Financial Statement Clarity How Intercompany Transactions Can Obscure Value

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Mar 2004

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When was the last time you picked up a company's annual report or U.S. Securities and Exchange Commission
(SEC) Form 10-K and tried to get a clear picture of how a company makes its money? Where was the real value?
When looking at the annual report, how easy was it to cut through the flashy copy about company operations or
assets and the glitzy photographs of corporate executives, to get to the nuts and bolts of the financial statements?
How clear of a picture did the annual report or SEC filing paint of the company's day-to-day operations?

More likely than not, the financial statement presentation did little to provide sufficient information for potential
investors or lenders about intercompany and related party transactions, which are eliminated during the process of
developing consolidated financial statements. This article discusses why the authors believe additional disclosures regarding
intercompany transactions will improve the usefulness of financial reporting to investors and lenders.
Business-segment reporting, for example, should highlight where one area of business subsidizes or materially
affects other business segments. The financial statements should spell out in clear terms information that allows the
average investor or lender to understand a company's business.

Due to the complex nature of today's corporate structures, and the relatively high level with which consolidated
financial statements are presented, it is often extremely difficult for an investor, lender or other stakeholder to
determine the value of an entity receiving an investment, loan or payments for services. Although lenders may have
greater access to information through interaction with management and have the ability to gain additional clarity
with regards to certain financial data, they must still ask the right questions to understand how a corporate structure
affects their relationship to the company. Most often, intercompany transfers of value are not explicitly or
sufficiently discussed in the financial statements to allow this assessment.

As a result of the corporate scandals of the past few years, companies are at least attempting to bring more clarity to
their financial reporting. The collapse of corporate giants such as Enron and WorldCom has led many companies
to allocate a greater proportion of their annual report to additional disclosure. For example, General Electric
increased text descriptions and disclosures by approximately 30 percent, adding 16 pages in total, between its 2000
and 2001 annual reports.<a href="#4" name="4a">4</a> In response to a petition from the (then) "Big Five" accounting firms, the SEC provided
guidance in January 2002 asking that companies provide additional disclosure for items such as related party
transactions, off-balance sheet or structured financing arrangements, certain fair-value trading activities and
intercompany transactions in their financial reporting.<a href="#5" name="5a">5</a> While additional disclosure will certainly help to provide a
clearer picture of a company's financial condition, it is still important to understand why a clear understanding of
those transactions will aid an investor or lender's decision-making process, what kinds of intercompany
transactions can occur and how they are utilized.

<h3>Why Is It Important to Understand Intercompany Transactions?</h3>

In a perfect world, investors and lenders should be able to look at a company's financial statements and easily make
informed investing and lending decisions. In reality, that is easier said than done. What if you are a lender or
potential purchaser of corporate bonds secured by specific assets of a company? Examples of such transactions
happen frequently in the energy industry. Often, lenders or other investors who purchase corporate debt may be
asked to lend money at a subsidiary level and have the debt secured by assets (tangible or intangible) of the
subsidiary company. In the case of a solvent company, everyone is happy. The borrower/bond issuer is happy
because it has a source of capital. The lender/investor is happy as long as they receive timely payment of interest
and principal. The ratepayer (stakeholder) is happy so long as the lights stay on or the gas continues to flow
uninterrupted and at reasonable prices. Unfortunately, we do not live in a perfect world.

In today's market, many of yesterday's stalwart, industry-leading companies are experiencing financial difficulty.
Lenders and bondholders are finding that they are holding debt at various levels of rather complex corporate
structures with varying levels of competing interests. For example, many of the larger energy companies over the
last decade developed distinct lines of business where one portion of the firm owned and operated assets. These
assets could be either regulated or unregulated in nature, and the assets typically generated a fair return on
investment while providing a steady stream of cash. A second line of business revolved around trading energy
commodities and providing varying levels of price risk management to third parties. Obviously, a lender, investor
or bondholder with a security interest at the subsidiary level owning the relatively valuable fixed assets will have
interests quite different than a lender or investor with security at the trading/risk management subsidiary or at the
parent level. In the not-so-perfect world of financial reorganizations, recapitalizations and bankruptcy, it is glaringly
clear that one must truly understand how value is transferred within a company via intercompany transactions
before investing in or loaning resources to the company.

Similarly, ratepayers and their protectors, the local public utility commissions (PUCs), are finding that even staid
utilities are facing potential financial ruin, due in part to an inability to monitor intercompany transfers of value
between the utility subsidiary and parental holding companies. A northeastern corporate holding company provides
an ideal case study of how poor financial statement disclosure of value transfers from a utility subsidiary to its
corporate parent (the corporation) caught the PUC, and the ratepayers it is supposed to protect, off-guard. The PUC
engaged an auditing firm in mid-2003 to audit the activities of the corporation with specific areas of focus to
include analysis of affiliate transactions. The preliminary audit report revealed a multitude of issues not apparent
when reading the corporation's annual report. Essentially, the regulated utility subsidiary had been funding a variety
of money-losing ventures entered into by the corporation at the expense of ratepayers and investors alike. Although
several lines of business were discontinued, the damage had been done, and losses were realized.

