Impacts section, we break down the impact that FIN 46 could

have into five categories: financial statement, economic, credit rating, debt covenants,

and regulatory capital.

Which Companies and Industries Have the Most Exposure?

We looked at the latest 10Ks and 10Qs for all the companies in the S&P 500 to seewhat they had to say about VIEs. Based on those disclosures, we estimate that the

companies in the S&P 500 will bring close to $400 billion of off-balance-sheet assets

and $400 billion of liabilities on balance sheet when FIN 46 goes into effect in the third

quarter. Almost two-thirds of the assets and liabilities that could come on balance sheet

are concentrated within the ten companies in Exhibit 7. That list includes seven banks,

two autos, and General Electric, each with possible VIE assets over $10 billion.

The actual amounts that will hit the balance sheets could vary dramatically as

companies rush to restructure transactions so they remain off balance sheet and as the

interpretations of FIN 46 continue to evolve. Our guess is that the amounts actually

hitting balance sheets will tend to be smaller, depending on the success of restructuringefforts. Over half the companies in the S&P 500 should have little or no impact from FIN

46 according to the disclosures to date. Of the 234 companies that FIN 46 could impact

we would keep an eye on the 57 companies listed in Appendix F for a potential surprise

as they have discussed some type of exposure to possible VIEs or are still evaluating

FIN 46 and have not yet been able to estimate the impact of applying it.

See the In Search of VIEsThe S&P 500 and Wide Variety of Impacts sections for

further analysis.


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What Types of Transactions Are Affected by FIN 46?

We divide the transactions that are subject to FIN 46 scrutiny into six categories:

synthetic leases, asset-backed commercial paper, collateralized debt obligations, equity

method investments, low-income housing, and other. In the Coming Soon to a

Balance Sheet Near You section, we briefly go through each of the transactions and list

the companies in the S&P 500 that participate in this activity. In Appendices B and C,

we spend some more time on a synthetic lease and asset-backed commercial paperconduit example.

We cover some important exceptions to FIN 46 in the Staying Off the Balance Sheet

section. Notably, most passive securitizations, for example, credit cards and mortgages,

will remain off balance sheet for now.

New Disclosures to the Rescue

The driving force behind the off-balance-sheet problem was lack of information. The

information provided by companies on off-balance-sheet activity was generally

confusing, weak, and in some cases, nonexistent. In the Finding the Skeletons in the

Closet section we review a new rule from the SEC, that along with the FIN 46

disclosure requirements should provide investors with much better information than they

were getting in the past on off-balance-sheet activity.

ConclusionThe market is generally thought to be pretty efficient. With an accounting rule that has

been in the public domain for over five months, you may think that the market has priced

in the impact of FIN 46. We are not so sure because of the great deal of uncertainty still

surrounding FIN 46. Its tough for the market to price in an impact when it doesnt even

know the dollar amounts. Even companies that provide estimates of a FIN 46 impact

cover them with numerous caveats. The combination of weak disclosures and a vague

new accounting rule leads us to believe we may be in for a few surprises over thecoming weeks and months as companies announce and investors digest the impact of

applying FIN 46.

We created a simple report card grading the exposure to FIN 46 for each industry group

in the S&P 500. Certain sectors appear to have a higher level of FIN 46 exposure,

including Financial Services, Automobiles, Industrial Conglomerates, Utilities,

Aerospace & Defense and the Airlines. On the other hand, industry groups such as

Pharmaceuticals, Electronic Equipment & Instruments, Tobacco and Personal Products

appear to have less exposure to FIN 46.


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Key Findings

We found that the 138 companies listed in Appendix D, either had no VIEs or reported

that they did not expect VIEs to have a material impact on their financial statements.

Another 128 companies listed in Appendix E didnt say a word about VIEs. In other

words, over half the companies in the S&P 500 should have little or no impact from

FIN 46. That leaves 234 that may experience an impact when applying FIN 46.

Of the 234 companies that FIN 46 could impact, we would keep an eye on the 57

companies listed in Appendix F for a potential surprise as they have discussed some

type of exposure to VIEs or are still evaluating FIN 46 and have not yet been able to

estimate the impact of applying it. Also take a look at the 92 companies listed in

Appendix G that have estimated an impact of applying FIN 46; however, that estimate

can vary dramatically as transactions are restructured and FIN 46 is interpreted.

We estimate that the companies in the S&P 500 will have to bring on balance sheet

approximately $379 billion of assets and $377 billion of liabilities when FIN 46 goes

into effect in the third quarter. That will increase total assets by approximately 2.0%,

from $18.8 trillion to $19.2 trillion, and total liabilities by about 2.4%, from $15.8 trillion

to $16.2 trillion. In the aggregate, we estimate VIE liabilities will be approximately

12.5% of total shareholders equity.

Almost two-thirds of the assets and liabilities that could come on balance sheet are

concentrated within the ten companies in Exhibit 7. That list includes seven banks,

two autos, and General Electric, each with possible VIE assets over $10 billion. The

three companies at the top of that listCitigroup (C, $44.05, OUTPERFORM, Target

$50, MARKET WEIGHT), General Electric, and Bank One (ONE, $38.09,

OUTPERFORM, Target $50, MARKET WEIGHT)constitute about one-third of the

total.

To evaluate the impact of FIN 46 on a companys financial leverage, we compared the

possible VIE liabilities to shareholders equity. Exhibit 10 shows the 19 S&P 500

companies with ratios of possible VIE liabilities-to-equity greater than 50%. The 8

companies at the top of the list could record VIE liabilities that are greater than

reported shareholders equity.

We noticed a heavy concentration of certain types of VIEs within specific industries.

For example, 50% of the companies with disclosed interests in CDOs are from the

Capital Markets industry group and 29% are from the Insurance industry. Heavy

industry concentration can also be found in Low Income Housing VIEs. Of the 16 Low

Income Housing VIEs mentioned by companies in the S&P 500, eight of those

companies are Commercial Banks. Commercial banks also account for 57% of the

companies that discussed ABCP conduits.

On the other hand, Synthetic Leases, Equity Method Investments and the Other VIEs

are spread across more industry groups. Note that Electric Utilities is at the top of the

list for Synthetic Leases and is tied with Commercial Banks for Other VIEs with nine

companies.

The companies within the 13 industry groups in Exhibit 17 did not disclose

relationships with any type of VIE.


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The FIN 46 Two Step

Sparked by the myriad off-balance-sheet arrangements used by Enron, the FASB was

poked and prodded by Congress, the SEC, and investors to fix this problem as quickly

as possible. In February 2002, the FASB began actively working on a project to identify

and account for special purpose entities (SPEs). On January 17, 2003, less than a year

after it started its project (light speed in the world of accounting), the FASB released one

of its Post-Enron rules, FIN 46, Consolidation of Variable Interest Entities, an

Interpretation of ARB No. 51. The FASB changed the name along the way from SPEs to

VIEs to make clear that the new rule applies to a larger population of entities other than

the typical SPE.

Variable interest entities are often created for a single specific purpose. For example:

Securitization (i.e., issuing debt to investors to finance the purchase of assets);

Leasing (i.e., borrowing funds to purchase an asset and then acting as the lessor);

Hedging;

Performing research and development; and Reinsurance.

Step One in FIN 46 requires that all entities (with a few exceptions) be placed into one

of two buckets: variable interest or voting interest. If an entity is deemed a variable

interest entity, then it moves on to Step Two, where it is evaluated for possible

consolidation according to the new risks-and-rewards approach in FIN 46. If the entity is

not a variable interest entity, it is evaluated for consolidation the old-fashioned way,

based on vote. Under GAAP, all majority-owned subsidiaries are generally consolidated

The facts and circumstances surrounding each entity must be evaluated to determine if

it is a VIE and who controls it. For some companies, this is an enormous undertaking.

