Module 9Module 9

Reporting and Reporting and Analyzing Off-Analyzing Off-Balance Sheet Balance Sheet

FinancingFinancing

Why is Off-Balance Sheet Why is Off-Balance Sheet Financing Important?Financing Important?

In other words, why are firms so In other words, why are firms so interested in “hiding” debt?interested in “hiding” debt? If analysis reveals that debt is If analysis reveals that debt is

excessive, companies may face the excessive, companies may face the prospect of a reductions in bond prospect of a reductions in bond ratings, resulting in higher cost of ratings, resulting in higher cost of debt. debt.

Likewise, excessive leverage can Likewise, excessive leverage can result in a higher cost of equity result in a higher cost of equity capital and a consequent reduction capital and a consequent reduction in stock price. in stock price.

““Window Dressing” Window Dressing” Financial Statements: Financial Statements:

Examples #1Examples #1 A company is concerned that its liquidity may A company is concerned that its liquidity may

not be perceived as sufficient. not be perceived as sufficient. Prior to the end of its financial reporting Prior to the end of its financial reporting

period it takes out a short-term loan from its period it takes out a short-term loan from its bank in order to increase its reported cash bank in order to increase its reported cash balance. The same result can also be obtained balance. The same result can also be obtained by delaying payment of accounts payable. by delaying payment of accounts payable.

In both cases, the company’s cash and current In both cases, the company’s cash and current assets have been increased. assets have been increased.

Even though current liabilities are also higher, Even though current liabilities are also higher, the liquidity of the balance sheet has been the liquidity of the balance sheet has been improved and the company appears somewhat improved and the company appears somewhat stronger from a liquidity point of view.stronger from a liquidity point of view.

““Window Dressing” Window Dressing” Financial Statements: Financial Statements:

Examples # 2Examples # 2 A company’s level of accounts receivable are A company’s level of accounts receivable are

perceived to be too high, thus indicating perceived to be too high, thus indicating possible collection problems and a reduction in possible collection problems and a reduction in liquidity. liquidity.

Prior to the statement date, the company offers Prior to the statement date, the company offers customers an additional discount in order to customers an additional discount in order to induce them to pay the accounts more quickly. induce them to pay the accounts more quickly.

Although the profitability on the sale has been Although the profitability on the sale has been reduced by the discount, the company reduces reduced by the discount, the company reduces its accounts receivable, increases its reported its accounts receivable, increases its reported cash balance and presents a somewhat cash balance and presents a somewhat healthier financial picture to the financial healthier financial picture to the financial markets. markets.

““Window Dressing” Window Dressing” Financial Statements: Financial Statements:

Examples # 3Examples # 3 A company may face the maturity of a long-A company may face the maturity of a long-

term liability, such as the scheduled maturity term liability, such as the scheduled maturity of a bond. of a bond.

The amounts coming due will be reported as a The amounts coming due will be reported as a current liability (current maturities of long-current liability (current maturities of long-term debt), thus reducing the net working term debt), thus reducing the net working capital of the company. capital of the company.

Prior to the end of its accounting period, the Prior to the end of its accounting period, the company renegotiates the debt to extend the company renegotiates the debt to extend the maturity date of the payment or refinances the maturity date of the payment or refinances the indebtedness with longer-term debt. indebtedness with longer-term debt.

The indebtedness is, thus, reported as a long-The indebtedness is, thus, reported as a long-term liability and net working capital has been term liability and net working capital has been increased. increased.

““Window Dressing” Window Dressing” Financial Statements: Financial Statements:

Examples # 4Examples # 4 The company’s financial leverage is The company’s financial leverage is

deemed excessive, resulting in lower deemed excessive, resulting in lower bond ratings and a consequent increase bond ratings and a consequent increase in borrowing costs. in borrowing costs.

To remedy the problem, the company To remedy the problem, the company issues new common equity and utilizes issues new common equity and utilizes the proceeds to reduce the the proceeds to reduce the indebtedness. indebtedness.

The increased equity provides a base to The increased equity provides a base to support the issuance of new debt to support the issuance of new debt to finance continued growth.finance continued growth.

Motives for using Off-Motives for using Off-Balance Sheet FinancingBalance Sheet Financing

In general, companies desire to present a In general, companies desire to present a balance sheet with sufficient liquidity and balance sheet with sufficient liquidity and less indebtedness. less indebtedness.

