Implications of off-balance-sheet financing and inferences for the future

THE NEED FOR TRANSPARENCY IN FINANCIAL REPORTING

MAIN ISSUES• Misuse of accounting rules by companies to

obscure their shady transactions(mainly off Balance sheet Items).

• Regulators should ensure more transparency, accountability and create ethical awareness and implement principal based accounting by disclosing the economic motivation of the practices.

• Off balance sheet item gives a wrong signal to the risk averse investor since it hides the true debt obligation of the company. Moreover it helps the firm for income smoothing, hide the volatile nature and increase borrowing capacity.

TYPES OF OFF-BALANCE-SHEET ARRANGEMENTS AND THEIR IMPLICATIONS

1. Investments in the equity of other entities To escape the (SFAS)No.94 rule to consolidate the subsidiaries debt obligation in

the parent co. B/S, firms sometimes forgo the voting right(less than 50%) but still maintains the option to cash onto the entity’s debt obligation. Therefore new law has been issued FIN No.46 which made firm disclose the billion dollar debt obligation.

2. Transfers of financial assets Companies often makes use of it through the SPE to take the advantage of

financial market, enhance liquidity, manage risk and obtain low cost funding. On the other hand obligation to the investors is borne by the SPE not the parent co.

3. Retirement arrangements Companies create legal entities to manage pension fund but the obligation of risk

remains on the employee if it underperforms. FIN NO.46 allows the co. not to consolidate an employee benefit plan so a lot is carried out as off balance sheet transaction. Since it is not recognized till its due there can be unrecognized pension obligation.

CON’T 4. Leases Firms have an incentive to avoid capital lease because it increases the

long term liabilities. 5. Contingent obligations and guarantees Contingent liabilities and guarantees are uncertain or potential obligations that

my give rise to liabilities but the timing and amount are not sure. In this article, two main approaches are described to disclosure the contingency on the balance sheet.

For SFAS NO. 5, “Accounting for contingencies” approach If a loss is deemed “probable” and estimable, the loss amount with the

highest probability of occurrence must be recognized on the balance sheet. If the potential loss is “probable” but not estimable, or if the loss is deemed

“reasonably possible” but not “probable,” the existence of the potential loss must be disclosed but no liability is recorded on the balance sheet.

If the loss is deemed “remote,” no disclosure or recognition of a liability is required. However, for FIN No.45 approach, contingencies must be disclosed on the balance sheet.

DISCUSSION1. Standards-setters2. Accounting professionals3. Boards of directors4. Investors Article states that the financial statement of a company is one of the key factors investors should look into in making investment decisions. Therefore, an investor need a minimum of skepticism in order to have deep checking on what is presented as final balance sheet by the company since companies may be involved in what is called “off-balance sheet”.

5. Regulators• Any bill that goes through Congress with that sort of vote cannot be

good.” The Act applies to all issuers of securities that are registered or have filed a registration statement with the SEC

• There is tangible evidence that more companies are going public on foreign exchanges instead of in the USA.

RECOMMENDATION1. Adopt international accounting Standard2. Uniform disclosure framework3. Education and awareness to UG accounting, finance

and business course4. Auditor’s independence5. Making FASB independent