Just think of all the different contractual, ownership, or other financial interests thatcompanies hold or have entered into with various entities that they have to run through

the FIN 46 filter. Some examples of variable interests that would need evaluation

include:

Exhibit 1: Examples of Variable Interests

Equity Investors Service Contracts

Investors in Beneficial interests Lessees

Debt Holders Asset Managers

Guarantors Transferors of Assets

Derivative Counterparties Creditors

Source: FIN 46.

The transition period to the new rule is a short one. FIN 46 is currently in effect for

variable interest entities (VIEsthe entities formerly known as special purpose entities,

or SPEs) created after January 31, 2003. The new rule applies to older entities in the

first fiscal year or quarter beginning after June 15, 2003; the third quarter for calendar

year companies. In other words, there is no grandfathering; all existing VIEs will be

subject to the new rule, and the FASB gave companies only five months to figure it out.


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How did the Old Rules Work?Before we take you through FIN 46, we thought a quick walk down memory lane

through the old rules for SPEs would help put the new requirements into perspective.

Accounting for Securitization of Financial AssetsThe accounting for securitizations of financial assets through SPEs is spelled out in FAS

No. 140, Accounting for Transfers and Servicing of Financial Assets and

Extinguishments of Liabilities. That includes the credit card, mortgage, home equity,

auto loan, and other passive securitizations that are structured as Qualifying SPEs or

QSPEs and account for the majority of the asset-backed securities market. FAS No. 140

will still apply to these passive securitizations, and they will remain off-balance sheet for

now. See the Staying Off Balance Sheet section of the report for more detail on

QSPEs.

Accounting for Other Types of SPEsIf FAS No. 140 didnt apply, the SPE was evaluated for consolidation the old-fashioned

waybased on vote. It is for this group of SPEs that FIN 46 will have the greatest

impact, requiring some companies to consolidate SPEs in which they have no votinginterest at all.

Consolidation accounting, determining when the financial statements of two companies

are combined together and displayed as one, is not a new issue for the FASB. In 1959,

the FASB issued ARB No. 51, Consolidated Financial Statements, which still provides

the backbone for much of the accounting guidance on this topic today. It established the

concept that control of one company over another is based upon voting interests. Under

GAAP, all majority-owned subsidiaries are generally consolidated.

As arrangements between companies became more complex (i.e., SPEs), the FASB

fought to stay ahead of the curve and failed. Consolidation accounting moved on and off

the FASBs agenda for over 20 years. Various rules from the FASB, EITF, and the SEC

staff were developed over the years to tackle specific types of off-balance-sheet activity,

resulting in a mish mosh of accounting guidance. In a nutshell, the accounting guidance

for off balance sheet activity was fragmented. Companies and their auditors did not

have a single, dominant source of accounting literature that they could turn to for

guidance and often tried to figure out how to account for off balance sheet activity by

digging for analogies to other accounting rules, leading to inconsistent accounting. FIN

46 nullified or modified most of the previous accounting guidance on SPEs and

dramatically changed how companies determine whether off-balance-sheet activity

should be on balance sheet.

The 3% Rule

The Enron debacle made clear that, under the old accounting rules, a company did not

have to consolidate an SPE where it owned less than a majority of the vote and where

the majority owner contributed at least three percent of the SPEs total capital,

uncovering the fact that companies could bear a majority of the risk and reap the

rewards of an SPE without having to bring it on balance sheet. FIN 46 changed that

practice, requiring the company that bears a majority of the risk and reaps the rewards

of an SPE to consolidate it.


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Step One: Is the Entity a VIE?The FASB went fishing with this standard, casting a wide net in an effort to catch any

other Enron-type transactions that were floating off balance sheet. The FASB was trying

to identify situations where the shareholder vote does not really tell you who controls the

entity, or where the old consolidation model did not work. It was not looking to rope in

entities that truly disperse risk, although it may have netted someCDOs, for example.

Step one in FIN 46 requires that all entities (with a few exceptions) be placed into one oftwo buckets: variable interest or voting interest. When a company first acquires a

variable interest in an entity, the new rule requires the company to evaluate whether the

entity is a VIE. Variable interests are contractual, ownership, or other financial interests

in an entity that change with changes in the entitys net asset value; a variable interest

absorbs losses and receives returns. For example, an investment, guarantee or lease

arrangement (see Exhibit 1).

An entity is broadly defined as any legal structure used to conduct activities or hold

assets, i.e., a corporation, partnership, trust, limited liability company, etc. In other

words, almost every relationship that a company has could require scrutiny.

What is the company looking for? It must determine whether the entity that it has arelationship with is subject to consolidation under the new rule. In other words, is it a

VIE? A VIE is broadly defined as an entity with either of two characteristics:

1. The equity investors lack the risks or rewards of ownership, or

2. The equity investors have not invested enough for the entity to stand on its own; in

other words, it cant finance its activities without additional support.

If the entity is not a variable interest entity, it is evaluated for consolidation the old-

fashioned way, based on vote.

Step Two: Who Controls the VIE?Lets assume several companies involved in a transaction with a VIE are seated around

a table. They must now figure out whether or not they control the VIE. The companies

must look around the table at all the other parties that have an interest in the VIE and

determine which one bears the most risk. For example, a synthetic lease would typically

involve four parties: the lessee, the equity investor, the lender, and the builder.

According to FIN 46, the company that is subject to the majority (i.e., greater than 50%)

of the risks from the VIE controls it. That company is known as the primary beneficiary

and is the lucky company that gets to consolidate the VIE in its financial statements.

If no company bears a majority of the risks, then each company must take another look

around the table to find the one that receives a majority of the rewards. The one with the

majority of the rewards is the primary beneficiary and gets to consolidate the VIE. If no

company has a majority of the risks and no company has a majority of the rewards, then

no one consolidates the VIE. In that case, the risks and rewards have been shared or

dispersed and the VIE does not belong on any one balance sheet. Instead, the

individual holders of variable interests would just have to account for their respective

interests in the VIE.


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FIN 46 is completely redefining the notion of control. In the past, control was based on

vote; generally, one company would consolidate another if it owned a majority of the

vote. The FASB figured out that determining control based on vote does not work for all

entities, that some entities may be controlled through other methods.

The FIN 46 definition of control is based on a risks-and-rewards approach that involves

estimating expected losses and returns; negative cash flows are risks and positive cash

flows are rewards. The concept is extremely complex and involves significantmanagement judgment, including a variety of assumptions and estimates of future

performance, potentially resulting in the consolidation of SPEs that would have escaped

consolidation under the old voting control accounting model.

Auditors and Companies, ConfusedCountless different types of entities must be reviewed and potentially accounted for

under FIN 46. For instance, at the FASBs SPE roundtable meeting late last year,

Citigroup stated that it would need to evaluate about 1,000 SPEs. The FASB does not

make the application of the rule any easier by using broad principles and extremely

simple examples to convey this new, complex form of accounting. The companies

applying the rule are having difficulty estimating its impact. For example, in GeneralElectrics March 31, 2003, 10Q, it claims that the very complexity of the new

consolidation rules and their evolving clarification make forecasting that July 1 effect

impracticable.

