1

AC301: Off Balance Sheet FinancingAC301: Off Balance Sheet Financing

Off-Balance Sheet Financing (OBSF): Schemes by which companies secure economic resources

(assets) and then avoid reporting liabilities in balance sheets and/or income/expense in P&L and/or related disclosures

May be financing through debt, equity, leases, complex financial instruments, revolving contacts, joint ventures, Special Purpose Vehicles.

Major companies have OBSF Common Types of OBSF Executory contracts e.g. payments at a future date for future

benefits. Contract entered now (e.g. Leases). Both parties have obligations

Contingent Liabilities: Obligations subject to a specified set of conditions

2

Off Balance Sheet Financing TerminologyOff Balance Sheet Financing Terminology

Some try to distinguish Off balance sheet finance from Window Dressing :

Off-balance sheet finance– Often part of the normal financing activities of a firm

and can be quite innocent. The result is that a part of the firm’s borrowings will not appear on the balance sheet

Window dressing– Not so innocent; usually a firm is deliberately trying to

give a favourable (but misleading) impression of its performance

In practice the distinction is lost and confused

3

REASONS FOR OBSFREASONS FOR OBSF:: Influence of the “Rules Avoidance” Industry

– Banks, Accountancy firms, Financial Services Avoid violating debt covenants Financial Engineering valued in the drive to extract shareholder

value Need to appease stock markets Link between executive rewards and accounting numbers Innovations in Financial Markets Capitalism finds new ways of raising finance Narrowness of Accounting thought Lack of consensus about what should be accounted, how and why No coherent Conceptual Framework of Accounting

4

AC301: Off Balance Sheet FinancingAC301: Off Balance Sheet Financing

Use of Special Purpose Vehicles (SPVs) Control of joint ventures and projects Used for Securitisation: Structured financing in which a pool of

financial assets (such as car finance loans, home or commercial mortgages, corporate loans, royalties, leases, non-performing receivables, and contractually pledged operating revenues) is transferred to a SPV that then issues debt, which is backed solely by the assets transferred and payments derived from those assets.

Used to relocate risky assets (e.g. aircraft, foreign investment) SPVs used for complex hedging transactions Accelerate revenue recognition

5

Enron and SPVsEnron and SPVs

Source: FT.com

6

CONSEQUENCES OF OBSFCONSEQUENCES OF OBSF

PROBLEMS Opaque Financial Statements:

– Hidden debt and assets; Losses not reported; Gearing nor reported; Future obligations not reported

Key financial ratios misreported Loss in predictive value of financial statements Loss of public confidence in accountingPossible Benefits Liabilities not reported – might secure lower cost of capital.

Assumes creditors and markets fooled by not reporting. Companies can raise finance without violating debt covenantsIS ACCOUNTING CAPABLE OF REPORTING ALL

ASSETS, LIABS, INOCME AND EXPENSES?

7

Some Approaches to Tackling OBSFSome Approaches to Tackling OBSF Redefine Subsidiaries and Control (e.g. Companies Act 1989) Use concept of Substance over Form i.e. focus on economic

substance rather than the strict legal interpretation of a transaction Tighter definition of assets and liabilities (e.g. FRS 5) More Accounting Standards (e.g. FRS4, FRS 5, SSAP 21) Seek more disclosures (e.g. US Sarbanes-Oxley Act 2002) -

Appeals to EMH Enforce Accounting Standards – e.g. through the Financial

Reporting Review Panel (FRRP). Can it be done internationally? Can the rules avoidance industry be shackled? Generate case law type of precedents Improved conceptual framework for financial reporting Encourage ethical corporate behaviour: How?

8

Attempts to Control OBSFAttempts to Control OBSF

Numerous Attempts in the UKTechnical Release 603 (1985)ED 42 (1988)ED 49 (1990)FRED 4 (1993)FRS 5: “Reporting the Substance of Transactions”

(1994).

