What is off-balance-sheet financing? How are they structured? How are they treated under U.S. GAAP and IFRS

Answer 1

OFF-BALANCE-SHEET FINANCING

Off-balance-sheet financing refers to obtaining cash, goods, or services without a formal borrowing arrangement that U.S GAAP or IFRS recognizes as a liability on the balance sheet. The following explores the rationale for off-balance-sheet financing, transaction structures that typically achieve off-balance-sheet financing, and the responses of standard-setting bodies that require firms to recognize an increasing number and variety of off-balance-sheet financing arrangements.

RATIONALE FOR OFF-BALANCE-SHEET FINANCING

Managers frequently cite these reasons, among others, for using off-balance sheet financing:

1 . Some managers believe that it lowers the cost of borrowing. Lower borrowing costs might result if lenders ignore off-balance-sheet financing, or are unaware of it because borrowers do not disclose it, leading lenders to set interest rates for loans lower than the underlying risk levels warrant.

2 . Off-balance-sheet financing may avoid violating debt covenants that include items recognized only in the financial statements. Covenants in existing debt contracts may preclude increases in debt ratios, but an off-balance-sheet arrangement that does not affect those ratios would allow the firm to borrow more.

The first suggested reason for off-balance-sheet financing assumes that some lenders, credit-rating agencies, and others who assess financial risks do not possess the knowledge, skills, and information needed to identify and deal with those financing arrangements. Even though there is little evidence that financial statement users systematically ignore these obligations, managers sometimes structure financing arrangements as though they believe that assumption. The second reason suggested for off-balance-sheet financing results from some lawyers' inability to understand that some of a firm's obligations do not appear on the balance sheet as liabilities.

STRUCTURING OFF-BALANCE-SHEET FINANCING

Liabilities are present obligations of an entity to transfer assets or provide services to other entities in the future as a result of past transactions and events. Many off-balance-sheet financings fall into one of two categories that accounting typically does not recognize as liabilities: executory contracts and contingent obligations.

Executory Contracts

Firms frequently sign contracts promising to pay defined amounts in the future in return for future benefits. For an obligation to qualify as an accounting liability, the firm must have received a past or current benefit, which gives rise to a current obligation. If the firm has not received past or current benefits, but will receive the benefits in the future, accounting treats the obligation as an executory contract and typically does not recognize a liability. Operating lease commitments are the most frequently encountered example of an executory contract.

Contingent Obligations

As an alternative to borrowing and using a particular asset as collateral, a firm might obtain cash by selling (transferring) an asset to a purchaser (transferee). In some cases, the arrangement includes a requirement that the seller will pay cash to the purchaser under certain conditions, for example, if the asset sold generates less cash for the purchaser than anticipated at the time of sale. In this arrangement, the seller has relinquished its claim to the cash flows that the transferred asset will generate and has assumed an obligation to stand ready to make a cash payment if the stated condition is met.

These are the accounting issues:

1 . Should the transferor account for the transfer of the asset as a sale or as a secured borrowing?

2 . If the transferor accounts for the transfer as a sale, how should it account for the obligation (referred to as a contingent obligation by U.S. GAAP and as a provision by IFRS) to stand ready to make a future cash payment?

TREATMENT OF OFF-BALANCE-SHEET FINANCING ARRANGEMENTS UNDER U.S. GAAP AND IFRS

U.S. GAAP and IFRS provide guidance for deciding whether a given financing arrangement appears as a liability on the balance sheet or is disclosed in the notes. Many financing arrangements are complex, and the authoritative guidance tends to relate to specific financing arrangements (for example, transfers of receivables, transfers of inventory) and tied to facts and circumstances of a particular arrangement. Two themes appear in much of this authoritative guidance: (1) identifying the party that enjoys the economic benefits of the resource in each transaction and that bears the economic risk of holding it, and (2) identifying the party that obtains financing. If the entity that obtains financing also controls the benefits and risks, the typical out-come is the recognition of a liability by that entity. If the entity that provides the financing also controls the benefits and risks, the typical outcome is no recognition of a liability by the entity needing financing—the financing remains off-balance-sheet.

TRANSFER OF RECEIVABLES IN EXCHANGE FOR CASH

A transfer of receivables is a common form of financing that sometimes achieves off- balance-sheet financing. In more complicated financing arrangements, firms sell batches of receivables to a legally separate entity whose sole purpose is to hold the receivables and issue claims on their cash flows. Common terminology refers to such an entity as a special purpose entity, or SPE, or a variable interest entity, or VIE and to the firm that sells the receivables as the transferor. The entity (VIE or SPE) holding the receivables issues securities to investors in return for cash and transfers the cash to the transferor in payment for the receivables. The investors in securities issued by the entity receive payments out of the cash flow from the transferred receivables. Common terminology refers to this process as securitization of the receivables.

Securitization transactions have become so complex that it is often difficult to ascertain whether the transaction is a collateralized loan or a sale of the receivables. For example, the transferor may continue to service the receivables on behalf of the purchasing entity (servicing involves, for example, collecting cash and pursuing customers who do not pay on time or at all). The transferor may also retain some credit risk, perhaps by agreeing to transfer additional receivables to the entity if uncollectible accounts exceed a specified level. Finally, the transferor may or may not retain some or all of the interest rate risk. U.S. GAAP and IFRS provide the accounting rules transferors must apply to account for transfers. Even if the transferor accounts for the transaction as a sale, the transferor must still recognize assets it controls and liabilities it has incurred. For example, if the transferor promises to service the receivables for the purchaser, it would recognize that servicing right on its balance sheet.