If you think the companies are frustrated, the auditors are pulling their hair out and

smashing their pocket protectors. One of the Final Four accounting firms, KPMG,

included the following remarks in a recent comment letter to the FASB:

We have now had approximately four months to try and understand and apply the

requirements of FIN 46. Our experience to date indicates that the FIN 46

accounting model is severely non-operational. This is largely due to the complexity

of the model, the subjectivity of many of the judgments that the model requires, andcompanies inability to obtain the information necessary to apply the provisions of

the Interpretation. We believe FIN 46 is understood and can be adequately applied

by only a handful of individuals within the financial reporting community. It is easily

more complex than the current GAAP guidance regarding the accounting for

derivatives, transfers of financial assets, and leasing, any one of which is

considered near the top of the list of complex accounting guidance.

For those of us that have spent time with either accounting for derivatives or lease

accounting, the commentary is frightening. Accounting for derivatives, including FAS

No. 133, its amendments, and implementation guidance, is housed in about 1,000 easy-

to-read pages. Accounting for leases, including FAS No. 13, 22, and 98, along with avariety of interpretations, is compiled in a 453-page thriller. The one thing that FIN 46

has going for it, its short43 pages, plus proposed implementation guidance that is

about 10 pages.


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Delay Is UnlikelyKPMG went on to ask that the Board delay the effective date for at least six months to a

year beyond the July 1 implementation date and for comprehensive examples to

ensure the Interpretations principles can be consistently applied in practice. The FASB

has delayed the implementation of accounting standards in the past. For example, FAS

No. 133, covering derivatives, was delayed for one year in May 1999 after the FASB

received over 70 comment letters that complained about a complex standard, coupled

with systems changes and Y2K issues. We think the FASB is unlikely to delay the

implementation of FIN 46 due to its very high profile.

For the accountant lurking inside all of us who is really interested in the nuts and bolts of

the accounting rule, or for those with problems sleeping, see Appendix A, where we

provide some of the more technical aspects of the rule. In Appendices B and C, we

apply the new rule to an asset-backed commercial paper conduit and a synthetic lease.


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In Search of VIEsThe S&P 500

To get a better idea for the types of entities, arrangements, and transactions that could

come on balance sheet, and to identify which sectors and companies have exposure,

we looked at the latest 10Ks and 10Qs for all the companies in the S&P 500 to see what

they had to say about Variable Interest Entities. Companies were required to discuss

the potential impact of applying FIN 46 in all financial statements issued after January

31, 2003; that included the 2002 10Ks and the first quarter 2003 10Qs for calendar-year

companies.

Our MethodologyTo gather the data, we first searched for the term variable interest in the most recent

quarterly or annual filing. In cases where a companys latest filing was a 10Q, the VIE

disclosure often either referred back to the 10K, or the company made no mention of

VIEs at all. In these cases, we went back and searched through the 10Ks as well. We

can sum up the results of our quest in one word: frustrating.

Companies and their auditors are all still grappling with the impact of FIN 46, and many

have been unable to get their arms around how the standard will ultimately affect them.

After looking at what each of the S&P 500 companies had to say about VIEs, we think

the only thing clear about FIN 46 at this time is that its ultimate impact remains unclear.

The quality of FIN 46 disclosures across S&P 500 companies covers a broad spectrum.

Many companies were unable to estimate the impact, or were still evaluating the impact

of FIN 46. However, it appears as if FIN 46 has already improved the consistency and

overall quality of disclosures relating to off-balance-sheet activity. If nothing else, FIN

46, by introducing the concept of a VIE, has at least brought under one umbrella much

of the unique off-balance-sheet activity that previously took different names and was

difficult to spot in company filings. Beginning with the third quarter 10-Qs the

combination of FIN 46 and the SECs new off-balance-sheet disclosure requirementsshould provide investors with enhanced disclosures and a consistent place to look for

possible red flags relating to off-balance-sheet activity.

VIE Exposure for the S&P 500We found that 138 companies in the S&P 500 either had no VIEs, or reported that they

did not expect VIEs to have a material impact on their financial statements. Another 128

companies didnt say a word about VIEs. In other words, over half the companies in the

S&P 500 should have little or no impact from FIN 46. That leaves 234 that may incur an

impact when applying the new rule.

We took a stab at assessing the VIE exposure for each company in the S&P 500 bydropping each into one of three categories:

1. No Impact. We estimate that FIN 46 will have no impact on approximately 138

companies in the S&P 500 that said that they had no VIEs, or otherwise indicated

that the impact of FIN 46 would be immaterial and described no VIEs subject to the

new rule. We list the companies in this category in Appendix D.


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2. Not Mentioned. There were 128 companies that did not even mention FIN 46. We

assume FIN 46 will not have much of an impact for these companies, as they were

required to disclose the potential impact of applying FIN 46 in all financial

statements issued after January 31, 2003 and didnt say anything. We list the

companies in this category in Appendix E.

3. Could Impact. We estimate that FIN 46 could impact 234 companies. Fifty-seven of

these companies describe various VIE structures in which they participate or arestill evaluating the impact of FIN 46 but do not estimate the potential dollar amount

of VIE assets or the maximum exposure to loss. We break these companies out in

Appendix F. We are particularly interested in this group, as these companies could

provide the biggest surprises when FIN 46 is implemented. Another 92 companies

give fairly detailed descriptions of the VIE structures in which they participate.

Although many of these companies indicate that they are also still evaluating the

impact of FIN 46, they all give some indication of either (a) the potential VIE assets

that could be coming onto their balance sheets, (b) the maximum potential loss

exposure they could face, or (c) both. We break these companies out in Appendix

G. The final 85 of 234 companies that FIN 46 could impact expect the impact to be

immaterial. We list the companies in this category in Appendix H.Appendices F, G and H also include for each company, the types of off-balance sheet

transactions they are involved in, possible VIE assets and loss exposure.

Exhibit 2: How Do S&P 500 Companies Stack Up under FIN 46?

Summary Statistics # of Companies % of S&P 500

No Impact (Appendix D) 138 28%

Not Mentioned (Appendix E) 128 26%

No Impact and Not Mentioned 266 54%

Could Impact - Breakdown:

No Estimate (Appendix F) 57 11%

Gives Estimate (Appendix G) 92 18%

Immaterial (Appendix H) 85 17%

Could Impact Total 234 46%

Totals 500 100%

Source: Company data, CSFB estimates.

Magnitude of VIE ImpactBased on the companies that provided data, we estimate that the companies in the S&P

500 will have to bring on balance sheet approximately $379 billion of assets and $377

billion of liabilities when FIN 46 goes into effect in the third quarter (see Exhibit 3). That

will increase total assets by approximately 2%, from $18.8 trillion to $19.2 trillion, and

total liabilities by about 2.4%, from $15.8 trillion to $16.2 trillion. In the aggregate, we

estimate VIE liabilities will be approximately 12.5% of total shareholders equity.

The actual amounts that will hit the balance sheets could vary dramatically as

companies rush to restructure transactions so they remain off balance sheet and as the

interpretations of FIN 46 continue to evolve. Our guess is that the amounts actually

hitting balance sheets will tend to be smaller, depending on the success of restructuring

efforts. For example, there are at least four restructuring alternatives for asset backed

commercial paper (ABCP) alone. These are discussed in the Wide Variety of Impacts

section.


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Exhibit 3: Total VIE Impact on S&P 500 Companies

US$ in millions

$379,234 $377,290

$184,736

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

Possible VIE Assets Possible VIE Liabilities Possible LossExposure


To put that potential balance-sheet impact into perspective, we estimate that the

companies in the S&P 500 carry close to $1 trillion in off-balance-sheet pension

liabilities and about $900 billion in off-balance-sheet pension assets.

