Corporate Reporting and Balance Sheet Financing - Essay Example

Corporate Reporting and Balance Sheet Financing, impairment on the value of non current assets and the use of accounting ratios as tool of analysis in these situations 1.0 Introduction: The Enron failure has given rise to several questions concerning the preparation and presentation of financial statements of accounts including off balance sheet financing resorted to by several corporate entities. All these questions have been cropped up due to the single factor of 'off balance sheet financing' (OBSF) techniques adopted by Enron and the consequent impact it created on the whole economy because of its failure. However there is truth in saying that no one has all relevant information and facts about Enron's failure and hence it cannot be said the OBSF is the lone factor responsible for the Enron debacle. Financial analysts are of the opinion that OBSF may be viewed as a scalpel in a surgeon's hands, which can be put to an effective use if handled properly. This paper presents a discussion on the ways of achieving OBSF. While the paper analyses the effect of the international standards for leasing and financial instruments as avenues of OBSF, it also reflects some views on the regulatory provisions on impairment of the non-current assets of listed companies and the inadequacies of the financial ratios in bringing out the correct financial strength of the companies adopting techniques of OBSF. 2.0 Off Balance Sheet Financing: According to Shiva and Lynda (2003) Off-balance sheet financing (OBSF) is a mode of organizing a financing transaction in such a way that it is not recognized easily as the entity's own liability. There are many distinct advantages of using OBSF under different circumstances. They are: Arranging for cheaper outside borrowings which are secured by debt contracts that are not backed by collateral securities The debt-to capitalization ratio can be maintained at such level as may be desired by the firm Helps in maintaining the credit ratings in the market and thereby enhance the future borrowing capacity and Providing finance for those projects which could not be approved due to non-availability of own funds. Although it can be argued that allowing the companies use OBSF method will materially alter the true and fair view of the financial status of the firm as represented by its balance sheet, still the companies may take a chance to use OBSF to look for raising additional funds for rather a risky capital project which is not otherwise available as its own funds. The individual company may attempt a safe play between BSF and OBSF in such a way that it presents useful information for valuing the firm's stock prices and derive the advantage. 2.1 Effective Ways of Using Off Balance Sheet Financing: While the items like loan, debt and equity appear in the financial statements of a company, the off balance sheet items do not find a place in the balance sheet. Creation of off balance sheet entities, joint ventures, research and development partnerships and operating leases are some of the ways in which the off balance sheet financing method can be employed by a firm. Creation of off balance sheet entities is one of the usual ways of using the OBSF for the advantage of the firm. These separate legal entities were permissible under Generally Accepted Accounting Principles (GAAP) and tax laws. According to Rick Wayman 2002 'off-balance-sheet' refers to separate legal entities comprising of separate or subsidiary companies where the parent company holds the majority of the shares. It also covers the contingent liabilities of the firm represented by the letters of credit or loans to separate legal entities which are guaranteed by the parent company. While these items are allowed to be excluded from the financial statements of the parent company, GAAP requires them to be shown by way of foot notes attached to the balance sheet and other financial statements. This way the parent company could fianc the new venture without diluting the existing shareholders equity or adding to the external borrowings of the existing company. These separate legal entities may take the form of partnerships held privately or may be public companies formed as spin offs from the parent company. At times the off balance sheet companies are created to help financing a project which is a part of the activity of the parent company. For example, oil-drilling companies established off balance sheet companies to finance oil exploration. These companies may be funded by the parent company as well as the outside investors who are willing to take the risk of oil exploration. Sometime it may so happen that off balance sheet companies are created to carry out an entirely different line of business. Example: Operating leases is another form of off balance sheet financing. In these cases the asset itself is kept on the balance sheet of the lessor and the lessee makes the financial report including only the required rental expenses for the use of the leased asset. Under GAAP, rules have been made to determine the capitalization of a particular asset or it can be shown as a leased asset with the lease rental charged to the expenses. 