9

ED 42 (1988)ED 42 (1988)

ED 42 adopted the innocuous (and rather uninformative) title ‘Accounting for special purpose transactions’

But ED 42 was criticized because it did not give specific guidance - it only gave general guidance. The Standard-Setters felt that it was ‘impractical to provide detailed rules to cope comprehensively with every development in a sophisticated and fast changing area of business’.

10

ED 49 (1990)ED 49 (1990)

Note the title ‘Reflecting the substance of transactions in assets and liabilities’

This reflects the notion of ‘substance over form’‘Substance over form’ essentially means that it is

more important to report in financial statements the economic substance rather than the legal form

11

FRED 4 (1993) and FRS 5 (1994)FRED 4 (1993) and FRS 5 (1994)

FRED 4 was quickly followed by FRS 5 which is the current standard

Note that FRS 5 continues to emphasise the importance of ‘SUBSTANCE OVER FORM’

FRS 5 (1994)Objective of FRS 5 (Para. 1): ‘The objective of this FRS

is to ensure that the substance of an entity’s transactions is reported in its financial statements. The commercial effect of the entity’s transactions, and any resulting assets, liabilities, gains or losses, should be faithfully represented in its financial statements’.

12

FRS 5: FRS 5: Reporting the Substance of TransactionsReporting the Substance of Transactions

DEFINITIONS Assets (para. 2): ‘Rights or other access to future economic benefits

controlled by an entity as a result of past transactions or events’. Control in the context of an asset (para. 3): ‘The ability to obtain the future economic benefits relating to an

asset and restrict the access of others to those benefits’. Liabilities (para. 4): ‘An entity’s obligations to transfer economic

benefits as a result of past transactions or events’. Risk (para. 5): ‘Uncertainty as to the amount of benefits. The term includes both

potential for gain and exposure to loss’.

13

FRS 5 DEFINITIONSFRS 5 DEFINITIONS

Recognition (para. 6): ‘The process of incorporating an item into the

primary financial statements under the appropriate heading. It involves depiction of the item in words and by a monetary amount and inclusion of that amount in the statement totals’.

14

FRS 5 DEFINITIONSFRS 5 DEFINITIONS

Quasi subsidiary (para. 7): ‘A quasi subsidiary of a reporting entity is a company, trust, partnership or other vehicle that, though not fulfilling the definition of a subsidiary, is directly or indirectly controlled by the reporting entity and gives rise to benefits for that entity that are in substance no different from those that would arise were the vehicle a subsidiary’.

Control of another entity (para. 8): ‘The ability to direct the financial and operating policies of that entity with a view to gaining economic benefits from its activities’.

15

Examples of OBSF arrangementsExamples of OBSF arrangements

Quasi subsidiaryThis was a technique used prior to the 1989

Companies Act. These types of entity have also been referred to as ‘non-subsidiary dependent companies’ or ‘non-subsidiary subsidiaries’.

They were mainly used to reduce a company’s reported indebtedness.

16

Quasi Subsidiary Example (1)Quasi Subsidiary Example (1)

See Example in the course booklet Company A attempts to reduce its reported debt. Company B is jointly owned and controlled by Company

A and an Intermediate Company I and is not a subsidiary of either. Company C is jointly owned and controlled by Company A and Company B. If voting rights are equally shared then Company C is not a subsidiary.

Assume that the following transactions take place; 1. C raises a loan of £10m from a bank. 2. C uses the cash to buy assets from A. 3. A uses the cash to pay off existing loans. 4. The result is that for A, gearing has reduced (i.e.

'improved')

17

Quasi Subsidiary Example (2)Quasi Subsidiary Example (2)

Note that A can still have the use of the assets it 'sold' to C if C leases the assets back to A. In order to avoid the assets being reinstated on the balance sheet of A, the lease would have to be set up as an operating lease

A summary of the above transactions is as follows:

C loans +£10m assets +£10m cash - no change

A loans -£10m assets -£10m cash - no change

18

Sale and repurchase of stock (1)Sale and repurchase of stock (1)

EXAMPLE Distiller 'sells' whisky to a finance house for £4m with an

agreement to repurchase it for £5 m in 4 year’s time. Note that in the sale and repurchase of stock, the distiller does not actually have to physically move the whisky to the finance house.Similarly, when the distiller ‘buys back’ the whisky, it does not need to transport it back to its distillery (because it never left in the first place).