Magnitude by IndustryIn Exhibit 4, we list the ten industry groups that we estimate will have to bring the largest

amounts of VIE assets on balance sheet as a result of FIN 46. The top three groups

commercial banks, capital markets, and diversified financial servicesaccount for 65%

of the $379 billion total for the S&P 500. Most of the impact for the companies in those

groups appears to be associated with ABCP conduits. The ten industries listed account

for about 95% of the total.

Exhibit 4: Top Ten Industries by VIE Assets

US$ in millions

Industry Possible VIE Assets

Commercial Banks $ 119,746

Capital Markets 65,974

Diversified Financial Services 59,100

Industrial Conglomerates 44,408

Automobiles 25,800

Insurance 18,768Aerospace & Defense 8,161

Electric Utilities 7,592

Consumer Finance 6,010

Oil & Gas 3,894



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Industry Report CardThe public filings for most of the S&P 500 companies do not currently provide investors

with a concrete picture of their VIE exposure. In general, the information that companies

have provided is fragmented. We attempted to pull together everything that companies

have said about VIEsand in some cases we even considered what they havent

saidand created a simple VIE report card. Our report card shows the grade we

assigned to each industry group in the S&P 500 based on its overall VIE exposure. We

assigned grades to each industry based on performance in two key subjects. We

highlight these subjects in Exhibit 5.

Exhibit 5: Report CardSubjects Graded

Two Subjects: Uncertainty Balance Sheet Impact

Weights: 50% 50%

Criteria Used to Score: No Impact VIE Assets/Total Assets

Not Mentioned VIE Liabilities/Total Liabilities

Could Impact - Immaterial VIE Liabilities/Total Equity

Could Impact - Gives Estimate

Could Impact No Estimate


Grading Each SubjectWithin each of the two subjects, we focused on a specific set of criteria that, when

combined, could be used to arrive at an overall grade. We describe our approach to

grading each subject below.

Subject 1: Uncertainty (50% Weight)

Here, we evaluate what companies are saying in their disclosures and assign grades

based on relative degrees of uncertainty. Note that this subject is biased against

companies that demonstrate uncertainty (i.e., companies that could be impacted by FIN

46 and have not quantified the magnitude of the impact). We hand these high-uncertainty companies the lowest grade. We applied grades as follows:

1. No Impact. We gave the highest grade to companies that do not expect to face an

impact from FIN 46. These companies said either they had no VIEs, or expected the

impact of FIN 46 to be immaterial and described no other involvement with VIEs.

VIE risk exposure here is low. Companies in this category were not penalized and

received the highest possible grade of plus 2.

2. Not Mentioned. We assigned a lower grade to companies that didnt say anything

about VIEs. Given that all companies are supposed to disclose the impact of FIN 46

on their financial statements, we assumed that these companies felt that FIN 46

was immaterial to them. However, we would feel a lot better knowing that FIN 46was immaterial to a company because the company actually said so, rather than

assuming this is the case simply because the company omitted any discussion of it

from its footnotes. As a result, we believe VIE exposure here is higher compared

with companies in the No Impact category. Companies in this category were

penalized with lower marks, receiving a grade of plus 1.


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3. Could ImpactImmaterial. We perceived higher risk and applied a lower score to

companies that could face an impact from FIN 46. Companies in this category

generally described their involvement with VIEs and concluded by saying that the

impact of FIN 46 would be immaterial. If a company expects to face an impact

however immaterial the impact may bewe believe its risk exposure increases,

particularly given the uncertainties that existed at the time of the latest filings. As a

result, we hit these companies with a lower grade of zero.

4. Could ImpactGives Estimate. Companies that did not say they expected FIN 46 to

have an immaterial impact, while also describing their involvement with VIEs in

considerable detail and quantifying the impact, received an even lower grade. We

penalized companies in this category with a grade of minus 1.

5. Could ImpactNo Estimate. We perceived the greatest risk, and assigned the

lowest possible scores to companies that described their involvement with VIEs in

detail, or said that they were still evaluating the impact of FIN 46 but did not quantify

the potential impact. We believe the biggest surprises could come from this

category. Companies in this category were penalized with the lowest possible grade

of minus 2.

Subject 2: Balance Sheet Impact (50% weight)

Here, we evaluate the possible VIE impact on company balance sheets. Note that this

subject is biased against companies that quantified the potential impact of consolidating

VIE assets and liabilities (i.e., companies disclosing that they may need to consolidate

large balances relating to VIEs). We hand these impacted companies low grades in this

subject based on the magnitude of the potential VIE impact. Companies not quantifying

a FIN 46 impact receive higher grades. We applied an equal weight to the ratios

highlighted below. Companies with the highest ratios received the lowest grades across

all of the categories listed below.

1. VIE Assets/Total Assets. Captures magnitude of VIE assets to total assets.

2. VIE Liabilities/Total Liabilities. Captures magnitude of VIE liabilities to total liabilities

3. VIE Liabilities/Equity. Captures incremental leverage.

Z-ScoresIndividually, the subjects highlighted above have their limitations and dont tell the whole

story. For example, the grades for the first subject are biased against companies that

dont quantify the impact that VIEs that could have on their financials, while grades for

the second subject are biased against companies that actually quantified the potential

impact of consolidating VIE assets and liabilities. By combining these two subjects,

however, we can gain insight into the VIE exposure of each company. Unfortunately, thegrades applied within each of our subjects are calculated using different units (i.e.,

whole numbers versus ratios). How can we combine such seemingly disparate data to

arrive at one meaningful score? We turn to a useful statistical tool to overcome this

hurdle: the Z-score. Z-scores help to standardize the scoring within each subject with

respect to the others. Once we have Z-scores across each key subject, we can combine

them to come up with one overall grade for each industry. We apply equal 50% weights

to each subject because we consider them equally important.


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Z-scores simply focus on the average. In our report card, industries with average VIE

exposure receive a Z-score of zero, while industries with above-average exposure

receive negative Z-scores and industries with below-average exposure receive a

positive score. We ultimately ranked industries by their combined weighted-average

Z-scores.

Interpreting the Report CardExhibit 6 shows the pension report card for each industry in the S&P 500. The industries

are ranked from lowest Z-score to highest (most exposure to FIN 46 to least exposure to

FIN 46). Its no surprise that commercial banks, capital markets, and diversified financial

services received among the lowest Z-scores given the large asset-backed commercial

paper conduits and CDO transactions to which they will likely be the primary

beneficiaries. Many other industries, including automobiles and industrial

conglomerates, utilize various types of VIEs and received low Z-scores because of their

broad use of VIEs, not because of the dominant use of any one type. In other cases,

certain industries received very low Z-scores, not because the use of VIEs was

pervasive across numerous companies, but rather because the industry had few

participants with high exposure. For example, Internet catalog and retail tops the list

with the lowest Z-score. However, this industry has only one company, eBay (EBAY,

$101.81, OUTPERFORM, Target $120, MARKET WEIGHT), and it has high exposure.

eBay has a synthetic lease that could increase the liabilities on its balance sheet by

$122.5 million, which represents a significant chunk (22%) of eBays total liabilities.

We recommend evaluating the grades in this report card along with Exhibit 15, which

shows the number of companies in each industry having different types of VIEs.


