Off-balance sheet finance

Level1 Level 2 Optional

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
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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.
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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.
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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

Non-current liabilities
Finance lease liability (W) 256,500
Deferred income (100,000x3/5) 60,000

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
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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.
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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
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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.
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