Balance Sheet Finance and Impairment

¶ … Balance Sheet Finance and Impairment

Off-Balance-Sheet Finance and Impairment

Off-balance-sheet financing refers to a situation in which the economic agent will not reveal all his capital expenditures within the balance sheet (it generally applies to large capital expenditures which would affect its debt ratios). Consequently then, a first effect of off-balance-sheet financing for the company's financial statement is that it makes it more controllable by massively reducing the revealed costs. This is achieved through various means of classification and its aim is to keep the leverage and debt to equity ratios at low levels. Examples of off-sheet-financing may include joint ventures, partnerships for research and development or operating leases (Investopedia, 2009).

However the capitals are not included in the company's balance sheet, they are included in the balance sheet of another company - specially formed with this purpose. These agencies are called Special Purpose Vehicles (SPV) or Special Purpose Entities (SPE). Given then that the assets and liabilities are moved to the SPV, it also means that their adherent risks are also moved (Risk Glossary, 2005). In other words, the second effect upon the financial statement is that it becomes better able to reveal and manage risks.

Also, a third effect is that the initial balance-sheet, or the on-balance-sheet-financing, it more flexible. Then, another effect of the SPVs is that they allow economic agents to pay less in taxes, coming as such next to fraud and immoral and unethical conduct. In the end, all these could mean that the public trust in the company's financial statement is reduced, all for the simple reason that the audience knows the agent has included on the statement only those assets and liabilities he desired. Enron for instance, before they went into bankruptcy, had created numerous Special Purpose Vehicles with the aim of hiding billions of dollars of its debt. The financial scandals at the beginning of the third millennium forced authorities to better regulate SPV and off-balance-sheet financing (Risk Glossary, 2005).

Financial impairment is understood in two ways: first of all, it represents a reduction in the company's stated capital as a result of poor estimation of incomes and losses. Secondly, it can represent the entire capital, which is lower than the company's par value capital stock. In both cases, impairment generates negative effects upon the economic agent and it is undesirable (Investopedia, 2009). The attention on cases of impairment has generally been reduced, but this is expected to increase with the more emphasis placed on financial analysis and audits, a need generated by the contemporaneous economic crisis (Wayman, 2009). As an addition then, there have been developed complementary regulations. IFRS 3 for instance, states that while amortisation tests will not be conducted, impairments tests will still be performed. IAS 39 states that the interest income related to impaired credits would be recognized starting with 2005; more net present value calculation on impaired loans will be conducted (Nordea, 2005).