Module 9

1
Module 9

• Reporting and Analyzing Off-Balance Sheet
  Financing

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Why is Off-Balance Sheet Financing Important?

• In the valuation process, the analysis of return
  on equity (ROE) and its components, net operating
  profit margin, total operating asset turnover,
  and financial leverage are very important.
• If analysis reveals that LEV is excessive,
  companies may face the prospect of a higher cost
  of equity capital and a consequent reduction in
  stock price.
• Likewise, excessive leverage can result in
  reductions in bond ratings, resulting in higher
  cost of debt.
• There is an incentive, therefore, to find ways to
  keep liabilities off of the balance sheet.

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• When management conducts off-balance sheet
  activity, it may motivated by a desire to
• Promote the welfare of shareholders, e.g., by
  increasing cash flow, lowering risk, raising
  low-cost capital to grow, etc.
• Window-dress in order to present a better
  picture of the firm.
• How can we tell the difference?
• Does it matter?

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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 companys 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 companys 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 companys 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, fewer assets,
  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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A Key Assumption

• Markets believe the balance sheet presentation
  and adjust expectations as the result of
  window-dressing actions.
• Is this really true?

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Off-Balance Sheet Financing

• Off-balance sheet financing means that either
  assets or liabilities, or both, are kept off of
  the face of the balance sheet.
• Leases, pensions/OPEBs, variable interest
  entities, and derivatives often involve
  off-balance sheet financing and risk.

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Off-balance sheet financing often arises as the
result of some weakness in current GAAP

• Form versus substance.
• Compromises codified within a GAAP standard
• Executory contracts that have not been executed.
• Historical vs current cost the choice of
  objectivity/reliability over relevance.
• Obscurity regarding the identity and scope of the
  economic entity being accounted for.

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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.

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Advantages to Leasing

• There are several advantages to leasing over bank
  financing
• Leases often require much less equity investment
  than bank financing. That is, banks may only lend
  a portion of the assets 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

• GAAP identifies for two different approaches in
  the reporting of leases by the lessee
• 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 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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Capital vs. Operating Leases
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Operating Leases

• Reporting of leases using the operating method
  has 4 important benefits for the lessee
• 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.
  Consequently, many managers believe the company
  would then command a better debt rating and lower
  interest rate on borrowed funds.

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Operating Leases

• 3. 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. Further, if the company is
  growing and adding operating leased assets at a
  high rate, the rent expense could always be less
  than first year depreciation and interest on
  capital leases, and the level of net profits
  would be permanently increased.
• 4. Without analytical adjustments, the portion
  of ROE derived from operating activities (RNOA)
  appears higher, and the companys ROE is
  perceived of higher quality.

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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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Footnote Disclosures of Lessees
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Midwest Air Groups 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 Airs leases are
  operating because its footnote does not disclose
  any payments relating to capital leases.

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Capitalization of Operating Leases

• Failure to recognize lease assets and
  liabilities when they should be capitalized
  yields distortions in ROE disaggregation analysis
  (in Module 4) specifically
• Net operating asset turnover is overstated.
• Financial leverage is understated by the
  non-reporting of lease liabilities.
• Net operating profit (NOPAT) margin is
  overstated. This is because rent expense under
  operating leases equals depreciation plus
  interest expense under capital leases, but only
  depreciation expense is included in NOPAT
  (interest is a non-operating expense).
• Reported expense is higher in the early years of
  a capital lease relative to an operating lease,
  but is lower in later years of the lease. This
  means the net income effect depends on whether
  the leases are in the early or later years of the
  lease life. If we assume that leases are, on
  average, at their midlife, then the net income
  effect is negligible.

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Capitalizing Operating Leases for Analysis
Purposes

• Given the lease disclosures required under GAAP,
  it is a relatively simple process to capitalize
  these operating leases for analysis purposes. The
  capitalization process involves the following
  steps
• 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 companys 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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Determination of the discount rate

• There are two alternative means to determine the
  discount rate
• 1) If the company provides disclosures relating
  to capital leases, we can infer the discount rate
  as the rate that yields the present value
  computed by the company given the projected
  capital leases payment stream, or
• 2) Use the companys debt rating and recent
  borrowing rate for intermediate term secured
  obligations as disclosed in its long-term debt
  footnote.

