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Module 9. Reporting and Analyzing Off-Balance Sheet Financing. Why is Off-Balance Sheet Financing Important?. In other words, why are firms so interested in “hiding” debt?

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Module 9

Reporting and Analyzing Off-Balance Sheet Financing

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Why is Off-Balance Sheet Financing Important?

  • In other words, why are firms so interested in “hiding” debt?

    • If analysis reveals that debt is excessive, companies may face the prospect of a reductions in bond ratings, resulting in higher cost of debt.

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

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“Window Dressing” Financial Statements: Examples #1

  • A company is concerned that its liquidity may not be perceived as sufficient.

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

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

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

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“Window Dressing” Financial Statements: Examples # 2

  • A company’s level of accounts receivable are perceived to be too high, thus indicating possible collection problems and a reduction in liquidity.

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

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

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“Window Dressing” Financial Statements: Examples # 3

  • A company may face the maturity of a long-term liability, such as the scheduled maturity of a bond.

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

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

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

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“Window Dressing” Financial Statements: Examples # 4

  • The company’s financial leverage is deemed excessive, resulting in lower bond ratings and a consequent increase in borrowing costs.

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

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

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Motives for using Off-Balance Sheet Financing

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

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

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

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

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Off-Balance Sheet Financing

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

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

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  • A lease is a contact between the owner of an asset (the lessor) and the party desiring to use that asset (the lessee).

  • Generally, leases provide for the following terms:

    • The lessor allows the lessee the unrestricted right to use the asset during the lease term

    • The lessee agrees to make periodic payments to the lessor and to maintain the asset

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

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Advantages to Leasing

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

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

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

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Capital vs. Operating Leases

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

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Operating Lease

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

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Benefits of Operating Leases

  • Leased asset is not reported on the balance sheet.

    • This means that net operating asset turnover is higher because reported assets are lower and revenues are unaffected.

  • Lease liability is not reported on the balance sheet.

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

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

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

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Operating Leases

  • The benefits of applying the operating method for leases are obvious to managers, leading many managers to avoid lease capitalization if possible.

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

  • This is form over substance.

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Midwest Air Group’s Lease Footnote

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

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

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

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

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Capital Leases

  • Capital leases

    • Effectively an installment purchase

    • Lessee assumes rights and risks of ownership

    • Treated as purchases

  • Examples of what constitutes a capital lease

    • PV of lease payments is the FMV of the asset

    • Period of the lease approximates the assets life

    • There is a bargain purchase price

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Capitalizing Operating Leases for Analysis Purposes

  • Determine the discount rate to compute the present value of the operating lease payments.

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

  • Compute the present value of the operating lease payments.

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

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  • Companies frequently offer retirement plans as an additional benefit for their employees. There are generally two types of plans:

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

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

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Accounting for Defined Contribution Plans

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

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

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Accounting for Defined Benefit Plans

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

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

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Two Accounting Issues Related to Pension Investments and Obligations: Problem # 1

  • The first of the two primary accounting issues relates to the appropriate balance sheet presentation of the pension investments and obligation.

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

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

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

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Two Accounting Issues Related to Pension Investments and Obligations: Problem # 2

  • The second issue facing the FASB was the treatment of fluctuations in pension investments and obligations in the income statement.

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

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Accounting for Defined Benefit Plans Obligations: Problem # 2

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

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

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

  • Benefits paid to employees – the company’s obligation is reduced as benefits are paid to employees. This is no different than the payment of any other liability.

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Expected Plans Return on Pension Investments

  • Notice that the computation of pension expense uses the expected return on pension investments, not the actual return.

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

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Unexpected Gains and Losses Plans

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

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

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

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Variable Interest Entities (VIEs) Plans

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

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

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

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

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Project and Real Estate Financing Plans

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

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

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

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

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Reporting of Consolidated VIEs Plans

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