Implication of Leases on Corporate Financial Strategy

Leasing is a gray area in capital structure. The exclusion of leases may result in an incorrect assessment of a firm's financial strength and creditworthiness since operating leases are off balance sheet and not therefore considered as part of debt. In addition, payments for operating leases are reported as operating expenses although interest expenses on debt financing are not typically reported as operating expenses but under other expenses. Consequently, managers and investors should adjust ratios that are based on operating income accordingly. Damodaran suggested the following adjustment procedure be used to convert operating leases to debt:50

SFAS No. 13 requires that companies disclose future required minimum rental payments as of the date of the latest balance sheet presented, in the aggregate and for each of the five succeeding fiscal years, and cumulated amounts thereafter in the footnotes to financial statements.51 Discount these payments back to the present using a pre-tax cost of unsecured debt since the lease commitments are pre-tax and the claims of lessees are similar to the claims of unsecured debt holders.

Special Purpose Entity

An SPE is a separate legal entity created by a firm to perform particular activities related to the intended "special purpose." SPEs have been used since the 1970s, mainly for securitization purposes. The original intent was to isolate financial risk and provide lower cost financing. By creating an SPE, a firm (sponsor) could insulate itself from risk when financing large project by separating the project from itself. The cost of financing was also typically lower for an SPE than for the sponsor since as the business activities of the SPE were restricted only to their intended purpose. Nowadays, objectives of firms in creating SPEs relate to off-balance sheet debt, securitization, and tax-free exchanges.52 Securitization represents the most common use of SPEs. In a typical securitization, a sponsor company establishes an SPE and sells a bundle of assets, such as loans, receivables, and patents to the SPE. The SPE then issues debt securities for cash and uses the cash to pay the sponsor for the assets. Through this process, the sponsor successfully securitizes the assets and turns them into debt instruments. However, this debt is not recorded on the sponsor's balance sheet if the sponsor does not have to consolidate financial statements.

Accounting Guidelines for SPEs

Sponsors did not have to consolidate the assets and liabilities of SPEs as long as the equity interest of a third-party owner is at least 3 percent of the SPE's total capitalization (the 3% rule).53 However, after various corporate scandals in the early 2000s, FASB tried to bring off-balance sheet entities back onto the balance sheet. In 2003, FASB increased the 3 percent threshold to 10 percent, saying that "an equity investment shall be presumed insufficient to allow the entity to finance its activities without relying on financial support from variable interest holders unless the investment is equal to at least 10 percent of the entity's total assets."54 FASB also classified SPEs as "variable interest entities" (VIEs), and if they lacked the ability to make decisions, the obligation to absorb losses, or the right to receive returns, the financial statements of the VIEs must be consolidated with those of the sponsor who was the primary beneficiary of the VIEs. However, if a sponsor structured a VIE such that it had no legal control over it, the sponsor could still keep the liabilities of the VIE off the balance sheet.

Implications of SPEs on Corporate Financial Strategy

Many firms still use financial engineering to make them look better capitalized and less risky than they really are. Without transparent disclosure of off-balance sheet financing instruments, investors and regulators can no longer accurately assess risk. Only managers have accurate information about the amount of off-balance sheet debt. They should thus be aware of the liabilities not reported on the balance sheets and consider them when making financial decisions. For example, managers should include the hidden debt when calculating the cost of equity and the WACC to be used in capital budgeting decisions. Although significant liabilities may be omitted from the balance sheets, they still exist somewhere.

< Prev   CONTENTS   Next >