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Exhibit 6: VIE Report Card by Industry

INDUSTRY "GRADED SUBJECT" WTD. AVERAGE EXPOSURE

Name

# of

Cos

VIE Uncertainty

Score

VIE Assets/ Total

Assets

VIE Liabilities/

Total Liabilities

VIE Liabilities/

Total Equity Z-Score

Internet & Catalog Retail 1 (1.82) (1.42) (6.36) (6.72) (3.32) HIGH

Automobiles 3 (0.98) (1.95) (0.74) (2.83) (1.41)Industrial Conglomerates 4 (0.57) (3.82) (1.96) (0.53) (1.34)Internet Software & Services 1 (3.06) 0.66 0.49 0.28 (1.29)Commercial Banks 24 (1.24) (2.08) (0.91) (0.57) (1.21)

Airlines 3 (0.98) (1.57) (0.67) (0.29) (0.91)

Consumer Finance 5 (1.32) (0.62) (0.18) (0.06) (0.80)Gas Utilities 6 (1.40) (0.42) (0.19) 0.15 (0.78)Aerospace & Defense 9 (0.57) (1.84) (0.99) 0.07 (0.75)

Electric Utilities 24 (1.35) (0.28) (0.07) 0.17 (0.70)Diversified Financial Services 4 0.06 (2.46) (1.10) (0.74) (0.69)Capital Markets 14 (0.75) (0.92) (0.28) (0.50) (0.66)

Construction & Engineering 2 (0.57) (1.00) (0.51) (0.20) (0.57)Chemicals 14 (0.75) (0.60) (0.33) 0.16 (0.50)Leisure Equipment & Products 4 (0.88) (0.28) (0.13) 0.20 (0.47)Household Durables 13 0.20 (1.93) (1.13) 0.06 (0.40)

Multi-Utilities & Unregulated Power 7 (0.75) (0.03) 0.09 0.16 (0.33)Biotechnology 5 (0.82) 0.33 (0.12) 0.27 (0.33)IT Services 11 (0.57) 0.30 0.24 0.25 (0.15)Containers & Packaging 5 (0.32) 0.37 0.31 0.24 (0.01)Insurance 24 (0.62) 0.08 0.19 0.14 (0.24)Communications Equipment 13 (0.66) 0.42 0.29 0.27 (0.17)Air Freight & Logistics 3 (0.15) (0.28) (0.23) 0.23 (0.12)

Commercial Services & Supplies 13 0.39 (1.09) (0.64) 0.09 (0.08)Road & Rail 4 (0.57) 0.54 0.42 0.27 (0.08)Distributors 1 (0.57) 0.66 0.49 0.28 (0.04)

Auto Components 6 (0.36) 0.33 0.31 0.23 (0.03)Oil & Gas 15 (0.07) 0.07 0.02 0.24 0.02Health Care Providers & Services 17 (0.35) 0.52 0.41 0.27 0.03Beverages 7 (0.39) 0.66 0.49 0.28 0.04

Food Products 9 (0.29) 0.57 0.44 0.27 0.07Software 17 (0.13) 0.60 0.40 0.28 0.15Household Products 4 (0.26) 0.63 0.47 0.28 0.10Diversified Telecommunication Services 9 (0.15) 0.60 0.45 0.28 0.14

Semiconductors & Semiconductor Equipment 20 0.31 0.39 (0.01) 0.27 0.26Energy Equipment & Services 8 0.06 0.66 0.49 0.28 0.27Computers & Peripherals 10 0.31 0.47 0.34 0.27 0.33

Wireless Telecommunication Services 3 0.26 0.61 0.46 0.28 0.36Metals & Mining 8 0.37 0.66 0.49 0.28 0.42Real Estate 4 0.37 0.66 0.49 0.28 0.42Specialty Retail 15 0.51 0.49 0.35 0.27 0.44

Health Care Equipment & Supplies 13 0.58 0.41 0.26 0.27 0.45Media 15 0.51 0.55 0.40 0.28 0.46Thrifts & Mortgage Finance 6 0.47 0.66 0.49 0.28 0.48Machinery 14 0.50 0.66 0.49 0.28 0.49Food & Staples Retailing 10 0.56 0.66 0.49 0.28 0.52

Hotels Restaurants & Leisure 11 0.79 0.45 0.31 0.27 0.57Paper & Forest Products 6 0.68 0.66 0.49 0.28 0.58

Textiles Apparel & Luxury Goods 5 0.68 0.66 0.49 0.28 0.58Electrical Equipment 6 0.89 0.66 0.49 0.28 0.68Multiline Retail 11 0.91 0.66 0.49 0.28 0.69Electronic Equipment & Instruments 10 1.43 0.66 0.49 0.28 0.95

Personal Products 3 1.51 0.66 0.49 0.28 1.00Tobacco 3 1.51 0.66 0.49 0.28 1.00Pharmaceuticals 13 1.64 0.66 0.49 0.28 1.06

Building Products 2 1.93 0.66 0.49 0.28 1.20Construction Materials 1 1.93 0.66 0.49 0.28 1.20Office Electronics 1 1.93 0.66 0.49 0.28 1.20Trading Companies & Distributors 1 1.93 0.66 0.49 0.28 1.20 LOW



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Wide Variety of Impacts

Depending upon the VIE, consolidating what was once off balance sheet could have an

impact on almost every line in the financial statements, affecting the balance sheet,

income statement, and cash flow statement. Performance measures such as EPS,

EBITDA, and free cash flow, along with many financial ratiosparticularly leverage

ratioscould be affected.

Credit ratings should not be affected, as the ratings agencies should have factored in

most of this off-balance-sheet activity when determining credit ratings, unless the new

disclosures provide the ratings agencies with new information. It is not clear how it will

impact debt and loan covenants. Some covenants may be insulated from changes in

leverage due to changes in GAAP, while others may not. Financial institutions could

face higher regulatory capital charges as asset levels rise; however, regulatory capital

relief is likely and should mitigate the impact.

When the accountants create a new rule, they dont change the economics of a

transaction, they change the picture of the transaction. In theory, there should be no

impact on valuation, as the cash flows dont change. That is true as long as no new

information about risk is conveyed. If investors learn that a company actually bears

more risk than was known before, that could have an impact on the estimates of future

cash flows and the return that investors would demand, which could affect valuation.

The actual economics could also change if a company were to restructure its off-

balance-sheet activity in an attempt to keep it off balance sheet.

In this section, we break down the impact that FIN 46 could have into five categories:

financial statement, economic, debt/loan covenants, regulatory capital, and credit

ratings. This list is not meant to be all-inclusive. It should give you a sense for some of

the potential impacts that FIN 46 could have. We are sure there are others lurking out

there that we have not yet thought of.

Moving TargetThe impact that FIN 46 may have on a specific company is a moving target; auditors

and companies continue to try and decipher the new rule, and structuring professionals

continue to come up with new ways to work around it. The combination of this vague

new rule and weak disclosures leads us to believe we should be in for a few surprises

when the rule is implemented and in the months and years to follow, as the rule

continues to be interpreted in practice.

Determining the impact on a specific company and whether it is material will be

extremely difficult, due to the limited disclosure that we now get about off-balance-sheet

activity. We advise readers to take a look at the commitments and contingenciesfootnotes and the new accounting pronouncements footnotes while reading the

management discussion and analysis (MD&A) section of the 10Ks and recent 10Qs for

any hints as to the impact of applying the new rule. A vague accounting rule and an

endless variety of off-balance-sheet activity make forecasting the impact of FIN 46 a bit

like throwing darts for the companies. Investors trying to look forward are also throwing

dartsblindfolded.


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With a short transition period and little implementation guidance from the FASB,

companies and auditors are applying FIN 46 by the seat of their pants. This could result

in inconsistent application by different companies and varying interpretations from

different auditors. In the current environment, the accountants will tend to take the

conservative route; if there is a question as to whether a VIE should come on balance

sheet, they will likely lean toward putting it on as opposed to leaving it off.

