Implications of Off-Balance Sheet Accounting - Essay Example

FINANCE AND ACCOUNTING: IMPLICATIONS OF OFF-BALANCE SHEET ACCOUNTING Affiliation: Introduction In each and every business entity, the financial statements are among the most important of documents (Rogers & Lindstrom, 1996). This is mainly because of the intensity of the weight that they are depicted to carry, with regard to information concerning a business entity (Boundless, Nd, p. 1). Business financial statements basically include two parts. The first is the profit and loss account, usually referred to as the income and expenditure statement (White & Fried, 1998, pp. 4-15). This simply shows how much the business has earned (revenue) and how much it has spent (expenditure). The other section is the statement of financial position, commonly referred to as the balance sheet (Albreicht & Stice, 2007, pp. 187-188). This simply constitutes a company’s assets and liabilities. As a matter of practice and of ethics, these financial statements are expected to reflect the true nature of a business entity (Boundless, Nd, p. 1). In other words, it is supposed to reflect correct figures, as these are key to and crucial in decision making. However, in practice, this has turned out not to be the case in many circumstances, especially due to off-balance sheet accounting (Lightstone, 2011, pp. 1-4). Understanding off-balance Sheet Accounting Off-balance sheet accounting is an accounting system that allows business entities to exclude certain vital information from the balance sheet (Dhamijaa, 2011, pp. 1-5). However, in most cases, this vital information is not entirely excluded or hidden from the eyes of those interested in the financial statements, since this information is included in the footnotes of these financial statements, and specifically, the balance sheet (Dhamijaa, 2011, pp. 1-5). As a matter of practice, this freedom has opened the floodgates, and it is true to say that many financial statements often do not represent the clear picture of an entities financial position (Lightstone, 2011, pp. 1-4). However, this is not always the case. Bearing the above in mind, the truthfulness of an entity’s financial statements depends on its motive for off-the balance sheet accounting. As much as there are those business entities that use it as an opportunity to misrepresent themselves and defraud members of the public, there are those who undertake it simply because some situations and circumstances call for it (Anson, 1999, pp. 1-10). This having been said, therefore, it is fair to acknowledge and appreciate the fact that there are legitimate reasons for off-the balance banking as well as illegitimate reasons for the same. It is; therefore, wrong to operate on the presumption that the financial statements of business entities are always not credible, simply because off-the balance sheet accounting is allowed in practice (Buttler, 2009, pp. 177-179). Legitimate Reasons for Off-balance Sheet Accounting Securing of loans when in large debt is one of the reasons for off-balance sheet accounting (Obringer, Nd, p. 1). For obvious reasons, financial institutions like banks and other lending corporations are never willing to extend loans or financial assistance to business entities whose financial statements testify of huge debts (Obringer, Nd, p. 1). This is because such loans are considered a risk, since the chances of them being recovered are minimal. For this reason, business entities in need of loans and in huge amounts of debts will always find a way of maneuvering around the situation. In such a scenario, many business entities would consider the option of special purpose entities (SPEs). This refers to starting a separate entity, usually a subsidiary, and borrowing money in form of loans through the same. Banks will, obviously, find it easy to advance loans to SPEs, since they have close to zero debt (Quiry & Salvi, 2011, pp. 412-420). When it comes to accounting, information with regard to the SPE will not be reflected in the parent entity’s financial statements, but will only appear in the footnotes of these statements. Venturing into new (risky) business is another reason (Lightstone, 2011, p. 8). In today’s corporate world, many business entities often avoid getting involved with risky ventures. However, where the risky ventures have the potential of heavy returns, business entities will consider SPEs. Here, an entity starts a new, separate entity, for the purposes of undertaking a new and risky venture. The major aim of doing so is usually because the business entity wants to avoid risking its assets, and therefore seeks to undertake the risk in the safest way possible (Lightstone, 2011, p. 8). In such a scenario, it is the same business entity that is operating both the existing and the new venture; it’s only that the parent entity will be allowed to exclude information about the SPE in its own financial statements, since the two are considered, by law, as separate legal entities. Synthetic leasing is another legitimate reason for off-balance sheet accounting (Lightstone, 2011, p. 9). This is where special purpose entities (SPEs) become owners of property belonging to an existing business entity, but leases the same back to the business. This therefore means that the company will be allowed to exclude tax charges on its balance sheet, since they are seen to reap tax benefits by leasing what belongs to them (Lightstone, 2011, p. 9).This is, as a matter of fact, a requirement as provided by the International Financial Reporting Standards and the Generally Accepted Accounting Principles. Therefore, as it can be seen, it is true that business entities are allowed to engage in off-balance sheet accounting in some instances. However, this is not, or rather, was not meant to open the flood gates of fraudulent accounting. For instance, in the above three scenarios, the business entities will present what can be said to be “faithful” financial statements, since they are not taking advantage of the off-balance sheet accounting allowance to defraud anyone, except for the good of the business. On the other side, however, there are those business entities who take advantage of the off-balance sheet accounting allowance to defraud shareholders and general members of the public. In such cases, business entities are motivated by ill intentions in excluding some information from their financial statements. Illegitimate Reasons For Off-balance Sheet Accounting Hiding debt from