Immediate effect: cash increases by £4m; stock reduces by £4m 4 years later the distiller 'buys back' the same whisky for £5m

Effect: cash reduces by £5m; stock increases by £5m Soon after the whisky is sold by the distiller for £7m Effect: cash increases by £7m; stock reduces by £5m.

19

Sale and repurchase of stock (2)Sale and repurchase of stock (2)

The 'Substance' is that the distiller has received a loan of £4m repayable 4 years later:

Principal £4 million Interest £1 million

£5 millionThere is effectively a loan with £1 million interest charge. Interest charge needs to be allocated

Let x = rate of interest4(1 + x)4 = 5 (1 + x)4 = 1.25 1 + x = (1.25)1/4 x = (1.25)1/4 - 1

x = 5.74% (approx)

20

Sale and Repurchase of Stock (3)Sale and Repurchase of Stock (3)

£000 Principal 4,000

Interest @ 5.74% 230 P & L a/c-----4,230 Bal end YR 1

Interest @ 5.74% 243 P & L a/c-----4,473 Bal end year 2

Interest @ 5.74% 257 P & L a/c-----4,730 Bal end year 3

Interest @ 5.74% 270 P & L a/c-----5,000 Bal end year 4=====

21

Sale and repurchase of stock (4)Sale and repurchase of stock (4)

Essentially, the commercial substance is that:In year 1 there was no sale and repurchaseDuring the first four years, the distillery rolled up

interest on a loan which it then repaid to the finance house

At the end of four years the distillery actually sold the whisky at which time it could recognize the sale and profit on sale

22

Consignment stock (1)Consignment stock (1)

Car distributor receives stock 'on consignment' from manufacturer. Vehicle is regarded as purchased from manufacturer only when sold on to the third party.

Manufacturer -----> Dealer -----> Customer Assumptions:

1. Vehicle is delivered to dealer on 1 January, and vehicle is later sold to a customer on 31 March.

2. 'Normal' arrangement would be for the dealer to pay £12,000 to the manufacturer on 1 January.

3. 'On consignment' arrangement would be for the dealer to pay £12,500 to the manufacturer on 31 March.

LEGAL FORM: At 31 March: DR Purchases; CR Cash £12,500

At 31 March: DR P&L Account; CR Purchases £12,500

23

Consignment stock (2)Consignment stock (2)

Substance over Form Distributor borrowed £12,000 from the manufacturer and repays

£12,000. £500 is interest. Interest rate is 16.7% per annum. At 31 Jan DR Purchases; CR Loan £12,000 At 31 March the loan is cleared: DR Loan; CR Cash £12,000 At 31 March – loan interest of £500 is also paid: DR Interest

Expense; CR Cash £500 At 31 March if financial statements are being prepared

DR P&L Account £12,500

CR Purchase £12,000

CR Interest Expense £ 500

24

Factoring of debtsFactoring of debts

Factoring of debts is a legitimate business activity undertaken by firms who sell goods or services on credit, but need the cash more quickly than the credit agreement specifies.

Factoring generally involves raising funds against the security of a company's trade debts, so that cash is received earlier than if the company waited for its credit customers to pay.

There is implicit borrowing and interest payment in the deal

Company Factor

Debtors Cash

25

Window dressingWindow dressing

Reduces transparency of financial reports.Clearly not a desirable form of accounting,

usually because there is no/little real underlying economic activity taking place

Circular transactions which have little economic substance

‘Overnight’ sale and repurchase of assetsPreference shares redeemable at option of

shareholder ****************