What lies beneath: how off-balance sheet treatment can hide the true debt picture

Feature | 8 February 2013
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Off balance sheet transactions can hide the true debt picture to the undiscerning. 
TERESA PALA explains the structures and practicalities

A balance sheet analysis may suggest that a company has low debt and few liabilities but it all depends on how the finance is classified. Measures to keep reported capital levels as low as possible (for example to improve debt to equity ratios), will often include financing that does not have to be reported in the balance sheet – the result of which is an incomplete corporate picture.

Some of the high profile business collapses, such as Enron, 
had their roots in hidden off-balance sheet (OBS) liabilities. For trade banks, the issue is not only how to assess the risk of a potential corporate client, but understanding what is on or off balance sheet in terms of their own liabilities for capital adequacy assessment purposes.

Definition

These examples (see  below) demonstrate the impact of off-balance sheet activities in the trade finance world. While all of the above qualify as trade finance operations, they also qualify as 
off-balance sheet ones.

While on-balance sheet financing is any form of direct debt or equity funding of a firm, which is included in the company’s balance sheet, off-balance sheet financing is any form of funding that avoids placing owners’ equity, liabilities or assets on a firm’s balance sheet or 
in the consolidated balance sheet of a group of companies.

OBS techniques can be used for a variety of reasons, including managing or mitigating the exposure to particular risks or reducing borrowing costs.

In fact, OBS funding lowers the cost of borrowing if lenders are not aware of the unrecorded liabilities and it avoids violating some debt covenants – the restrictions specified in the debt agreement to protect the lender. These restrictions are sometimes stated in the form of financial ratios which may be affected by whether or not the liability is recorded.

Therefore, these methods can affect key financial ratios, especially the financing ratios that use total debt as a denominator, showing them to be lower (and more favourable) than they would be if the financing were recognised.

Example off-balance sheet scenarios

Scenario 1: 
Client risk assessment

You are a banker with a corporate client asking EUR1m of funding. Before deciding to make this loan, you analyse the balance sheet and you see no relevant liabilities. Does that mean the credit risk for this client is good?
What if you analyse the remaining financial statements and stumble upon a note mentioning a EUR2m leverage associated with a joint venture in technical bankruptcy? Should you be worried? Does it even matter when it comes to deciding whether, or not, you should go ahead and grant the client’s requested funding? Should this liability affect the client’s credit risk?
 
 Scenario 2: 
Letters of credit

A different corporate client approaches you and mentions he intends to buy goods from another company. This company is requesting a guarantee that the client will pay for the goods so your client asks you to issue a letter of credit. At first glance, you see no objection. Should there be any?

Scenario 3: 
Selling down liabilities

Your bank needs to reduce balance sheet liabilities to comply with the most recent Basel requirements 1. But liabilities don’t just go away and you’re on the team incorporated to come up with ways to make it happen.
Then, it occurs to you; why not sell some of the liabilities to a fund? Problem solved and fewer liabilities 
for the bank, better leverage and 
capital ratios. Should there be any reason for concern?
 
For all three of these scenarios the answer is ‘yes’. They demonstrate some of the many forms of OBS funding. In each case, there are advantages but also risks for all parties involved.
 
In the first one, if you hadn’t seen the note in the financial statements, you could have granted a perfect credit risk along with a EUR1m loan to a client that may be on the verge of having to cope with a EUR2m responsibility.
 
In the second and third situations, you contributed to increase the banks’ leverage and capital ratios but also to create additional potential exposures which are not obvious unless you know where to look.
 

Main OBS vehicles

The main vehicles used to obtain OBS funding are set out 
in Figure 1.

Two of the more common OBS vehicles are operational leases and special purpose vehicles.

Operational leases

An operational lease means the company does not have to use its equity in an investment or assume a responsibility, as opposed to a financial lease where the company is substantially bound to all the risks. In fact, from an accounting standpoint, the main difference between a financial and operational lease is the fact a lease will be classified as operational if it does not transfer substantially all the risks and rewards incidental to ownership, unlike the financial lease. In practical terms, unlike with the financial leases, at the end of an operating lease, the title to the asset does not pass to the lessee, but remains with the lessor.

Thus, as with other types of OBS activities, operating leases ‘hide’ the underlying debt associated with the transaction. Although the lease agreements are disclosed in the notes to the financial statements, the actual financial statements themselves are not representative of all future obligations of the company, which is what happens with financial leases.

International Accounting Standard (IAS) 17 establishes that, if the lessee assumes no risk whatsoever with the lease agreement, then the lease will not be booked in its accounts and lease payments will be “recognised as an expense in profit or loss on a straight-line basis over the lease term, unless another systematic basis is more representative of the pattern of benefit.”2

A recommendation by the US Securities and Exchange Commission (SEC), as well as the convergence of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) accounting standards, 
are driving a movement to change the OBS treatment of 
operating leases.

IASB issued, in 2010, an exposure draft on lease accounting,3 which would significantly affect the accounting for lease contracts for both lessees and lessors. It proposes to eliminate the distinction between operating and finance leases and would introduce new accounting models for lessees and lessors. Lessees would no longer be permitted to treat leases as OBS financings but instead would be required to recognise an asset and liability for all leases within the defined scope.

This exposure draft also foresees a significant increase on the required disclosures related to lease arrangements. It states: “An entity would be required to disclose quantitative and qualitative information that identifies and explains the amounts recognised in the financial statements arising from leases,” and describes how leases may “affect the amount, timing and uncertainty of the entity’s future cash flows”. Disclosures, it explains, “would need to be disaggregated to a level so that the information provided is useful to the users of the financial statements.”

