Off-Balance Sheet Items Hold
The Key for Curious Investors
Here's a question for you: If an asset is "off-balance sheet," is it:
b. In danger of falling over
c. In the CFOs personal account
Try none of the above. That's because this whole notion of off-balance sheet reporting can be as understandable as a two-year old's babbling. If a company has an asset or liability and it's not on the balance sheet, then where is it? That's what we're going to find out. It's going to be a bit grinding, but this is the kind of stuff that helps smart investors steer clear of the Enrons of the world.
Some of the confusion surrounding off-balance sheet items, which include things like lease agreements, is the name itself. "Off-balance sheet" is a bit misleading because it implies that something should be on the balance sheet instead, says Tim Lucas, the Financial Accounting Standards Board's research director.
The off-balance sheet items are usually found in the footnotes to the financials, which come after the cash flow statement. The problem is you have to read them. And, frankly, the folks who write these footnotes were not English majors. So while, in most cases, no one is pulling the wool over your eyes, the writing may be jerky and confusing.
Take Tyco. a company that doesn't appear in the news these days without the words "accounting questions" nearby. Look at Note 7 in Tyco's current 10-K filing, where it discusses its sale of trade receivables. No surprise in that, but who did Tyco sell that stuff to? The note says it sold the balance to a "limited purpose subsidiary of the Company." Huh? According to the footnote, it's tough to tell who the buyer is, though it appears the buyer is affiliated with the company. And that's one reason accounting-addled investors have Tyco on their mind. (Why can't they all be like you, Mr. Buffett?)
There are certainly legitimate reasons to report an item off-balance sheet, according to FASB. And while the rationale for these off-balance sheet items is up for debate these days, it's up to FASB to change the standards. And FASB long has been accused of taking its own sweet time coming out with new standards. So as in most situations, you need to help yourself.
The four main items reported in the footnotes are lease agreements, pension assets and liabilities, investments in joint ventures and affiliates and special purpose entities, otherwise known as the securitization of assets. We'll tackle the first three today and save special purpose entities (or SPEs) for next week.
Let's look at the most obvious and oldest item being sent off-balance sheet: lease agreements.
If you lease an item and the contract doesn't have a special buy-out option at the end of the lease, then FASB says you can't really call that an asset you own. Let's say you've leased a BMW Z3 for three years and you've got a baby on the way. Your wife says it's got to go when the lease is up since it's a two-seater. While it's a joy ride today, you can't consider it a personal asset.
The accountants would dub that an operating lease since at the end of the lease you will return the item and (sadly) move on.
Lots of companies have operating leases. Take Staples, the office supplies store. It leases a bunch of different buildings for its stores but at the end of these leases, there's no guarantee for renewals or option to buy the building, says Albert Meyer, an analyst with David W. Tice & Assoc. an investment research and management firm in Dallas. Since Staples risks losing the store, it's not really an asset to them. This is all spelled out in their footnotes.
Keep in mind, there is nothing wrong with having operating leases but they are future liabilities that will need to be funded by future revenue. So it helps to compare. The total cash Staples would have to pay to cover its leases, which are generally over an extended period of time, is around $4.4 billion, says Meyer. That's around 41.8% of it's annual revenue. Is that bad? To find out, compare the figures to a peer company. Office Depot 's operating leases are only 19.5% of its annual revenue, according to Mr. Meyer, who says he would never analyze a company without taking into account its operating leases. Mr. Meyer's firm does
not have a position in either Staples or Office Depot.
Pension Assets and Liabilities
Other big items not shown on the balance sheet are the pension assets and liabilities. Since the pension assets are put into a trust, a separate legal entity, the argument is that those assets belong to the employees, says FASB's Lucas. So it's not fair that the company tries to claim them.
(But they can manipulate them to pump up earnings, can't they? IBM recently raised the rate of return on its pension assets from 9.5% to 10%. In this market? But, in very simple terms, that will increase its pension assets, thereby decreasing its pension liability and, voila, earnings go up. We'll look into that accounting maneuver on a future date.)
One thing to look for: "net pension liability," found on the company's balance sheet. Why only the net? Here's the current logic. Let's assume there are $300 million in pension assets. But if everyone retired, the company would need to pay out $500 million. So the company is short $200 million at this time. That's a liability to the company and it better show up on its balance sheet (and management better come up with the money before we all retire.)
After the go-go market of the late 90's many companies actually had a surplus in their pension funds thanks to those rocketing returns. But things no doubt will change. Sprint PCS. for instance, had a surplus in its pension plan over the last few years. But in 2000, the plan's assets actually lost $157 million, according to Mr. Meyer of Tice & Assoc. If that keeps up Sprint will have to add money to the fund and that will take away from the cash it needs for its day-to-day business. Mr. Meyer's firm doesn't have a position in Sprint PCS.
Joint Ventures and Affiliates
If a company owns a piece of an affiliate or joint venture, in many instances, it doesn't have to separately report its proportional piece of the assets and liabilities on its balance sheet. Again, only the footnotes need the details.
If a company owns 50% or less of an affiliate or a joint venture, then only the net of the assets and liabilities the company owns pertaining to that affiliate should hit the balance sheet. In most instances, you'll find that number under the investments section.
This net number is the result of the "equity method," in accounting-speak. So if our company owns 50% of a company with $10 million in assets and $8 million in debt, net assets are $2 million, assuming no goodwill. Since the company owns half, it reports $1 million as an asset in the investment section of its balance sheet.
But isn't the company responsible for $4 million in debt? Why doesn't that ever hit its books? Technically, the company doesn't have to pay that debt back, says Ed Ketz, associate accounting professor at Penn State University. The affiliate is given the benefit of the doubt that it will come up with the money to repay anything outstanding.
No surprise this stuff can appear fishy. And this kind of accounting may be one reason the stock of highly-acquisitive Cendant stock was hit earlier this year. Investors were concerned that it was not fully disclosing all the details of its off-balance sheet investments. Cendant, no stranger to accounting flub-ups, posted an explanation of its investment in affiliates on its Web site to attempt to appease the troops. The stock has since recovered.
It's very easy to argue that showing a net number on the balance sheet and leaving all the meat in the footnotes will not give you a clear picture of a company's total leverage. But let's face it, your portfolio will be long gone if you wait for FASB to heroically jump to your aid. So take ownership and do your own digging.
And just doing a debt-to-equity ratio (which is long-term liabilities divided by stockholders' equity) won't cut it these days. Tally total debt but then comb through those footnotes and find the total pension liability, leases outstanding, and affiliate liabilities to name a few. Then run your debt-to-equity ratio. And be sure to compare that number to its industry peers.
Whew. Nothing like a little straightforward accounting. And we've only just begun. Tune in next week as we dissect special purpose entities.
Write to Tracy Byrnes at firstname.lastname@example.org
Updated February 15, 2002 9:26 a.m. EST