by David Tillett
The recently published Companies Bill will have a radical effect on the accounts of many property companies: it could, indeed, result in significant changes in the financial structure of property deals. Take the balance sheet of a typical property group. It may show the full extent of the group’s development and investment activities and how they are financed, but these days the chances are that at least as much activity will be “off balance sheet” as on it. One of the wags in the industry has defined a liability as “an obligation you have not managed to get off your balance sheet”.
Why do groups like to get assets and related loan finance from banks or other institutions off their balance sheets? The reason is that this treatment reduces gearing, the ratio of loan finance to shareholders’ equity. Gearing matters because the higher the ratio, the more the profit after interest payments remaining for equity shareholders is seen as vulnerable. The investment, in short, becomes, apparently, riskier. Investment analysts, who like to see a significant but steady growth in profits each year and do not necessarily appreciate that property development is essentially a lumpy business, seem until recently to have been unaware that the gearing ratio shown by a balance sheet may not tell the whole story. Off-balance-sheet deals have consequently flourished.
For property companies there are two typical “off-balance-sheet” scenarios. The first is an arrangement whereby a sole developer contrives (or more likely his bankers contrive for him) to off-load assets and liabilities. The second relates to joint ventures. In either case the company would include only a single “net investment” figure in its balance sheet rather than consolidating the individual assets and liabilities: thus the liabilities only appear in the notes to the accounts if they appear at all.
Let us look at these two scenarios in turn.
Sole developments
It is at present not difficult to set up an off-balance-sheet vehicle in such a way that the “parent” obtains all the benefits of owning it without the disadvantage of having to consolidate its assets and liabilities.
A subsidiary is currently defined as a company in which the parent either:
- is a member of it and controls the (numerical) composition of its board of directors; or
- holds more than half the nominal value of its equity share capital.
Accounting standards require a company to be excluded from consolidation, even though legally it is a subsidiary, if the would-be parent cannot exercise control over the composition of the board.
Ways of avoiding the vehicle coming within both the legal and accounting definitions of an effectively controlled subsidiary include:
- The “controlled non-subsidiary” approach — devising a capital structure so that the “parent” owns less than 50% in nominal value of the equity, and cannot appoint more than half the members of the board, while still being entitled to a large proportion of the profits through disproportionate profit sharing, and controlling the voting of the directors through their representatives having additional votes.
- The “non-consolidated subsidiary” route — while the “parent” owns all or the greater part of the share capital of the subsidiary, the subsidiary is excluded from consolidation under accounting standards because the “parent” does not control the composition of the board.
- The “friendly third party” method — “parking” 50% or more of the share capital with a friendly third party, while retaining a legally binding option to acquire the remaining shares. For the time being the “parent” has no shareholding, so the other company is technically not a subsidiary. At the appropriate time — perhaps when the development is nearing completion — the parent company exercises its option to acquire the shares at par.
All this is likely to change. The proposed new definition of a subsidiary is a seven-legged one — see Table 1. It contains several traps for the sort of arrangement described above:
- If any “participating interest” — which can include options over shares — is held, the “parent” only has to exercise a dominant influence over the company to make it a subsidiary. Though there is as yet no definition in the Bill of a dominant influence, controlling its principal activity — ie its property development — could hardly be thought to escape this particular net.
- Managing the subsidiary “on a unified basis” with the parent company — which presumably means as part of the parent’s own business — has a similar effect.
- A legal agreement which gives the parent the right to control the “operating and financial policies” catches the company concerned as a subsidiary and note that in this case there is not even a requirement for a “participating interest”.
- The shift in the definition of “subsidiary” from control of the numerical composition of the board to the more meaningful test of control over the decisions of the board will prevent the artificial use of numerical strength to avoid consolidation.
- The considerable curtailment of the circumstances in which a subsidiary may legally be excluded from consolidation will further restrict the scope for off-balance-sheet vehicles.
- A subsidiary will no longer have to be a body corporate, so vehicles such as limited partnerships will be drawn into the consolidation net.
Thus it seems reasonable to suggest that the Bill, when enacted, will outlaw the artificial use of “non-subsidiaries” to leave off-balance-sheet assets and liabilities which really ought to be consolidated if a true and fair presentation is to be achieved.
Instead, only those vehicles where the “parent” genuinely surrenders control will survive off balance sheet.
Joint ventures
With the enormous number of property developments now being structured as joint ventures, it is particularly interesting that the Bill not only specifically legislates for them for the first time but also introduces the concept of “proportional consolidation”. Though this is not a new idea on the Continent, it certainly is here.
To illustrate the concept, if you assume a 50:50 joint venture between two property companies, under proportional consolidation each would consolidate 50% of each of the assets and liabilities of the joint venture. This contrasts with the present treatment which would be to record the investment in the joint venture in one figure representing its cost with the addition of the appropriate share of its realised and unrealised post-acquisition profits. The Bill limits the new treatment to cases where there are not more than four participants in the joint venture and each participant has a substantially equal interest in the management and capital of the joint venture, or, if it has no interest in the capital, in its profits and losses.
The wording allows rather than requires proportional consolidation and presumably it will be left to the accountants to decide how it should be implemented. Two points stand out:
- The interpretation of “substantially equal”: what degree of inequality will be taken to mean that proportional consolidation is not permitted by the new law?
- Assuming that they pass the “substantially equal” test, how will the more complicated types of sharing arrangement be dealt with? Sometimes the respective interests in assets and profits can be different and can be based on sliding scales. What would make sense to me would be to assume for the split initially that the development achieves the rents and/or sale price on which the original investment appraisal was based, and to up-date this in the light of new estimates as the development proceeds.
I certainly hope that an accounting standard on the subject will not make it too easy for the imbalance of interests to be used as grounds for avoiding proportional consolidation: in my view proportional consolidation is the most satisfactory way of dealing with joint ventures in the accounts of the venturers — and it will of course mean that the appropriate proportion of the scheme’s liabilities appears on the balance sheet of the venturer.
Conclusion
There is no doubt that the Companies Bill will, when enacted, bring to an abrupt end the use of the “non-subsidiary”. And it is to be hoped that advantage will be taken of the new tool, proportional consolidation, to give a greatly improved presentation of joint ventures. The combination of these two changes will greatly alter the gearing shown in the consolidated balance sheets of the liveliest property development groups.
