Off-Balance Sheet Financing:
An Explosive Situation?
An Honors Thesis (ID 499)
by
Michael D. Carder
Thesis Director
/
Ball State University
Muncie, Indiana
February, 1986
Expected date of graduation:
-.
Spring, 1986
~1;~I:i~
! '"'-.
,-
~2~53
-<,
,L1
(c
.. c:r'
,..;
,,:;
, ,:,'1
'v-,'
TABLE OF CONTENTS
Introduction
•
•
•
•
1
The Reason for Off-Balance Sheet Financing.
•
•
•
1
l'1ethods of Off-Balance Sheet Financing.
•
•
•
•
2
•
•
•
•
•
Leases
•
•
•
•
•
•
•
•
Product Financing Arrangements
•
•
•
•
•
•
2
•
•
•
•
•
•
3
Accounts Receivable •
•
•
•
•
•
•
4
Advantages of Off-Balance Sheet Financing •
Disadvantages of Off-Balance Sheet Financing
•
•
•
5
•
•
•
6
Conflict with Accounting Objectives
•
•
•
•
•
7
Conclusion.
•
•
•
•
•
9
•
•
•
•
•
•
•
•
OFF-BALANCE SHEET FINANCING:
AN EXPLOSIVE SITUATION?
INTRODUCTION
The most explosive topic of corporate finance may well
be off-balance sheet financing.
While the amount of off-
balance sheet obligations owed by U.S. corporations is impossible to determine, the use of such techniques is extensive.
Tens of billions of dollars in obligations for every-
thing from plants and buildings to oil refineries and airplanes are believed to be unreported as liabilities. 1 Over
the last several years the accounting profession has issued
many pronouncements in an attempt to end off-balance sheet
financing.
Such attempts as FASB Statement No. 13, however,
have been circumvented by the "creative financiers" who have
managed to find the loopholes in the standards.
The purpose
of this paper is to examine some of the effects, both good
and bad, of off-balance sheet financing on financial reporting.
THE REASON FOR
OFF~BALANCE
SHEET FINANCING
The primary reason for using off-balance sheet financing techniques is to keep as much debt as possible off of
the company's balance sheet. 2 When it is recognized that
the financial statements will be used by several parties--
-
among them bankers, investors, rating agencies, and the
SEC--it is understandable that there is much pressure to
2
keep liabilities to a minimum.
By using off-balance sheet
financing to conceal obligations, companies believe that
they can improve the appearance of their financial condition,
which, in turn, will encourage investors and lead to higher
credit ratings than the company could attain if all liabilities were reported.
This belief is confirmed by a study
conducted by Professor Rashad Abdel-khalik which indicated
that a substantial number of bankers and analysts believe,
incorrectly, that a company with off-balance sheet debt is
more profitable than a company with the same debt on the
balance sheet. 3
As long as companies have such profitable
reasons to keep liabilities off the balance sheet they will
continue to use a variety of off-balance sheet financing
methods.
METHODS OF OFF-BALANCE SHEET FINANCING
Leases
Among the off-balance sheet financing instruments,
leasing is perhaps the most popular.
Due to the attractive-
ness of leasing as a means of financing the cost of assets
used in business, the number of leases has increased steadily
over the past twenty years. 4
the lessee.
Leases offer many benefits to
Leases protect the lessee against obsolescence,
reduce the costs of maintenance, offer tax benefits and keep
what is, in fact, debt off the lessee's balance sheet.
In
an attempt to force lessees to capitalize their leases the
Financial Accounting Standards Board (FASB) promulgated
3
Statement of Financial Accounting Standards No. 13, "Accounting for Leases", which has been only partially successful in achieving its overall purpose.
As Statement No. 13 states, "a lease that transfers
substantially all the benefits and risks incident to the
ownership of property should be accounted for as the acquisition of an asset and an incurrence of an obligation by
the lessee ••• ".5
For a short period of time the criteria
of Statement No. 13 did bring a halt to leasing as a means
of off-balance sheet financing.
Unfortunately, financial
advisors for companies whose debt/equity ratios suffered
from capitalization soon found loopholes in Statement No.
13. 6
Giant lessors, particularly banks, used their comput-
ers to keep payments under 90 per cent of the fair market
value of the leased assets and arranged shorter lease terms
which were less than 75 per cent of the life of the assets
so that their retailing tenants would not have to capitalize. 7 The expenses involved with this procedure are often
high and result in higher rents.
The stockholder, there-
fore, pays for the privilege of being deceived.
Product Financing Arrangements
Product financing arrangements provide companies with
another method of off-balance sheet financing:
repurchase arrangement.
the product
Under such an arrangement a company
sells its product to a third party and agrees to buy the
product back.
