Issues in Liability Recognition

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Issues in Liability Recognition

• Lecture 7

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Topics

• Criteria for Liability Recognition
• Hybrid Securities
• Off-Balance Sheet Financing
• Leases

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Criteria for Liability Recognition

• We know what the criteria are
• Future sacrifice of resources at a specified date
• Little or no discretion to avoid the sacrifice
• The transaction giving rise to the obligation has
  already occurred
• Measurement?
• Monetary liabilities
• Cash value
• Present value of future cash payments using an
  interest rate at the time the liability is
  recorded
• Future delivery of service
• Estimated cost

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Criteria for Liability Recognition

• Six groups based on how well these criteria are
  satisfied
• Obligations with fixed payments and dates
• Obligations with fixed payments but estimated
  payment dates
• Obligations with estimated payment dates and
  amounts
• Obligations arising from advances from customers
  for work still to be performed
• Obligations arising from binding arrangements
  that are as yet unexecuted
• Do not result in recognition of a liability
• Contingent obligations
• Loss contingencies
• Liability arising out of a guarantee

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Issues in Liability Recognition

• Many firms are using innovative financing
  arrangements to reduce the liabilities recognized
  on the balance sheet
• To influence the perception of riskiness of the
  firm in order to reduce the cost of funds
• Future lenders may be willing to provide funds at
  a lower interest rate
• Structure an arrangement in such a way that it is
  not classified as debt
• Structure an arrangement in such a way that the
  arrangement fits the definition of an executory
  contract or a contingency

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Topics

• Criteria for Liability Recognition
• Hybrid Securities
• Off-Balance Sheet Financing
• Leases

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Hybrid Securities

• Securities that look like debt, but are
  classified as equity
• Preferred stock subject to mandatory redemption
• Preferred stock that can be called by the
  issuing firm
• Some securities look like equity, but are
  classified as debt
• Convertible bonds whose conversion to equity is
  highly probable
• To obtain tax deduction for the interest
  component
• Will impact capital structure and leverage ratios
• Analysts have to pay attention to the substance
  of these instruments to assess the riskiness in
  the capital structure
• Sensitivity analysis to alternate definition can
  be helpful

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Topics

• Criteria for Liability Recognition
• Hybrid Securities
• Off-Balance Sheet Financing
• Leases

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Off-Balance Sheet Financing

• Keeping debt off the balance sheet entirely, in
  order to lower the cost of money being raised
• Typically, footnote disclosures, but no balance
  sheet recognition
• There is an implicit assumption that investors,
  lenders and analysts do not pay as much attention
  to footnote disclosures as they do to information
  in the statements. This may well be true!
• If the market is efficient, how information is
  presented should not matter!
• Ahmed, Kilic, Lobo (2006) find that recognized
  derivative information is value relevant whereas
  disclosed derivative information is not value
  relevant

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Reasons for Off-Balance Sheet Financing

• Existing loan covenants prevent or restrict
  amount of additional debt that can be issued
• Credit ratings
• Increased borrowing costs
• Current values of many assets are far below their
  reported amounts (historical cost). This reduces
  the ability to carry liabilities

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Some Off-Balance Sheet Financing arrangements

• Sale of assets without recourse
• Selling the asset to the provider of funds
• Collecting cash, and recognizing gain or loss
• Providing any contingency cover for the lender
• Structuring the sale so that what arises is a
  contingent obligation and not an accounting
  liability
• Relegated to footnote disclosure

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The Nigerian Barge deal
In the Nigerian barge transaction, Skilling and
others agreed to a sham sale of an interest in
certain power-producing barges off the coast of
Nigeria to Merrill Lynch so that Enron could meet
its fourth quarter 1999 budget targets. In order
to induce Merrill Lynch to enter into the
transaction, Enron promised in an oral and
undisclosed handshake deal that Merrill Lynch
would receive a return of its investment plus an
agreed-upon profit within six months. As a
result, Merrill Lynchs equity investment was not
"at risk" and Enron should not have treated the
transaction as a sale from which it could record
earnings and cash flow. In June 2000, Enron
delivered on its "handshake" promise. Causey and
Fastow ensured that LJM repurchased the Nigerian
barges from Merrill Lynch at the agreed-upon
profit.
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The Cuiaba project
In another transaction the Cuiaba project
Skilling and others used LJM to move a poorly
performing asset temporarily off Enron's balance
sheet, when in fact such off-balance-sheet
treatment was improper. When no true third-party
buyer could be found, Skilling and others caused
Enron to "sell" a portion of Enrons interest in
the Cuiaba project to LJM for 11.3 million. LJM
agreed to "buy" this interest only because
Skilling, Causey, Fastow and others, in an
undisclosed side deal, agreed that Enron would
buy back the interest, if necessary, at a profit
to LJM. Based on this purported "sale," which was
in fact an asset parking or warehousing
arrangement, Enron improperly recognized
approximately 65 million in income in the third
and fourth quarters of 1999. In the spring of
2001, even though the project was approximately
200 million over budget, Skilling, Causey and
Fastow agreed that Enron would buy back LJMs
interest in the Cuiaba project at a considerable
profit to LJM. After agreeing to execute the
repurchase, Skilling, Causey, Fastow and others
delayed consummating the deal until Fastow sold
his interest in LJM so that Fastows role in the
transaction would not have to be publicly
disclosed.
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Sale of receivables