The limited disclosures to date indicate that the impact of FIN 46 on a companysfinancial statements is a moving target. For example, in its December 31, 2002 10K,

DuPont (DD, $42.53, UNDERPERFORM, Target $45, OVERWEIGHT) identified $330

million of VIE assets associated with three synthetic leases. Then in its March 31, 2003,

10Q, DuPont identified $798 million of VIE assets, adding on its commercial paper

conduit to the three synthetic leases noted in the 10K.

We are probably in for a rough ride as practice evolves and companies and auditors

revise their initial opinions on FIN 46. We would not be surprised to see companies still

working out the kinks over the next couple of years, potentially resulting in future

restatementsnot very different than the implementation problems that some

companies have had and continue to have with accounting for derivatives.

With the large number of transactions that need to be evaluated under FIN 46, we

wonder whether or not companies will initially apply the rule only to the big-ticket, high-

profile items, and then work their way down to other transactions. In other words, as the

rule is implemented, it could be applied to more and more transactions, resulting in

future uncertainty.

Financial Statement ImpactDepending upon the VIE, consolidating what was once off balance sheet could have an

impact on almost every line in the financial statements, affecting the balance sheet,

income statement, and cash flow statement. One bit of guidance the FASB glossed over

in its new accounting standard: how to consolidate all this stuff. It simply states that aVIE should be accounted for as if it were consolidated based on vote, defaulting to

existing consolidation guidance from ARB No. 51, Consolidated Financial Statements, a

rule developed in 1959. Its not as easy as it sounds. Identifying a VIE and determining

the primary beneficiary is difficult enough, actually accounting for it opens up a whole

new can of worms. Adding another layer of complexity to a complicated topic.

We quickly take you through some of the impacts that FIN 46 could have on the balance

sheet, income statement, and cash flow statement.

Balance Sheet Impact

Clearly, bringing VIEs on balance sheet is going to have an impact on the balancesheet. We estimate that over $379 billion in assets and $377 in liabilities could land on

the balance sheets of S&P 500 companies as a result of FIN 46. Almost two-thirds of

the assets and liabilities that could come on balance sheet are concentrated within the

ten companies in Exhibit 7. That list includes seven banks, two autos, and General

Electric, each with possible VIE assets over $10 billion. The three companies at the top

of that listCitigroup, General Electric, and Bank Oneconstitute about one-third of the

total.


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We believe the amounts that will actually find their way on to balance sheets could be

smaller than the initial estimates as transactions are restructured. However, as FIN 46

continues to be interpreted, new VIEs could be found that need to be included on a

balance sheet. For example Keycorp (KEY, $26, UNDERPERFORM, Target $23,

MARKET WEIGHT) stated that as it continued its FIN 46 implementation efforts,

additional entities could be identified that will need to be consolidated or disclosed. The

possibility of restructuring, coupled with the hesitation by many companies to make

estimates, makes us very skeptical of the amounts disclosed. An example of that

hesitation: John Hancock Financial Services (JHF, $31.09, Not Rated) stated that it

cannot, at this time, reliably estimate the future potential impact of consolidating any

VIEs with which it is involved.

Exhibit 7: Possible VIE Assets over $10 Billion

US$ in millions

Company Ticker Possible VIE Assets

Citigroup Inc C $ 55,000

General Electric Co GE 43,568

Bank One Corp ONE 39,500

J P Morgan Chase & Co JPM 25,000Bank Of America Corp BAC 24,500

Wachovia Corp WB 19,200

General Motors Corp GM 15,100

U S Bancorp USB 12,288

State Street Corp STT 11,100

Ford Motor Co F 10,700


For the entire S&P 500 we estimate that total assets could increase by approximately

2% as a result of FIN 46. There are 53 companies where total assets will increase by

more than 2% and ten companies, listed in Exhibit 8, where total assets could increase

by 10% or more when the VIE assets are brought on balance sheet.

Exhibit 8: Possible VIE Assets As % of Total Assets Greater than 10%

US$ in millions

Company Ticker Possible VIE Assets Total Assets

Possible VIE Assets

Total Assets

Price (T. Rowe) Group TROW $ 600 $ 1,370 43.8%

Teco Energy Inc TE 3,517 8,638 40.7%

Franklin Resources Inc BEN 1,700 6,423 26.5%

Centex Corp CTX 2,270 11,611 19.6%

Novellus Systems Inc NVLS 456 2,494 18.3%

Marsh & McLennan Cos MMC 2,300 13,855 16.6%

Boeing Co1 BA 7,841 52,342 15.0%

Bank One Corp ONE 39,500 277,383 14.2%

State Street Corp STT 11,100 85,794 12.9%

Ryder System Inc R 486 4,767 10.2%

1 Includes $5.8 billion of notes, ETCs, and EETCs as well as 3.9% of Boeings assets as a proxy for the total

assets of the Sea Launch Venture.



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Looking over to the right hand side of the balance sheet, we estimate total liabilities for

the S&P 500 could increase by about 2.4% due to FIN 46. Exhibit 9 shows the 15

companies whose liabilities would increase by 10% or more if their VIEs were

consolidated under FIN 46. T. Rowe Price (TROW, $36.47) could potentially see its

liabilities increase over 2.5 times, and Novellus Systems (NVLS, $36.48,

OUTPERFORM [V], Target $35, UNDERWEIGHT) could double. Note that companies

often disclosed only the amount of VIE assets that could be coming back onto their

balance sheets without saying anything else about possible VIE liabilities. In these

cases, we assumed that VIE liabilities were equal to VIE assets.

Exhibit 9: Possible VIE Liabilities As % of Total Liabilities Greater than 10%

US$ in millions

Company Ticker Possible VIE Liabilities Total Liabilities

Possible VIE Liabilities

Total Liabilities

Price (T. Rowe) Group TROW $ 600 $ 237 253.6%

Novellus Systems Inc NVLS 456 438 104.1%

Franklin Resources Inc BEN 1,700 2,156 78.9%

Teco Energy Inc TE 3,517 6,026 58.4%

Centex Corp CTX 2,160 6,869 31.4%

Marsh & McLennan Cos MMC 2,300 8,837 26.0%

eBay Inc EBAY 123 568 21.6%

Chiron Corp CHIR 173 865 19.9%

Sabre Hldgs Corp - Cl A TSG 202 1,115 18.1%

Boeing Co BA 7,141 44,646 16.0%

Bank One Corp ONE 39,500 254,943 15.5%

State Street Corp STT 11,100 81,007 13.7%

PeopleSoft Inc PSFT 105 893 11.8%

Ryder System Inc R 422 3,659 11.5%

Intl Game Technology IGT 213 1,883 11.3%


Leverage

To evaluate the impact of FIN 46 on a companys financial leverage, we compared the

possible VIE liabilities to shareholders equity. In the aggregate, we estimate VIE

liabilities could be approximately 12.5% of total shareholders equity for the S&P 500.

VIE liabilities could be more than 12.5% of equity for 49 companies. Exhibit 10 shows

the 19 S&P 500 companies with ratios of possible VIE liabilities-to-equity greater than

50%. The 8 companies at the top of the list could record VIE liabilities that are greater

than reported shareholders equity. For example, State Street Corp. (STT, $40.07,

NEUTRAL, Target $35, MARKET WEIGHT) could record $11.1 billion of VIE liabilities,

versus $4.8 billion of shareholders equity.

If we were to assume that VIE liabilities are the equivalent of debt, the debt-to-equityratio for the S&P 500 goes from 227% to 240%.


