FRA Packet 4

Off Balance Sheet Financing

Definition and Overview

• Off-Balance Sheet Financing: A strategy whereby firms keep certain debt and liabilities off their balance sheets (B/S) to maintain a less risky appearance to investors.

Rationale Behind Off-Balancing

• Companies in debt-intensive industries (e.g., energy, communication, airlines) utilize off-balance sheet financing to manage how their financial health is perceived.

Types of Off-Balance Sheet Financing

1. Debt Recognized but not on B/S of Primary Firm:

   • Debt is recorded on the balance sheet of affiliated companies rather than the primary firm’s B/S.

   • Examples include:

     • Special Purpose Entities (SPEs): Used for transactions such as sale of receivables.

     • Variable Interest Entities (VIEs).

     • Joint Ventures.

     • Equity Method: Subsidiaries using equity method instead of consolidation.

2. Debt Not Recognized:

   • This category includes:

     • Executory Contracts: These are contracts that are mutually unfulfilled, meaning each party has yet to perform their obligations.

     • Existence of liability arises only after one party transfers resources to another.

     • Key requirement: disclosure of these contracts in financial statements.

     • Operating Leases (vs. Capital Leases): In contrast to capital leases, operating leases may remain unrecorded on the balance sheet.

     • Purchase Commitments: Firm agrees to acquire inventory in future at fixed price without recognizing liability until transfer of inventory occurs.

Detailed Explanation of Executory Contracts

• Executory Contracts: Defined as:

  • Contracts that are not yet executed; hence no immediate financial liability is present.

  • Both parties have an exchange of promises but no transfer of resources has happened.

• Example:

  • A company (Company A) agrees to buy inventory from another company (Company B) at a specific price at a future date with no inventory received or cash paid at that time. This situation accounts for a mutually unexecuted agreement and does not necessitate B/S recognition.

Purchase Commitments Explained

• Purchase Commitments: When one firm makes a commitment to buy inventory in the future.

  • Since no delivery or payment has happened, the buying firm doesn’t recognize a liability until necessary criteria are met.

  • Requirement for Recognizing Loss: If the market price of the inventory declines below the price in the purchase commitment, then the firm must recognize a loss as follows:

    • Loss Calculation: Loss = Market Price - Contract Price.

  • Journal Entries:

    • Debit unrealized holding loss.

    • Credit purchase commitment liability.

Disclosure Requirements for Liabilities

• Tabular Disclosure of Future Cash Payments: In the Management Discussion & Analysis (MD&A) section, companies must report scheduled future cash payments based on time horizons.

  • Example - Coca-Cola 2021 10-K:

    • Disclosures includes payments due in 1 year, 2-3 years, 4-5 years, and beyond 5 years.

  • Present Value Calculation:

    • If using a 10% discount rate, payments expected in arrears must be converted to present values:

    • Calculation example:
      $PV = rac{12,569}{1.1} + rac{1,158}{1.12} + rac{1,158}{1.13} + rac{808}{1.14} + rac{808}{1.15} + rac{4,616}{1.16} = 16,913$

  • Upon calculation, the journal entries for inventory and commitment liability would be:

    • DR: Inventory 16,913

    • CR: Purchase commitment liability 16,913.

  • Note: Adopts a conservative approach to assume all obligations beyond 5 years will take place in year 6.

Liability Amortization

• Amortization Using Effective Interest Method:

  • Calculation for amortization would include:

    • DR: Interest expense 1,691*

    • DR: Liability 10,878 (current liability)**

    • CR: Cash 12,569.

  • Inventory accounting follows typical decline processes:

    • DR: COGS

    • CR: Inventory.

  • Interest Expense Calculation:

    • Interest expense = rate ($r ext{%}$) * Present Value.

    • Example: $1,691 = 0.10 * 16,913$.

  • Current liabilities: 10,878 serve as a plug; non-current liability calculated as:

    • Non-current Liability = Total liability – Current liability

    • $6,035 = 16,913 - 10,878$.

Coca-Cola 2021 Financial Analysis

• Actual Ratios:

  • Current Ratio (CA/CL):

    • $rac{22,545}{19,950} = 1.13$

  • Debt to Equity Ratio (LT Debt + ONCL)/OE:

    • $rac{38,116 + 8,607}{22,999} = 2.03$.

• Adjusted Ratios:

  • Adjusted Current Ratio:

    • $rac{(22,545 + 11,426<em>)}{(19,950 + 10,878</em>*)} = 1.10$.

  • Adjusted Debt to Equity Ratio:

    • $rac{(38,116 + 8,607 + 6,035**)}{22,999} = 2.29$.

  • * 11,426 represents the present value (PV) of the inventory due in 2022.

  • References to Components: 10,878 indicates liabilities detailed on previous slides.

Summary of Key Practices

• To find purchase commitments, utilize the disclosures found in the MD&A section.

• Calculate present values of liabilities and assets through the Effective Interest Method.

• To amortize liability, apply the Effective Interest Method consistently.

• Handle asset reductions using normal COGS accounting.

• Always re-evaluate financial ratios post-amortization and asset adjustments.