Off-Balance Sheet Financing and Balance Sheet Fraud

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OFF BALANCE SHEET REPORTING 1

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Introduction:

Off-Balance Sheet Financing is an accounting procedure that is associated with debts that are not reported on the balance sheet of a company. Aboagye‐Otchere and Agbeibor (2012, p. 197) is against the use of off sheet balance reporting, in the financial records of companies. This is because financial statements, which are prepared through this style of financial reporting normally, fail to give a true representation of the economic value or substance of the company. This is because of the legitimate failure to report some assets and liabilities.

This paper provides a discussion to the extent to which this statement is true. In meeting the objectives of this paper, the researcher will identify examples of off balance sheet reporting. This is to help in understanding this concept. Thereafter, the researcher will explain how this concept helps in aiding balance sheet fraud. This paper will also contain a case study on companies that failed because of the use of this type of financial reporting. This paper has a conclusion, which is a summary of the major point’s addresses in it.

Examples of Off Balance Sheet Reporting:

A good example of off-balance sheet reporting is the unconsolidated subsidiary. Under the principles of unconsolidated subsidiary, a parent organization may not be mandated to consolidate or report the activities of its subsidiaries in their financial records or statements (Stickney and Brown, 2007, p. 81). However, it is important to explain that the company has an obligation to pay any unconsolidated liabilities, of its subsidiary companies (Lemieux and Limonad, 2011, p. 35). Operating lease is another example of an off balance sheet financing/ reporting. These are normally entered for purposes of using the leases on a short period of time, relative to their overall useful lives. Brigham and Houston (2004, p. 27) explain that an operating lease does not involve the transfer of any risks or rewards of ownership.

Based on this fact, it is not possible to report them on the balance sheet of an organization that has entered into the lease agreement (Chorafas, 2000, p. 114). Other examples of off balance sheet reporting includes, take or pay contract, sale of accounts receivables, etc (Caracuzzo, 2009, p. 373). It is important to have a consideration of these off-balance-sheet financial arrangements, because they can have an impact on the financial stability of a company. For example, if an organization defaults on the rental payments, that is required because of operating a lease, then the lessor can repossess the assets of the company.

Off Balance Sheet Reporting and Balance Sheet Fraud:

One of the major reasons given, as to why Off Balance Sheet reporting does not denote the true value of an organization, is the fact that it encourages balance sheet fraud (Petrick and Scherer, 2003, p. 43). Balance sheet fraud normally occurs when an organization gives an inaccurate report on their liabilities and debts (Elliott and Elliot, 2005, p. 60). Normally, this happens when the company provides an inaccurate low figure of their liabilities and debts. One of the off balance sheet schemes aimed at inaccurately reducing the liabilities of a company is the misclassification of a capital lease. In as much as capital leases are normally recorded as liabilities under international accounting rules, it is not a requirement to report operating leases as a liability.

Some financial experts normally misclassify capital leases as operational leases, hence avoiding enlisting them in the balance sheet (Ketz, 2003, p. 21). Through this action, the financial experts have managed to record a low figure of their liabilities. This therefore fails to provide the true value of the company, because of an understatement of its liabilities. The Lehman brother was accused of a false misclassification of its capital leases, thereby misleading investors on the true value of the business organization (Paramasivan and Subramanian, 2009, p. 51). Doran (2012, p. 44). Failure to record accrued expenses as another balance sheet crime, made possible through the principles of off balance sheet reporting. Accountants normally use this method for purposes of understating the liabilities of the company, therefore increasing its income (Lander and Auger, 2008, p. 35) .

Prior to its fall in 2001, the chief executives of Enron used this method at overstating its financial performance. This made investors to think that the company was performing well, only to surprisingly hear that the company was filing for bankruptcy. The use accounting records of their unconsolidated subsidiaries, for purposes of concealing liabilities is another off balance sheet activity that contributes to fraud. This is a method that is mostly used by shell companies, in a bid to avoid taxations, or launder money (Rogers, 2005, p. 41).

Shell companies are small private companies, which do not have a physical address. They are normally formed as stock holding companies, or for purposes of holding and managing the intangible assets of other companies (Doran, 2012, p. 42). Enron was accused of using its shell subsidiary companies to offload its financial liabilities, to these companies (Petrick and Scherer, 2003, p. 39). This had an effect of failing to produce a true and accurate financial position of the company.

Doran (2012, p. 12) explains that the use of sophisticated financial transactions to remove liabilities from the balance sheets of a company has an impact in inaccurately increasing the revenues of a company. Lehman brothers developed their own financial system referred to as Repo 105, whose main intention was to hide the liabilities of the company, for purposes of increasing its revenues. Repo 105 refers to a short term loan, where the company is able to classify short term loans as sales, and use these “sales proceeds” for purposes of reducing the debts or liabilities of the company (Hines, Kreuze and Langsam, 2011, p. 47).

Case Study Examples:

WorldCom is a company that was accused of using the principles of off balance sheet reporting for purposes of inflating its profits, by a whopping 3.8 billion dollars (Laing and Perrin, 2011, p. 44). The company was accused of capitalizing certain costs, which were supposed to be treated as expenses. This was able to allow the organization to spread its various expenses over a period of many years (Clikeman, 2009, p. 31). This is as opposed to recording these costs as expenses in their current periods. Such a deferral of costs was able to allow the company to report a low expense, hence inflating their incomes (Elliott and Elliott, 2008, p. 19).

The accountants of the company were able to misclassify their expenses, marking them as long-term sources of revenue (Clikeman, 2009, p. 37). The company also had undocumented computer related expenses, totaling to 500 million dollars, which were seen as assets. Another company is called Health-South. This is a company with its headquarters in Birmingham (Clikeman, 2009, p. 33). The company was accused of deliberately using the principles of off balance sheet reporting to inflate its income, so that it may meet the earning standards and expectations of Wall Street.

This fraudulent activity began in the year 1996, upon which, the true financial value of the company was 1.7 billion dollars (Holtzman, 2008, p. 31). In the year 2003, the managers of the company were charged for willing overstating its cash deposits by 300 million dollars and overstating the total assets of the company by 800 million dollars (Clikeman, 2009, p. 39). However, evidence presented during the trial of this company indicated that it used legitimate accounting methods in providing financial reports to its shareholders. Another company accused of using off balance sheet reporting to commit fraud was Olympus Corporation.

Olympus is a Japanese multi-national corporation, and it was accused of hiding its losses and liabilities to various subsidiary companies that were under its control (Wolny, 2013, p. 19). These subsidiary companies were unconsolidated financial organizations. Furthermore, the company recorded these losses at value that exceeded their fair values. Later on, the company was able to categorize these losses as costs which were incurred because of the acquisition of other entities, or financial advisory costs. Enron is another company responsible for using the principles of off balance sheet reporting to hide its losses and liabilities. Through subsidiary organizations, and complex financial reporting, the company was able to hide its losses and liabilities.

Conclusion:

As illustrated through the examples contained in this paper, it is possible to assert that off balance sheet reporting does not give a true value of the company. In fact, this technique of financial reporting makes it easier for companies to engage in fraudulent activities. This is by overstating their assets, and reducing their liabilities. Companies such as World Com, and Health South managed to take advantage of the provisions of off balance sheet reporting to commit fraud in their balance sheets.

This is by failing to account for the numerous expenses and liabilities that the companies incurred. Based on these facts, the companies managed to portray an inaccurate financial position, hence misleading its shareholders, and other stake holders of the organization. This made them to lose millions of dollars. Based on these facts, it is therefore prudent for a company to use the on balance sheet financial reporting. This would help in identifying the true value of an organization.

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