Module 9
Reporting and Analyzing
Off-Balance Sheet
Financing
Why is Off-Balance Sheet Financing
Important?

In other words, why are firms so interested
in “hiding” debt?
If analysis reveals that debt is excessive,
companies may face the prospect of a
reductions in bond ratings, resulting in higher
cost of debt.
 Likewise, excessive leverage can result in a
higher cost of equity capital and a consequent
reduction in stock price.

“Window Dressing” Financial
Statements: Examples #1
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A company is concerned that its liquidity may not be
perceived as sufficient.
Prior to the end of its financial reporting period it takes
out a short-term loan from its bank in order to increase
its reported cash balance. The same result can also be
obtained by delaying payment of accounts payable.
In both cases, the company’s cash and current assets
have been increased.
Even though current liabilities are also higher, the
liquidity of the balance sheet has been improved and
the company appears somewhat stronger from a
liquidity point of view.
“Window Dressing” Financial
Statements: Examples # 2
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A company’s level of accounts receivable are perceived
to be too high, thus indicating possible collection
problems and a reduction in liquidity.
Prior to the statement date, the company offers
customers an additional discount in order to induce
them to pay the accounts more quickly.
Although the profitability on the sale has been reduced
by the discount, the company reduces its accounts
receivable, increases its reported cash balance and
presents a somewhat healthier financial picture to the
financial markets.
“Window Dressing” Financial
Statements: Examples # 3
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A company may face the maturity of a long-term
liability, such as the scheduled maturity of a bond.
The amounts coming due will be reported as a current
liability (current maturities of long-term debt), thus
reducing the net working capital of the company.
Prior to the end of its accounting period, the company
renegotiates the debt to extend the maturity date of the
payment or refinances the indebtedness with longerterm debt.
The indebtedness is, thus, reported as a long-term
liability and net working capital has been increased.
“Window Dressing” Financial
Statements: Examples # 4
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The company’s financial leverage is deemed
excessive, resulting in lower bond ratings and a
consequent increase in borrowing costs.
To remedy the problem, the company issues
new common equity and utilizes the proceeds to
reduce the indebtedness.
The increased equity provides a base to support
the issuance of new debt to finance continued
growth.
Motives for using Off-Balance Sheet
Financing
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In general, companies desire to present a balance sheet
with sufficient liquidity and less indebtedness.
The reasons for this are as follows: liquidity and the
level of indebtedness are viewed as two measures of
solvency.
Companies that are more liquid and less highly
financially leveraged are generally viewed as less likely
to go bankrupt.
As a result, the risk of default on their bonds is less,
resulting in a higher rating on the bonds and a lower
interest rate.
Off-Balance Sheet Financing

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Off-balance sheet financing means that either
liabilities are kept off of the face of the balance
sheet.
In this module, we discuss leases, pensions,
variable interest entities (called SPEs in the
past), and derivatives .
Leasing

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A lease is a contact between the owner of an asset
(the lessor) and the party desiring to use that asset
(the lessee).
Generally, leases provide for the following terms:
1.
2.
3.
The lessor allows the lessee the unrestricted right to use the
asset during the lease term
The lessee agrees to make periodic payments to the lessor
and to maintain the asset
Title to the asset remains with the lessor, who usually
retakes possession of the asset at the conclusion of the
lease.
Advantages to Leasing
1.
Leases often require much less equity investment than bank
financing. That is, banks may only lend a portion of the
asset’s cost and require the borrower to make up the
difference form its available cash. Leases, on the other
hand, usually only require that the first lease payment be
made at the inception of the lease.
2.
Since leases are contracts between two willing parties, their
terms can be structured in any way to meet their respective
needs.
3.
If properly structured, neither the leased asset not the lease
liability are reported on the face of the balance sheet.
Capital vs. Operating Leases

Capital lease method. This method
requires that both the lease asset and the
lease liability be reported on the balance
sheet. The leased asset is depreciated like
any other long-term asset. The lease
liability is amortized like a note, where
lease payments are separated into interest
expense and principal repayment.
Operating Lease

