Off-balance sheet finance involves funding or refinancing a company's operations in ways that do not show all or part of the finance on its statement of financial position under legal and accounting conventions. Common forms of off-balance sheet finance include consignment inventory, sale and repurchase agreements, and sale and leaseback transactions involving finance or operating leases. Off-balance sheet finance is used by some companies to keep gearing ratios low but can obscure a company's true financial position if not properly disclosed.
Off-balance sheet finance involves funding or refinancing a company's operations in ways that do not show all or part of the finance on its statement of financial position under legal and accounting conventions. Common forms of off-balance sheet finance include consignment inventory, sale and repurchase agreements, and sale and leaseback transactions involving finance or operating leases. Off-balance sheet finance is used by some companies to keep gearing ratios low but can obscure a company's true financial position if not properly disclosed.
Off-balance sheet finance involves funding or refinancing a company's operations in ways that do not show all or part of the finance on its statement of financial position under legal and accounting conventions. Common forms of off-balance sheet finance include consignment inventory, sale and repurchase agreements, and sale and leaseback transactions involving finance or operating leases. Off-balance sheet finance is used by some companies to keep gearing ratios low but can obscure a company's true financial position if not properly disclosed.
Off-balance sheet finance involves funding or refinancing a company's operations in ways that do not show all or part of the finance on its statement of financial position under legal and accounting conventions. Common forms of off-balance sheet finance include consignment inventory, sale and repurchase agreements, and sale and leaseback transactions involving finance or operating leases. Off-balance sheet finance is used by some companies to keep gearing ratios low but can obscure a company's true financial position if not properly disclosed.
Off-balance sheet finance Y Y Consignment inventory Y Y Sale and repurchase agreements Y Y Sale and (finance) leaseback Y transactions Sale and (operating) leaseback Y Y transactions Factoring of receivables/debts Y Y Off-balance sheet finance Off-balance sheet finance
Off-balance sheet finance is the funding or refinancing
of a company's operations in such a way that, under legal requirements and traditional accounting conventions, some or all of the finance may not be shown in its state Off-balance sheet transactions
'Off-balance sheet transactions' are transactions which
meet the above objective. These transactions may involve the removal of assets from the statement of financial position, as well as liabilities, and they are also likely to have a significant impact on profit or loss. Why off-balance sheet finance exists
In some countries, companies traditionally have a lower level
of gearing (ratio of debt to equity) than companies in other countries. Off balance sheet finance is used to keep gearing low, probably because of the views of analysts and brokers. A company may need to keep its gearing down in order to stay within the terms of loan covenants imposed by lenders. The off-balance sheet finance problem Whatever the purpose of such transactions, insufficient disclosure creates a problem. This problem has been debated over the years by the accountancy profession However, company collapses during recessions have often revealed much higher borrowings than originally thought, because part of the borrowing was off-balance sheet. The main argument used for banning off-balance sheet finance is that the true substance of the transactions should be shown, not merely the legal form, particularly when it is exacerbated by poor disclosure. Substance over form
The principle that transactions and other events are
accounted for and presented in accordance with their substance and economic reality and not merely their legal form. Common forms of off-balance sheet finance
Consignment inventory Sale and repurchase agreements/sale and leaseback agreements Factoring of receivables/debts You’re a Champion! Thanks for staying with us. You have finished this task. Consignment inventory Consignment inventory Consignment inventory is an arrangement where inventory is held by one party (say a distributor) but is owned by another party (for example a manufacturer or a finance company). Consignment inventory is common in the motor trade and is similar to goods sold on a 'sale or return' basis. Indications that the inventory is not an asset of the dealer at delivery Manufacturer can require dealer to return inventory (or transfer inventory to another dealer) without compensation. Dealer has unfettered right to return inventory to the manufacturer without penalty and actually exercises the right in practice. Required accounting
Where it is concluded that the inventory is not in