3.0 Effect of International Accounting Standards of Leasing and Financial Instruments on Off Balance Sheet Financing: There are different standards prescribed by the International Accounting Standards Board (IASB) in respect of the leasing and financial instruments. It is observed that in spite of the changes that these standards propose to bring about the companies are still able to resort to Off Balance Sheet Financing. A detailed review of these standards is appended below: 3.1 IAS 17 The main purpose of the proposed changes in IAS 17 is to prescribe the companies the treatment of land and buildings. The change requires the companies to treat the land and building as separate leases. Now the business entities have to arrive at the rental values of land and buildings separately. Similarly the type of lease has to be determined by them and should be accounted for. With the changes in International Accounting Standard 17, which deals with the leasing transactions, if in a leasing transaction all or substantially all risks and rewards incidental to the ownership is transferred to the lessee by the covenants of the lease deed, then the lease is to be treated as a capital item and should be included in the balance sheet and reported as capital item. Thus IAS 17 has made it difficult for the companies to execute lease agreements with minimum requirements to be used to cover leasing as OBSF. However Statements on Financial Accounting Standards 13, which deals exclusively with the leasing transactions under US GAAP. (SFAS 13) requires that there must necessarily be a distinction between both operating and capital lease. For making this distinction explicit the standard has specified four specific criteria like transfer of ownership at the end of the lease, bargain price options, extension of lease for 75 percent of the asset's life and present value of lease payments. The purpose for specifying such criteria is to ensure that the lease transactions are characterized with their natural intentions and classified as capital or lease transaction depending upon the true nature of such transactions... If a contract satisfies any of the four criteria, it must be recognized as a capital lease in the financial statements. However the provision of such specification has not resulted in the expected way to make the firms show the true nature of the individual transactions. In many cases, the firms have taken advantage of these provisions and have made the lease contracts in such a way to avoid them being caught in any of these four criteria. "Because precise rules were established, companies carefully structured lease contracts to qualify as operating leases. As a result, the explicit rule allows the off-balance-sheet financing to continue, and provides justification for the treatment."(Rebecca Toppe Shortridge and Mark Myring) 3.2 IAS 32 and IAS 39: The standards IAS 32 and IAS 39 accounting and reporting on all financial instruments except those covered under interests in subsidiaries (IAS 27, 28 and 31), leasing transactions under IAS 17, employee benefit plans IAS 19 guarantees under IAS 37 and business combinations under IAS 22. The main changes proposed in these standards include the following: IAS 37 excludes all loan commitments subject to certain conditions Insurance contracts under certain circumstances "The standards will treat the contract for the purchase or sale of a non-financial asset is treated as a financial instrument if a) it gives either party the right to settle in cash or another financial instrument, or is readily convertible to cash, unless the contract is "normal", ie it is expected to result in receipt or delivery of the non-financial item for the entity's expected purchase, sale or usage requirements; or b) the contact does not provide for net cash settlement, but: - the entity has a past practice of selling or closing out the contract and settling the gain or loss (by reference to market prices) net in cash with the counterparty or entering into offsetting contracts; or - the entity has a past practice of taking delivery of the underlying commodity and selling it shortly thereafter, to generate a profit from short-term fluctuations in price or a dealer's margin". (Ernst & Young) 3.3 Other International Standards: In the case of financial instruments SFAS 133 provides the standards for the accounting for derivatives and hedging activities. The statement purports to develop presentation standards for income statements that clearly separate the effect on earnings of realized and unrealized changes in the fair value of financial instruments from the effect on earnings of the issuer's core operations. However there were numerous questions and statements issued on the fundamental definition as well as the methods to measure the fair value of an identified derivative. Because of this a rule was added to delineate exactly how fair value should be determined. Thus, a principle requiring financial instruments to be measured at fair value became a detailed rule with complex stipulations and exceptions that allow corporations to structure contracts to achieve favorable reporting. 4.0 Impact of International Regulations (IAS 36 and IFRS 3) upon the Non-Current Asset Values of Listed companies: A comprehensive and consistent framework to be used for the accounting for the business combinations has been provided by the International Accounting Standards Board by issuing the IFRS 3 Business combinations, together with the revised standards IAS 36 Impairment of Assets and IAS 38 Intangible Assets. This also marks the completion of one of the major objective of the IASB. IFRS 3 defines a business combination as the function of combining the business activities of one or more separate entities into one common reporting organization. In other words under IFRS 3 a business is an integration of all activities and combining of assets with the intention of providing a return to the investor. It also covers such integrated activities which are combined for the purpose of reducing the costs or other economic benefits and such reduction should have been effected directly and proportionately to the policyholders or participants connected with the activities. To illustrate the purchase by an entity all the hardware that comprises the computer and telephone system of a company that is winding up will not be considered as a business activity within IFRS 3, as such action cannot provide a return to the investor or lower costs. The transaction will be accounted for as the acquisition of the assets at their respective fair values. Under IAS 36 as revised in 2004 which deals with the Impairment