CFA Level 1

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Liabilities - Types Of Off-Balance-Sheet Financing

Many economic transactions and events are not recognized in the financial statements because they do not qualify as accounting assets or transactions under GAAP standards. That said, these unreported assets and liabilities have real cash flow consequences. As a result, it is important to be able to identify and qualify these assets and liabilities.

  • Operating lease - Classifying a lease as an operating lease provides a company with the opportunity to utilize the leased asset and assume a contractual obligation to pay the lessor during a specific period of time without having to report the asset and, more importantly, the liability.
  • Take-or-pay contract - This is an agreement between a buyer and seller in which the buyer will still pay some amount even if the product or service is not provided. Companies use take-or-pay contracts to ensure that their vendor makes the materials, such as raw materials, that they need to sustain operations available to them. In the event that a company does not purchase the material from the vendor, the company will have to pay some amount to the vendor. This provides a company with the ability to acquire the use of an asset without having to record it as an asset and a liability. These arrangements are common in the natural-gas, chemical, paper and metal industry.
  • Throughput arrangements - Natural-gas companies use throughput arrangements with pipelines or processors to ensure distribution or processing. The effects are the same as take-or-pay contracts.
  • Commodity-linked bonds - Natural-resource companies may also finance inventory purchases through commodity-indexed debt where interest and/or principal repayments are a function of the price of the underling commodity.
  • The sale of accounts receivables - A company may sell its receivables to an unrelated third party to reduce its debt and improve its financial position. Most sales of receivables provide the buyer with a limited recourse to the seller. However, the recourse provision is generally well above the expected loss ratio on the receivables (allowance for doubtful accounts). The potential liability associated with the buyer-recourse provision is not displayed on the balance sheet.

A more elaborate sale of account receivables is a parent company selling its receivables to a finance subsidiary where the parent owns less than 50% of the subsidiary. If the parent owns less than 50%, the financial asset and liability of the subsidiary are not included in the parent balance sheet; only the investment in the subsidiary is recorded as an asset. (If less than 50%, the equity method is used). Furthermore, the parent generally supports the subsidiary borrowings through extensive income-maintenance agreements and direct and indirect guarantees of debt.

  • Joint ventures - Companies may enter into a joint venture with a supplier or other company. To obtain financing for such a venture, companies often enter into a take-or-pay or throughput contract with minimum payments designed to meet the venture's debt-service requirements. Furthermore, direct or indirect guarantees may be present. Generally, companies account their investments in joint ventures using the equity method since no single company holds a controlling interest. As a result, the balance sheet reports on the net investment in the venture.
  • Investments - Some companies issue long-term debt that is exchangeable for common shares of another publicly-traded company. Since the debt is secured by another liquid asset, the interest expense on the loan is usually smaller.

    This issuance is also used by companies with a large capital-gain liability on stock held. The company's biggest concern in this case would be the large capital-gains tax liability they would have to pay should they default on the loan and have to exchange the debt for the securities it holds.

Effects Of Off-Balance Sheet Financing Transactions On Financial Ratios
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