OFF BALANCE SHEET FINANCING

[4thelement]

CAN ANYBODY TELL ME WAT IS OFF BALANCE SHEET FINANCING, IT HAD BEEN INVOLVED IN COLLAPSE OF ENRON

[idreesdurrani]

<font color="navy"></font id="navy"><font size="4"></font id="size4"><font face="Century Gothic">you are right 4th element, the term became popular after the Enron collapse..

Off balance sheet financing refers to a form of financing which is kept off of a company's balance sheet i.e. these are not recognized on the balance sheet in contrast to on balance sheet financing like direct debt or equity funding. This is normally achieved through creating an Special purpose Entity (SPE), a firm or legal entity established to perform some narrowly-defined or temporary purpose. Therefore, the purpose is achieved without having to recognize any of the associated assets or liabilities on its own balance sheet. The purpose is achieved "off-balance sheet."
Companies often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low, mostly to comply with the debt covenants. Operating leases and L/Cs are the most common forms of off-balance-sheet financing.

Enron's collapse occurred when it was discovered that much of its profits and revenues were the results of deals with Special Purpose Entities which were not consolidated in the financial statements.

SPEs are discussed in the forum topic

http//www.accountancy.com.pk/forum/topic.asp?topic_id=6039</font id="Century Gothic">

[4thelement]

thanx idrees

[4thelement]

dear idrees

can u tell me if a company sets up a SPE than it can do financing through SPE but wat wud be the benefit for the company obtaining finance throug the SPE but it cant show that on its own balance sheet.

if it obtains loan from SPE than it has to show that on its balance sheet that the company has acquired financing from related party or associated so how can its leverage or D/E ratio improves

regards

[idreesdurrani]

4th element...ur questions are somewhat ambiguous. Anyway,I'll give you a brief explanation.

"can u tell me if a company sets up a SPE than it can do financing through SPE but wat wud be the benefit for the company obtaining finance throug the SPE but it cant show that on its own balance sheet ".

The benefit as I mentioned earlier is to keep ur financing ratios low, so as to give a better picture to the stakeholders.

The sponsor (or entity on whose behalf the SPE is created) usually transfers assets to the SPE, obtains the right to use assets held by the SPE ( e.g through an operating lease arrangement) or performs services for the SPE, while other parties (“capital providers”) may provide the funding to the SPE. For example an SPE may trasnfer an asset to the sponsor through an operating lease arrangement, implying that neither this asset nor its associated liability will be recorded in the balance sheet of sponsor, yet the sponsor is able to use the asset.

"if it obtains loan from SPE than it has to show that on its balance sheet that the company has acquired financing from related party or associated so how can its leverage or D/E ratio improve".

This is not the direct financing or funding you are thinking about..that's why it is called off balance sheet financing. Further, I mentioned in my last post that the purpose is to keep the leverage. Debt equity ratios low, not about the improvement in these ratios. Obviously, if a financing is not recorded/recognized in the balance sheet, the above ratios will be low.

During the growth phase of Enron, it used borrowing through SPEs' to finance its growing operations rather than direct equity/debt issue. The said SPEs used to borrow money from Lenders, which (the debt) was guaranteed by Enron, thus creating a contingent liability for Enron. Therefore, when these contingent liabilities crsytallized, the only result was Bankruptcy of Enron.

wud love to see contribution from other members on this...

[kamranACA]

Dear Idrees,

You have given good detail. It's useful for all members.

Off balance sheet financing could also be arranged even without creating SPEs or controlled entities. Modarabas are widely providing Operating Lease facilities in Pakistan. Even companies are having such arrangements with group companies, associates and sposnors etc that need not to be consolidated. People do it here in Pakistan using so many techniques either by using off balance sheet instruments or on-balance sheet instruments. You know Pakistanis are known for finding out the solutions of their own choices that's why our titanic prima facie appears to sink. God save us.

For example, all the black money of sponsors / owners (that is created by under-invoicing or taking out money from operations through so many malpractices and fictitious transactions)is un-officially sent out of the country without using banking channel in the form of foreign currency purchased from open market and then it's sent back to such sponsors/owners through T.Ts. using proper cross banking channel. The Pakistani tax laws give relief and protection to all such moneys remitted from abroad through banking channel. The receipt of such white money by sponsors create "SOURCE" in their wealth statements and they lend such white money to their companies (from which it was actually taken out by malpractices) thus creating sponsors loan to the company. Money laundering measures have not so far controlled such situations entirely.

