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Liabilities: Off-Balance-Sheet Financing

Liabilities: Off-Balance-Sheet Financing. Off-Balance-Sheet Financing. Off-Balance-Sheet Financing (OBF) is obtaining resources through liability financing without reporting the liabilities on the balance sheet statement.

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Liabilities: Off-Balance-Sheet Financing

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  1. Liabilities: Off-Balance-Sheet Financing

  2. Off-Balance-Sheet Financing • Off-Balance-Sheet Financing (OBF) is obtaining resources through liability financing without reporting the liabilities on the balance sheet statement. • Although the OBF is not reported in the balance sheet, it is, in most cases, disclosed in the footnotes. Liabilities: Off-Balance-Sheet Financing

  3. Off-Balance-Sheet Financing: Examples • Cash obtained by selling accounts receivable to company’s non-consolidated special purpose entity (SPE). • Reporting leases as operating leases. • The unreported pension liabilities. Liabilities: Off-Balance-Sheet Financing

  4. Off-Balance-Sheet Financing: SPE • A SPE is an entity created by a company for one specific purpose (i.e., for the purpose of purchasing company’s accounts receivable.) Liabilities: Off-Balance-Sheet Financing

  5. Creating A Special Purpose Entity • An independent third party of a company creates a SPE on behalf of the company (referred to as the sponsor) by investing x % (i.e., 10%) of the total assets (i.e., cash) needed for the SPE. • The SPE will finance the remaining (1-x%) (i.e., 90%) by borrowing and the sponsor usually guarantees the loans borrowed by its SPE. Liabilities: Off-Balance-Sheet Financing

  6. Off-Balance-Sheet Financing: SPE (contd.) • With the cash available, the SPE purchases the accounts receivable of the sponsor. • If the independent third party invests 10% or more of the total assets of the SPE, the sponsor does not have to consolidate the SPE in its financial statements. Liabilities: Off-Balance-Sheet Financing

  7. Off-Balance-Sheet Financing: SPE (Contd.) • Without consolidation of its SPE, the liabilities of the SPE guaranteed by the sponsor are not reported in the balance sheet of the sponsor. • Therefore, the sponsor receives financing (i.e., cash from sale of A/R to its SPE) without reporting the liabilities of the SPE guaranteed by the sponsor. Liabilities: Off-Balance-Sheet Financing

  8. Securitization by A Special Purpose Entity • The SPE can issue securities such as bonds backed by the purchased accounts receivable (i.e. use the A/R as collateral to borrow money). • This process is referred to as “securitization”. • The sponsor usually guarantees the securities issued by the SPE. Liabilities: Off-Balance-Sheet Financing

  9. Off-Balance-Sheet Financing: leases • A Lease is “an agreement conveying the right to use property, plant, or equipment for a stated period of time”. (Source: SFAS No. 13) Liabilities: Off-Balance-Sheet Financing

  10. Accounting for Leases • A lease involves a lessee and a lessor. • A lessee acquires the right to use the property, plant and equipment (PPE) and a lessor gives up the right. • A lessee will pay the periodic lease payments to the lessor in order to obtain the right to use the PPE. Liabilities: Off-Balance-Sheet Financing

  11. Advantages of Leasing from Lessees' Viewpoint 1. Financing benefits: a. The lease provides 100% financing (no down payment is needed). For companies with cash shortage, lease is a good alternative to purchase; b. The lease contract may contain fewer restrictive provisions than other debt agreement; and c. The lease agreement creates a claim that is against only the leased asset , not against all assets. Liabilities: Off-Balance-Sheet Financing

  12. Advantages of Leasing from Lessees' Viewpoint :(contd.) 2. Risk benefit: Reduce the risk of obsolescence. • Tax benefit: • Tax deduction may be accelerated since it is often spread over the lease term (rather than the economic life of the property). Liabilities: Off-Balance-Sheet Financing

  13. Advantages of Leasing from Lessees' Viewpoint :(contd.) • 4.Financial reporting benefit (off-balance- sheet financing): • For an operating lease, the lease does not add a liability or an asset to the balance sheet, and therefore does not affect financial ratios. • By maintaining these ratios, the company's borrowing capacity can also be maintained. Liabilities: Off-Balance-Sheet Financing

  14. Advantages of Leasing from Lessees' Viewpoint :(contd.) 5.Less Costly Financing: The income tax savings on depreciation expenses for the lessor may be passed on to the lessee in the form of a reduced rental payment. Liabilities: Off-Balance-Sheet Financing