The reasons for this are as follows: The reasons for this are as follows: liquidity and the level of indebtedness are liquidity and the level of indebtedness are viewed as two measures of solvency. viewed as two measures of solvency.

Companies that are more liquid and less Companies that are more liquid and less highly financially leveraged are generally highly financially leveraged are generally viewed as less likely to go bankrupt. viewed as less likely to go bankrupt.

As a result, the risk of default on their As a result, the risk of default on their bonds is less, resulting in a higher rating bonds is less, resulting in a higher rating on the bonds and a lower interest rate.on the bonds and a lower interest rate.

Off-Balance Sheet Financing

Off-balance sheet Off-balance sheet financing means financing means that either liabilities are kept off of that either liabilities are kept off of the face of the balance sheet. the face of the balance sheet.

In this module, we discuss leases, In this module, we discuss leases, pensions, variable interest entities pensions, variable interest entities (called SPEs in the past), and (called SPEs in the past), and derivatives . derivatives .

LeasingLeasing A lease is a contact between the owner A lease is a contact between the owner

of an asset (the of an asset (the lessorlessor) and the party ) and the party desiring to use that asset (the desiring to use that asset (the lesseelessee). ).

Generally, leases provide for the Generally, leases provide for the following terms:following terms:

1.1. The lessor allows the lessee the unrestricted The lessor allows the lessee the unrestricted right to use the asset during the lease termright to use the asset during the lease term

2.2. The lessee agrees to make periodic payments The lessee agrees to make periodic payments to the lessor and to maintain the assetto the lessor and to maintain the asset

3.3. Title to the asset remains with the lessor, Title to the asset remains with the lessor, who usually retakes possession of the asset at who usually retakes possession of the asset at the conclusion of the lease. the conclusion of the lease.

Advantages to LeasingAdvantages to Leasing1.1. Leases often require much less equity Leases often require much less equity

investment than bank financing. That is, banks investment than bank financing. That is, banks may only lend a portion of the asset’s cost and may only lend a portion of the asset’s cost and require the borrower to make up the difference require the borrower to make up the difference form its available cash. Leases, on the other form its available cash. Leases, on the other hand, usually only require that the first lease hand, usually only require that the first lease payment be made at the inception of the lease. payment be made at the inception of the lease.

2.2. Since leases are contracts between two willing Since leases are contracts between two willing parties, their terms can be structured in any parties, their terms can be structured in any way to meet their respective needs. way to meet their respective needs.

3.3. If properly structured, neither the leased asset If properly structured, neither the leased asset not the lease liability are reported on the face of not the lease liability are reported on the face of the balance sheet. the balance sheet.

Capital vs. Operating Capital vs. Operating LeasesLeases

Capital lease methodCapital lease method. This method . This method requires that both the lease asset requires that both the lease asset and the lease liability be reported on and the lease liability be reported on the balance sheet. The leased asset the balance sheet. The leased asset is depreciated like any other long-is depreciated like any other long-term asset. The lease liability is term asset. The lease liability is amortized like a note, where lease amortized like a note, where lease payments are separated into interest payments are separated into interest expense and principal repayment.expense and principal repayment.

Operating LeaseOperating Lease

Operating lease methodOperating lease method. . Under this method, neither the Under this method, neither the lease asset nor the lease liability lease asset nor the lease liability is on the balance sheet. Lease is on the balance sheet. Lease payments are recorded as rent payments are recorded as rent expense when paid.expense when paid.

Benefits of Operating Benefits of Operating LeasesLeases1.1. Leased asset is not reported on the Leased asset is not reported on the

balance sheet.balance sheet. This means that net operating asset turnover is This means that net operating asset turnover is

higher because reported assets are lower and higher because reported assets are lower and revenues are unaffected. revenues are unaffected.

2.2. Lease liability is not reported on the Lease liability is not reported on the balance sheet.balance sheet.

This means that the usual balance sheet related This means that the usual balance sheet related measures of leverage are improved. measures of leverage are improved.

3.3. For the early years of the lease term, rent For the early years of the lease term, rent expense reported for an operating lease expense reported for an operating lease is less than the depreciation and interest is less than the depreciation and interest expense reported for a capital lease.expense reported for a capital lease.

This means that net income is higher for those This means that net income is higher for those years with an operating lease. years with an operating lease.