After six months of work, the auditing firm had released only a preliminary report and was still attempting to fully
unravel the financial relationships, facts and circumstances surrounding the corporation's investments. If a six- to
twelve-month investigation is required to determine how intercompany transactions helped bring a company to the
brink of financial ruin, one can conclude that financial disclosure in the firm's financial reports are seriously lacking
the appropriate level of detail. In this example, the corporation was attempting to transform itself into a diversified
energy company by utilizing the successful utility line of business that was providing the lion's share of earnings
and cash. Once again, full disclosure would aid investors or lenders in making more informed decisions about where
the real value of this company is derived. A lender with debt secured at the utility level, for example, would be very
interested in knowing that the company was using capital from the profitable utility to fund other risky
investments.

Intercompany transactions are used for a variety of mundane accounting reasons, most of which are purely innocent
in nature. They can involve either transfers of value or assignment of obligations. Generally, the transactions are
simply a method for tracking the daily operations of the company. For example, many larger companies typically
contain either multiple lines of business or multiple legal entities consolidated into one parent company for
financial-reporting purposes. Companies may utilize specific entities within their organization to segregate
back-office support functions such as accounting, finance or human resources. Costs accumulated in the "back
office" are subsequently allocated out to other lines of business so that profit and loss can be calculated for each
operating division or line of business. This example of an intercompany transaction seems innocuous enough so
long as the method for allocating costs fairly represents the costs attributable to each line of business and does not
disproportionately allocate costs to any one area in an effort to manipulate results.

Other examples of intercompany transactions entered into during the normal course of business include recording
receivables and payables between related companies, as well as interest income or expense, payment of dividends to
the parent, and loans to or between subsidiaries. Cash-management practices may require that accumulated cash in a
subsidiary's bank account be "swept" to the parent's concentration bank account. This gives rise to intercompany
payables and receivables between the parent and subsidiary. Finally, parent companies may contribute cash or assets
to existing or new entities (corporate or partnership) to create or capitalize new lines of business. All of the
aforementioned transaction examples represent intercompany transactions or transfers of value one would expect in
the normal course of business. Daily business operations require interaction between corporate entities, and most
times there is a clear business purpose.

Occasionally, as has been extensively reported by the media in a number of high-profile bankruptcy cases,
intercompany (and related party) transactions are used to confuse and mislead both the investing public and
sophisticated creditors alike. Complex off-balance-sheet financing structures such as special purpose entities (so
called SPEs), which have attracted a great deal of legal and media scrutiny over the past two years, are examples of
related-party transactions that have not been clearly disclosed in the financial statements of a number of
corporations. Creation of complex organizational structures and complex transactions help to obscure the true
business purpose of many transactions. Insufficient disclosure of the business purpose of intercompany or
related-party transactions in a company's financial statements makes it difficult to determine the true financial
condition of that company. Exhibit 1 provides a list of additional transactions that may indicate related party
transactions have occurred that require additional disclosure.<a href="#6" name="6a">6</a>

<h3>Buyers (or Lenders) Beware...</h3>

When analyzing financial statements and their related footnote disclosures, it is important to read between the lines.
Consolidated financial statements do not necessarily provide the full picture of a company's operations, particularly
as related to intercompany or related-party transactions. Unless broad changes for disclosing intercompany
transactions are made to financial-reporting requirements, or companies take it upon themselves to voluntarily
provide additional clarity to their financial statements, investors and lenders must dig deeper than the latest glossy
annual report or SEC Forms 10-K and 10-Q to determine where the value they seek resides.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Robert L. Sammon is a manager in Huron Consulting Group's Energy and Valuation practice. He has a broad background in financial and tax reporting, deal structuring and asset
valuation as related to acquisitions and project development. He has provided financial advisory services to a variety of regulated and merchant energy clients over the past
eight years in the energy industry. <a href="#1a">Return to article</a>

<a name="2">2</a> Daniel J. Bautch is a manager in Huron Consulting Group's Energy and Valuation practice. He has a wide variety of experience in financial transactions and valuations of
energy-related assets including oil, gas, power and LNG. <a href="#2a">Return to article</a>

<a name="3">3</a> Any opinions expressed in this article are those of the authors and do not reflect the opinions of Huron Consulting Group LLC. <a href="#3a">Return to article</a>

<a name="4">4</a> Reason, Tim, "Corporations Supersize Annual Reports," CFO Magazine, July 2001. <a href="#4a">Return to article</a>

<a name="5">5</a> Securities and Exchange Commission release No. 34-45321. <a href="#5a">Return to article</a>

<a name="6">6</a> AICPA Practice Guide: Accounting and Auditing for Related Parties and Related Party Transactions—A Toolkit for Accountants and Auditors, December 2002. <a href="#6a">Return to article</a>

Journal Authors

Daniel J. Bautch

Robert Sammon

Journal Date

Monday, March 1, 2004 - 12:00

Bankruptcy Rule

2004