  15. Advantages of Leasing from Lessors' Viewpoint :(contd.) 1. A way of indirectly making a sale. 2. An alternative means of engaging in a profit opportunity. The lease agreement enables the lessor to earn a normal rate of return (in a form of interest) on the cost of leased asset. Liabilities: Off-Balance-Sheet Financing

  16. Classification of Personal property Leases • A lease that transfers substantially all the risks and benefits of ownership to the lessee represents a purchase by the lessee and a sale by the lessor and should be treated as a capital lease (SFAS No. 13). • SFAS 13 provides rules for determining the classification of leases by both lessees and lessors. Liabilities: Off-Balance-Sheet Financing

  17. Column A Criteria Applicable to Both Lessee and Lessor a.The lease transfers ownership of the property to the lessee by the end of the lease term. b.The lease contains a bargain purchase option c.The lease term is equal to or greater than 75% of the estimated economic life of the leased property. d.The present value of the minimum lease payments (MLP) is equal to 90% or more of the fair value of the leased property to the lessor. Column B Criteria Applicable to Lessor Only a.The collectibility of the minimum lease payments is reasonably assured (i.e., predictable). b.No important uncertainties surround the amount of unreimbursable cost yet to be incurred by the lessor under the lease. General Criteria for classifying leases Liabilities: Off-Balance-Sheet Financing

  18. Classification by the lessee • Capital lease: • Lease that meets one or more of the criteria in column A. • Lessee should treat capital lease as a purchase of asset; recognize leased asset and lease liabilities under capital lease. • Operating lease: • Lease that does not meet any of the criteria in Column A. Liabilities: Off-Balance-Sheet Financing

  19. Key Terms Related to Leases • Bargain Purchase Option • A provision allowing the lessee to purchase the leased property at the end of the life of the lease at a price so favorable that the exercise of the option appears, at the inception of the lease, to be reasonably assured. Liabilities: Off-Balance-Sheet Financing

  20. Key Terms Related to Leases :(contd.) • Fair Value of Leased Property • Price for which the property can be sold in an arm's length transaction between unrelated parties. • For manufacturers and dealers, the fair value is the selling price. For others, the fair value is the cost of the asset to the lessor. Liabilities: Off-Balance-Sheet Financing

  21. Key Terms Related to Leases :(contd.) • Minimum Lease Payments(MLP): Payments that are required to be paid by the lessee to the lessor over the life of the lease. Liabilities: Off-Balance-Sheet Financing

  22. Accounting for Leases -Treatment of operating lease: • Terms and provisions of lease agreement between landlord company (lessor) and tenant company (lessee) dated January 1, 20x6 • 1.The lease term is 5 years. The lease is noncancelable and requires equal rental payments of $50,000 at the beginning of each year. • 2.The cost, and also fair value, of the equipment to the Landlord Company at the inception of the lease is $400,000. The equipment has an estimated economic life of 10 years and has a zero estimated residual value at the end of this time. Liabilities: Off-Balance-Sheet Financing

  23. I. Accounting for Leases -Treatment of Operating Lease: (contd.) • 3.The equipment reverts to the Landlord Company at the end of the 5 years; • 4.The Tenant Company's incremental borrowing rate is 12.5% per year. • 5.For the Landlord Company, the interest rate implicit in the lease is 12%. • 6.The present value of an annuity due of 5 payments of $50,000 each at 12% is 4.037349 * $50,000 = $201,867.45 Liabilities: Off-Balance-Sheet Financing

  24. Application of Criteria for Determination of Lease Classification by Lessee • Classification CriteriaCriteria Met?Remarks • 1. Transfer of ownership at end of lease No • 2. Bargain purchase option No • 3. Lease term is 75% of economic life No It is 50% • 4. Present value of lease payments is 90% • of fair value No The present value is $201,867.45, or 50.5% of fair value • Conclusion: the lease is an operating lease. It meets none of the criteria. Liabilities: Off-Balance-Sheet Financing

  25. Journal Entries – Operating Lease for Lessee • The journal entry recorded by the lessee is: 1-1-20x6 Rent Expense 50,000 Cash 50,000 • Note: Similar entries will be recorded at the beginning of 20x7 through 2010. • Under the operating lease, neither a leased asset nor a lease liability is recognized in the balance sheet statement (i.e.,off-balance-sheet Financing). Liabilities: Off-Balance-Sheet Financing