• Many firms (transferors) sell receivables to
  financing companies (transferees) to quickly
  collect cash instead of short-term borrowing
• The receivables sold must be isolated from the
  seller and its creditor
• The buying firm has the right to pledge or
  transfer the assets
• The transferor must surrender control completely
  (no recourse)
• There should be no agreement to repurchase or
  cover for uncollectible receivables

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Product financing arrangements

• Sales of inventories with buyback arrangements
• A method of financing inventory without reporting
  either the liability or the inventory on the
  balance sheet
• Risk of ownership is retained by the seller
• SFAS No. 49 curtails such arrangements.
• One way firms get around it is to set up an SPE
  which purchases inventory with no recourse, and
  then provide a purchase commitment to the SPE

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Project financing arrangements

• Suppose a company wants to add manufacturing
  capacity or wants to ensure uninterrupted supply
  of a critical input
• Options
• Raise the necessary finances (say, debt) and
  acquire the necessary assets. Both the assets and
  the debt will be on the balance sheet
• Project financing to keep assets and the debt off
  the balance sheet

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Project financing

• Set up a joint venture with other companies
  (e.g., with similar needs) with equity
  participation less than what is required for
  consolidation
• Enter into a purchase commitment
• The joint venture uses the purchase commitment to
  raise the necessary debt financing
• Take-or-pay contracts
• Throughput contracts
• The senior debt holders of the parent company
  have no recourse to the joint ventures assets in
  the event the parent company goes bankrupt
• So lenders to the joint venture have the first
  claim over the joint ventures assets so are
  more likely to provide attractive terms
• What is the obligation for the Parent company?
• The unconditional purchase obligation arising
  from the future commitment. SFAS 47 stipulates
  disclosure, not recognition

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RD Arrangements

• The primary objective is to obtain funds for RD
  without having to recognize a liability
• Set up a joint venture to do RD work in a way
  that no consolidation is required
• Avoid recognition of any liability and RD
  expenses
• RD limited partnerships

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RD Limited partnership
General Sponsor (GP)
Investors (LP)
Base technology
Tax benefits Royalties

License/purchase option
RD Contract
RD Limited Partnership
RD Contractor
Developed technology
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Topics

• Criteria for Liability Recognition
• Hybrid Securities
• Off-Balance Sheet Financing
• Leases

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Leases

• Why lease?
• Flexibility to increase or decrease capacity as
  needed
• A way to deal with obsolescence
• Ability to finance through the lessor
• Ability to shift tax benefits
• Another off-balance sheet financing tool if
  structured as operating lease for the lessee

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Operating lease

• Only the rights to use the asset for a specified
  period of time is transferred to the lessee
• At the end of the lease period, the asset reverts
  back to the lessor
• Lessee recognizes rent expense
• No accounting entry at the time of signing the
  lease even though there is future commitment
• The asset appears on the balance sheet of the
  lessor. Lessor recognizes rent revenue, and
  records depreciation expense both for accounting
  and for tax purposes
• So if a company is not able to avail of tax
  benefits of depreciation, sell the asset to
  another company which can, and lease to back as
  an operating lease for use

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Capital lease

• Conditions to be satisfied (SFAS 13). Any one of
  the following
• Lease term at least 75 percent of useful life
• A clause transferring ownership at the end of the
  lease term
• A bargain purchase option
• The present value of lease payment exceeds 90
  percent of value of the asset
• Easy to avoid criteria? The Delta Airlines
  example in the book

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Capital lease

• Effects on lessee
• A lease asset and a lease obligation appears on
  the balance sheet (PV of lease payments)
• Depreciation expense
• Interest expense
• Depreciation for tax purposes (if it qualifies as
  a capital lease for tax purposes)
• Criteria for tax purposes in page 543 of the text
• Because these criteria differ from the criteria
  for financial reporting, lessor and lessee can
  possibly treat the one way for tax purpose and
  another way for financial reporting
• Effects on lessor
• Upfront revenue recognition. Thus, a good way to
  accelerate revenue recognition
• Asset (e.g., inventory in the case of a product)
  replaced by a lease receivable
• Interest revenue with the passage of time.
• Global Crossing-Qwest Deal

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What should the analyst do?

• Understand the economic substance of a lease
  transaction
• For a lessee, convert the operating lease to a
  capital lease using footnote disclosures
• Use incremental borrowing rate of the company to
  compute PV of lease payments
• Convert the lease expense to interest expense and
  depreciation expense in the income statement
• Assess materiality
• Recompute balance sheet ratios (capital
  structure, asset turnover etc.)
• Generally, firms follow industry practice. So
  comparability is not typically an issue