The Problems of Off-Balance Sheet Financing - Assignment Example

The Problems of Off-Balance Sheet Financing of of School 1561 words Introduction This paper critically evaluates the following the statements: “The problem of off-balance sheet accounting is rooted in the structure of the market economies and pressures upon companies to publish higher earnings and superior financial statements. It has not obvious accounting solution.” The structure of the market economies basically follows capitalism where everybody is free to accumulate wealth and everybody is entitled to private ownership1 by allowing the market forces or the law of supply and demand to attain allocative efficiency in the use of limited resources.2 Industries for similar goods and services are created where companies as industry players maximize their profit in order to attain sustainability in the long-run. These companies or business organizations selling goods and services to consumers would not run without the investors that would provide the capitalization, whose providers of capital would expected to have their returns above their cost of capital or what is called as opportunity cost3 in economics. Each provider wants to have maximized profit where is each investor can be virtually assumed to be capable to selling his stocks and buy another as an alternative investment if the first company is not maximizing wealth. 2.1. The various form of Off-balance sheet financing (OBSF) One form or method of off-balance sheet financing is through lease which can be reported as operating lease or capital lease or finance. Another example is on quasi-subsidiary which has the effect also not properly also reflecting the substance of the transaction with the risk of misleading the users of financial information. An example of the latter is the case of Enron which would discussed more latter. 2.2 Why companies are pressured to publish higher earnings and want superior financial statements? Shareholders are presumed to be maximizing their wealth4 and they would always be looking at investment opportunities that would give them the higher return possible as driven by their opportunity cost. The pressure to publish higher earnings is brought about by the need to please to shareholders. The pressure is on managers as represented by the board of directors and top executive officers of the corporation since the higher the earnings the closer are these managers in doing what is expected of them by the shareholders. But, of course, managements may not do just anything about the accounting information just to make them higher since there are accounting standards5 that should guide in the preparation of the financial statements. The meaning of higher earnings of course is not limited to making the business more profitable than actual but anything that would make the company look good in the eyes of the investing public that the company is doing good and its stocks are getting higher overtime. As the stock prices get higher, the shareholders are deemed to getting wealthier6 from their investments and the therefore publishing favourable financial information would more like accomplish the objectives than not, all other things being held equal. 2.3. Consequences of off balance sheet financing The consequence of OBSF therefore is the high chance of misleading users of the financial information if the latter does not know how to restate the financial statements before the financial ratios are extracted for decision making purposes. Under the present IAS 17, a lease contract could either be classified as finance lease or an operating lease. The lessee will record as asset the lease under capital or finance lease with the corresponding long-term liability from the obligation to pay the lease. When IAS 17 requirement is compiled as when the lease transfers substantially all the risks and rewards incidental to ownership of the lease, capital lease or finance lease is justified.7 Otherwise, this would to be recorded as expense under an operating lease.8 Under off-balance sheet financing the chance of the making a better financial impression by the company if the preparers of the financial information would have the chance not to effect certain transactions in the balance sheet, hence the name “off-balance sheet”. The best example would the case of a lease contract. By not reporting and a long-term lease as an asset when it should have been reported as assets on the basis the substance should prevail over the transaction, the company has in effect understated the fixed assets in terms of total assets but at the same time it did not report a long-term liability. Companies are evaluated for financial leverage and not reporting assets without the corresponding liability would have a better financial leverage than reporting the same. Hence the practice of not reporting in the balance sheet is working against the interests of would be investors who may put a good rating to a company when in fact the risk could have been higher had the assets from the long-term lease and the related liability would have been reported. The consequences of OBSF could be summarized as follows: understatement of assets and liabilities, financial risk understated, return on capital employed becomes questionable, and company comparison becomes difficult and the resulting user confidence in financial reporting to be undermined.9 To appreciate the effect of off-balance sheet accounting relating the lesson from Enron’s case could make things