Operating LeasesOperating Leases The benefits of applying the operating method The benefits of applying the operating method

for leases are obvious to managers, leading for leases are obvious to managers, leading many managers to avoid lease capitalization if many managers to avoid lease capitalization if possible. possible.

The lease accounting standard, unfortunately, The lease accounting standard, unfortunately, is structured around rigid requirements. is structured around rigid requirements. Whenever the outcome is rigidly defined, clever Whenever the outcome is rigidly defined, clever managers that are so-inclined can structure managers that are so-inclined can structure lease contracts to meet the letter of the lease contracts to meet the letter of the standard to achieve a desired accounting result standard to achieve a desired accounting result when the essence of the transaction would when the essence of the transaction would suggest a different result. suggest a different result.

This is This is form over substanceform over substance..

Footnote Disclosures of Footnote Disclosures of LesseesLessees

Midwest Air Group’s Lease Midwest Air Group’s Lease FootnoteFootnote

In the Midwest Air footnote disclosure, it In the Midwest Air footnote disclosure, it reports minimum (base) contractual lease reports minimum (base) contractual lease payment obligations for each of the next 5 payment obligations for each of the next 5 years and the total lease payment obligations years and the total lease payment obligations that come due after that 5-year period. that come due after that 5-year period.

This is similar to disclosures of future This is similar to disclosures of future maturities for long-term debt. maturities for long-term debt.

The company must also provide separate The company must also provide separate disclosures for operating leases and capital disclosures for operating leases and capital leases. leases.

We know that all of Midwest Air’s leases are We know that all of Midwest Air’s leases are operating because its footnote does not operating because its footnote does not disclose any payments relating to capital disclose any payments relating to capital leases.leases.

Capital LeasesCapital Leases Capital leasesCapital leases

Effectively an installment purchaseEffectively an installment purchase Lessee assumes rights and risks of ownershipLessee assumes rights and risks of ownership Treated as purchasesTreated as purchases

Examples of what constitutes a capital Examples of what constitutes a capital leaselease PV of lease payments is the FMV of the assetPV of lease payments is the FMV of the asset Period of the lease approximates the assets Period of the lease approximates the assets

lifelife There is a bargain purchase priceThere is a bargain purchase price

Capitalizing Operating Capitalizing Operating Leases for Analysis Leases for Analysis

Purposes Purposes 1.1. Determine the discount rate to Determine the discount rate to

compute the present value of the compute the present value of the operating lease payments.operating lease payments.

This can be inferred from the capital lease This can be inferred from the capital lease disclosures, or one can use the company’s disclosures, or one can use the company’s debt rating and recent borrowing rate for debt rating and recent borrowing rate for intermediate term secured obligations as intermediate term secured obligations as disclosed in its long-term debt footnote.disclosed in its long-term debt footnote.

2.2. Compute the present value of the Compute the present value of the operating lease payments.operating lease payments.

3.3. Add the present value computed in Add the present value computed in step 2 to both assets and liabilities. step 2 to both assets and liabilities. This is the process that would have This is the process that would have been used if the leases had been been used if the leases had been classified as capital leases.classified as capital leases.

Capitalization of Midwest Capitalization of Midwest Air Operating LeasesAir Operating Leases

PensionsPensions Companies frequently offer retirement plans as Companies frequently offer retirement plans as

an additional benefit for their employees. There an additional benefit for their employees. There are generally two types of plans:are generally two types of plans:

Defined contribution plan.Defined contribution plan. This plan This plan has the company make periodic contributions has the company make periodic contributions to an employee’s account (usually with a third to an employee’s account (usually with a third party trustee like a bank), and many plans party trustee like a bank), and many plans require an employee matching contribution. require an employee matching contribution. Following retirement the employee makes Following retirement the employee makes periodic withdrawals from that account. A tax-periodic withdrawals from that account. A tax-advantaged 401(k) account is a typical advantaged 401(k) account is a typical example. Under a 401(k) plan, the employee example. Under a 401(k) plan, the employee makes contributions that are exempt from makes contributions that are exempt from federal taxes until they are withdrawn after federal taxes until they are withdrawn after retirement.retirement.

PensionsPensions

Defined benefit plan.Defined benefit plan. This plan has This plan has the company make periodic payments to the company make periodic payments to an employee after retirement. Payments an employee after retirement. Payments are usually based on years of service are usually based on years of service and/or the employee’s salary. The and/or the employee’s salary. The company may or may not set aside company may or may not set aside sufficient funds to make these payments. sufficient funds to make these payments. As a result, defined benefit plans can be As a result, defined benefit plans can be overfunded or underfunded. overfunded or underfunded.

