Financing
A Off-Balance-Sheet concern for analysts when they evaluate a company's liquidity and solvency is whether that
company has properly recorded all of its obligations. The bankruptcy of Enron Corporation, one
of the largest bankruptcies in U.S. history, demonstrated how much damage can result when a
company does not properly record or disclose all of its debts. Many would say Enron was
practicing off-balance-sheet financing. Off-balance-sheet financing is an intentional effort by a
company to structure its financing arrangements so as to avoid showing liabilities on its balance
sheet. Two common types of off-balance-sheet financing result from unreported contingencies
and lease transactions.
Contingencies
One reason a company's balance sheet might not fully reflect its potential obligations is due to
contingencies. Contingencies are events with uncertain outcomes that may represent potential
liabilities. A common type of contingency is lawsuits. Suppose, for example, that you were
analyzing the financial statements of a cigarette manufacturer and did not consider the possible
negative implications of existing unsettled lawsuits. Your analysis of the company's financial
position would certainly be misleading. Other common types of contingencies are product
warranties and environmental clean-up obligations. For example, in a recent year Novartis AG
began offering a money-back guarantee on its blood-pressure medications. This guarantee would
necessitate an accrual for the estimated claims that will result from returns.
Accounting rules require that companies disclose contingencies in the notes; in some cases they
must accrue them as liabilities. For example, suppose that Waterbury Inc. is sued by a customer
for $1 million due to an injury sustained by a defective product. If at the company's year-end, the
lawsuit had not yet been resolved, how should Waterbury account for this event? If the company
can determine a reasonable estimate of the expected loss and if it is probable it will lose the
suit, then the company should accrue for the loss. It records the loss by increasing (debiting) a
loss account and increasing (crediting) a liability such as Lawsuit Liability. If both of these
conditions are not met, then the company discloses the basic facts regarding this suit in the notes
to its financial statements.
Leasing
One common type of off-balance-sheet financing results leasing. from Most lessees do not like to
report leases on their balance sheets because the lease increases the company's total liabilities.
Recall from Chapter 9 that operating leases are treated like rentalsno asset or liabilities show
on the books. Capital leases are treated like a debt-financed purchaseincreasing both assets and
liabilities. As a result, many companies structure their lease agreements to avoid meeting
the criteria of a capital lease.
Ethics Note
Accounting standard setters are attempting
to rewrite rules on lease accounting
because of concerns that abuse of the
current standards is reducing the usefulness
of financial statements.
Recall from Chapter 9 that many U.S. airlines lease a large portion of their planes without
showing any debt related to them on their balance sheets. For example, the total increase in
assets and liabilities that would result if Southwest Airlines recorded on the balance sheet its offbalance-sheet operating leases would be approximately $2.3 billion. Illustration 10-19
presents Southwest Airlines' debt to total assets ratio using the numbers presented in its balance
sheet and also shows the ratio after adjusting for the off-balance-sheet leases. After those
adjustments, Southwest has a ratio of 64% versus 59% before. This means that of every dollar of
assets, 64 cents was funded by debt. This would be of interest to analysts evaluating Southwest's
solvency.
Illustration 10-19 Debt to total assets ratio adjusted for
leases
International Note
GAAP accounting for leases is more
rules-based than IFRS. GAAP relies on
precisely defined cutoffs to determine
whether an item is treated as a capital or
operating lease. This rules-based approach
may enable companies to structure leases
around the rules. Creating a jointly
prepared leasing standard is a top priority
for the IASB and FASB.
Critics of off-balance-sheet financing contend that many leases represent unavoidable obligations
that meet the definition of a liability, and therefore companies should report them as liabilities on
the balance sheet. To reduce these concerns, companies are required to report their operating
lease obligations for subsequent years in a note. This allows analysts and other financial
statement users to adjust a company's financial statements by adding leased assets and lease
liabilities if they feel that this treatment is more appropriate.