Reporting and Analyzing Off-Balance Sheet Financing 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? 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.

“Window Dressing” Financial Statements: Examples # 1 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.

“Window Dressing” Financial Statements: Examples # 2 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.

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.

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 and pensions. Variable interest entities (called SPEs in the past) were previously discussed when we covered the equity method of accounting.

Leasing 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.

Advantages to Leasing Leases often require much less equity investment than bank financing. 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.

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.

Benefits of Operating Leases Leased asset is not reported on the balance sheet. Lease liability is not reported on the balance sheet. 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.

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.

Operating Leases The benefits of applying the operating method for leases are obvious to managers. 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.

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

Footnote Disclosures of Lessees

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.

Capitalization of Midwest Air Operating Leases

Pensions 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.

Pensions 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.

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.

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.

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.

Problem # 1 - Continued 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. The amount reported, however, is not what you or I would likely consider the true funding status.

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).

The Balance of the Pension Liability (PBO) Computation    

Accounting for Defined Benefit Plans Service cost – the increase in the pension obligation due to employees working another year for the employer. Interest cost – the increase in the pension obligation due to the accrual of an additional year of interest. Benefits paid to employees – the company’s obligation is reduced as benefits are paid to employees.

Computation of the Balance of the Pension Investments

Computation for Pension Expense Reported in the Income Statement

Footnote Disclosures of Pensions

Footnote Disclosures of Pensions

Footnote Disclosures of Pensions

Expected 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.