Accounting for Defined Accounting for Defined Contribution PlansContribution Plans

From an accounting standpoint, From an accounting standpoint, defined contribution plans offer no defined contribution plans offer no particular problems. particular problems.

The contribution is recorded as an The contribution is recorded as an expense in the income statement expense in the income statement when paid or accrued. when paid or accrued.

Accounting for Defined Accounting for Defined Benefit PlansBenefit Plans

Defined benefit plans are more Defined benefit plans are more problematic due to the fact that the problematic due to the fact that the company retains the pension company retains the pension investments and the pension investments and the pension obligation is not satisfied until paid. obligation is not satisfied until paid.

Account balances, income and Account balances, income and expenses, therefore, need to be expenses, therefore, need to be reported in the company’s financial reported in the company’s financial statements. statements.

Two Accounting Issues Two Accounting Issues Related to Pension Related to Pension Investments and Investments and

Obligations: Problem # 1Obligations: Problem # 1 The The firstfirst of the two primary accounting issues of the two primary accounting issues relates to the appropriate balance sheet relates to the appropriate balance sheet presentation of the pension investments and presentation of the pension investments and obligation.obligation.

The pension standard allows companies to report The pension standard allows companies to report the the netnet pension liability on their balance sheet. pension liability on their balance sheet.

That is, if the pension obligation is greater than That is, if the pension obligation is greater than the fair market value of the pension investments, the fair market value of the pension investments, the underfunded amount is reported on the the underfunded amount is reported on the balance sheet as a long-term liability. balance sheet as a long-term liability.

Conversely, if the pension investments exceed the Conversely, if the pension investments exceed the company’s obligation, the overfunded amount is company’s obligation, the overfunded amount is reported as a long-term asset. reported as a long-term asset.

Two Accounting Issues Two Accounting Issues Related to Pension Related to Pension Investments and Investments and

Obligations: Problem # 2Obligations: Problem # 2 The The secondsecond issue facing the FASB was issue facing the FASB was the treatment of fluctuations in pension the treatment of fluctuations in pension investments and obligations in the investments and obligations in the income statement. income statement.

The FASB allows companies to report The FASB allows companies to report pension income based on pension income based on expectedexpected long- long-term returns on pension investments term returns on pension investments (rather than actual investment returns), (rather than actual investment returns), and to defer the recognition of unrealized and to defer the recognition of unrealized gains and losses on both pension gains and losses on both pension investments and pension obligations investments and pension obligations

Financial Statement Effects Financial Statement Effects of Defined Benefit Plans of Defined Benefit Plans

Accounting for Defined Accounting for Defined Benefit PlansBenefit Plans

Once the initial pension obligation has been Once the initial pension obligation has been estimated, changes to that obligation estimated, changes to that obligation subsequently arise from 3 sources:subsequently arise from 3 sources:

Service costService cost – the increase in the pension obligation due to – the increase in the pension obligation due to employees working another year for the employer. Since pension employees working another year for the employer. Since pension payments are based on final salaries and years of service, these will payments are based on final salaries and years of service, these will increase each year as employees continue to work for the company. increase each year as employees continue to work for the company. This increase due to employment is the service cost.This increase due to employment is the service cost.

Interest costInterest cost – the increase in the pension obligation due to – the increase in the pension obligation due to the accrual of an additional year of interest. This is similar to the the accrual of an additional year of interest. This is similar to the increase in the carrying amount of discount bonds that we discuss increase in the carrying amount of discount bonds that we discuss in Module 8. in Module 8.

Benefits paid to employeesBenefits paid to employees – the company’s – the company’s obligation is reduced as benefits are paid to employees. This is no obligation is reduced as benefits are paid to employees. This is no

different than the payment of any other liability.different than the payment of any other liability.

The Balance of the The Balance of the Pension Liability (PBO) Pension Liability (PBO)

ComputationComputation

 

      

 

      

Computation of the Computation of the Balance of the Pension Balance of the Pension

Investments Investments

Computation for Pension Computation for Pension Expense Reported in the Expense Reported in the

Income StatementIncome Statement

Sources of Financial Sources of Financial Statement Effects of Statement Effects of

Defined Benefit Plans Defined Benefit Plans

Footnote Disclosures of Footnote Disclosures of PensionsPensions

Footnote Disclosures of Footnote Disclosures of PensionsPensions

Footnote Disclosures of Footnote Disclosures of PensionsPensions

ExpectedExpected Return on Return on Pension InvestmentsPension Investments

Notice that the computation of pension Notice that the computation of pension expense uses the expense uses the expectedexpected return on return on pension investments, not the pension investments, not the actualactual return. return.

