Economic Substance and Sales of Receivables - Essay Example

CURRENT ISSUES IN FINACIAL REPORTING By School Introduction Legally, it is required that business firms and other entities provide accurate reflections of their financial capabilities through proper documentation, and clear logistically and statistically sound presentations. As such, income statements for various firms have often been scrutinized, with profit and loss accounts, and the balance sheets being key documents of interest. Indeed, such statements have for long been used to gauge the level of solvency of various firms. As a result, such financial documents have remained fundamental in attempts by a firm to secure loans of financial support. Such statements, however, have inaccuracies due to increased off-balance sheet activities devised by firms to escape legal bondages. In this case, the aspect of OBS transactions and their relative representation of economic substance in a business setup is explored. Economic Substance This refers to the structures put in place by corporate to reflect their economic reality for the purpose of facilitating various transactions including tax optimization. In the United States, the doctrine of economic substance is used to direct tax policies, with focus on reducing tax burdens on the given firm. Through this doctrinal setup, the validity and intentions of various organizational structures relative to tax-policy compliance are determined. It provides precise procedures used in computation of taxable income, and other deductions payable by a given entity (Jacobson, 2009; 3). Through court processes, various amendments have been made on the standard economic substance doctrine. Such amendments have been aimed at curbing unethical practices which may be motivated by financial gains. Through legislative reforms, it is widely acceptable that courts can deny firms or individuals from enjoying specified tax benefits if such transactions are ill-intentioned. By all indications, however, the application of this doctrine has been marred with several instances of inconsistencies, with courts challenged with determination of the liquidity of various entities. Such challenges in ascertaining accurate financial positions of firms have been compounded by the increasing adoption of OBS transactions, a prospect that has rendered financial statements of many firms inaccurate and unreliable in predicting financial position of the firms. Sales of Receivables One of the common ways through which firms promote off-balance sheet transactions is through sales of receivables (Molina and Preve, 2009: 653). Basically, accounts receivable are representative of sales that are yet to be collected. Through sale of receivables, the financial flow within the firm is altered. Through the sudden hikes in financial flow within the firm due to the sales, the need for short-term borrowing is alleviated. While such sales of receivables boost financial position of the firm, they equally disrupt cash flow within the firm. Unfortunately, such sales of receivables are never shown in many financial documents, rendering such documents inaccurate in painting the true image of the financial position of the firm. For instance, such sales are likely to lead to overstatement of receivable turnover, current asset ratio and working capital (Hill, Kelly and Lockhart, 2012: 225). In addition, the debt-to-equity ratio shoots upwards while the reported income reflects relatively high figures. OBS Transactions in Operational Leases and Securitization Many firms are increasingly adopting ways of minimizing legal risks. This has led to rearrangements, with securitization and operational leasing being key strategies. In this arrangement, the lessee is unable to know the exact assets owned by the company. Such arrangements have promoted the culture of absconding loan repayments among firms. Therefore, operational lease, as a form of OBS, helps to substantially hide the debts owed by the given firm to other business bodies (Duff, 2014). In accordance with the IAS legislation, the lease cannot be blocked as long as the lesser is comfortable. Notably, such transactional arrangements between the leaser and the lessee are hardly incorporated in financial records of the firm, bringing into doubt the validity and accuracy of such statements in reflecting the financial position of the firm. Due to increasing concern over this setup, oversight bodies have been setup in different nations. In US, the oversight commission, in liaison with the FASB and IASB, recommend adoption of workable frameworks that would ensure enhanced accuracy and validity of financial statements for the given firm. OBS Transactions and Special Purpose Entities Many firms have restrictive assets-to-liability ratio which prevents them from accessing crucial financial facilities such as bank loans. In the absence of financing, many firms can collapse. Therefore, the firms develop the SPEs to hide the financial position of the parent firm. Such SPEs are often short lived, and are dissolved following accomplishment of the roles for which they were established. The SPVs can also conduct transactions on behalf of the parent company. In summary, such entities act as tools for hiding transparency in business operations, a move that is against corporate values. Indeed, such an arrangement is likely to dupe investors and the public on the financial positioning and solvency of a firm. Following the Enron scandal, however, it is appreciable that development of SPVs may equally pose challenges to the certified public accountants investigating a given financial case. In some cases, the firms may opt to enter