AC301: Off Balance Sheet Financing

1
AC301 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 PL 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 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 firms 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

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REASONS 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

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AC301 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

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Enron and SPVs
Source FT.com
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CONSEQUENCES 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 accounting
• Possible 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 covenants
• IS ACCOUNTING CAPABLE OF REPORTING ALL ASSETS,
  LIABS, INOCME AND EXPENSES?

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Some 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?

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Attempts to Control OBSF

• Numerous Attempts in the UK
• Technical Release 603 (1985)
• ED 42 (1988)
• ED 49 (1990)
• FRED 4 (1993)
• FRS 5 Reporting the Substance of Transactions
  (1994).

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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)

• 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

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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
  entitys transactions is reported in its
  financial statements. The commercial effect of
  the entitys transactions, and any resulting
  assets, liabilities, gains or losses, should be
  faithfully represented in its financial
  statements.

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FRS 5 Reporting 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 entitys 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.

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FRS 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.

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FRS 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.

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Examples of OBSF arrangements

• Quasi subsidiary
• This 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 companys
  reported indebtedness.

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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')

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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

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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 years 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.

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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 million
• There is effectively a loan with 1 million
  interest charge.
• Interest charge needs to be allocated
• Let x rate of interest
• 4(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)

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Sale and Repurchase of Stock (3)

• 000
• Principal 4,000 Interest _at_ 5.74 230 P
  L a/c ----- 4,230 Bal end YR
  1 Interest _at_ 5.74 243 P L
  a/c ----- 4,473 Bal end year
  2 Interest _at_ 5.74 257 P L
  a/c ----- 4,730 Bal end year
  3 Interest _at_ 5.74 270 P L
  a/c ----- 5,000 Bal end year
  4

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Sale and repurchase of stock (4)

• Essentially, the commercial substance is that
• In year 1 there was no sale and repurchase
• During 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

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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 -----gt Dealer -----gt 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 PL Account CR Purchases 12,500

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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 PL Account 12,500
• CR Purchase 12,000
• CR Interest Expense 500

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Factoring 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

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Window 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 assets
• Preference shares redeemable at option of
  shareholder