of Assets as and when there appears to be the incidence of impairment of the value of an asset , it becomes necessary for the firm to measure such impairment. Wherever there is an excess value of an asset more than its recoverable value, then an impairment loss is considered to be present in those circumstances. For the purpose of calculation of impairment, an asset's recoverable amount is the higher of its value in use (the present value of the future cash flows expected to be derived from the asset) and its fair value less costs to sell. (Deloitte 2004) Goodwill being a non current asset this paper examines the impairment of the value of the goodwill by listed companies under IFRS 3 and IAS 36. The new model of IRFS 3 will require the acquirer to: recognise the minority interest in goodwill; recognise in the income statement any holding gain or loss when it acquires control in stages; charge transaction costs in the income statement; and recognise contingent consideration at fair value, and recognize subsequent changes in fair value in the income statement. "The current model requires the parent company to recognize its share of goodwill arising on the acquisition. The new model will require recognition of the entire value of the business acquired, including the minority interest in goodwill. This will do more than just gross up the balance sheet." (IFRS News) According to the journal Corporate Watch 2006 currently, in accordance with IAS 36 Impairment of Assets and IAS 39 Financial Instruments: Recognition and Measurement, "impairment assessment is required for: goodwill at every reporting date; investment in equity instrument at every balance sheet date; and financial assets carried at cost at every balance sheet date". It is important to note that IAS 36.124, IAS 39.69 and IAS 39.66 do not allow any reversal of impairment in respect of the abovementioned items at any cost and the assessment has to be carried out in the circumstances mentioned without fail. Thus IAS 36 "impairment of goodwill' requires that goodwill should be subject to impairment review, both annually and when there are indications that the carrying value may not be recoverable. The requirement under the new IFRS 3 (Business combinations) combined with the changes made to IAS 36 (Impairment of Assets) and IAS 38 (Intangible Assets) that the goodwill needs to be tested at frequent intervals for impairment have resulted in abnormal business situations to be handled by the firms in respect of the accounting for goodwill and other intangible assets being held by them. According to the changes made to IAS 36 and IAS 38 the value of goodwill needs to be tested on an ongoing basis for impairment in its value. The revised standards also specify the accounting procedures related to goodwill as well as other intangible assets. The new provisions of these three legislations apply to the accounting for all business combinations. They also consider the valuation and accounting of the goodwill and other intangible assets acquired by the firms as on or after March 31, 2004. The new model IFRS 3 has reversed the existing position in relation to the amortisation of goodwill. Hereafter the goodwill can not be automatically amortised automatically over its estimated useful life by the firms as has been done earlier. With the changed situation, the companies must test goodwill for impairment either annually, or if necessary more frequently. This assessment or testing is to be undertaken, if there occur any events or changes in circumstances that indicate a possible impairment and because of such impairment the carrying value of the goodwill may not anymore be recoverable as is stated in the financial statements. "Because of the new requirement for goodwill impairment testing, the application of the revised IAS 36 will become all the more critical. Furthermore, since the application of IAS 38 and IFRS 3 together will result in a significant increase in the number of intangible assets that will be recognised in future accounting procedures for business combinations, the number and nature of the types of assets that will be subject to impairment tests will become even more significant". (David Haigh, Unni Krishnan 2004) Calculation of Brand Values on acquisition may be considered as an example for the operation of IAS 3 and IFRS 36 which should be reviewed for impairment at frequent intervals and it cannot be amortised over a period as was being done earlier. Example: The best example for the higher value of intangible assets being shown in their financial statements is CADBURY SCHWEPPS. This company because of it acquiring varied other brands like Halls, 7-up, Dr.Peppers etc. With these brand acquisitions the company is showing intangible assets worth 5 billion in their books of account 5.0 Inadequacies of Accounting Ratios as financial tools in OBSF and Impairment of Non-Current Assets: Analysis of key financial ratios is the usual method being adopted by the users of the financial statements of companies as well as the investors to assess the financial position of the companies in whose stocks they want to invest. Ratios are found useful in a meaningful analysis of the companies' significant financial data and a financial ratio signifies the relationship between the various activities of the company and its worth in terms of its assets and liabilities. Ratios indicate the relative usefulness of assets to the companies and the extent of the liabilities of the companies as against its realizable value of its assets. This way it becomes possible for the user to make a judgment about the financial position of the company as well as its profitability. The income generating capacity of the company is also exhibited by the financial ratios... Financial ratios become meaningful only when they are compared with other available information about the entity under question. "Since they are most often compared with industry