into limited liability partnerships to help in risk alleviation, and to promote the negative corporate culture in accounting. Response to OBS Transaction Trends Despite the various issues observed with the increasing popularity in business entities, various states and governments have began to device strategic ways of countering the vice, a move that will consequently promote positive corporate culture and accountability (Far-Media, 1998). Evidently, legislative reforms have seen enactment of laws pushing for disclosure of all off-balance sheet arrangements made by different firms. In the United Kingdom, for instance, there has been focus on adoption of the FRS5 legislation which promotes economic aspect of various transactions between firms as opposed to legal interpretations of such transaction. In addition, newer and better accounting strategies under the IFRS frameworks have been adopted in a bid to eliminate avoidance perspectives promoted by the former legal setups. Through IFRS 10, it has been possible to determine the extent to which a particular firm influences decisions on key consolidated decisions and assets that would have otherwise been ignored by former setups. The IFRS 11, on the other hand, defines the ideal approach in determining the influence posed by a given entity on a joint venture (Soroosh and Ciesielki, 2009). Through this legislative amendment, it becomes possible to attain equity in the accounting process. The provisions of the IFRS 10 and 11 are further bolstered by legislative amendments contained in IFRS 12 in which comprehensive disclosure of assets, liabilities and interests attributable to a firm, including those under joint ventures, is outlined. The Enron Case and Other Sample Cases Few OBS scandal cases have ever had much public attention like the Enron scandal that led to the subsequent collapse of the American firm. The firm employed diversification strategy to expand its operations, capturing new business segments (Thomas, 2002). However, the firm portrayed complex financial statements which were highly confusing to analysts and shareholders. In addition, some of the statements indicated revenue rises of over 300%. As it came out, the firm was at the center of intensive balance sheet alterations to portray positive performance within public domains, effectively hiding its debts and liabilities which were alarming (Healy and Krishna, 2003: 9). In addition, the firm intensively exploited the use of SPEs such as JEDI, LJM and Whitewing to drive its short-term goals and to help in risk management. Similar corporate malpractices have also been seen in Barclays bank, Barings bank, Northern Rock, Citigroup and NatWest bank. Implications to the Labor and Financial Markets As Paulsen (2002) notes, the impacts of fraudulent activities hidden through off-balance sheet transactions on the labor market can be far reaching. Upon revelation of such fraud, the firms stand higher chances of dissolution. In short-term though, OBS activities can help maintain positive image of the firm (Filomia-Aktas, 2009: 22). In long-term, many employees are forced out of their positions thus rendering them jobless as was seen in Eron case. Similarly, dissolutions of such firms impact on investors, with the Enron case recording a $60 billion loss on the part of the investors. At a global scale, revelations of such malpractices within an economy are likely to paint a negative picture of the economic setup. In this largest OBS scandal ever, involving Enron, the public trust in American economic setup was greatly affected. Notably, not everyone remains on the dark regarding the financial position of the firm. The top managerial organs are aware of the negative environment, but prefer to keep dumb. In fact, occurrences of such loopholes give the top managers an opportunity to embezzle funds, making millions of dollars in the process. Conclusion From various indications, it has been shown that the corporate culture is quite difficult to change. Indeed, the government and champions for the change in corporate changes risk experiencing backlash from the corporate sector. Moreover, all indications point towards increasing support of the OBS by the firms as a technique for alleviating risks and liabilities. As such, even if the OBS loophole of accounting is conclusively tackled, there is higher possibility that negative accounting ethics will still survive (Silverstein, 2013: 5). By all indications, the business sector is a field founded on innovation and adaptability to change. As such, chances of the firms devising new techniques to escape accountability remains high. Further, some firms are highly influential politically and economically. Many of such firms have prominent political personalities as stakeholders, hence have commanding political influence. Some firms can go as far as corrupting politicians to enact favorable laws, a trend that is common in capitalist states. Bibliography Duff, V. 2014. How does securitization affect the balance sheet? Demand Media. [Online] Available at: [Accessed 01 February 2015]. Far-Master, 1998. 14-306 Review of Off-Balance Sheet Arrangements and Related Party Transactions. TSA, Inc. [Online] Available at: [Accessed 01 February 2015]. Filomia-Aktas, L., 2009. Off-balance sheet transactions: the changing landscape. The Journal of structured finance. [Online] Available at: [Accessed 01 February 2015]. Healy, P. and Krishna, P., 2003. The fall of Enron. Journal of Economic Perspectives 17 (2): 9. Hill, M., Kelly, W. and Lockhart, B., 2012. Shareholder returns from supplying trade credit. Financial Management. 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