Question

Off balance sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded.

1. Explain and discuss one reason for off balance sheet financing.

2.Discuss and explain a form of off balance sheet financing and research and discuss a company that has used off balance sheet financing in an inappropriate way.

Answer 1

1. Off-balance sheet (OBS) financing is a scary term. Off-balance sheet financing means a company does not include a liability on its balance sheet. It is an accounting term and impacts a company’s level of debt and liability.

Off balance sheet financing has become a common financing tool among many companies. It has found much favour particularly with capital-intense companies. Why is off balance sheet financing practiced by companies? There are several possible, reasons why companies might be motivated to procure finance off balance sheet. These include avoiding restrictive debt covenants, improving key financial ratios, preventing unfavourable profit and loss account impact, keeping line of credit available for on going operations and overcoming GAAP anomalies. In most of the cases, the undertaking off balance sheet financing transactions is triggered by the consideration of getting access to capital which otherwise be difficult to access. If a company has profitable investment opportunities but has difficulty raising finance using the regular on balance sheet channels, it may elect to choose the off balance sheet routes. Companies in financial difficulties or companies that have exhausted all possible regular financing sources may have no alternative but to use off balance sheet financing instruments. Following is the reason that motivate companies to undertake off balance sheet financing transactions are described below.

Circumventing Borrowing Restrictions

A company’s access to capital may be restricted if it has borrowing constraints or restrictions. There are several types of borrowing restrictions. These restrictions are in most cases imposed by the providers of loan capital. The borrowing restrictions, which are called protective covenants, are contained in the debt agreement. Providers of loan capital have reasons to be concerned about the safety of their funds. To ensure the safety of their funds they often write debt covenants to restrict the borrower’s future borrowings. Debt covenants are provisions that require the borrower to do or not to do something. They can be qualitative as well as quantitative. There are three significant qualitative debt covenants: a negative pledge, a cross-default clause and a material adverse change clause. A negative pledge is an undertaking by the borrower that it will not procure additional debts of higher or equal priority until the existing debts are liquidated. An issue of debt with higher or equal priority has the possibility ofreducing the value of existing debt. There are covenants that state that if new debt is issued with higher priority, the existing debts’ priority must be upgraded. The existence ofrestrictive debt covenants imposes a serious restriction on companies that have a continuing need to borrow. Lenders sometimes need covenants requiring that ifthe borrower is in default on any one of its debts above a certain value, this will create a default automatically on every other debt. Covenants ofthis type are known as “cross-default clause”. A cross-default clause usually is quantified to a certain extent (e g, a certain percentage of equity or an absolute amount). The clause can be triggered ifthe minimum size ofthe default crosses that quantified measure. Debt agreements may contain a covenant that makes an event of default if a material adverse change occurs in the borrower’s financial condition. Material-adverse-change clauses are applied mainly to syndicated loan arrangements rather than bilateral loans. But the difficulty with this type of covenant is that there is no precise legal definition of what constitutes a material adverse change. Judgements have to be made in deciding when such a change has occurred. Many debt covenants are quantitative. In quantitative debt covenants, there are financial undertakings setting limitations on the borrower’s financial position so long as the debt remains outstanding. Examples of quantitative debt covenants include, net-worth tests, restrictions on secured borrowings, interest-cover tests, minimum net-worth requirement, and minimum current ratio requirement. The net-worth test, which is also referred to as gearingratio covenant, is a very important test. Under this test, the borrowing limit is expressed in terms ofa gearing ratio. It sets the maximum limit to the borrower’s permitted gearing ratio. Restrictions on secured borrowings constitute a subsidiary covenant to the net-worth test. Under this covenant, the borrower agrees to accept a restriction on the amount of borrowings either by a secured charge on specific assets or by a floating charge on all assets. The restriction is expressed as a percentage of the equity in the range of 10 per cent to 100 per cent. This percentage depends on the nature ofthe business.

The interest-cover test is based on the profit and loss account data. In this covenant, the borrower is required to give an undertaking that its profit before interest and taxes (PBIT) will be at least a specified multiple of the total interest obligation in an accounting period. The ratio ofPBIT to debt interest is referred to as the interest cover ratio. The requirement is in the range of 2 times to 4 times, depending On the nature of the business. In many cases loan agreements specify how PBIT and debt interest cost should be computed. Under the minimum net-worth requirement, the borrower is required to maintain the shareholder equity at a minimum amount. A company’s net worth, it may be pointed out here, is its assets less liabilities. It is the same as ownership equity. When a loan agreement contains the minimum net-worth requirement covenant, the borrower has to see to it that its net worth does not fall below the specified amount. If the actual amount drops below the specified amount, there may be a breach of covenant. The minimum net worth normally is set slightly lower than the borrower’s net worth as at the start of the period during which the loan is negotiated. The minimum current ratio requirement covenant is frequently used in bank borrowings. The current ratio happens to be one of the key financial ratios used to evaluate the liquidity position of the company. The ratio is computed by dividing current assets by current liabilities. A covenant may specify that the ratio must not fall below a certain value. Banks specify this minimum value after taking into consideration factors such as the cash generative nature of the business, and the working capital cycle. In general cases, bankers look for a minimum ratio between 1.0 and 1.5. Borrowing restrictions come not only from debt covenants but also from the Company’s Articles ofAssociation. The Articles ofAssociation ofmany companies have provisions that restrict the power of managers to procure debts beyond a certain level. These restrictive clauses are provided in order to ensure that the company is not committed to any unreasonable level of borrowings. If a company’s borrowings touch the maximum limit, no further debt can be procured. In a situation like this the company management may elect to procure additional debts via the off balance sheet route. Ifthis is done, additional finance will come but there will be no violation or breach ofthe Articles ofAssociation.