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A Question

• If its so easy to reverse the operating lease and
  modify reported numbers, why does management
  bother?
• Or, to put it more bluntly, who cares?

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Capitalization of Midwest Air Operating Leases
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Capitalization of Midwest Air Operating Leases

• The capitalization of operating leases has a
  marked impact on Midwest Airs balance sheet.
• The net operating asset turnover is lower (net
  operating assets increase and revenues remain
  constant)
• Financial leverage (liabilities to equity) is
  higher than we would infer from reported
  financial statements. Financial leverage is also
  revealed to play a greater role in ROE.
• The adjusted assets and liabilities arguably
  present a more realistic picture of the invested
  capital required to operate and the amount of
  financial leverage represented by the leasing of
  assets.

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Pensions

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

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Defined Contribution Plans

• This plan has the company make periodic
  contributions to an employees 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 Plans

• This plan has the company make periodic payments
  to an employee after retirement. Payments are
  usually based on years of service and/or the
  employees 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. Any pension investments are
  retained by the company until paid to the
  employee. In the event of bankruptcy, employees
  have the standing of a general creditor, and may
  have additional protection in the form of
  government pension benefit insurance.

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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 companys 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
  companys 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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Financial Statement Effects of Defined Benefit
Plans
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Accounting for Defined Benefit Plans

• 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 companys
  obligation is reduced as benefits are paid to
  employees. This is no different than the payment
  of any other liability.

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The Balance of the Pension Liability (PBO)
Computation
             
             
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Computation of the Balance of the Pension
Investments
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Computation for Pension Expense Reported in the
Income Statement
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Sources of Financial Statement Effects of Defined
Benefit Plans
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Footnote Disclosures of Pensions
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Footnote Disclosures of Pensions
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Footnote Disclosures of Pensions
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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 argued to be a better
  indicator of the true cost of the pension.

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Unexpected Gains and Losses

• 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 unexpected gains and
  losses to impact profits, it decided to
  accumulate them off-balance sheet.

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OPEBs- Other Post-Employment Benefits

• Usually health care coverage.
• Reporting issues are just like Pensions except
  that
• There is not, necessarily, a legal liability as
  with pensions.
• Most companies provide little, if any, advance
  funding for OPEBs.
• As a result, for many firms, very big liabilities
  can show up on the balance sheet.

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• Pensions and OPEBs reflect a very new and
  different accounting that is becoming more and
  more prevalent- This is called Fair Value
  accounting.
• Fair value accounting requires many judgements
  and predictions of future performance.
• With judgement and prediction comes increased
  information risk.

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Variable Interest Entities (VIEs)

• 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 entitys balance sheet.

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A major question concerning VIEs

• Are they really a distinct economic entity or
  part of the originating firm?
• Part of the answer concerns
• Who is really in control?
• Who is really bearing the risk?

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Sears Asset Securitization
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The benefits of VIEs

• 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 sponsors
  operating performance ratios (return on assets,
  asset turnover, leverage, etc.) improve.

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Reporting of Consolidated VIEs

• 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.
• The effects of FIN 46 are far-reaching, and the
  pendulum has swung toward consolidation. Entities
  that were never intended to be VIEs are now
  caught up in the VIE sweep. These can include
  hedge funds, venture capital partnerships, joint
  ventures, general partnerships, limited
  partnerships, trusts and leases, and many others.
  Companies consolidating these VIEs will realize a
  marked increase in assets and related
  liabilities.

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Sears Consolidation of VIEs
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Derivatives

• These are financial instruments that are
  derivative in the sense that there value is
  driven by the price movement of another security.
  
• All derivatives, no matter how complex, are a
  combination of forwards, options and swaps.

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Derivatives

• The problem with derivatives is that they are off
  balance sheet until gains/losses are experienced.
  
• As a result, the reported assets and liabilities
  may not reflect the true economic risk of firm.
• Derivatives are often used to hedge, or reduce
  risk, but they can also be used for speculation,
  which increases risk.
• The difference depends on whether there is a
  counterbalancing position.