Operating lease method. Under this
method, neither the lease asset nor the
lease liability is on the balance sheet. Lease
payments are recorded as rent expense
when paid.
Benefits of Operating Leases
1.
Leased asset is not reported on the balance sheet.
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2.
Lease liability is not reported on the balance
sheet.
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3.
This means that net operating asset turnover is higher
because reported assets are lower and revenues are
unaffected.
This means that the usual balance sheet related measures of
leverage are improved.
For the early years of the lease term, rent expense
reported for an operating lease is less than the
depreciation and interest expense reported for a
capital lease.
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This means that net income is higher for those years with an
operating lease.
Operating Leases
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The benefits of applying the operating method for
leases are obvious to managers, leading many managers
to avoid lease capitalization if possible.
The lease accounting standard, unfortunately, is
structured around rigid requirements. Whenever the
outcome is rigidly defined, clever managers that are soinclined can structure lease contracts to meet the letter
of the standard to achieve a desired accounting result
when the essence of the transaction would suggest a
different result.
This is form over substance.
Footnote Disclosures of Lessees
Midwest Air Group’s Lease Footnote
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In the Midwest Air footnote disclosure, it reports
minimum (base) contractual lease payment obligations
for each of the next 5 years and the total lease payment
obligations that come due after that 5-year period.
This is similar to disclosures of future maturities for
long-term debt.
The company must also provide separate disclosures
for operating leases and capital leases.
We know that all of Midwest Air’s leases are operating
because its footnote does not disclose any payments
relating to capital leases.
Capital Leases
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Capital leases
Effectively an installment purchase
 Lessee assumes rights and risks of ownership
 Treated as purchases
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Examples of what constitutes a capital lease
PV of lease payments is the FMV of the asset
 Period of the lease approximates the assets life
 There is a bargain purchase price
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Capitalizing Operating Leases for
Analysis Purposes
1.
Determine the discount rate to compute the
present value of the operating lease payments.
This can be inferred from the capital lease disclosures, or
one can use the company’s debt rating and recent
borrowing rate for intermediate term secured obligations as
disclosed in its long-term debt footnote.
2.
3.
Compute the present value of the operating lease
payments.
Add the present value computed in step 2 to both
assets and liabilities. This is the process that
would have been used if the leases had been
classified as capital leases.
Capitalization of Midwest Air
Operating Leases
Pensions
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Companies frequently offer retirement plans as an
additional benefit for their employees. There are generally
two types of plans:
 Defined contribution plan. This plan has the
company make periodic contributions to an employee’s
account (usually with a third party trustee like a bank),
and many plans require an employee matching
contribution. Following retirement the employee
makes periodic withdrawals from that account. A taxadvantaged 401(k) account is a typical example. Under
a 401(k) plan, the employee makes contributions that
are exempt from federal taxes until they are withdrawn
after retirement.
Pensions
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Defined benefit plan. This plan has the company
make periodic payments to an employee after
retirement. Payments are usually based on years of
service and/or the employee’s salary. The company may
or may not set aside sufficient funds to make these
payments. As a result, defined benefit plans can be
overfunded or underfunded.
Accounting for Defined
Contribution Plans
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From an accounting standpoint, defined
contribution plans offer no particular problems.
The contribution is recorded as an expense in
the income statement when paid or accrued.
Accounting for Defined Benefit
Plans
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Defined benefit plans are more problematic due
to the fact that the company retains the pension
investments and the pension obligation is not
satisfied until paid.
Account balances, income and expenses,
therefore, need to be reported in the company’s
financial statements.
Two Accounting Issues Related
to Pension Investments and
Obligations: Problem # 1
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The first of the two primary accounting issues relates
to the appropriate balance sheet presentation of the
pension investments and obligation.
The pension standard allows companies to report the
net pension liability on their balance sheet.
That is, if the pension obligation is greater than the fair
market value of the pension investments, the
underfunded amount is reported on the balance sheet
as a long-term liability.
Conversely, if the pension investments exceed the
company’s obligation, the overfunded amount is
reported as a long-term asset.
Two Accounting Issues Related
to Pension Investments and
Obligations: Problem # 2
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The second issue facing the FASB was the
treatment of fluctuations in pension investments
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), and to defer the recognition
of unrealized gains and losses on both pension
investments and pension obligations
Financial Statement Effects of
Defined Benefit Plans
Accounting for Defined Benefit
Plans
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Once the initial pension obligation has been estimated,
changes to that obligation subsequently arise from 3
sources:
Service cost – the increase in the pension obligation due to employees
working another year for the employer. Since pension payments are based on
final salaries and years of service, these will increase each year as employees
continue to work for the company. This increase due to employment is the
service cost.
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Interest cost – the increase in the pension obligation due to the accrual
of an additional year of interest. This is similar to the increase in the carrying
amount of discount bonds that we discuss in Module 8.
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Benefits paid to employees – the company’s obligation is
reduced as benefits are paid to employees. This is no different than the
payment of any other liability.
The Balance of the Pension
Liability (PBO) Computation
Computation of the Balance of
the Pension Investments
Computation for Pension
Expense Reported in the Income
Statement
Sources of Financial Statement
Effects of Defined Benefit Plans
Footnote Disclosures of Pensions
Footnote Disclosures of Pensions
Footnote Disclosures of Pensions
Expected Return on Pension
Investments
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Notice that the computation of pension expense uses
the expected return on pension investments, not the
actual return.
The reason for this is that stock returns are expected to
revert to a long-term average if currently abnormally
high or low. Therefore, this expected return is a better
indicator of the true cost of the pension.
Unexpected Gains and Losses
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Stock analysts generally do not like wild swings in
reported profitability and companies were very
concerned that the use of actual investments returns in
the computation of pension expense would adversely
impact their stock price.
As a result, they lobbied the FASB, and the FASB
agreed to use expected long-run returns instead of
actual returns in order to smooth reported earnings.
Since the FASB did not want unexpected gains and
losses to impact profits, it decided to accumulate them
off-balance sheet.
Variable Interest Entities (VIEs)
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A VIE is formed by a sponsoring company and is
capitalized with an equity investment.
The VIE leverages this equity investment with
borrowings from the debt market and purchases assets
from, or for, the sponsoring company.
Cash flows from the VIE assets are used to repay the
debt and earn a return for its equity investors.
The sponsoring company benefits from its asset
reduction and/or from the benefits of assets reported
on another entity’s balance sheet.
Project and Real Estate Financing
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VIEs can provide a lower cost financing alternative than
borrowing from the debt market.
This is because the activities of the VIE are constrained and, as a result,
investors purchase well-secured cash flows that are not subject to the
business risks of providing capital directly to the sponsoring company.
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A properly structured VIE is accounted for as a separate
entity and is unconsolidated with the sponsoring company.
The sponsoring company is, thus, able to utilize VIEs to remove assets,
liabilities, or both from its balance sheet. Further, since the sponsor
realizes the economic benefits of the VIEs’ transactions, the sponsor’s
operating performance ratios (return on assets, asset turnover, leverage,
etc.) improve.
Reporting of Consolidated VIEs
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Subsequent to passage of SFAS 140, the FASB
issued FIN 46 in 2003. This interpretation
identified the characteristics of VIEs that require
consolidation. Generally, any entity that lacks
independence from the sponsoring company and
lacks sufficient capital to conduct its operations
apart from the sponsoring company, must be
consolidated with whatever entity bears the
greatest risk of loss and stands to reap the greatest
rewards from its activities.