accounting memo

Off Balance Sheet Financing

What is Off Balance Sheet Financing?

Form of financing in which large capital expenditures are not reflected in a company’s balance sheet.

Especially common if the inclusion of a large expense would break negative debt covenants.

Motivation for Off Balance Sheet Financing

To keep debt off of the balance sheet

To have low debt to equity and leverage ratios/comply with financial covenants

Managers generally believe that keeping such assets/liabilities off of the balance sheet helps improve market perception of their operating performance and financial condition.

Examples of Off Balance Sheet Financing

Operating leases, where the asset is kept on the lessor's balance sheet, and the lessee reports only the required rental expense for use of the asset.

Outstanding loan commitments

Joint ventures

Research and development partnerships

Sale-Leaseback

Application of Off Balance Sheet Financing

Issue:

Company A has $4,000,000 line of credit at bank ABC

Line of credit comes with a financial covenant that requires Company A to stay under a 0.5 debt-to-equity ratio at all times

Company A wants to buy a new piece of equipment that costs $1,000,000

Company A does not have the cash to make the purchase and cannot use debt because it will violate the covenant

Application of Off Balance Sheet Financing

Continued..

Solution

Company A creates a separate entity that will purchase the equipment and then lease it to Company A utilizing an operating lease

Although Company A has virtually complete control of and responsibility for the machine, it records only its monthly lease expense on its income statement

The company does not have to record the additional debt on its balance sheet, and it does not record an increase in assets since Company A does not legally own it.

Benefits

Operating leases are recorded as an expense

Keeps liabilities and debt to equity ratios down

Less likely to break debt covenants

How it is done

Operating Leases- Is a lease that allows for use of an asset, but does not convey rights of ownership. This is a way of funding assets without major liabilities hitting the books.

Companies do not claim ownership of the leased asset

Only shows up as an expense

Companies are able to avoid major increases in their liability account

Reword that second sentence!!

How it is done cont.

R&D Partnerships

Expensive liability with no major asset to offset cost

R&D doesn't always equate to breakthroughs so it can be perceived by investors as “risky”

A way to come off to investors as a safer company

Maybe elaborate the third bullet point??

How it is done cont.

Joint Ventures- An off balance sheet financing technique where two or more parties pool their resources together to accomplish a specific task.

Disclosed in the footnotes

Does not always state the full extent at which they are liable

Average investor doesnt always look at the footnotes and might not know exactly the exent of the liability at hand

Who Does It

Major Industries-

Airlines

Restaurants

Hotel chains

Retailers

Banks

Who Does It

Pharmaceutical companies- OBS financing is a way for pharmaceutical companies to obtain cash without hitting the expense account hard if they partner up with another company.

The risks associated with the R&D effort do not appear in correlation with related expense and debts

if an R&D company is in need of cash, it can enter into a limited partnership with an investor. If the risks associated with the R&D effort are assumed by this limited partnership, the related expense and debt do not need to appear on the research and development company's books.

Consequences

Companies would prefer to have a lower debt-equity ratio, therefore use off balance sheet financing.

Companies are required to disclose all off balance sheet financing

Investor must read in full detail the companies footnotes to determine OBS financing is occurring, and it’s effects.

Example: Eron

FASB’s Reaction

February 25, 2016 FASB proposed ASU 842- Leases

Will replace ASU 840-Lease

Was created to end OBS financing for operating leases

IASB released a similar Subtopic, IFRS 16

ASU- 842

Lessee- operating leases

1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position

2. Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis

3. Classify all cash payments within operating activities in the statement of cash flows.

Lessor: remains unchanged

ASU 842 EFFECTIVE DATES

Public Companies: the fiscal year beginning after December 15, 2018

Nonpublic Companies: the fiscal year beginning after December 15, 2019.

All companies are allowed to apply early.

WORKS CITED

Investopedia. Off-Balance-Sheet Financing n.d. Web. 29 Jan. 2017.

"Update 2016-02-Leases (Topic 842) Section A-Leases: Amendments to the FASB Accounting

Standards Codification®." Update 2016-02-Leases (Topic 842) Section A-Leases:

Amendments to the FASB Accounting Standards Codification®. N.p., n.d. Web. 01 Feb.

2017.

The Wait Is Over: FASB Issues New Guidance on Lease Accounting." AccountingWEB. N.p., 25

Feb. 2016. Web. 01 Feb. 2017.