Week 8 Slides S06

7/29/2019 Week 8 Slides S06

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Module 9

Reporting andAnalyzing Off-BalanceSheet Financing


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Why is Off-Balance Sheet FinancingImportant?

In other words, why are firms sointerested in hiding debt?

If analysis reveals that debt is excessive,companies may face the prospect of areductions in bond ratings, resulting inhigher cost of debt.

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


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Window Dressing FinancialStatements: Examples # 1

A companys level of accounts receivable areperceived to be too high, thus indicatingpossible collection problems and a reduction inliquidity.

Prior to the statement date, the companyoffers customers an additional discount inorder to induce them to pay the accounts morequickly.

Although the profitability on the sale has beenreduced by the discount, the company reducesits accounts receivable, increases its reportedcash balance and presents a somewhathealthier financial picture to the financial

markets.


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Window Dressing FinancialStatements: Examples # 2

The companys financial leverage isdeemed excessive, resulting in lowerbond ratings and a consequent

increase in borrowing costs. To remedy the problem, the company

issues new common equity andutilizes the proceeds to reduce theindebtedness.

The increased equity provides a baseto support the issuance of new debt

to finance continued growth.


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Motives for using Off-Balance SheetFinancing

In general, companies desire to present abalance sheet with sufficient liquidity andless indebtedness.

The reasons for this are as follows: liquidityand the level of indebtedness are viewed astwo measures of solvency.

Companies that are more liquid and lesshighly financially leveraged are generallyviewed as less likely to go bankrupt.

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


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Off-Balance Sheet Financing

Off-balance sheet financing meansthat either liabilities are kept off ofthe face of the balance sheet.

In this module, we discuss leases andpensions.

Variable interest entities (called SPEs

in the past) were previouslydiscussed when we covered theequity method of accounting.


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Leasing

A lease is a contact between the owner ofan asset (the lessor) and the partydesiring to use that asset (the lessee).

Generally, leases provide for the followingterms:1. The lessor allows the lessee the unrestricted

right to use the asset during the lease term

2. The lessee agrees to make periodic payments to

the lessor and to maintain the asset3. Title to the asset remains with the lessor, who

usually retakes possession of the asset at theconclusion of the lease.


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Advantages to Leasing

1. Leases often require much less equityinvestment than bank financing.

2. Since leases are contracts betweentwo willing parties, their terms can bestructured in any way to meet theirrespective needs.

3. If properly structured, neither theleased asset not the lease liability arereported on the face of the balancesheet.


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Operating Lease

Operating lease method.Under this method, neither the

lease asset nor the lease liabilityis on the balance sheet. Leasepayments are recorded as rent

expense when paid.


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Benefits of Operating Leases

1. Leased asset is not reported on the balancesheet.

2. Lease liability is not reported on the balancesheet.

3. For the early years of the lease term, rentexpense reported for an operating lease isless than the depreciation and interestexpense reported for a capital lease.


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Capital vs. Operating Leases

Capital lease method. This methodrequires that both the lease asset andthe lease liability be reported on the

balance sheet. The leased asset isdepreciated like any other long-termasset. The lease liability is amortizedlike a note, where lease payments areseparated into interest expense andprincipal repayment.


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Operating Leases

The benefits of applying the operating methodfor 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 canstructure lease contracts to meet the letter ofthe standard to achieve a desired accountingresult when the essence of the transactionwould suggest a different result.

This is form over substance.


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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 acapital lease

PV of lease payments is the FMV of theasset

Period of the lease approximates the assetslife

There is a bargain purchase price


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Footnote Disclosures of Lessees


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Capitalizing Operating Leases forAnalysis Purposes

1. Determine the discount rate tocompute the present value of theoperating lease payments.

This can be inferred from the capital leasedisclosures, or one can use the companysdebt rating and recent borrowing rate forintermediate term secured obligations asdisclosed in its long-term debt footnote.

2. Compute the present value of theoperating lease payments.

3. Add the present value computed in

step 2 to both assets and liabilities.


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Capitalization of Midwest AirOperating Leases


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Pensions

There are generally two types of plans:

Defined contribution plan.This planhas the company make periodic contributions

to an employees account (usually with athird party trustee like a bank), and manyplans require an employee matchingcontribution. Following retirement theemployee makes periodic withdrawals fromthat account. A tax-advantaged 401(k)account is a typical example.


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Pensions

Defined benefit plan.This plan hasthe company make periodic payments to anemployee after retirement. Payments are

usually based on years of service and/orthe employees salary. The company mayor may not set aside sufficient funds tomake these payments. As a result, definedbenefit plans can be overfunded or

underfunded.


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Accounting for DefinedContribution Plans

From an accounting standpoint,defined contribution plans offer noparticular problems.

The contribution is recorded as anexpense in the income statementwhen paid or accrued.


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Accounting for Defined BenefitPlans

Defined benefit plans are moreproblematic due to the fact that thecompany retains the pensioninvestments and the pensionobligation is not satisfied until paid.

Account balances, income and

expenses, therefore, need to bereported in the companys financialstatements.


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Two Accounting Issues Related to PensionInvestments and Obligations: Problem # 1

The first of the two primary accountingissues relates to the appropriate balancesheet presentation of the pension

investments and obligation.

The pension standard allows companiesto report the netpension liability on their

balance sheet.


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Problem # 1 - Continued

That is, if the pension obligation is greater thanthe fair market value of the pensioninvestments, the underfunded amount isreported on the balance sheet as a long-term

liability. Conversely, if the pension investments exceed

the companys obligation, the overfundedamount is reported as a long-term asset.

The amount reported, however, is not whatyou or I would likely consider the true fundingstatus.


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Two Accounting Issues Related to PensionInvestments and Obligations: Problem # 2

The second issue facing the FASB was thetreatment of fluctuations in pensioninvestments 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).


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The Balance of the PensionLiability (PBO) Computation


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Accounting for Defined BenefitPlans

Service cost the increase in thepension obligation due to employeesworking another year for the employer.

Interest cost the increase in thepension obligation due to the accrual ofan additional year of interest.

Benefits paid to employees thecompanys obligation is reduced asbenefits are paid to employees.


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Computation of the Balance ofthe Pension Investments


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Computation for Pension ExpenseReported in the Income Statement


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Footnote Disclosures ofPensions


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ExpectedReturn on PensionInvestments

Notice that the computation of pensionexpense uses the expected return onpension investments, not the actual return.

The reason for this is that stock returns areexpected to revert to a long-term average ifcurrently abnormally high or low. Therefore,this expected return is a better indicator of

the true cost of the pension.

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Week 8 Slides S06