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
 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 # 2
 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
 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
 Off-balance sheet financing means
that either liabilities are kept off of
the face of the balance sheet.
 In this module, we discuss leases and
pensions.
 Variable interest entities (called SPEs
in the past) were previously
discussed when we covered the
equity method of accounting.
Leasing
 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. The lessor allows the lessee the unrestricted
right to use the asset during the lease term
2. The lessee agrees to make periodic payments to
the lessor and to maintain the asset
3. 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.
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.
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.
2. Lease liability is not reported on the balance
sheet.
3. 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.
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 Leases
 The benefits of applying the operating method
for leases are obvious to managers.
 The lease accounting standard, unfortunately,
is structured around rigid requirements.
Whenever the outcome is rigidly defined, clever
managers that are so-inclined 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.
Capital Leases
 Capital leases
 Effectively an installment purchase
 Lessee assumes rights and risks of
ownership
 Treated as purchases
 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
Footnote Disclosures of Lessees
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. Compute the present value of the
operating lease payments.
3. Add the present value computed in
step 2 to both assets and liabilities.
Capitalization of Midwest Air
Operating Leases
Pensions
 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 tax-advantaged 401(k)
account is a typical example.
Pensions
 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
 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
 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
 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.
Problem # 1 - Continued
 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.
 The amount reported, however, is not what
you or I would likely consider the true funding
status.
Two Accounting Issues Related to Pension
Investments and Obligations: Problem # 2
 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 longterm returns on pension investments
(rather than actual investment returns).
The Balance of the Pension
Liability (PBO) Computation
Accounting for Defined Benefit
Plans
 Service cost – the increase in the
pension obligation due to employees
working another year for the employer.
 Interest cost – the increase in the
pension obligation due to the accrual of
an additional year of interest.
 Benefits paid to employees – the
company’s obligation is reduced as
benefits are paid to employees.
Computation of the Balance of
the Pension Investments
Computation for Pension Expense
Reported in the Income Statement
Footnote Disclosures of
Pensions
Footnote Disclosures of
Pensions
Footnote Disclosures of
Pensions
Expected Return on Pension
Investments
 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.