Instructions for the classmate classmate response (around 125 words each)
Please, respond to the below two classmate main posts. (Please, the responses need to be a discussion, not an evaluation. You can agree with them and add/comment about their response. No citation required)
Thank you
Classmate discussion posts
Discussion 1:
David Greco
Off balance sheet transactions are a group of financing a
angements made outside of the ordinary course of business for an organization, which allow for reporting exceptions off of the traditional balance sheet (Su
amanyam, 2014). A
angements like operating leases, purchase agreements, through-put agreements and take-or-pay a
angements are handled in this manner. Under a through-put agreement, organizations agree to possession of a commodity for a specific period of time. One of the parties utilized the commodity for production, while not having ownership. This allows a smaller organization access to materials they might not otherwise be able to afford, paying for usage via the through put agreement (Su
amanyam, 2014). One example of such an a
angement is oil companies and owners of pipelines (Platz, 2019). An oil company might enter a through-put agreement with the owner of the pipeline to allow the oil company to use the commodity, without having to purchase their own pipeline.
Off balance sheet agreements can cause complications with financial analysis, because these agreements understate both assets and liabilities. Traditional ratios like return on investment, asset turnover and debt to equity can be impacted by these items not being included in asset and liability valuations (Su
amanyam, 2014). However, the SEC had ensured that organizations would have to report these a
angements in a specific area of the Management Discussion and Analysis section of financial statements (FindLaw, 2019). The standard set by the SEC requires not only disclosure of off balance sheet agreements, but an overview of all contractual agreements in a table (FindLaw, 2019). A
angements like these call to attention the importance of complete financial statements. Off balance sheet a
angements allow companies to take advantage of substantial financial investments without the full impact on financial reports. By examining management’s discussion and analysis, analysts can get a more complete picture of an organization’s activities.
References
FindLaw. (2019, January 22). SEC Adopts Final Rules for Disclosure of Off-Balance Sheet A
angements and Aggregate Contractual Obligations. Retrieved from FindLaw.com: https:
corporate.findlaw.com/finance/sec-adopts-final-rules-for-disclosure-of-off-balance-sheet.html
Platz, S XXXXXXXXXXWhat Is a Throughput Contract? Retrieved from Chron.com: https:
smallbusiness.chron.com/throughput-contract-36884.html
Su
amanyam, K XXXXXXXXXXFinancial Statement Analysis . New York: McGraw-Hill Education.
Discussion 2:
Emily Pittenge
At first, the idea of an off-balance-sheet item seemed strange to me. My initial thought was that something not on the books of a company couldn’t have a significant impact on the financial analysis of that company, but that is not the case. “Off-balance-sheet financing refers to the non-recording of certain financing obligations.” This can include a variety of mechanisms, but the way they work is alike. The a
angements can include operating leases, purchase agreements, through-put agreements, and take-or-pay a
angements. One key off-balance-sheet financing mechanism is the use of special purpose entities (SPE), which have become an integral part of corporate finance today. The SPE is formed by the sponsoring company (Avis, as shown in our text) and is capitalized with equity. In the case of Avis Rent-A-Car, they set up a trust, which acts as an SPE. The SPE leverages the equity investment with money bo
owed from credit markets and they purchase earning assets from or for the sponsoring company. The cash flow generated from these assets is then used to repay the debt and provide returns to equity investors. In our Avis Rent-A-Car example, the trust they set up was the entity that bo
owed the money to purchase cars. Avis then leased the cars from the trust. This set up only causes Avis to report lease expenses. The millions of dollars needed to purchase the vehicles initially never shows up on the balance sheet of Avis, but on the financial statements of the trust. This puts Avis in a better financial standing in terms of financial analysis and allows them to bo
ow money from banks that they may not have been able to obtain without creating the trust/SPE. One of the most important things to note about the SPE and how it is possible to use this way, is the fact that under GAAP, it is accounted for as a separate entity, unconsolidated from the sponsoring company. “The company thus is able to use SPEs to achieve off-balance-sheet transactions to remove assets, liabilities, or both from its balance sheet.” This in turn then may significantly improve the company’s return on assets, asset turnover ratio, and leverage ratios.
Among all of this off-balance-sheet financing, one major question might arise. How do we treat these items, and do they affect our analysis of the financial statements? These items typically only appear in a company’s notes, so they may be difficult to identify. “Off-balance-sheet items are not inherently intended to be deceptive or misleading, although they can be misused by bad actors to be deceptive.” They are not used with the intention of hiding liabilities or for gain, but they do provide great advantages that may otherwise be unavailable. Using these off-balance-sheet financing items enables a company to maintain compliance with existing financial covenants and to share risks and benefits of assets and liabilities. In the Avis example, while Avis may not be reporting these liabilities on their financial statements, they are still ultimately responsible for repaying the money that was spent to purchase the vehicles, since it is still their trust. This type of financing was
ought into the public eye with the Enron scandal. Enron would obtain
uild an earning asset, such as a power plant, project profits, and claim the profit on the books. If they did not generate the anticipated profit, they transfe
ed the loss to a corporation that was off their books. This caused the loss to go unreported on their financials, even though they still suffered from it, thus still affecting their overall financial position and making the financial analysis look much more favorable than it is. So ultimately, although we do not to account for these off-balance-sheet items by themselves, it is definitely very important to recognize them and analyze them in relation to the company’s financials.
References:
Hayes, A. (2019, August 23). Off-Balance Sheet (OBS) Definition. Retrieved from https:
www.investopedia.com/terms/o/off-balance-sheet-obs.asp.
Su
amanyam, K. R. (2014). Financial statement analysis (11th ed.). New York, NY: McGraw Hill Education.