  26. Accounting for Leases - Capital Lease for lessees • When a lease is reported as a capital lease, Lessee records an asset (i.e., leased asset) and a liability (i.e., lease liability). • The amount of leased asset equals lease liability at the inception of the lease term and is calculated as the present value of the minimum lease payments (MLP). Liabilities: Off-Balance-Sheet Financing

  27. Discount Rate used in computing the present value of MLP • In computing the PV of the MLP, lessee should use the lower of a.The lessee's incremental borrowing rate, or b.The lessor's implicit rate . • If b is unknown to lessee, lessee uses a. Liabilities: Off-Balance-Sheet Financing

  28. Discount Rate used in computing the present value of MLP (cont.) • The present value of MLP may be different for a lessee and a lessor when different discount rates are used in computing the PV. • The lower the rate is, the greater the PV of MLP. Liabilities: Off-Balance-Sheet Financing

  29. Capital Lease: An Example • Equipment is leased under an agreement without a transfer of ownership, a bargain purchase option or a guaranteed RV. • Terms and provisions of lease agreement between Gardner company (lessor) and Martin company (lessee) dated January 1,20x6: • 1.The lease term is 4 years. The lease is noncancelable and requires equal payments of $32,923.45 at the end of each year. Liabilities: Off-Balance-Sheet Financing

  30. Example A1 (contd.) • 2.The cost, and also fair value, of the equipment to the lessor at the inception of the lease is $100,000. The equipment has an estimated economic life of 4 years and has a zero estimated residual value at the end of lease term. • The annual lease payment charged by the lessor is calculated as follow: • $100,000 a/ 3.037349b = 32,923.45 • b. P.V. of an ordinary annuity of $1 for 4 periods at 12% interest rate Liabilities: Off-Balance-Sheet Financing

  31. Example A1 (contd.) 3.The equipment reverts to Gardner at the end of the 4 years; 4. Martin Company's (lesee) incremental borrowing rate is 12.5% per year. 5.For Gardner Company (lessor), the interest rate implicit in the lease is 12%. Martin Company knows this rate. 6.Martin Company uses the straight-line method to record depreciation on similar equipment's.3 Liabilities: Off-Balance-Sheet Financing

  32. The Accounting Treatments for Capital Lease-Lessor • 7. The present value of an ordinary annuity of four payments of $32,923.45 at 12% is $100,000, calculated as follows: • 3.037349 *$32,923.45 = $100,000. Liabilities: Off-Balance-Sheet Financing

  33. Application of criteria to determine the lease classification by Lessee and Lessor: • Classification CriteriaCriteria Met?Remarks • 1. Transfer of ownership at end of lease No Title reverts to lessor • 2. Bargain purchase option No • 3. Leas term is 75% or more of economic life Yes 100% of estimated life • 4. Present value of MLP is 90% or more • of fair value Yes The Present value is $100,000, or 100% of fair value Liabilities: Off-Balance-Sheet Financing

  34. The Accounting Treatment for Capital Lease (Lessor):(contd.) • The lease is a capital lease for lessee because it meets two of the four criteria under Column A (on p17) . Liabilities: Off-Balance-Sheet Financing

  35. Journal Entries for the Capital Lease Example • The journal entries to record the acquisition of the leased asset, the amortization (depreciation) for 4 years by the lessee are as follows: • 1. Initial Recording of capital lease on 1/1/x6 • Leased Equipment 100,000 • Lease Payable 100,000 • (PV of MLP = $32,923.45 * 3.037349 = 100,000) Liabilities: Off-Balance-Sheet Financing

  36. Journal Entries for Capital Lease Example (Contd.) • 2. First payment (on 12/31/x6) • Interest Expense 12,000* Lease Payable 20,923 Cash 32,923 • * 100,000 * 12% = 12,000 Interest Expense under effective interest method Interest Expense = P.V. of liability. * effective interest rate. Liabilities: Off-Balance-Sheet Financing

  37. Journal Entries (contd.) • 3.Recognition of annual depreciation (or amortization)of leased equipment on 12/31/x6: • Depreciation Expense: Leased Equip.* 25,000 Acc. Depreciation: Leased Equip. 25,000 • * The asset is amortized over the lease term. Liabilities: Off-Balance-Sheet Financing