The third party then uses the sales and buy-
back agreement as collateral and borrows money to carry the
4
inventory. 8
Thus, without recording an obligation to buy
the product back, the sponsor increases both its cash and
sales.
Since the sponsor in product financing arrangements
retains the risks and rewards of ownership, the FASB believes
that the economic substance of such an arrangement creates
a borrowing transaction rather than a sale.
In an effort to force sponsors to record such arrangements as liabilities, the FASB promulgated Statement of Financial Accounting Standards No. 49, "Accounting for Product
Financing Arrangements".
Under this statement, sponsors are
required to record the original purchase price or product
cost of the product as a liability.
In addition, the finance
and carrying costs of the arrangement are to be accrued as
expenses by the sponsoring company when
behalf. 9
incu~red
on its
While Statement No. 49 covers simple repurchase
arrangements, it is not all-inclusive.
The pressures placed
on companies to keep liabilities off the balance sheet are
strong and innovative financiers are constantly looking for
ways around the rules.
Accounts Receivable
Accounts receivable historically have been a popular
method of off-balance sheet financing.
One reason for this
popularity stems from the fact that receivables can be used
as financing tools in a variety of ways.
One such technique
employs an unconsolidated finance subsidiary which borrows
money from a bank (usually guaranteed by the parent company).
The subsidiary then buys receivables from the parent.
As a
5
result, the parent has cash, the subsidiary has the shifted
receivables and no debt is shown on the parentis books. 10
Receivables can also be a financing tool without a finance
subsidiary.
By selling accounts receivable without recourse,
but at a discount--a provision against bad debts--a company
can obtain cash without recording a liability.11
While at
first glance this appears to be no more than a sale, the
company actually obtains a large sum of cash which it pays
back in installments as customers pay their accounts.
If
that is not debt, what is?
ADVANTAGES OF OFF-BALANCE SHEET FINANCING
Off-balance sheet financing offers many advantages to
companies that use such techniques.
One advantage results
from the fact that off-balance sheet financing improves the
appearance of a company's financial statements and financial
ratios.
By keeping liabilities off the financial statements,
a company is more likely to obtain loans from financial
institutions than it could if all of the company's off-balance sheet obligations were reported.
This is due to the
fact that financial institutions have increased their attention to the financial strength ratios and liquidity indica- .
tors in their borrower's balance sheets and seem to believe
that a company with off-balance sheet debt is more profitable than a company with the same debt on the balance sheet. 12
The advantage of off-balance sheet financing can be
illustrated by the Metromedia case.
In 1982, Metromedia,
6
Inc. engaged in a product financing arrangement through
which it received a 570 million note and 5415 million in
cash.
Net result:
Metromedia was able to obtain $485
million which it most probably could not have obtained from
a financial institution. 13
Through such techniques, companies are often able to
arrange interest costs below the market rate.
Another
advantage of off-balance sheet financing results from a
company's ability to obtain an asset, a truck for instance,
with no down payment, thereby gaining the ability to finance
100 per cent.
With such advantages, one need not wonder why
even large companies like General Motors and American Airlines, who once frowned upon off-balance sheet financing,
now consider every new technique developed. 14
DISADVANTAGES OF OFF-BALANCE SHEET FINANCING
Although there are significant advantages to off-balance sheet financing, companies engaging in such techniques
also must accept a few disadvantages.
While it has been
shown that many investors disregard leases and other offbalance sheet methods of financing, some investors attempt
to capitalize off-balance sheet obligations using the factor
method.
Unfortunately, due to the fact that FASB Statement
No. 13 does not require lessees to report the present value
of their off-balance sheet leases, investors often overestimate the debt equivalent amount of such-leases.
AS.a
result, investors may be led to believe that a company is
7
more highly leveraged and less attractive than it actually
is. 15 Further, since such significant agencies as Moody's
and Standard & Poor's capitalize leases using the factor
method, a company's credit rating could potentially be
harmed by using off-balance sheet financing.
Although the firm faces risks by using off-balance
sheet reporting, perhaps the investors who rely on the published financial data incur the greater disadvantage.
By
assuming that the annual report. of a company includes all
of the company's obligations, investors are often misled into
overestimating the financial condition of the company.
This
mistake may lead investors to make investment errors which
they would avoid if they are provided with complete financial
information.
This aspect of off-balance sheet financing
highlights the fact that the use of such techniques contradicts some of the basic concepts of accounting.
CONFLICT WITH ACCOUNTING OBJECTIVES
The purpose of off-balance sheet financing is to conceal liabilities from the users of financial statements in
order to create an image of a healthier company than actually exists.
This purpose conflicts With the basic object-
ives of financial reporting as stated in Statement of Financial Accounting Concepts No.1, "Objectives of Financial
Reporting by Business Enterprises".
-
According to this state-
ment, the objective of financial reporting is to provide
information that is useful to present and potential investors,
8
creditors and other users in making rational investment,
credit and similar decisions.
