From the blog
Off Balance Sheet Financing
Off balance sheet financing refers to contractual arrangements that look like financing but do not get recorded as such on the recipient’s balance sheet. The effect of shifting liabilities off-balance sheet is a tendency to understate gearing and leverage ratios had those liabilities been capitalised.
Why aim for off balance sheet treatment
For commodity traders in particular, getting commodity trade finance structures off balance sheet can be as important as the financing itself. There are many reasons why commodity traders strive for off balance sheet treatment, but we can list a few:
- Finance departments keep a watchful eye over group interest-bearing debt levels, to ensure they remain well within debt covenants under corporate loan facilities
- Credit rating agency analysts can adjust as-reported balance sheet debt figures upwards if they feel those figures are under-stated, which would cause cost of funding for the debt issuer to unexpectedly increase
- External auditors may form a negative view of the aggressiveness of the company’s accounting policies, if they view such items as clearly not off balance sheet worthy
Principle of substance over form
True and fair representation are core tenets of accounting for assets and liabilities. Not accounting for certain transactions, especially financing related ones, seems to go against this principle.
That said, accountants are also guided by international accounting standards which require them to consider a transaction’s economic substance over and above its legal form. However, ascertaining the substance is easier said than done, as this requires being aware of the true commercial impact/intent of each transaction, where economic risks/obligations and rewards/rights sit between parties, notwithstanding the legal/contractual drafting.
Consider a sale and re-purchase (a.k.a. “repo”) transaction. If one party initially sells goods at market price, and subsequently repurchases the goods at the then prevailing market price, one could view that market risk is borne by both seller and buyer over the duration of the transaction. However, if the re-purchase price reflects even a hint of reference to the initial sale price, this feature may suggest it is merely an alternative characterisation of principal and interest. In this latter case, risk is borne by the seller who is in substance a borrower and buyer is in effect a lender from the onset.
Signs of on balance sheet treatment required
On balance sheet treatment is generally required if 1) there is sufficient evidence and 2) it is reasonably expected that a transfer of economic benefits between parties is probable. Also, if a monetary outflow in question can be quantified with sufficient reliability it is another sign that the item should be on balance sheet.
Consider a receivables factoring transaction. If economic risks and rewards have been well and truly transferred to the party purchasing the debt, this may indicate a genuine or true sale of receivables. This may warrant a derecognition of the transaction from the balance sheet of the seller, regardless of the transaction’s contractual form. However if post the sale, certain risks are retained by the seller or if the purchaser of receivables has the benefit of seller indemnities, then the transaction’s substance would indicate more of a loan arrangement between seller as borrower and buyer as lender.
With or without recourse
If a party transfers debt without recourse to it, with the transferee accepting risk transfer of non-payment of debtor/producer, this indicates a true sale has taken place. On this basis, recording a matching reduction in amount of such debt on the balance sheet could be warranted.
However, if a party transfers debt with recourse to it, it seems to suggest the transferee has not fully accepted risk transfer of non-payment of end debtor and could seek recourse from the transferor in a default. On this basis, this seems to indicate that in effect, a financing has taken place. Accounting-wise, cash received by transferor from the transferee should be recorded as a liability or debt until the end debtor pays. Only when the end debtor pays, does the risk/obligation for the transferor to repay the transferee gets extinguished.
Tips to spot an off balance sheet financing
Look out for neutralising provisions in the contract i.e. clauses that operate to negate the effect of guarantees, indemnities and warranties. Also, language that limits any liability or loss suffered e.g. loss limited to amounts received by the end debtor, may also suggest an element of off balance sheet financing structuring at play.
Be sensitive to back-to-back contract structuring or passthrough / set-off language that in effect transfers risks via using the transferee entity as the corporate sleeve. It would be even clearer if cashflows are also segregated from the transferee’s bank accounts, although this is a nice-to-have rather than a tell-tale sign that on balance sheet treatment required.
Follow the financing costs. Where the transferee is able to demonstrate that it does not earn revenue from the financing activities of the transaction, or where financing revenue is charged to cover financing transaction costs, it is likely a sign that the company is unlikely to be a risk party to the transaction.
Lastly, we observe that transactions that do not impose a high degree of commitments between parties e.g. commitments to fund, commitments to buy back the same product specification generally are more “off balance sheet” in nature. However, substance over form would continue to apply. For illustration in a repo trade, where a particular buyer may not be contractually bound to buy back goods from the seller but if past track record indicates that the buyer regularly buys back products from the seller, accountants may have grounds to question the authenticity of the contractually uncommitted nature of the repo and may require the transaction to be on balance sheet.
We receive queries relating to off balance sheet structuring from our clients in the commodity trading industry. From our interactions, we find off balance sheet financing a topic that is fairly misunderstood and even viewed with suspicion – as if parties involved are doing something they shouldn’t be doing. Hopefully we have demonstrated that this may not always be the case.