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 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
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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 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 2
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
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Source: [Link]
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’.
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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 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’.
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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 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’.
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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
company’s 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 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.
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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 @ 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
=====
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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 -----> 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
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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 P&L 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
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