substance an asset of the dealer, the following apply. a) The inventory should not be included in the dealer's statement of financial position until the transfer of risks and rewards has crystallised. b) Any deposit should be included under 'other receivables'. Indications that the inventory is an asset of the dealer at delivery Manufacturer cannot require dealer to return or transfer inventory. Dealer has no right to return inventory or is commercially compelled not to exercise its right of return. Required accounting The following apply where it is concluded that the inventory is in substance an asset of the dealer. a) The inventory should be recognised as such in the dealer's statement of financial position, together with a corresponding liability to the manufacturer. b) Any deposit should be deducted from the liability and the excess classified as a trade payable. You’re a Champion! Thanks for staying with us. You have finished this task. Sale and repurchase agreements Sale and repurchase agreements These are arrangements under which the company sells an asset to another person on terms that allow the company to repurchase the asset in certain circumstances. A common example is the sale and repurchase of maturing whisky inventories. The key question is whether the transaction is a straightforward sale, or whether it is, in effect, a secured loan. It is necessary to look at the arrangement to determine who has the rights to the economic benefits that the asset generates, and the terms on which the asset is to be repurchased. If the seller has the right to the benefits of the use of the asset, and the repurchase terms are such that the repurchase is likely to take place, the transaction should be accounted for as a loan. Required accounting Where the substance of the transaction is that of a secured loan: a) The seller should continue to recognise the original asset and record the proceeds received from the buyer as a liability. b) Interest should be accrued. c) The carrying amount of the asset should be reviewed for impairment and written down if necessary. Example Revenue includes the sale of $10 million of maturing inventory made to Xpede on 1 October 2012. The cost of the goods at the date of sale was $7 million and Atlas has an option to repurchase these goods at any time within three years of the sale at a price of $10 million plus accrued interest from the date of sale at 10% per annum. You’re a Champion! Thanks for staying with us. You have finished this task. Sale and (finance) leaseback transactions Sale and leaseback transactions
A sale and leaseback transaction involves the sale of
an asset and the leasing back of the same asset. The lease payment and the sale price are usually negotiated as a package. The accounting treatment depends upon the type of lease involved. If the transaction results in a finance lease, then it is in substance a loan from the lessor to the lessee (the lessee has sold the asset and then leased it back), with the asset as security. In this case, any 'profit' on the sale should not be recognised as such, but should be deferred and amortised over the lease term. Question Capital Co entered into a sale and finance lease on 1 April 20X7. It sold a lathe with a carrying amount of $300,00 for $400,00 and leased it back over a five-year period, equivalent to its remaining useful life. The finance lease provided for five annual payments in arrears of $90,000. The rate of interest implicit in the lease is 5%. Required What are the amounts to be recognised in the financial statements at 31 March 20X8 in respect of this transaction? Answer
Statement of profit or loss
Profit on disposal (100,000/5) 20,000 Depreciation (400,000/5) (80,000) Interest (W) (20,000) Statement of financial position Non-current asset Property, plant and equipment(400,000-80,000) 320,000
Current liabilities Finance lease liability (330,000-256,500)(W) 73,500 Deferred income(100,000/5) 20,000 Working-lease liability $ 1 April 20X7 400,000 Interest 5% 20,000 Instalment paid (90,000) Balance 31 March 20X8 330,000 Interest 5% 16,500 Instalment paid (90,000) Balance 31 March 20X9 256,500 You’re a Champion! Thanks for staying with us. You have finished this task. Sale and (operating) leaseback transactions If the transaction results in an operating lease and the transaction has been conducted at fair value, then it can be regarded as a normal sale transaction. The asset is derecognised and any profit on the sale is recognised. The operating lease instalments are treated as lease payments, rather than repayments of capital plus interest. If the sale price was above fair value any excess is deferred and amortised over the period for which the asset is expected to be used. The excess sale proceeds above the asset's fair value is in substance a loan rather than part of the sale proceeds, given that it is linked to the higher than market rental payments, and so it should be accounted for as a loan. Example On 1 January 20X2 a company held a freehold building in its books with a carrying amount of $18m and a remaining useful life of 30 years. On the same date, it entered into an agreement to sell the building to a bank for $30m, but to continue to occupy it for the next 6 years at an annual rental of $3m per annum payable in advance. The market value of the building at the date of sale was approximately $25m and an 'arm's length' rental would be approximately $2m per annum. Assume any finance costs are 8% per annum. Required Describe how the above transaction should be treated in the financial statements of the company for the year ended 31 December 20X2. 1 January 20X2, sale should be accounted for as follows: Cash 30 PPE 18 Income 7 Loan 5 1 January 20X2, first payment should be accounted for as follows: Cash 3 Loan 1 Prepayment 2 31 Dec 20X2, the transaction should be accounted for as follows: Prepayment 2 Ex 2