  38. Journal Entries (contd.) • 4. Payment on 12/31/x7: Interest Expense 9,489.19a Lease Payable 23,434.26b Cash 32,923.45 • a. P.V. of liability at the beginning of 1996 * 12% = (100,000-20,923.45) * 12% = 9,489.12 • b. 32,923.45 -9489.19 = 23,434.26 • 5. Depreciation Expense of x7: Depreciation Expense: Leased Equip. 25,000 Acc. Depreciation : Leased Equip 25,000 Liabilities: Off-Balance-Sheet Financing

  39. Journal Entries (contd.) • 20x8:Interest Expense 6,677.17 • Lease Payable 26,246.38 • Cash 32,923.45 • Depreciation Expense : L. E. 25,000 • Acc Depreciation: L.E 25,000 • 20x9:Interest Expense 3,527.54 • Lease Payable 29,395.91 • Cash 32,923.45 • Depreciation Expense : L. E. 25,000 • Acc Depreciation: LE 25,000 Liabilities: Off-Balance-Sheet Financing

  40. Journal Entries (contd.) • Selected account balance at the end of the lease term: • lease payable = $0 • Acc. Depreciation = $100,000 • Leased Equipment = $100,000 • Journal entry on 12/31/x9: • Acc. Depre. 100,000 • Leased Equip. 100,000 Liabilities: Off-Balance-Sheet Financing

  41. Summary of lease payments and interest expense of the Capital lease Example • Payments at End of Year Liabilities: Off-Balance-Sheet Financing

  42. Summary of Lease Payments and Interest Expense of Martin company (contd.) • a. Column 5 at beginning of year * 12 %, the effective interest expense • b. Column 2 - Column 3 • c. Column 5 at beginning of year - Column 4 • d. adjusted for rounded error of 0.03. Liabilities: Off-Balance-Sheet Financing

  43. Issues in Accounting for Leases • By reporting lease as operating lease, companies can obtain the usage of an asset (i.e., leased asset) without reporting the liability (i.e., lease payable). • With the rules established by SFAS No. 13, a company can structure a lease contract to be qualified as an operating lease by setting the present value of MLP to be less than 90% (i.e., 89.99%) of the fair value of the leased asset alone with not meeting the other three criteria. Liabilities: Off-Balance-Sheet Financing

  44. Issues in Accounting for Leases – the present value of MLP • The present value of MLP depends on the lease payment and the discount rate used. • The discount rate used by the lessee is the lower of • a. the lessee’s incremental borrowing rate, • b. the implicit interest of lessor used in determining the lease payment. • If b is unknown to lessee, use a. Liabilities: Off-Balance-Sheet Financing

  45. The Revisit of Accounting for Leases • Under the rules-based GAAP for leases, two similar lease contracts with a mere 0.01% difference on the present value of MLP could result in different reporting. • The contract with PV of MLP equals or greater than 90% of the fair value of asset will report the lease as a capital lease. • The other contract with PV of MLP equals 89.99% of the fair value of asset will report the lease as an operating lease. Liabilities: Off-Balance-Sheet Financing

  46. The Revisit of Accounting for Leases • In an effort to improve the comparability of accounting for leases and eliminate narrow difference between GAAP and IASB, the FASB added the topic of lease accounting on its agenda in July, 2006 as a joint project with the International Accounting Standards Board. Liabilities: Off-Balance-Sheet Financing

  47. Income Tax Accounting • The differences between accounting income and taxable income include permanent and temporary differences. • Permanent differences: revenues or expenses are included in financial reporting but are never taxable. Liabilities: Off-Balance-Sheet Financing

  48. Income Tax Accounting • Examples of Permanent Differences • 1. Accounting revenues which are not taxable: • a. Interest on municipal bonds. • b. Portion of dividends received from investment in U.S. corp. stock is tax exempted(i.e., 70% exemption for if investor owns less that 20% of investee’s shares). Liabilities: Off-Balance-Sheet Financing

  49. Permanent Differences (contd.) • Examples (contd.) • 2. Accounting expense but is never tax deductible: • Employee stock option expense under incentive plans. • 3. Tax expense but is never included as accounting expense: • Percentage depletion in excess of cost depletion. Liabilities: Off-Balance-Sheet Financing

  50. Permanent Differences (contd.) • Accounting Treatment for permanent differences: • Not included in the journal entries as deferred tax liabilities/assets. Liabilities: Off-Balance-Sheet Financing

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