public and potential investors is what some business entities use off-balance sheet accounting for (Lightstone, 2011, p. 9). The goal of every business entity is always to protect its name and image before right-minded members of the public, and also to attract more investors to invest in or with it. This, therefore, implies that business entities will do whatever it takes to do away with anything that might prevent them from achieving their major goal. In most cases, huge debt is the obstacle, since many investors are risk averse. Off-balance sheet accounting comes in handy to help business entities, since it allows them not to include the huge debt figures in their financial statements. This is fraudulent, since it fails to presents a true picture of the affairs of the business, and therefore many investors and members of the public are usually at risk of making crucial decisions based on false information. Siphoning Funds from the business entity is the other negative consequence of off-balance sheet accounting (Lightstone, 2011, p. 19). Since this type of accounting allows the exclusion of some information from the balance sheet, some entities end up excluding the very vital information, leading to the deception of those who are interested in the financial statements. When it comes to siphoning funds from the business, off-balance sheet accounting allows for the exclusion of such withdrawal information and details from the balance sheet, and the same is indicated in the footnotes of the financial statements as “(general) business expenditure (Lightstone, 2011, p. 19). In such a scenario, it is impossible to tell that it was a withdrawal, since the finer details of the indicated “business expenditure” are not provided in the financial statements, as was the case at Parmalat company (Lightstone, 2011, p. 19). Therefore, borrowing from the above discussion, it is fair, in those particular circumstances, to conclude that business financial statements do not always faithfully represent the economic substance of business entities due to the allowed accounting system. It is worth noting and appreciating that this is not just a matter of theory, but rather, it is something that happens in the real corporate world. A good example would be the financial crisis, to which off-balancing accounting by world major business corporations hugely made a contribution, as discussed in the following case studies (Partnoy & Turner, Nd, p. 1). American Insurance Group (A.I.G) This is one of the largest insurance companies in the world. In order to protect its name and image, the company got involved in some fraudulent business, which was aided by off-the balance sheet accounting (Partnoy & Turner, Nd, p. 1). The company used this accounting system to disclose only part of its credit default swaps and failed to list the actual potential liabilities associated with the business (Partnoy & Turner, Nd, p. 1). This therefore means that the company failed to warn its shareholders and investors that it was in a financial crisis, and this was propagated by its motive to defraud. Lehman Brothers Just like A.I.G, this company also enjoyed the status of being among the largest firms in the world. However, due to the flood gates opened by the allowance to use off-balance sheet system of accounting, the company came up with a “repo 105” project to exclude funds amounting to fifty billion dollars of short-term debt from their balance sheet (Lightstone, 2011, p. 20). They did this by modifying liabilities to appear as “re-purchase agreement debt” (liabilities) as “sales” (revenue” (Lightstone, 2011, p. 20). This made the company appear to be in a far much better financial position that it actually was (Lightstone, 2011, p. 20). Conclusion As much as it is seen to open the floodgates of fraudulent accounting, off-balance sheet accounting should also be seen as a practice that is essential in the corporate world, necessitated by the provision that each and every company to be regarded as a legal entity. However, it is not entirely true to claim that all financial statements provide false information (Ketz, 2003). As a matter of fact, some business entities operate on high standard ethics, which operate to minimize the chances of fraud or dishonesty (Wilkinson, 2005, pp. 54-57). However, they are left with no option but to embrace off-the balance sheet accounting, as a matter of practice (Ronen & Saunders, 1990, pp. 86-100). Reference List Albreicht, S. W., & Stice, E. K. (2007). Financial Accounting. Boston: Cengage Learning. Anson, M. J. (1999). Accounting and Tax Rule for Derivatives. Hoboken: John Wiley & Sons. Boundless. (Nd). Uses of a Financial Statement. Retrieved February 18, 2015, from Boundless.com: 1. https://www.boundless.com/finance/textbooks/boundless-finance- textbook/financial-statements-taxes-and-cash-flow-2/introducing-financial-statements- 31/uses-of-a-financial-statement-177-1000/ Buttler, C. (2009). Accounting For Financial Instruments. Hoboken: John Wiley & Sons. Dhamijaa, I. (2011, July 13). Off-balance Sheet Risk. Retrieved February 18, 2015, from Slideshare.net: http://www.slideshare.net/IshikaaDhamijaa/off-balance-sheet-risk Ketz, E. J. (2003). Hidden Financial Risk: Understanding Off-balance Sheet Accounting. Hoboken: John Wiley & Sons. Lightstone, A. (2011, October). Exploring Off-balance Sheet Accounting and Fraudulent Accounting Practices. Retrieved February 18, 2015, from 2. http://www.newlearner.com/courses/hts/bat4m/pdf/Exploring%20Off- Balance%20Sheet%20Accounting.pdf Obringer, L. A. (Nd). How Cooking The Books Works: Off-balance Sheet Accounting and Manipulation. Retrieved February 18, 2015, from Howstuffworks.com: http://money.howstuffworks.com/cooking-books4.htm Partnoy, F., & Turner, L. (Nd). Bring Transparency to Off-balance Sheet Accounting. Retrieved February 18, 2015, from Make Markets Be Markets: http://www.makemarketsbemarkets.org/modals/report_off.php Quiry, P., & Salvi, A. (2011). Corporate Finance: Theory and Practice. Hoboken: John Wiley & Sons. Rogers, E. R., & Lindstrom, G. (1996). Ethical Implications of Off-balance Sheet Financing. Business and Professional Ethics Journal , 19-32. Ronen, J., & Saunders, A. (1990). Off-balance Sheet Activities. Santa Barbara: Greenwood Publishing Group. White, G., & Fried, D. (1998). The Analysis and Use of Financial Statements. Hoboken: John Wiley & Sons. Wilkinson, N. (2005). Managerial Economics: A problem-Splving Approach. Cambridge: Cambridge University Press. Read More