Loan (5-1)*8%=0.32 Ex 0.32 If the result is an operating lease and the sale price was below fair value, this may be being compensated for by lower rentals in the future. If this is the case, any loss on sale should be amortised over the period for which the asset is expected to be used. You’re a Champion! Thanks for staying with us. You have finished this task. Factoring of receivables/debts Factoring of receivables/debts
Where debts or receivables are factored, the original
creditor sells the debts to the factor. The sales price may be fixed at the outset or may be adjusted later. In order to determine the correct accounting treatment it is necessary to consider whether the benefit of the debts has been passed on to the factor, or whether the factor is, in effect, providing a loan on the security of the receivable balances. If the seller has to pay interest on the difference between the amounts advanced to him and the amounts that the factor has received, and if the seller bears the risks of nonpayment by the debtor, then the indications would be that the transaction is, in effect, a loan. Example On 31 March 2011 Highwood factored (sold) trade receivables with a book value of $10 million to Easyfinance. Highwood received an immediate payment of $8·7 million and will pay Easyfinance 2% per month on any uncollected balances. Any of the factored receivables outstanding after six months will be refunded to Easyfinance. Highwood has derecognised the receivables and charged $1·3 million to administrative expenses. Solution Summary of off-balance transaction You’re a Champion! Thanks for staying with us. You have finished this task. OT1 B65 Sale and leaseback or sale and repurchase arrangements can be used to disguise the substance of loan transactions by taking them 'off balance sheet'. In this case the legal position is that the asset has been sold but the substance is that the seller still retains the benefits of ownership. Which one of the following is not a feature which suggests that the substance of a transaction differs from its legal form? A.The seller of an asset retains the ability to use the asset. B.The seller has no further exposure to the risks of ownership C.The asset has been transferred at a price substantially above or below its fair value. D.The 'sold' asset remains on the sellers premises. (2 marks) B65 Answer B This feature suggests that the transaction is a genuine sale. If the seller retains the right to use the asset or it remains on his premises, then the risks and rewards have not been transferred. If the sale price does not equal market value, then the transaction is likely to be a secured loan. B7-7~ Recognition is the process of including within the financial statements items which meet the definition of an element according to the IASB's Conceptual Framework for Financial Reporting. Which of the following items should be recognised as an asset in the statement of financial position of a company? A skilled and efficient workforce which has been very expensive to train. Some of these staff are still in the employment of the company. A highly lucrative contract signed during the year which is due to commence shortly after the year end A government grant relating to the purchase of an item of plant several years ago, which has a remaining life of four years A receivable from a customer which has been sold (factored) to a finance company. The finance company has full recourse to the company for any losses. (2 marks) B7 Answer A receivable from a customer which has been sold (factored) to a finance company. The finance company has full recourse to the company for any losses. The receivable has been factored with recourse so should continue to be recognised as an asset. The other options do not meet the criteria to be recognised as an asset. B157 Tourmalet sold an item of plant for $50 million on 1 April 20X4. The plant had a carrying amount of $40 million at the date of sale, which was charged to cost of sales. On the same date, Tourmalet entered into an agreement to lease back the plant for the next five years (being the estimated remaining life of the plant) at a cost of $14 million per annum payable annually in arrears. An arrangement of this type is normally deemed to have a financing cost of 10% per annum. What amount will be shown as income from this transaction in the statement of profit or loss for the year ended 30 September 20X4? $ (2 marks) B157 Answer $1 million This is in substance a secured loan, so the asset will be recognised at its new carrying amount of $50m and a lease liability will be set up for the same amount. The $10m increase in carrying amount will be treated as other income deferred over the life of the asset. The amount which can be recognised for the year to 30 September 20X4 is: ($10m / 5) × 6/12 = $1m B158 A sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset. If the lease arrangement results in a finance lease, how should any 'profit' on the sale be treated? Recognise immediately in profit or loss Defer and amortise over the lease term Any excess above fair value to be deferred and amortised, rest to be recognised in profit or loss No profit should be recognised (2 marks) B158 Answer The correct answer is: Defer and amortise over the lease term. Immediate recognition in profit or loss would apply if there was no leaseback. Deferral of the excess over FV would apply if the leaseback involved an operating lease. You’re a Champion! Thanks for staying with us. You have finished this task.