The statement declares that
financial statements should provide information about the
economic resources of a business and the claims to those
resources (obligations of the business to transfer resources
to others).16
By concealing liabilities from the users of
financial statements, off-balance sheet financiers are disregarding the objectives of financial reporting and misleading investors and creditors who depend upon reliable
data.
This fact also places off-balance sheet financing in
conflict with the qualitative accounting characteristic of
reliability.
Reliability and relevance are the two primary qualities
that make accounting information useful for decision making.
Reliability rests on the faithfulness with which it represents what it proports to represent, along with an assurance for the user that it is complete and neutral. Completeness states that all material items which are necessary to validify that the information represents the supporting events are to be included. 17 Relevance is also dependent upon the completeness of information.
For instance, if
important pieces of information are not included in a financial statement, the relevance of the entire statement must
be questioned.
Completeness, therefore, is a crucial ele-
ment of both relevance and reliability, the two primary
qualities of accounting information.
9
When companies use off-balance sheet financing, they
are supplying incomplete information to the users.
Such
information can neither be considered reliable or relevant.
Thus, the accounting information of companies using offbalance sheet financing lacks the primary qualities of useful financial information.
CONCLUSION
Through the use of off-balance sheet financing, companies are able to improve the appearance of their financial
statements, achieve higher credit ratings and finance assets
100 per cent.
As long as off-balance sheet financing offers
such profitable advantages, the use of these techniques will
remain widespread.
Unfortunately, the users of these finan-
cial statements, who depend upon reliable accounting information, will continue to be misled and make investment
decisions based upon incorrect information.
Such flawed
investments could cost investors and creditors a great deal
of money.
As a result, investors and other users of finan-
cial statements, may lose confidence in financial accounting
statements.
The Financial Accounting Standards Board is obviously
aware of the dangers posed by off-balance sheet financing
and has promulgated several statements which have restricted
the use of such techniques.
-
Unfortunately these statements
neither protect investors from concealed obligations or
achieve the objectives of financial reporting.
To achieve
10
these objectives this writer believes that companies should
be required to capitalize all off-balance sheet obligations.
This solution would restore user confidence in financial
statements and meet the objectives of financial reporting.
-
ENDNOTES
1. Hershman, Arlene, "New Game in Off-Balance Sheet Financing," Dun's Business Month, v. 119, February, 1982, p. 56.
2.
Ibid.
3. Greene, Richard, "How to Owe Money Without Seeming to,"
Forbes, v. 125, May 26, 1980, p. 55.
4.
Hershman, p. 56.
5. Financial Accounting Standards Board, statement of
Financial Accounting Standards No. 13, "Accounting for
Leases," Stamford, Connecticut: FASB, 1976.
6. Anonymous, "The FASB's Rule 13: Enough Loopholes for
Everybody," Dun's Review, v. 114, November, 1979, p. 87.
7.
Greene, p. 56.
8. Taper, Eugene G., "Leases and Off-Balance Sheet Financing," in Handbook of Accounting and Auditing, Boston: 1981,
p. 27.
9. Financial Accounting Standards Board, Statement of
Financial Accounting Standards No. 49, "Accounting for
Product Financing Arrangements," Stamford, Connecticut:
FASB, 1981.
10.
Taper, p. 28.
11.
Greene, p. 56.
12.
Hershman, p. 56.
13. Briloff, Abraham J., "More on Metromedia," Barron's,
August 8, 1983, pp. 32.
14. Hershman, Arlene, Lynn Adkins and G. Bruce Knecht, "The
Creative New Look in Corporate Finance," Dun's Review,
v. 118, July, 1981, p. 18.
15. Fioriti, Andrew A. and Stephen I. Wellborn, "Accounting
for Specialized Product Sales," Virginia Accountant, v. 34,
September, 1982, pp. 13-14.
-
16. Financial Accounting Standards Board, Statement of
Financial Accounting Concepts No.1, "Objectives of Financial Reporting by Business Enterprises," Stamford, Connecticut: FASB, 1978.
17.
Financial Accounting Standards Board, Statement of
Finan~ial Accounting Concepts No.2, "Qualitative Characteristics of Accounting Information," Stamford, Connecticut:
FASB, 1980.
-
BIBLIOGRAPHY
Anonymous, "To Capitalize or Not to Capitalize, That is the
Question," Forbes, v. 115, January 15, 1975, pp. 42-43.
Anonymous, "The FASB's Rule 13: Enough Loopholes for Everybody," Dun's Review, v. 114, November, 1979, p. 87.
Ashton, R. K., "Accounting for Finance Leases: A Field
Test," Accounting and Business Research, Summer, 1985,
Pp. 233-238.