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Exhibit 10: Possible VIE Liabilities to Equity Greater than 50%

US$ in millions

Company Ticker Possible VIE Liabilities Equity

Possible VIE Liabilities

Total Equity

State Street Corp STT $ 11,100 $ 4,787 232%

General Motors Corp GM 15,100 6,814 222%AMR Corp/De AMR 2,100 957 219%

Ford Motor Co F 10,300 5,590 184%Bank One Corp ONE 39,500 22,440 176%Hancock John Finl Svcs Inc JHF 8,495 6,211 137%

Teco Energy Inc TE 3,517 2,612 135%Centex Corp CTX 2,160 2,117 102%

Boeing Co BA 7,141 7,696 93%Huntington Bancshares HBAN 2,124 2,304 92%PNC Financial Svcs Group Inc PNC 5,732 6,859 84%

Bear Stearns Companies Inc BSC 4,770 6,382 75%General Electric Co GE 43,568 63,706 68%

U S Bancorp USB 12,288 18,101 68%Citigroup Inc C 55,000 86,718 63%

Principal Financial Grp Inc PFG 4,100 6,657 62%

Wachovia Corp WB 19,200 32,078 60%J P Morgan Chase & Co JPM 25,000 42,306 59%

Price (T. Rowe) Group TROW 600 1,134 53%


Do These Amounts Represent Assets and Liabilities of a Company?

Once FIN 46 goes into effect, balance sheets will be grossed up with VIE assets and

liabilities. Are they truly assets and liabilities of a company? We look to FASB Concepts

Statement No. 6, Elements of Financial Statements, for the accounting definitions of

each, and we leave you to make your own decision based on this guidance:

Assets. Probable future economic benefits obtained or controlled by a particular entityas a result of past transactions or events.

Liabilities. Probable future sacrifices of economic benefits arising from present

obligations of a particular entity to transfer assets or provide services to other entities in

the future as a result of past transactions or events.

The FASB makes a leap to tie its new rule to these definitions. It states that the

relationship between a VIE and its primary beneficiary results in control by the primary

beneficiary of future benefits from the assets of the VIE, even though the primary

beneficiary may not have the direct ability to make decisions about the uses of the

assets. The FASB goes on to say that because the liabilities of the VIE will require

sacrificing consolidated assets, those liabilities are obligations of the primarybeneficiary, even though the creditors of the VIE may have no recourse to the general

credit of the primary beneficiary.

Another Future Balance Sheet Impact

The ongoing effects on the balance sheet could be complicated in certain situations. For

example, accounting for CDOs, where the assets will be marked to market but the debt

issued to investors will not, could result in balance-sheet mismatch and volatility.


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Income Statement ImpactThe future earnings impact of FIN 46 is almost impossible to determine from the

disclosures that most companies have provided. The ultimate impact will depend on the

type of off-balance-sheet activity that a company engages in.

Bottom-Line Earnings Impact

Bottom-line earnings are unlikely to change if a company consolidates an investment

that was previously accounted for under the equity method. However, this may not be

true in other cases. For example, bottom-line earnings would likely decline if a synthetic

lease that was previously treated as an operating lease is brought on balance sheet

because of the additional depreciation that a company would have to run through

earnings.

Income Statement Geography

Income statement geography could also change, affecting EBITDA and operating

margins. For example, a lessee in a synthetic lease would have previously reported only

rent expense on the income statement. By placing the synthetic lease on balance sheet,

the company would now have to report both depreciation and interest expense, pushing

both operating income and EBITDA higher. For an asset-backed commercial paper

(ABCP) conduit, what was once the administrators fee would be replaced with interest

income and interest expense. Another example is an equity method investment. In the

past, the investor would show one line representing its share of the unconsolidated

subsidiarys earnings; now, if the unconsolidated subsidiary is consolidated, each line in

the income statement could change.

Intercompany Transactions

One of the trickier potential aspects of the new rule involves intercompany transactions.

Consolidation accounting guidance requires the elimination of intercompany

transactions. If the company had been recognizing revenue based on transactions withthe special purpose entity that it now has to consolidate, that revenue will be deemed an

intercompany sale and will be eliminated when the VIE is consolidated.

Immateriality Varying Shades of Gray

Immateriality comes in different shades of gray. Of the 219 companies that claim FIN 46

will have an immaterial impact, over 75% said the impact on the financial statements

would be immaterial. The remainder said that the impact would be immaterial to

earnings or a specific financial statement. We are not sure how much to read into these

variations in disclosure. For example, if a company specifically states that FIN 46 will

not have a material impact on earnings what can we infer about its impact on the

balance sheet. Exhibit 11 includes a few examples of the different types of immaterialitythat we came across from the companies in the S&P 500. We suggest investors read

the FIN 46 disclosures carefully and ask questions about the potential impact on the

other financial statements if it is not clear.


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Exhibit 11: Different Shades of Immateriality

Company Ticker FIN 46 Materiality Disclosure

Circuit City Stores CC We do not expect the adoption of this standard to have a material

impact on our financial position, results of operations or cash flows.

Intl Game Technology IGT We do not believe that consolidation of these entities will have amaterial impact to our net income.

Marsh & McLennan Cos MMC MMC is assessing the overall impact of this pronouncement and does

not expect the implementation of FIN 46 to have a significant impact on

its consolidated results of operations.Scherwin-Williams Co SHW Management does not believe the consolidation of any variable interest

entities discovered will have a material effect on the Company's resultsof operations, financial condition or liquidity.

Wells Fargo & Co WFC The Company does not expect that the adoption of FIN 46 will have amaterial effect on the Company's financial statements.


Cash Flow Statement ImpactCash flows should not be affected by a change in accounting, and they wont be unless

the company restructures the transaction. However, once an off-balance-sheet entity is

brought on balance sheet, the cash flows in the cash flow statement for the consolidated

company will, in many cases, change.

For example, if a company had been accounting for its investment in a joint venture

under the equity method, the only ongoing cash flow impact was from any joint venture

dividends received by the investor. Now, if that company consolidates the JV, all of the

JVs cash flows will appear on the cash flow statement; cash flows from operations,

financing, and investing could all change.

Impact on Free Cash Flow

One of many definitions for free cash flow is cash flow from operations plus interest

expense less capital expenditures. Previously, the rent paid on a synthetic lease would

run through cash flow from operations, reducing free cash flow. When the lease isbrought on balance sheet as a result of FIN 46, the rent paid is treated as both interest

expense and a reduction in the lease obligation, both of which are excluded from the

definition of free cash flow, pushing it higher.

Economic ImpactIn theory, a change in an accounting rule does not change the economics of a

transaction; it just takes a different picture of the economics. The cash flows dont

change . . . or do they? That would depend upon how companies react to the new rules.

Restructuring

Now, if the transactions are restructured to better fit, or get around, the new accounting

rule to paint a prettier picture, then the economics and cash flows could change. Many

companies are discussing restructuring transactions in response to FIN 46 to keep the

off-balance-sheet activity off balance sheet.

For example, we have heard of the following four restructuring alternatives for asset-

backed commercial paper conduits that could result in many amendments to ABCP

structures in the next few weeks:


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1. Take my losses, please. Bring in an outside party willing to bear a majority of the

expected losses and to carry the ABCP conduit on its balance sheet.

2. Share and share alike. Establish a joint venture to share expected losses and

returns evenly so that no one party is deemed the primary beneficiary.

3. The silo. Create individual VIEs (silos) within the conduit so that the seller of

receivables is the primary beneficiary; such a structure works if the seller has kept

the receivables on balance sheet.