This is critical to companies and users of financial statements since it could lead to breaches of loan covenants or lower credit ratings as more debt is added to the balance sheet and debt-to-equity ratios increase. However, for financial statement users, it could lead to greater transparency and easier examination of a company’s financial wellbeing. On the basis of feedback received from constituents, IASB and FASB made significant changes to the August 2010 exposure draft proposal and plan to issue a revised exposure draft in the first quarter of 2013.

Special purpose entities (SPE)

Another form of OBS is the SPE. Also called special purpose vehicles (SPVs), SPEs are companies incorporated to perform some narrowly-defined or temporary purpose.

For example, if a hotel (parent company) wants to get into the food market but doesn’t want to expose itself to the risks of that market, it might create a separate entity solely for that purpose.

By incorporating a new company to develop this new 
activity, the parent company is not required to carry on any of associated assets or, above all, any of the associated liabilities to its balance sheet.

One of the advantages of incorporating a SPE is that it 
may afford considerable flexibility in obtaining funds since 
the SPE does not use the parent company’s credit lines. It 
presents itself to creditors as a stand-alone entity with its own 
risk-reward characteristics.

Nonetheless, under most accounting regimes, if a parent company wholly owns the SPE, then it may be bound to consolidate the SPE’s balance sheet into its own at the 
financial year’s end. However, this consolidation will defeat all purpose of incorporation of the SPE in the first place since the mentioned assets and liabilities will still appear on its balance sheet. That is why, usually, the parent company will not fully own the SPE. It can even occur the parent company may hold no shareholding in the SPE.

To achieve this goal, the new entity may sell shares of stock or borrow funds directly from investors, and this decreases the ownership stake of the parent. If the parent company has less than a majority interest in the new entity, it does not have to consolidate the financial statements, thereby keeping the new entity’s debt off the parent’s financial statements.

Despite all this it may not be attractive to eliminate all connection between the SPE and the parent company. For 
example, it may be relevant that the financial markets are aware the SPE is somehow connected with the parent company. For instance, if the SPE’s financial capability is not considered sufficient to raise debt by itself; the parent company may guarantee the debt acquired by the new entity.

As a result, a common intermediate solution is one where the parent transfers some of its own management to the new entity upon incorporation, ensuring that the structure and vision desired by the parent is achieved. In this scenario, the parent is able to pass all of the debt and risks associated with entering a new market to the newly created entity, exert some amount of influence through the placement of management, list the partial ownership as an asset (investment) on the balance sheet, and 
keep the contingent liability (the guarantee of debt) off of the balance sheet.

Risks of OBS transactions

While it is not difficult to understand why OBS transactions are popular, they have their risks. While OBS is performed by many companies for the reasons set out above – risk management and reduction of borrowing costs – the position expressed by Anthony Love, Jennifer Shotwell, and T. J. Henderson, in their article ‘Off-Balance-Sheet Activities and Their Related Risk’4, helpfully summarises the main risks:

  1. There is a risk to the company carrying out the transaction. If a company has too many OBS transactions, and at the same time management is highly dependent or focused on the numbers in the financial statement, it can perceive the company’s financial health to be greater than it really is.

  2. It is important to consider the perception that is passed to the users of financial statements. While financial institutions and major investors are aware of the presence and influence of OBS disclosures, many other financial statement users may not be. When professionals evaluate the financial statements of a company, they almost always dissect the disclosures related to OBS transactions and add them back to the balance sheet to arrive at a more realistic statement of position. Other financial statement users may not be as equipped with the detailed financial and accounting knowledge to do the same. This could lead to a misinterpretation by the user and possibly a bad investment in, or relationship with, the company.

  3. OBS activities may present a risk to the company’s certified public accountants (CPAs). Here, we can take a step back and point to the dissolution of worldwide group Arthur Andersen as a result of the Enron scandal.5 CPAs should be provided 
with as much knowledge as possible about all of the 
company’s OBS activities to ensure their proper disclosure 
in the financial statements, and consequently, an accurate opinion on the audit report.

Risk mitigation mechanisms

In an attempt to mitigate these risks, and with reinforced motivation since the Enron scandal, regulatory bodies have worked toward increasing disclosure requirements in 
financial statements.

In 2010, International Financial Reporting Standard (IFRS) 7, concerning disclosure requirements of financial instruments, was amended to overcome the issues raised with the crisis. Commenting on the amendments, Sir David Tweedie, chair of the IASB, stated: “These are important disclosure requirements that will help investors to better understand off-balance sheet risks, and to alert them to the possibility of so-called ‘window dressing’ transactions occurring at the end of a reporting period.

In Europe, off-balance sheet exposure has been treated 
mostly through the Capital Requirements Directive, which was last amended in 2010.

OBS as a positive tool

Efforts are being made to change accounting rules and pass legislation to limit the use of OBS transactions and/or entities. However, these attempts do not change the fact companies 
still want to have more assets and fewer liabilities on their 
balance sheets.

The use of OBS accounting is often stereotyped as dangerously misleading due to the fraudulent activity of a 
few bad eggs, such as Enron. While there have been instances 
of misuse, there are many legitimate uses of these transactions 
as well. A company that has justification to use OBS transactions can, in some cases, produce financial statements that present 
an arguably more accurate financial portrayal of its 
corporate structure.


Teresa Pala is a senior associate at MC&A, an international legal consultancy created in association with SNR Denton headquartered in Portugal.


References:

1.  See Ruth Wandhöfer’s article, “Oil and water? Basel III and best practice in trade finance’ at www.tfreview.com/node/7766. Further information can also be found at: www.bis.org/bcbs/basel3.html
2.  Available at http://tinyurl.com/a3trh4p
3.  See http://tinyurl.com/a95jyx7
4.  Source: www.bap.org/BAPNewsletter/2_3/article2.html.
5.  See Forbes’ ‘The scapegoating of Arthur Andersen’ at 
http://tinyurl.com/abqx6ge