clearer. Enron’s practice of off-balance sheet accounting was not on lease issues but its entering into transactions that should have resulted to more liabilities which the company and its auditor failed to comply as required by US GAAP. Enron was managing partner of LJM2 partnership and said transaction was only mentioned in the notes to financial statements, when otherwise the transaction should have been consolidated with other Enron SPEs, like JEDE and Chewco, which are also considered as off-balance sheet entities. Enron had in effect losses from these off-balance sheet entities which were not made known to investors, so the effect was to mislead the latter. The fraud in effect resulted in reporting higher earning and understated liability while the truth would have changed the way decisions were made by investors10. It was too late when those who planned the criminal act have benefited from the temporary high price of stocks before the fraud became known to many. The same could be the situation if the practice of off-balance sheet accounting continues not only in special entities or in leases but in other ways of understating liabilities, and/or overstating income of companies. 2.4 International Accounting Standards (IAS) involved for off-balance sheet finance Since there are standards that cover the off-balance sheet financing methods, the accountant should comply with them. Thus there are existing requirement when to capitalize leases and when the report the same only as operating leases as provided under IAS 17, IAS 18 and IAS 39. IAS 17 as discussed earlier essentially requires recognizing as finance lease when the risk incidental to ownership is substantially transferred to the lessee who would recognition of the corresponding asset and liabilities. Other instances were also cited to qualify as finance lease. The conceptual framework of IFRS also mentions to have substance over form in accordance with the requirement of faithful representation of the effect of transaction.11 IAS 18 requires the recognition of revenue when the economic benefits will flow to the recognizing entity and the amount of revenue can be measures with reliability. Off-balance sheet accounting could happen if receivables are not reported when there is basis to do the same as this would have effect of understating the assets. IAS 39 on Financial Instruments; Recognition and Measurement could produce off-balance sheet results if there is failure recognize and adjust change to value of financial assets and liabilities including derivatives and certain embedded derivatives when fair value changes.12 2.5 How to address the problem OBSF, using substance-over-form, etc. The idea to solve the problem includes applying the principle of substance over form13, developing possibly new standards, requiring all lease items to be included in the balance through inclusion or disclosure, reducing operating lease or reduce the scope of operating lease or better enforcement of the standards. Other ways could include the need introduce tougher penalties via government regulation, more vigilance from auditors, investors and journalist or other appropriate case to deal with rules-avoidance industry.14 Imposing complete disclosure under the principle of conservatism15, which would enhance reliability of information, on things that fall on borderline to enable users to adjust the financial statements before they would use the same. 3. Conclusion Accounting and other regulation through the use of standards can never assure about the possibilities of controlling OBSF accounting because of the very nature of accounting itself. It is a natural tendency of a company to look good in the public and it takes a unique courage to be very truthful and objective about anything that would be said if the same could not assure the people who will be affected by such decision. The practice of off-balance financing and consequent effect may just be one form of creative accounting and the companies can do many other things to look good. The basis of course is on changing conditions that may eventually render present accounting standard ineffective an updated. Controlling OBSF may be attained to a certain level but other ways to get around may still come with different set of conditions and circumstances. Reference List 1. Arnold, R. Economics. Cengage Learning. 2008, p.330 2. Brigham and Houston. Fundamentals of Financial Management. Cengage Learning 2009, p. 14 3. Deloitte. IFRS in your pocket 2010. 2011. Retrieved 19 November 2011, 4. Epstein & Jermakowicz. Wiley IFRS 2008: Interpretation and Application of International Accounting and Financial Reporting Standards. John Wiley and Sons. 2008, p.9 5. Glantz. Managing bank risk: an introduction to broad-base credit engineering, Volume 1, Academic Press, 2003, page 85 6. Innes, W, et al, The Essential GAAR Manual: Policies, Principles and Procedures. CCH Canadian Limited, 2006 p. 213 7. Kieso, et al. Intermediate Accounting. John Wiley and Sons, 2007, p. 46 8. Matilal. Lecture Notes -- Accounting for Leases. Essex Business School, 2011 9. McConnell and Brue (2004). An Introduction to Economics and Economy. The McGraw-Hill Companies 10. Si̇li̇er, Y. Freedom: political, metaphysical, negative and positive. Ashgate Publishing, Ltd. 2005, p.93 11. Tarantino, A. Managers guide to compliance: Sarbanes-Oxley, COSO, ERM, COBIT, IFRS, BASEL II, OMB A-123, ASX 10, OECD principles, Turnbull guidance, best practices, and case studies. John Wiley and Sons. 2006 , p. 298 Read More