4. Q. Set up the conduit as a QSPE; this one is not getting much attention due to the

uncertainty surrounding QSPEs. (See the Staying Off Balance Sheet section of

this report.)

We provide a few other company specific examples below.

LSI Logic (LSI, $7.74) is an example of a company that highlighted its restructuring

intentions in its December 31, 2002, 10-K:

We currently have two operating leases for equipment. The assets currently held

under these operating leases had an original cost of approximately $332 million

and are held in entities generally set up to own and lease such assets to theCompany. Based on our interpretation of FIN 46, we currently believe that we will

be required to consolidate the variable interest entities associated with these

operating leases on July 1, 2003, the effective date of the statement for us, barring

financial restructuring. We are currently seeking to refinance these leases in a

manner that best meets our capital financing strategy and our cost of capital

objectives. We believe that these leases once refinanced, would not require

consolidation.

In its filing for the first quarter, LSI notes that it has been successful in its restructuring

efforts:

On March 28, 2003, the Company entered into new operating leases to refinancethe old leases. The Company refinanced these leases in a manner that best met

our capital financing strategy and cost of capital objectives and the new leases are

not subject to the consolidation provisions of FIN 46.

A closer look at LSIs disclosure gives us a sense of how the company worked with

other financial institutions to coordinate the restructuring necessary to keep the lease off

the books:

On March 28, 2003, the Company entered into two lease and security agreements,

each with Bank of America, National Association ("BANA"), acting as the Lessor,

and Wells Fargo Bank Northwest as the Agent for a total of $395 million for certain

wafer fabrication equipment ("the equipment"). The leases qualify for operatinglease accounting treatment. As of March 31, 2003, the amount under both leases

was fully drawn. Each lease has a term of 3.5 years with no option for renewal. The

Company may, at the end of the lease term, return or purchase, at a pre-

determined amount, all of the equipment. The first lease was for $235 million and

was for equipment that was previously on lease immediately prior to closing this

transaction. There was no impact to our results of operations for the three months

ended March 31, 2003, as a result of terminating the former leases and entering


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into the new lease. The second lease was for $160 million and was for fabrication

equipment that was sold to BANA and then immediately leased back in a

transaction commonly referred to as a sale-leaseback. The equipment sold had a

book value of approximately $103 million. The resulting $57 million gain on the sale

of the equipment will be deferred until the end of the lease term and has been

recorded as a non-current liability as of March 31, 2003. The Company has $389

million in cash that is posted as collateral for the new leases. The lessor has

access to the Company's cash collateral only in the event of a default. Of this cash

collateral, $46 million, representing the amount of cash collateral to be released in

the next 12 months, is reflected in other current assets and the remaining cash

collateral of $343 million is recorded in non-current assets and deposits. The

Company is required to maintain unrestricted cash reserves in an amount no less

than the higher of a) the sum of $100 million plus the principal amount outstanding

under the 4% Convertible Subordinated Notes due February 15, 2005 or b) $350

million. The Company was in compliance with this requirement as of March 31,

2003.

Exhibit 12 shows examples of other companies in the S&P 500 that are currently

seeking to restructure VIEs.

Exhibit 12: Examples of Companies Evaluating VIE Restructuring Alternatives

Company Restructuring Action

Bank of America The actual amount that will be consolidated is dependent on actions taken by the Corporation and its customers prior to September30, 2003. Management is assessing alternatives with regards to these entities including restructuring the entities and/or alternativesources of cost-efficient funding for the Corporation's customers and expects that the amount of assets consolidated will be less than

the $24.5 billion due to these actions and those of its customers.

Citigroup The Company is actively pursuing certain restructuring solutions that would enable certain VIEs to meet the criteria for non-

consolidation. At this time, it is anticipated that the effect on the Company's Consolidated Statement of Financial Position could be anincrease of $55 billion to assets and liabilities, primarily due to several multi-seller finance companies administered by the Company

and certain structured investment vehicles if these non-consolidation solutions are not successful. If consolidation is required, the

future viability of these businesses will be assessed.

DuPont The company continues to review the provisions of FIN No. 46 and to assess its options relating to the VIEs discussed above for

which a decision has not yet been made. These options include (1) consolidating the VIEs into the company's financial statements, (2)purchasing selected assets from the VIEs, or (3) finding alternative financing sources. The impact on the company's liquidity, financialcondition and results of operations is dependent upon the option selected for each individual VIE, which has not yet been determined.

PNC Financial Management is in the process of finalizing changes to the equity ownership and/or control structure of certain hedge funds previouslyidentified in the 2002 Form 10-K that management believes will remove them from the scope of FIN 46. As a result, these entities will

not be required to be consolidated in the third quarter of 2003.

Source: Company data.

Once companies decide to restructure transactions, investors should try and focus on

the structure of the new transactions and determine whether they continue to be

economically viable.

How Much Risk?

With a new, clearer picture of the off-balance-sheet activity, investors may obtain newinsights into the amount of risk that a company takes. The perception of risk may

change. Companies may have offloaded less or retained more risk than investors once

thought. With a better understanding of a companys risks and rewards, investors may

have to rethink forecasts of future cash flows and the return that investors would

demand, which could affect valuations.


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Cost of Financing Could Go Up

As certain transactions are restructured to stay off the balance sheet, the economics

may no longer be as favorable to the parties involved with the SPE. For example, ABCP

restructurings and regulatory capital charges could cut into the profit margins of the

conduits administrator; some of the increased cost will likely get passed to the seller of

receivables to the conduit in the form of higher borrowing costs. If a company were to

trip over a debt covenant or if the ratings agencies were to alter their outlook afterlearning of new off-balance sheet activity, debt cost of capital could rise.

Maximum Exposure to Loss

Companies have also been providing estimates of their maximum exposure to loss. In

other words, in the absolute worst-case scenario, what is the company on the hook for?

We estimate that the aggregate maximum exposure to loss is $185 billion for the

companies in the S&P 500. The 6 companies in Exhibit 13 each carry an estimated

maximum exposure to loss from VIEs of over $5 billion.

Exhibit 13: Possible VIE Maximum Exposure to Loss over $5 Billion

US$ in millionsCompany Ticker Maximum VIE Loss Exposure

Citigroup Inc C $ 63,000

General Electric Co GE 39,154

Bank Of America Corp BAC 26,100

Wachovia Corp WB 20,600

Lehman Brothers Holdings Inc LEH 5,779

General Motors Corp GM 5,500


Debt/Loan CovenantsThe inputs to many of the ratios used in debt/loan covenants are based on GAAP. With

new liabilities potentially landing on balance sheet as a result of FIN 46, there is a fear

that companies could begin to trip over these covenants, resulting in defaults or

covenant renegotiations, which could drive up the cost of borrowing.

We posed the following question to experts in this area: If an accounting rule were to

change, does the covenant take into account the rule change or is it based on the

accounting rules that were in place at the time the covenant was established?

We discovered that older covenants, those created more than three years ago,

generally used frozen GAAP. Since then, most covenant calculations have floated with

GAAP. With the caveat that if a change in GAAP would cause a covenant default, then it

would not create an event of default, and both the company and lenders would have to

renegotiate the covenants in good faith. Each deal has the potential to treat this pointdifferently though and should be checked. The Calculations section of the relevant

credit agreement typically has the governing language.

Just as each special purpose entity is unique, so are covenants. If you think that a

company is getting close to tripping over its covenants as a result of FIN 46, ask the

company the same question that we posed, or try and get your hands on the credit

agreement.


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Regulatory CapitalThe basic concept behind regulatory capital is that banks and other regulated industries

are required to set aside a certain amount of capi

fin 46 new rule

Documents