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Off Balance Sheet Finance

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Off Balance Sheet Finance CHAPTER 11 Off balance sheet finance 11.1 Introduction The main purpose of this chapter is to introduce the concept of ‘off-balance sheet finance’ which arises when accounting treatments allow companies not to recognise assets and liabilities that they control or on which they suffer the risks and enjoy the rewards. Various accounting standards have been issued to try to ensure that the statement of financial position properly reflects assets and liabilities such as IAS 37 Provisions, Contingent Liabilities and Contingent Assets and IAS 10 Events after the Reporting Period. Also the conceptual framework of accounting is important in how it requires the substance of transactions to be reflected when giving reliable information in financial statements. Objectives By the end of this chapter, you should be able to: ● understand and explain why it is important that companies reflect as accurately as possible their assets and liabilities, and the implications if assets and liabilities are not reflected on the statement of financial position; ● understand and explain the concept of substance over form and why it is important in accounting; ● account for provisions, contingent liabilities and contingent assets under IAS 37 and explain the potential changes the IASB is considering in relation to provisions. 11.2 Traditional statements – conceptual changes Accountants have traditionally followed an objective, transaction-based, book-keeping system for recording financial data and a conservative, accrual-based system for classifying into income and capital and reporting to users and financial analysts. Capital gearing was able to be calculated from the balance sheet on the assumption that it reported all of the liabilities used in the debt/equity ratio; and income gearing was able to be calculated from the income statement on the assumption that it reported all interest expense. However, since the 1950s there has been a growth in the use of off balance sheet finance and complex capital instruments. The financial analyst can no longer assume that all liabi- lities are disclosed in the residual balances that appear in the traditional balance sheet and 284 • Statement of financial position – equity, liability and asset measurement and disclosure all interest expense is disclosed as such in the income statement when assessing risks and returns. Off balance sheet finance has made it impossible to use ratios to make valid inter- period or inter-firm comparisons based on the published financial statements. 11.3 Off balance sheet finance – its impact Off balance sheet finance is the descriptive phrase for all financing arrangements where strict recognition of the legal aspects of the individual contract results in the exclusion of liabilities and associated assets from the statement of financial position. The impact of such transactions is to understate resources (assets) and obligations (liabilities) to the detriment of the true and fair view.1 The analyst cannot determine the amount of capital employed or the real gearing ratio when attempting to assess risk and it could be said that the financial statements do not provide a fair view of the financial position, particularly if there are con- tracts for extended periods with heavy penalties for early termination. This can happen as an innocent side-effect of the transaction-based book-keeping system. For example, when a company undertakes the long-term hire of a machine by payment of annual rentals, the rental is recorded in the income statement, but the machine, because it is not owned by the hirer, will not be shown in the hirer’s statement of financial position. If the facility to hire did not exist, the asset could still be used and a similar cash outflow pattern incurred by purchasing it with the aid of a loan. A hiring agreement, if perceived in terms of its accounting substance rather than its legal form, has the same effect as entering into a loan agreement to acquire the machine. The true and fair view can also be compromised by deliberate design when the substance of transactions is camouflaged by relying on a strictly legal distinction. For example, loan capital arrangements were concealed from shareholders and other creditors by a legal sub- terfuge to which management and lenders were party. One of the earliest measures to bring liabities into the balance sheet taken by standard setters was that relating to accounting for leases. 11.3.1 Substance over form IAS 17 Leases2 was the first formal imposition of the principle of accounting for substance over legal form, aiming to ensure that the legal characteristics of a financial agreement did not obscure its commercial impact. In particular, it was intended to prevent the commercial level of gearing from being concealed. The standard’s aim of getting the liability onto the statement of financial position is gradually being achieved but it has proved difficult with some companies structuring lease contracts to have leases, which are in substance finance leases, classified as operating leases. The effect has been that the asset and liability did not appear on the statement of financial position and so the debt/equity ratio was artificially lower and the return on capital employed artificially higher. The explosive growth of additional and complex forms of financial arrangements during the 1980s focused attention on the need to increase the disclosure and awareness of such arrangements and led to substance over form being included as one of the qualities of reli- able information in the Framework for the Preparation and Presentation of Financial Statements. 11.3.2 Framework for the Preparation and Presentation of Financial Statements The Framework makes the following observations relating to the reliability characteristic: Off balance sheet finance • 285 Reliability To be useful, information must also be reliable. Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to repre- sent faithfully that which it either purports to represent or could reasonably be expected to represent. Faithful representation To be reliable, information must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent. Thus, for example, a balance sheet should represent faithfully the transactions and other events that result in assets, liabilities and equity of the entity at the reporting date which meet the recognition criteria. Substance over form If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they be accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The key points are that faithful representation requires that assets, liabilities and equity be reported in the statement of financial position in accordance with their substance. In fact, it is difficult to see how a faithful representation could be achieved if the economic reality of transactions were not reported in accordance with their commercial substance. 11.3.3 Accounting for substance over form The IASB has not issued a standard on accounting for substance over form and therefore guidance must be sought from the Framework for the Preparation and Presentation of Financial Statements which we see from above provides that: a balance sheet should represent faithfully the transactions and other events that result in assets, liabilities and equity. This means that to account for substance we need to consider the definitions of assets and liabilities as these will dictate the substance of a transaction. If a transaction or item meets the definition of an asset or liability and certain recognition criteria, it should be recognised on the statement of financial position regardless of the legal nature of the transaction or item. The definitions of assets and liabilities3 are as follows: ● An asset is a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity. ● A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. The definitions emphasise economic benefits controlled (assets) and economic benefits transferable (liabilities) – not legal ownership of, or title to, assets and possession of legal responsibilities for liabilities. 11.3.4 How to apply the definitions This involves the consideration of key factors in analysing the commercial implications of an individual transaction. The key factors are: 286 • Statement of financial position – equity, liability and asset measurement and disclosure 1 Substance must first be identified by determining whether the transaction has given rise to new assets or liabilities for the reporting entity and whether it has changed the entity’s existing assets and liabilities. 2 Rights or other access to benefits (i.e. possession of an asset) must be evidenced by the entity’s exposure to risks inherent in the benefits, taking into account the likelihood of those risks having a commercial effect in practice. 3 Obligations to transfer benefits (i.e. acceptance of a liability) must be evidenced by the existence of some circumstance by which the entity is unable to avoid, legally or commercially, an outflow of benefits. 4 Options, guarantees or conditional provisions incorporated in a transaction should have their commercial effect assessed within
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