The reason for this is that stock returns The reason for this is that stock returns are expected to revert to a long-termare expected to revert to a long-term average if currently abnormally high or average if currently abnormally high or low. Therefore, this expected return is a low. Therefore, this expected return is a better indicator of the true cost of the better indicator of the true cost of the pension. pension.

Unexpected Gains and Unexpected Gains and LossesLosses

Stock analysts generally do not like wild swings Stock analysts generally do not like wild swings in reported profitability and companies were in reported profitability and companies were very concerned that the use of actual very concerned that the use of actual investments returns in the computation of investments returns in the computation of pension expense would adversely impact their pension expense would adversely impact their stock price. stock price.

As a result, they lobbied the FASB, and the As a result, they lobbied the FASB, and the FASB agreed to use expected long-run returns FASB agreed to use expected long-run returns instead of actual returns in order to smooth instead of actual returns in order to smooth reported earnings.reported earnings.

Since the FASB did not want unexpected gains Since the FASB did not want unexpected gains and losses to impact profits, it decided to and losses to impact profits, it decided to accumulate them off-balance sheet. accumulate them off-balance sheet.

Variable Interest Entities Variable Interest Entities (VIEs)(VIEs)

A VIE is formed by a sponsoring company and A VIE is formed by a sponsoring company and is capitalized with an equity investment.is capitalized with an equity investment.

The VIE leverages this equity investment with The VIE leverages this equity investment with borrowings from the debt market and borrowings from the debt market and purchases assets from, or for, the sponsoring purchases assets from, or for, the sponsoring company. company.

Cash flows from the VIE assets are used to Cash flows from the VIE assets are used to repay the debt and earn a return for its equity repay the debt and earn a return for its equity investors.investors.

The sponsoring company benefits from its asset The sponsoring company benefits from its asset reduction and/or from the benefits of assets reduction and/or from the benefits of assets reported on another entity’s balance sheet.reported on another entity’s balance sheet.

Project and Real Estate Project and Real Estate Financing Financing

VIEs can provide a lower cost financing VIEs can provide a lower cost financing alternative than borrowing from the debt alternative than borrowing from the debt market.market.

This is because the activities of the VIE are This is because the activities of the VIE are constrained and, as a result, investors purchase well-constrained and, as a result, investors purchase well-secured cash flows that are not subject to the business secured cash flows that are not subject to the business risks of providing capital directly to the sponsoring risks of providing capital directly to the sponsoring company.company.

A properly structured VIE is accounted for A properly structured VIE is accounted for as a separate entity and is unconsolidated as a separate entity and is unconsolidated with the sponsoring company.with the sponsoring company.

The sponsoring company is, thus, able to utilize VIEs to The sponsoring company is, thus, able to utilize VIEs to remove assets, liabilities, or both from its balance remove assets, liabilities, or both from its balance sheet. Further, since the sponsor realizes the economic sheet. Further, since the sponsor realizes the economic benefits of the VIEs’ transactions, the sponsor’s benefits of the VIEs’ transactions, the sponsor’s operating performance ratios (return on assets, asset operating performance ratios (return on assets, asset turnover, leverage, etc.) improve.turnover, leverage, etc.) improve.

Reporting of Reporting of Consolidated VIEsConsolidated VIEs

Subsequent to passage of SFAS 140, Subsequent to passage of SFAS 140, the FASB issued FIN 46 in 2003. This the FASB issued FIN 46 in 2003. This interpretation identified the interpretation identified the characteristics of VIEs that require characteristics of VIEs that require consolidation. Generally, any entity consolidation. Generally, any entity that lacks independence from the that lacks independence from the sponsoring company and lacks sponsoring company and lacks sufficient capital to conduct its sufficient capital to conduct its operations apart from the sponsoring operations apart from the sponsoring company, must be consolidated with company, must be consolidated with whatever entity bears the greatest whatever entity bears the greatest risk of loss and stands to reap the risk of loss and stands to reap the greatest rewards from its activities.greatest rewards from its activities.