Baker, C. Richard and Rick Hayes, Lease Financing:
tical Guide, New York: 1981.
A Prac-
Bierman, Harold Jr., The Lease Versus Buy Decision, Englewood Cliffs: 1982.
Bohan, Michael P., "Balance Sheet Financing--On and Off,"
Journal of Accounting, Auditing, & Finance, v. 4,
Summer, 1981, PP. 360-364.
Bowman, Robert G., "The Debt Equivalence of Leases: An
Empirical Investigation," The Accounting Rev~ew, v. 55,
April, 1980, pp. 237-253.
Briloff, Abraham J., "More on Metromedia," Barron's, August
8, 1983, pP. 32-34.
Burstein, Emanuel S., "Distinguishing True Leases from Conditional Sales and Financing Arrangements," Taxes, v. 63,
June, 1985, pp. 395-412.
Cohen, Albert H., Long Term Leases: Problems of Taxation,
Finance and Accounting, Ann Arbor: 1954.
Elam, Rick, "The Effect of Lease Data on the Predictive
Ability of Financial Ratios,1t The Accounting Review,
v. 50, January, 1975, pp. 25-43.
Financial Accounting Standards Board, Statement of Financial
Accounting Concepts No.1, "Objectives of Financial
Reporting by Business Enterprises," Stamford, Connecticut: FASB, 1978.
Financial Accounting Standards Board, Statement of ~nancial
Accounting Concepts No.2, "Qualitative Characteristics
of Accounting Information," Stamford, Connecticut:
FASB, 1980.
Financial Accounting Standards Board, Statement of Financial
Accounting Concepts No.3, "Elements of Financial Statements of Business Enterprises," Stamford, Connecticut:
FASB, 1980.
-
Financial Accounting Standards Board, Statement of Financial
Accounting Concepts No.5, "Recognition and Measurement
in Financial Statements of Business Enterprises," Stamford, Connecticut: FASB, 1984.
Financial Accounting Standards Board, statement of Financial
Accounting Standards No. 13, "Accounting for Leases,"
Stamford, Connecticut: FASB, 1976.
Financial Accounting Standards Board, statement of Financial
Accounting Standards No. 47, "Disclosure of Long-Term
Obligations," Stamford, Connecticut: FASB, 1981.
Financial Accounting Standards Board, Statement of Financial
Accounting Standards No. 49, "Accounting for Product
Financing Arrangements," Stamford, Connecticut: FASB,
1981.
Fioriti, Andrew A. and Stephen I. Wellborn, "Accounting for
Specialized Product Sales," Virginia Accountant, v. 34,
September, 1982, pp. 13-14.
Gant, Donald R., "Illusion in Lease Financing," Harvard
Business Review, v. 37, November-December, 1959, pp.
121-142.
Goodman, Hortense and Leonard Lorensen, Illustrations of
Accounting for Leases, New York: 1978.
Greene, Richard, "How to Owe Money Without Seeming to,"
Forbes, v. 125, May 26, 1980, pp. 56-57.
Hannon, John M., "Lease Accounting: A Current Controversy,"
Management Accounting, v. 58, September, 1976, pp. 25~
28.
Hershman, Arlene, Lynn Adkins and G. Bruce Knecht, "The
Creati-ve New Look in Corporate Finance," Dun's Review,
v. 118, July, 1981, pp. 18-30,32.
Hershman, Arlene, "New Game in Off-Balance Sheet Financing,"
Dun's Business Month, v. 119, February, 1982, pp. 56-
57, 60.
Houlihan, William A. and Ashwinpaul C. Sondhi, "DeFacto
capitalization of Operating Leases: The Effect on
Debt Capacity," Corporate Accounting, v. 2, SUmmer,
1984,
-
PP.
3-13.
Ingberman, Monroe, Joshua Ronen and George H. Sorter, " How
Lease Capitalization Under FASB Statement No. 13 Will
Affect Financial Ratios," Financial Analysts Journal,
v. 35 , January-February, 1979, -1>P. 28-31.
-
Kalata, John, Dennis Campbell and Ian Shumaker, uLease Financing Reporting," Financial Executive, v. 45, March,
1977, pp. 34-40.
Malandro, Rudolph, Financial Reporting of Long-Term Leases,
Kent, Ohio: 1965.
Myers, John H., Re~orting of Leases in Financial Statements,
New York: 19 2.
Nordgren, Roger K., "Lease Accounting and Financial Statements," The Journal of Commercial Bank Lending, v. 61,
December 1978, pp. 12-22.
Taper, Eugene G., "Leases and Off-Balance Sheet Financing,"
in Handbook of Accounting and Auditing~ Boston: 1981,
pp. 23-1-23-33.
Towles, Martin F., "Leases and the Relevant APB Opinions,"
Management Accounting, v. 55, May, 1974, pp. 37-41.