2. Form of Off Balane Sheet Financing

For anyone who was invested in Enron, off-balance sheet (OBS) financing is a scary term. Off-balance sheet financing means a company does not include a liability on its balance sheet. It is an accounting term and impacts a company’s level of debt and liability.

Common forms of off-balance sheet financing include operating leases and partnerships. Operating leases have been widely used over the years, although the accounting rules have been tightened to lessen the use. For example, a company can rent or lease a piece of equipment and then buy the equipment at the end of the lease period for a minimal amount of money, or it can buy the equipment outright. In both cases, a company will eventually own the equipment or building. The difference is in how a company accounts for the purchase. In an operating lease, the company records only the rental expense for the equipment rather than the full cost of buying it outright. When a company buys it outright, it records the asset (the equipment) and the liability (the purchase price). So by using the operating lease, the company is recording only rental expense, which is significantly lower than booking the entire purchase price, resulting in a cleaner balance sheet.

Partnerships are another common OBS financing item, and this is the way Enron hid its liabilities. When a company engages in a partnership, even if the company has a controlling interest, it does not have to show the partnership’s liabilities on its balance sheet, again resulting in a cleaner balance sheet.

These two examples of OBS financing arrangements depict the reason their use is attractive to many companies. The problem investors encounter when analyzing a company’s financial statements is that many of these OBS financing agreements are not required to be disclosed at all, or they have partial disclosures, which are very minimal and do not provide adequate data required to fully understand a company’s total debt. Even more perplexing is that these financing arrangements are allowable under current accounting rules, although some rules govern how each can be used. Because of the lack of full disclosure, investors need to determine the worthiness of the reported statements prior to investing by understanding any OBS arrangements.

FRAUDULENT FINANCIAL REPORTING

Fraudulent reporting is intentional misstatements or omissions of amounts or disclosures in financial statements, done to deceive users. Financial reporting fraud is perpetrated by dishonest presenters of financial information. In fraudulent reporting there is a premeditated intent to deceive in a material way. The Roman Catholic Church has officially classified fraudulent financial reporting as a sin (Fridson, 1998, p.73). Non-compliance with GAAP or even violations of regulatory mandates are not necessarily fraudulent acts. The US SEC employs a three-tiered hierarchy when assessing violations. The first and most basic is simply a breach ofsecurities law. The next category is for violations that were actually fraud; in other words, that someone deliberately attempted to break the law. The third and most serious category of violation are for those in which there was a deliberate intent to break the law, and the public either lost or were put at risk of losing a substantial amount of money. When frauds are perpetrated, financial statements are divorced from reality. Companies that are engaged in fraudulent financial reporting move beyond the boundaries of GAAP. They move much beyond the mere exploitation of financial reporting loopholes. Fraudulent practices can assume a variety offorms. These include capitalization of expenditures that are revenue in nature, advancing the timing ofrecognition of revenues, delaying the recognition of expenses and losses, omissions of expenses and liabilities, overvaluing assets, undervaluing liabilities, recording fictitious transactions, using wrong classification, and 171 making inadequate footnote disclosures. Fraudulent financial reporting is potential serious threat to the efficient and effective functioning ofthe financial markets. The US Treadway Commission Report1 identified a number offactors that might contribute to fraudulent financial reporting, including a number of environmental, institutional, and individual personal incentives to engage in fraudulent financial reporting. Institutional incentives include falsely improving financial appearances in financial statements for the purpose of preventing market prices ofshares from falling or to meet investors’ expectations as well as delaying the reporting of financial difficulties in order to avoid failure to comply with debt covenants. Individual incentives include falsely reporting results in order to achieve targeted results for bonus or incentive compensation purposes, as well as to avoid penalties for poor performance in achieving targeted profit objectives. One ofthe most notorious examples of accounting fraud in recent times involved Cendant Corporation, A US marketing and franchising company. A few years ago, Cendant admitted to using irregular accounting practices to inflate earnings by as much as $500 million dollars over a three year period. When the scandal was made public, the company lost several billions in market value in a single day. Shareholders sued. Scared company executives tried to shift blame to the outside auditors, Ernst & Young, who in turn had to hire high priced lawyers (David Boies) to defend them against Cendant and the SEC who said that Ernst & Young should have uncovered the fraud. When all was said and done Cendant lost $11.3 billion in market capitalization and some senior managers were indicted. Ernst & Young (and their insurers) had to pay a settlement of $335 million. Both Cendant and Ernst & Young have survived this scandal. It was the shareholders in Cendant who paid the biggest price. When is off balance sheet accounting labeled as fraudulent? According to one view, off balance sheet accounting is fraudulent ifit is practiced with ill motives. There are others who make a distinction between off balance accounting, which is aggressive, and off balance sheet accounting, which is fraudulent. According to Mulford and Comiskey, E.E. (2002, p.390), aggressive accounting is not fraudulent accounting. They view aggressive accounting as an accounting, which “presses the envelope of what is permitted under GAAP, although it remains within the GAAP boundaries” (p.39). When the line is crossed, aggressive accounting becomes fraudulent accounting. Essentially, the line between aggressive accounting and accounting fraud is crossed when management judgement as to the assumptions made in the preparation and presentation offinancial statements are indefensible 172 - completely contrary to established accounting theory. It should be admitted that identifying the point beyond which aggressive accounting becomes fraudulent is difficult. Mulfold et al (ibid, p.41) mention that what starts, as an aggressive application of accounting principles may later become known as fraudulent financial reporting ifit is continued over an extended period and is found to entail material amounts.