data, ratios help an individual understand a company's performance relative to that of competitors; they are often used to trace performance over time." (Venture line) Ratio Analysis can reveal much about a company and its operations. However there are several points that create certain inadequacies on the Accounting ratios as an effective tool of analysis. They are: The accounting ratios are only indicators of strength or weakness of the financial position of a firm. Studying one or even several ratios might be misleading. Combining the ratio analysis with other knowledge of the company's management and economic circumstances alone will enable the reader to have a full picture about the financial standing of the company. Secondly a ratio is never represented by a single correct value. The observation and commentary that a ratio is to high or too low depend on several other factors like the perception of the analyst and on the company's competitive strength. A ratio delivers a meaningful analysis only when it is compared with some standard, such as industry standards or ratio trend. Much depends on the availability and the reliability of the available comparative standards. For example in trend analysis financial ratios are compared over time, typically years. Hence collection and presentation of the historical data is a prerequisite for an efficient financial ratio analysis and to arrive at effective decisions on the basis of such ratio analysis. Financial ratio analysis uses formulas to gain insight into the company and its operations. Ratios like Debt to equity ratio calculated on the basis of figures appearing in a company's balance sheet can show the company's financial condition along with its operational efficiency. Off Balance Sheet financing can affect the financial ratios especially the financing ratios that use total debt as a denominator, showing them to be lower and more favourable than they would be if the financing were recognized. A high debt equity ratio generally means a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expenses. If a total debt is used to finance the increased operations the company could potentially generate more earnings than it would have without this outside financing. The effect abovementioned weaknesses of the ratio analysis is further accentuated by the off line balance sheet financing policies of the firm. For example by shifting the debt liability to an off balance sheet entity the parent company would be showing a higher debt equity ratio signifying that the company's own funds are more as compared to the long-term external debt liability of the company, which in reality is not so. The reliance on such a vitiated ratio may prove risky for the investment anybody is making on the projects of the company in the long run. Similarly in a situation there may be an adverse effect on the sales to fixed assets ratio or any other ratio of the company worked out with the asset value of the company including value of the non current assets like goodwill or brand value as the denominator, because of the impairment in the value of such non current assets. The real worth of the assets may not be represented in the ratios due to the fact that the value of the assets is overstated in the financial reports of the company. Since the value of non current assets 6.0 Conclusion: In the course of the last few years, the world of financial reporting has undergone a phenomenal change. The impact of the mandatory introduction of International Financial Reporting Standards across Europe and the voluntary introduction across the financial reporting regimes of many other countries around the world has become one of the biggest challenges facing companies today. A smooth and efficient transition to the new reporting regime requires early planning by the companies concerned. Especially those companies who have used techniques like off balance sheet financing must do a lot of home work before they make a presentation of their financial reports to the regulatory authorities as well as other stakeholders in order to be within the legal framework of the reporting requirements. Reference List: 1. Corporate Watch 2006 Connected Thinking Price Waterhouse Coopers Vol.2 [Online] Available from http://www.pwc.com/sg/corporatewatch/corporatewatch200608.pdf Accessed on 04th March 2007 2. David Haigh, Unni Krishnan 2004 M&A success in banking - Enhancing value with BrandDueDiligence Business Line News Paper October 16, 2004 [Online] Available from http://www.thehindubusinessline.com/2004/10/06/stories/2004100600020900.htm Accessed on 04th March 2007 3. Deloitte 2004 Business Combinations: A Guide to IFRS 3 [Online] Available from http://www.iasplus.com/dttpubs/ifrs3.pdf Accessed on 04th March 2007 4. Ernst & Young IAS 32 and IAS 39 revised: An overview [Online] Available from http://www.ey.com/global/download.nsf/International/IAS32-39_Overview_Febr04/$file/IAS32-39_Overview_Febr04.pdf Accessed on 24th March 2007 5. IFRS News Business Combinations- Phase 2 [Online] Available from http://www.pwc.com/images/gx/eng/fs/0604ifrsnews.pdf Accessed on 04th March 2007 6. Rebecca Toppe Shortridge and Mark Myring Defining Principles-Based Accounting Standards The CPA Journal [Online] Available from http://www.nysscpa.org/cpajournal/2004/804/essentials/p34.htm Accessed on 04th March 2007 7. Rick Wayman 2002 Off-Balance-Sheet Entities: The Good, The Bad And The Ugly Article in Investopedia [Online] Available from http://www.investopedia.com/articles/analyst/022002.asp Accessed on 04th March 2007 8. Shiva Sivatamakrishnan and Lynda thoman 2003 Diversification and the Accounting for New Projects On or Off the Balance Sheet [Online] Available from http://papers.ssrn.com/sol3/papers.cfmabstract_id=488004 Accessed on 04th March 2007 9. Ventureline Financial Rato Analysis [Online] Available from http://www.ventureline.com/FinAnal_OnePrivate.asp Accessed on 04th March 2007 Read More