FINANCIAL STATEMENT

ANALYSIS & VALUATION

Third Edition

Peter D.
Easton
Cambridge Business Publishers, 2013

Mary Lea
McAnally

Gregory A.
Sommers

Xiao-Jun
Zhang

Module 10:
Off-Balance-Sheet
Financing

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Off-Balance Sheet
Financing

Off-balance sheet financing means that

either assets or liabilities, or both, are not
reported on the face of the balance sheet.
Managers generally believe that keeping
such assets and liabilities off the balance
sheet improves market perception of their
operating performance and financial
condition.
Empirical evidence suggests that analysts
adjust balance sheets to include assets
and liabilities that managers exclude.

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Leasing

A lease is a contract between the owner

of an asset (the lessor) and the party
desiring to use that asset (the lessee).
Generally, leases provide for the
following terms:
1.
2.
3.

The lessor allows the lessee the unrestricted

right to use the asset during the lease term.
The lessee agrees to make periodic payments
to the lessor and to maintain the asset.
Title to the asset remains with the lessor,
who usually retakes possession of the asset
at the conclusion of the lease.

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Capital vs. Operating

Leases

GAAP identifies for two different

approaches in the reporting of leases
by the lessee:
Capital lease method - both the
lease asset and the lease liability are
reported on the balance sheet.
Operating lease method - neither
the lease asset nor the lease liability
is on the balance sheet.

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Capital vs. Operating

Leases

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Operating Leases
Consequences for the lessee:
1.
2.
3.

4.

The lease asset is not reported on the balance sheet - net

operating asset turnover (NOAT) is higher.
The lease liability is not reported on the balance sheet financial leverage is improved.
Without analytical adjustments (see later section on
capitalization of operating leases), the portion of ROE
derived from operating activities (RNOA) appears higher,
which improves the perceived quality of the companys
ROE.
During the early years of the lease term, rent expense
reported for an operating lease is less than the
depreciation and interest expense reported for a capital
lease. This means that net income is higher in those early
years with an operating lease. Further, if the company is
growing and continually adding operating lease assets, the
level of profits will continue to remain higher during the
growth period.

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Deltas
Footnote
Disclosu
res of
Lessees

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Capitalizing Operating
Leases
for Analysis Purposes
1.
2.

3.

Determine the discount rate.

Compute the present value of
future operating lease payments.
Adjust the financials to include the
present value of the lease asset
and lease liability.

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Deltas Implicit Discount

Rate

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Capitalization of Deltas
Operating Leases on the
Balance Sheet

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Adjustments to the
Income Statement

Remove rent expense from operating

expense.
Add depreciation expense from the
lease assets to operating expense and
add interest expense from the lease
obligation as a nonoperating expense.

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Capitalization of Deltas
Operating Leases

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Pensions

Generally two types of plans:

Defined contribution plan. This plan has

the company make periodic contributions to
an employees account, and many plans
require an employee matching contribution.
Defined benefit plan. This plan has the
company make periodic payments to an
employee after retirement.

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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 statement
when paid or accrued.

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1.

Two Accounting Issues

Related to Defined Benefit
Plans
The appropriate balance sheet presentation of

The appropriate balance sheet presentation of

the pension investments and obligation.

2.

The pension standard allows companies to report the

net pension liability on their balance sheet.
Underfunded plans are reported on the balance
sheet as a long-term liability.
Overfunded plans are reported as a long-term asset.

The treatment of fluctuations in pension

investments 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), and to defer the recognition of unrealized
gains and losses on both pension investments and
pension obligations.

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Plan Assets and PBO

Computations

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Balance Sheet Presentation

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PBO Components

Service cost the increase in the

pension obligation due to employees
working another year for the
employer.
Interest cost the increase in the
pension obligation due to the accrual
of an additional year of interest.
Benefits paid to employees the
companys obligation is reduced as
benefits are paid to employees.

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Pension Expense

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Deltas Funded Status

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Deltas Pension Expense

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Cash Flow Implications

One application of the pension footnote

is to assess the likelihood that the
company will be required to increase its
cash contributions to the pension plan.

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Profit Implications

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How Pensions Confound

Income Analysis

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Global Accounting

Leases - IFRS lease standards currently allow

for operating leases, but the standards are such

that it is very difficult for a lease agreement to
qualify as an operating lease.
Pensions - U.S. GAAP permits deferral of
actuarial gains and losses and then amortizes
them to net income over time. IFRS companies
can recognize all actuarial gains and losses in
comprehensive income in the year they occur.
Special Purpose Entities - Under U.S. GAAP,
the primary beneficiary is required to consolidate
the SPE. IFRS focuses on the general concept of
control to determine if the SPE is consolidated.

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Special Purpose Entities

(SPEs): Asset Securitization

A sponsoring company forms a subsidiary that

is capitalized entirely with equity; this creates
a bankruptcy remote transaction, which
reduces the likelihood of bankruptcy for
subsequent investors).
The subsidiary purchases assets from the
sponsoring company and sells them to a
securitization (off-balance-sheet) trust (the
SPE), which purchases the assets using
borrowed funds.
Cash flows from the acquired assets are used
by the SPE to repay its debt.

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Special Purpose Entities

(SPEs): Ford Motor Credit

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Fords Asset Securitization

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Rationale for SPE

Financing

Lower cost of capital. SPEs can

provide lower cost financing for a
company.

Liquidity. Securitization of assets

provides a consistent cash flow source.

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Consolidation of SPEs

Generally, any entity that

lacks independence from the sponsoring

company
lacks sufficient capital to conduct its
operations apart from the sponsoring
company

must be consolidated with whatever entity

bears the greatest risk of loss and stands
to reap the greatest rewards from its
activities.

The effect of consolidation of SPEs is to

report both the assets and liabilities on the
consolidated balance sheet.

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End Module 10

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