Off-balance-sheet examples

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Off-Balance-Sheet Examples
One way to finance property, plant, and equipment is to have an outside party acquire them while a company agrees to use the assets and provide funds sufficient to service the debt. Examples of these arrangements are purchase agreements and through-put agreements, where a company agrees to purchase output from or run a specified amount of goods through a processing facility, and take-or-pay arrangements, where a company guarantees to pay for a specified quantity of goods whether needed or not. A variation on these arrangements involves creating separate entities and then providing financing not to exceed 50% ownership  such as joint ventures or limited partnerships. Companies carry these activities as an investment and do not consolidate them with the company’s financial statements. This means they are excluded from liabilities. Consider the following two practices: Also, many retailers sell receivables arising from proprietary credit cards to trusts that they establish for this purpose. The trusts raise funds for these purchases by selling bonds that are repaid from the cash collected.

Special Purpose Entities
Special purpose entities (SPE), now made infamous in the wake of Enron’s bankruptcy, have been a legitimate financing mechanism for decades and are an integral part of corporate finance today. The concept is straightforward:

• An SPE is formed by the sponsoring company and is capitalized with equity investment, some of which must be from independent third parties.
• The SPE leverages this equity investment with borrowings from the credit markets and purchases earning assets from or for the sponsoring company.
• The cash flow from the earning assets is used to repay the debt and provide a return to the equity investors.

Some examples:

• A company sells accounts receivable to the SPE. These receivables may arise, for example, from the company’s proprietary credit card that it offers its customers to attempt to ensure their future patronage (e.g., the Target credit card). The company removes the receivables from its balance sheet and receives cash that can be invested in other earning assets. The SPE collateralizes bonds that it sells in the credit markets with the receivables and uses the cash to purchase additional receivables on an ongoing basis as the company’s credit card portfolio grows. This process is called securitization. Consumer finance companies like Capital One are significant issuers of receivable-backed bonds. Exhibit 3.10 provides an illustration of the flow of funds in this use of SPEs.
• A company desires to construct a manufacturing facility. It executes a contract to purchase output from the plant. An SPE uses the contract and the property to collateralize bonds that it sells to finance the plant’s construction. The company obtains the benefits of the manufacturing plant, but does not recognize either the asset or the liability on its balance sheet since executory contracts (commitments) are not recorded underGAAP and are also not considered derivatives that would require balance sheet recognition 

• A company desires to construct an office building, but does not want to record either the asset or the liability on its balance sheet. An SPE agrees to finance and construct the building and lease it to the company under an operating lease, called a synthetic lease. If structured properly, neither the leased asset nor the lease obligation are reflected on the company’s balance sheet.

There are two primary reasons for the popularity of SPEs:
1. SPEs may provide a lower-cost financing alternative than borrowing from the credit markets directly. This is because the activities of the SPE are restricted and, as a result, investors purchase a well-secured cash flow stream that is not subject to the range of business risks inherent in providing capital directly to the sponsoring company.
2. Under present GAAP, so long as the SPE is properly structured, the SPE is accounted for as a separate entity, unconsolidated with the sponsoring company(see Chapter 5 for a discussion of consolidations). The company thus is able to use SPEs to achieve off-balance-sheet transactions to remove assets, liabilities, or both from its balance sheet. Because the company continues to realize the economic benefits of the transactions, operating performance ratios (like return on assets, asset turnover ratios, leverage ratios, and so on) improve significantly.

US GAAP guidance relating to the accounting for SPEs and the rules for their consolidation with the sponsoring company is provided in ASC 810 and ASC 860. At issue is defining when “control” of one entity over another is established, especially when the SPE does not issue common stock.

Many SPEs are not corporations and do not have stock ownership. For these entities, control is conferred via legal documents rather than stock ownership, and the typical 50% stock ownership threshold for consolidation does not apply. The FASB now classifies these SPEs as variable interest entities (VIEs) if either the total equity at risk is insufficient to finance its operations (usually less than 10% of assets) or the VIE lacks any one of the following: (1) the ability to make decisions, (2) the obligation to absorb losses, or (3) the right to receive returns. In this case, the VIE is consolidated with that entity that has the ability to make decisions, the obligation to absorb losses, and the right to receive returns (called the “Primary Beneficiary”). Consolidation results in the adding together of the financial statements of the Primary Beneficiary and the VIE, thus eliminating any perceived benefits resulting from off-balance-sheet treatment of the VIE.

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