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Module 9. Reporting and Analyzing Off-Balance Sheet Financing. Why is Off-Balance Sheet Financing Important?.
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Module 9 Reporting and Analyzing Off-Balance Sheet Financing
Why is Off-Balance Sheet Financing Important? • In the valuation process, the analysis of return on equity (ROE) and its components, net operating profit margin, total operating asset turnover, and financial leverage are very important. • If analysis reveals that LEV is excessive, companies may face the prospect of a higher cost of equity capital and a consequent reduction in stock price. • Likewise, excessive leverage can result in reductions in bond ratings, resulting in higher cost of debt. • There is an incentive, therefore, to find ways to keep liabilities off of the balance sheet.
When management conducts off-balance sheet activity, it may motivated by a desire to: • Promote the welfare of shareholders, e.g., by increasing cash flow, lowering risk, raising low-cost capital to grow, etc. • “Window-dress” in order to present a better picture of the firm. • How can we tell the difference? • Does it matter?
“Window Dressing” Financial Statements: Examples #1 • 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 • 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 • 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 longer-term debt. • The indebtedness is thus reported as a long-term liability and net working capital has been increased.
“Window Dressing” Financial Statements: Examples # 4 • 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, fewer assets, 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.
A Key Assumption • Markets believe the balance sheet presentation and adjust expectations as the result of “window-dressing” actions. • Is this really true?
Off-Balance Sheet Financing • Off-balance sheet financing means that either assets or liabilities, or both, are kept off of the face of the balance sheet. • Leases, pensions/OPEBs, variable interest entities, and derivatives often involve off-balance sheet financing and risk.
Off-balance sheet financing often arises as the result of some weakness in current GAAP • “Form” versus substance. • Compromises codified within a GAAP standard • Executory contracts that have not been executed. • Historical vs current cost: the choice of objectivity/reliability over relevance. • Obscurity regarding the identity and scope of the economic entity being accounted for.
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: • 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 • There are several advantages to leasing over bank financing: • 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. • Since leases are contracts between two willing parties, their terms can be structured in any way to meet their respective needs. • If properly structured, neither the leased asset not the lease liability are reported on the face of the balance sheet.
Capital vs. Operating Leases GAAP identifies for two different approaches in the reporting of leases by the lessee: • 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 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.
Operating Leases • Reporting of leases using the operating method has 4 important benefits for the lessee: • Leased asset isnot reported on the balance sheet. This means that net operating asset turnover is higher because reported assets are lower and revenues are unaffected. • Lease liability is not reported on the balance sheet. This means that the usual balance sheet related measures of leverage are improved. Consequently, many managers believe the company would then command a better debt rating and lower interest rate on borrowed funds.
Operating Leases 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. This means that net income is higher for those years with an operating lease. Further, if the company is growing and adding operating leased assets at a high rate, the rent expense could always be less than first year depreciation and interest on capital leases, and the level of net profits would be permanently increased. 4. Without analytical adjustments, the portion of ROE derived from operating activities (RNOA) appears higher, and the company’s ROE is perceived of higher quality.
Operating Leases • 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 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.
Midwest Air Group’s Lease Footnote • 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.
Capitalization of Operating Leases Failure to recognize lease assets and liabilities when they should be capitalized yields distortions in ROE disaggregation analysis (in Module 4) — specifically: • Net operating asset turnover is overstated. • Financial leverage is understated by the non-reporting of lease liabilities. • Net operating profit (NOPAT) margin is overstated. This is because rent expense under operating leases equals depreciation plus interest expense under capital leases, but only depreciation expense is included in NOPAT (interest is a non-operating expense). • Reported expense is higher in the early years of a capital lease relative to an operating lease, but is lower in later years of the lease. This means the net income effect depends on whether the leases are in the early or later years of the lease life. If we assume that leases are, on average, at their midlife, then the net income effect is negligible.
Capitalizing Operating Leases for Analysis Purposes • Given the lease disclosures required under GAAP, it is a relatively simple process to capitalize these operating leases for analysis purposes. The capitalization process involves the following steps: • 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. • 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.
Determination of the discount rate • There are two alternative means to determine the discount rate: • 1) If the company provides disclosures relating to capital leases, we can infer the discount rate as the rate that yields the present value computed by the company given the projected capital leases payment stream, or • 2) Use the company’s debt rating and recent borrowing rate for intermediate term secured obligations as disclosed in its long-term debt footnote.
A Question • If its so easy to reverse the operating lease and modify reported numbers, why does management bother? • Or, to put it more bluntly, who cares?
Capitalization of Midwest Air Operating Leases • The capitalization of operating leases has a marked impact on Midwest Air’s balance sheet. • The net operating asset turnover is lower (net operating assets increase and revenues remain constant) • Financial leverage (liabilities to equity) is higher than we would infer from reported financial statements. Financial leverage is also revealed to play a greater role in ROE. • The adjusted assets and liabilities arguably present a more realistic picture of the invested capital required to operate and the amount of financial leverage represented by the leasing of assets.
Pensions • Companies frequently offer retirement plans as an additional benefit for their employees. There are generally two types of plans: • Defined contribution plan. • Defined benefit plan.
Defined Contribution Plans • 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. Under a 401(k) plan, the employee makes contributions that are exempt from federal taxes until they are withdrawn after retirement.
Defined Benefit Plans • 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. Any pension investments are retained by the company until paid to the employee. In the event of bankruptcy, employees have the standing of a general creditor, and may have additional protection in the form of government pension benefit insurance.
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. • 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 • 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 expectedlong-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
Accounting for Defined Benefit Plans • 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. • 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. • 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.
Computation for Pension Expense Reported in the Income Statement
Sources of Financial Statement Effects of Defined Benefit Plans
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 argued to be a better indicator of the true cost of the pension.
Unexpected Gains and Losses • 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 unexpected gains and losses to impact profits, it decided to accumulate them off-balance sheet.
OPEBs- Other Post-Employment Benefits • Usually health care coverage. • Reporting issues are just like Pensions except that: • There is not, necessarily, a legal liability as with pensions. • Most companies provide little, if any, advance funding for OPEBs. • As a result, for many firms, very big liabilities can show up on the balance sheet.
Pensions and OPEBs reflect a very new and different accounting that is becoming more and more prevalent- This is called “Fair Value” accounting. • Fair value accounting requires many judgements and predictions of future performance. • With judgement and prediction comes increased information risk.
Variable Interest Entities (VIEs) • 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.
A major question concerning VIEs • Are they really a distinct economic entity or part of the originating firm? • Part of the answer concerns: • Who is really in control? • Who is really bearing the risk?
The benefits of VIEs • 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. • 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.