For bank financing purpose, as per prudential regulations, these sponsor loans don't affect the gearing / leverage and are treated the part of equity when calculating D/E ratio.

Further, import L/Cs and banks facilities there-against are typically off balance sheet items. That's why certain disclosures are required to enumerate the details of such arranagements that have to remain off the balance sheet.

In my view, off balance sheet items are the most criticl areas for auditors and regulators.


Regards,



KAMRAN.

[4thelement]

THNX IDREES AND KAMRAN BHAI
WELL AS FAR AS OPERATING LEASE IS CONCERNED I UNDERSTAND THAT IF A COMPANY OBTAINS AN ASSET FROM ITS SPE AND LOAN HAS TO BE REDEEM BY THE SPE
WAT R THE OTHER ARRANGEMENTS THROUGH WHICH OFF BALANCE SHEET FINANCING CAN BE ACQUIRED
REGARDS

[idreesdurrani]

Thanks kamran for the information. You are absolutely right, I have seen many companies having director's loan subordinated to all other payments and loans, which prudential regulations donot require to be classified as loans.

"WAT R THE OTHER ARRANGEMENTS THROUGH WHICH OFF BALANCE SHEET FINANCING CAN BE ACQUIRED"

4th element, I guess this was already answered by our previous posts. L/C's, guarantees are other forms of obtaining off balance sheet financing.

Regards,

[4thelement]

well wat are subordinated directors loan and how they are treated in presentation of financial statements and how they can be regarded as off balance sheet components
loan given to directors
or loan obtain from the directors
i have also seen directors account for making payments and receipts using it as a bank account

[kamranACA]

Dear,

I did not say sponsors' loans are off balance sheet financing. I only told how people camouflage the things. this was just an example. These are on balance sheet loans and for bank financing purpose are considered part of equity. However, in balance sheet these are shown as non-current or current liability.

IAS 39 requires to state such financial liabilities initially on fair value. This may have huge impact and resulting adjustments in respect of such loans. However, in most of cases, it is mentioned that terms and repayment period of such loan is not decided. That's why fair valuation remains impracticable and no adjustments are made by the companies in financial statements regarding such loans which are typically interest free loans.

There could be number of facets of off balance sheet financing and products/methodologies have to be evoluted for such purposes like SPE discussed in above posts. Common examples of such financing are operating lease and facilities of letters of credit for import purposes. However, after the payment of imported material by the relevant banks such liabilities have to be taken on balance sheet.


Regards,



KAMRAN.

[4thelement]

thanx for helping me

[idreesdurrani]

Dear Kamran

It is evident that the financial liability should be recorded at fair value on initial recognition. The question to consider is how to determine the fair value when there are no repayment terms? These loans pose a challenge in determining their fair values at initial recognition as it is not possible to estimate the future cashflows where there is no repayment date.

There is a tendency that such loans are given for a long period of time and in essence form part of the equity, therefore, should be measured at their transaction prices and thereby treat them as capital. However, this view cannot be supported by IAS 39 because there is a contractual obligation to repay these loans, which makes them liabilities. All liabilities need to be initially measured at fair value.

In my view, Just as the case for zero interest loans, where we determine the fair value using the market intrest rate for similar loans, Management shall establish the best estimate of the repayment date in order to determine the fair values on initial recognition, and accordingly the loan should be recognized at fair value.

Regards,

[kamranACA]

Dear,

I find no point in disagreeing to you. However, in practice, wherever such terms are not finalized, companies don't calculate the fair values and don't make the adjustments required under IAS 39 to state such financial liabilities on fair value initially.

Now making such assessment of repayment date (without having a contract in place to repay) would be subjective and will require management representations and agreeing of auditors on such estimate of the management.

We "normally" don't see this in practice.


Regards,



KAMRAN.

[idreesdurrani]

Yeah estimates and judgments are always subject to a certain degree of subjectivity.

"However, in practice, wherever such terms are not finalized, companies don't calculate the fair values and don't make the adjustments required under IAS 39 to state such financial liabilities on fair value initially."

I believe that the onus is on the auditors to require the managements to do what is correct. It is only this way, we can change the practices, otherwise, these incorrect practices will prosper never letting the right approach to be followed.

Kind regards,

[kamranACA]

Dear,

Yes you are right. But good and bad both have to remain together.


Regards,


Kamran.