off b s financing lease pension

8/8/2019 OFF b S Financing Lease Pension

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Unit III smot

Reporting andAnalyzing Off-BalanceSheet Financing


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Why is Off-Balance Sheet Financing

Important? In other words, why are firms so

interested in hiding debt?

If analysis reveals that debt is excessive,companies may face the prospect of areductions in bond ratings, resulting inhigher cost of debt.

Likewise, excessive leverage can resultin a higher cost of equity capital and aconsequent reduction in stock price.


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Window Dressing Financial

Statements: Examples # 1 A companys level of accounts receivable are

perceived to be too high, thus indicatingpossible collection problems and a reduction in

liquidity. Prior to the statement date, the company

offers customers an additional discount inorder to induce them to pay the accounts morequickly.

Although the profitability on the sale has beenreduced by the discount, the company reducesits accounts receivable, increases its reportedcash balance and presents a somewhathealthier financial picture to the financial

markets.


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Window Dressing Financial

Statements: Examples # 2 The companys financial leverage is

deemed excessive, resulting in lowerbond ratings and a consequentincrease in borrowing costs.

To remedy the problem, the companyissues new common equity andutilizes the proceeds to reduce theindebtedness.

The increased equity provides a baseto support the issuance of new debt

to finance continued growth.


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Motives for using Off-Balance Sheet

Financing In general, companies desire to present a

balance sheet with sufficient liquidity andless indebtedness.

The reasons for this are as follows: liquidityand the level of indebtedness are viewed astwo measures of solvency.

Companies that are more liquid and lesshighly financially leveraged are generally

viewed as less likely to go bankrupt. As a result, the risk of default on theirbonds is less, resulting in a higher rating onthe bonds and a lower interest rate.


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Leasing A lease is a contact between the owner of

an asset (the lessor) and the partydesiring to use that asset (the lessee).

Generally, leases provide for the followingterms:1. The lessor allows the lessee the unrestricted

right to use the asset during the lease term

2. The lessee agrees to make periodic payments to

the lessor and to maintain the asset3. Title to the asset remains with the lessor, who

usually retakes possession of the asset at theconclusion of the lease.


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Advantages to Leasing1. Leases often require much less equity

investment than bank financing.

2. Since leases are contracts betweentwo willing parties, their terms can bestructured in any way to meet theirrespective needs.

3. If properly structured, neither theleased asset not the lease liability arereported on the face of the balancesheet.


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Operating Lease Operating lease method.

Under this method, neither the

lease asset nor the lease liabilityis on the balance sheet. Leasepayments are recorded as rent

expense when paid.


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Benefits of Operating Leases

1. Leased asset is not reported on the balancesheet.

2. Lease liability is not reported on the balancesheet.

3. For the earlyyears of the lease term, rentexpense reported for an operating lease isless than the depreciation and interestexpense reported for a capital lease.


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Capital vs. Operating Leases Capital lease method. This method

requires that both the lease asset andthe lease liability be reported on thebalance sheet. The leased asset isdepreciated like any other long-termasset. The lease liability is amortizedlike a note, where lease payments areseparated into interest expense andprincipal repayment.


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Operating Leases The benefits of applying the operating method

for leases are obvious to managers.

The lease accounting standard, unfortunately,

is structured around rigid requirements.Whenever the outcome is rigidly defined,clever managers that are so-inclined canstructure lease contracts to meet the letter ofthe standard to achieve a desired accounting

result when the essence of the transactionwould suggest a different result.

This is form over substance.


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Capital Leases Capital leases

Effectively an installment purchase

Lessee assumes rights and risks of

ownership Treated as purchases

Examples of what constitutes acapital lease PV of lease payments is the FMV of the

asset

Period of the lease approximates the assetslife

There is a bargain purchase price


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Footnote Disclosures of Lessees


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Capitalizing Operating Leases for

Analysis Purposes1. Determine the discount rate to

compute the present value of theoperating lease payments.

This can be inferred from the capital leasedisclosures, or one can use the companysdebt rating and recent borrowing rate forintermediate term secured obligations asdisclosed in its long-term debt footnote.

2. Compute the present value of theoperating lease payments.

3. Add the present value computed in

step 2 to both assets and liabilities.


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Capitalization ofMidwest Air

Operating Leases


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Pensions There are generally two types of plans:

Defined contribution plan. This planhas the company make periodic contributions

to an employees account (usually with athird party trustee like a bank), and manyplans require an employee matchingcontribution. Following retirement theemployee makes periodic withdrawals fromthat account. A tax-advantaged 401(k)account is a typical example.


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Pensions Defined benefit plan. This plan has

the company make periodic payments to anemployee after retirement. Payments are

usually based on years of service and/orthe employees salary. The company mayor may not set aside sufficient funds tomake these payments. As a result, definedbenefit plans can be overfunded or

underfunded.


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Accounting for Defined

Contribution Plans From an accounting standpoint,

defined contribution plans offer no

particular problems. The contribution is recorded as an

expense in the income statementwhen paid or accrued.


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Accounting for Defined Benefit

Plans Defined benefit plans are more

problematic due to the fact that the

company retains the pensioninvestments and the pensionobligation is not satisfied until paid.

Account balances, income and

expenses, therefore, need to bereported in the companys financialstatements.


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Two Accounting Issues Related to Pension

Investments and Obligations: Problem # 1

The first of the two primary accountingissues relates to the appropriate balance

sheet presentation of the pensioninvestments and obligation.

The pension standard allows companiesto report the netpension liability on their

balance sheet.


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Problem # 1 - Continued That is, if the pension obligation is greater than

the fair market value of the pensioninvestments, the underfunded amount isreported on the balance sheet as a long-termliability.

Conversely, if the pension investments exceedthe companys obligation, the overfundedamount is reported as a long-term asset.

The amount reported, however, is not whatyou or I would likely consider the true fundingstatus.


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Two Accounting Issues Related to Pension

Investments and Obligations: Problem # 2

The second issue facing the FASB was thetreatment of fluctuations in pensioninvestments and obligations in the

income statement. The FASB allows companies to report

pension income based on expected long-term returns on pension investments

(rather than actual investment returns).


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The Balance of the Pension

Liability (PBO) Computation


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Accounting for Defined Benefit

Plans Service cost the increase in the

pension obligation due to employeesworking another year for the employer.

Interest cost the increase in thepension obligation due to the accrual ofan additional year of interest.

Benefits paid to employees thecompanys obligation is reduced asbenefits are paid to employees.


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Computation of the Balance of

the Pension Investments


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Footnote Disclosures of

Pensions


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Pensions


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Pensions


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off b s financing lease pension

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