Question

Discuss your thoughts on Off-Balance Sheet Financing and Fair Value Option accounting using the textbook (Chapter 14) and internet research. What issues surround each accounting issue? What, if any, are some adjustments and/or improvements you think should be made towards the accounting methods for each.

Answer 1

Solution :

Offbalance sheet financing :

It is a financing method where in some assets and liabilities are kept away from recording them on balance sheet and income statement. In short those which do not appear on Financial Statements. For this there are various different reasons every business organization has , for not mentioning them on the balance sheet. Off balance sheet financing is common used in case of financial covenant. A covenant is a promise made by a company in return of loan or bonds. It is like an agreement in which standardized structure of lending parameters are set for no obstacles in lendings in future.

This off balance sheet financing is not allowed ethically ,and cannot be totally kept hidden. The Securities and Exchange commission( SEC )and GAAP has made it mandatory for the companies to disclose this off balance sheet financing items by way of a note.

This type of disclosure creates a kind of hidden information from the people who are not watching day to day transaction of the organization & fully rely on the financials at the year end. This in kind is a manipulation towards investors and creditors about the real creditability of the organization.

Fair Value Option Accounting

The fair value option is a method of valuation of financial instruments at fair value on financial statements.

This option is provided by GAAP. Though there are certain limitations for the type of financial transactions for which fair value is allowed.

Usually fair value option of valuation is allowed for financial asset or liability, insurance contracts, warranty contracts etc.

Fair value option is not allowed for financial leases, investment in subsidiaries, deposit liabilities, financial instruments classified under shareholders equity etc.

The main objective of providing fair value option of reporting is to provide opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply the complex hedge accounting provisions.