ACHIEVING OFF-BALANCE-SHEET FINANCING (ADAPTED FROM MATERIALS BY R. DIETER, D. LANDSITTEL, J. STEWART, AND A. WYATT).
Patrick Company wants to raise $50 million cash but for various reasons does not want to do so in a way that results in a newly recorded liability. The firm is suffi- ciently solvent and profitable, so its bank is willing to lend up to $50 million at the prime interest rate. Patrick Company's financial executives have devised six different plans, described in the following sections.
Transfer of Receivables with Recourse
Patrick Company will transfer to Credit Company its long-term accounts receivable, which call for payments over the next two years. Credit Company will pay an amount equal to the present value of the receivables, less an allowance for uncollectibles, as well as a discount, because it is paying now but will collect cash later. Patrick Company must repurchase from Credit Company at face value any receivables that become uncollectible in excess of the allowance. In addition, Patrick Company may repurchase any of the receivables not yet due at face value less a discount specified by formula and based on the prime rate at the time of the initial transfer. (This option permits Patrick Company to benefit if an unexpected drop in interest rates occurs after the transfer.) The accounting issue is whether the transfer is a sale (in which Patrick Company increases Cash, reduces Accounts Receivable, and recognizes expense or loss on transfer) or merely a loan collateralized by the receivables (in which Patrick Company increases Cash and increases Notes Payable at the time of transfer).
Product Financing Arrangement
Patrick Company will transfer inventory to Credit Company, which will store the inventory in a public warehouse. Credit Company may use the inventory as collateral for its own bor- rowings, whose proceeds will be used to pay Patrick Company. Patrick Company will pay storage costs and will repurchase the entire inventory within the next four years at contractually fixed prices plus interest accrued for the time elapsed between the transfer and later repurchase. The accounting issue is whether the inventory is sold to Credit Company, with later repurchases treated as new acquisitions for Patrick's inventory, or whether the trans- action is merely a loan, with the inventory remaining on Patrick's balance sheet.
Throughput Contract
Patrick Company wants a branch line of a railroad built from the main rail line to carry raw material directly to its plant. It could, of course, borrow the funds and build the branch line itself. Instead, it will sign an agreement with the railroad to ship specified amounts of mate- rial each month for ten years. Even if Patrick Company does not ship the specified amounts of material, it will pay the agreed shipping costs. The railroad will take the contract to its bank and, using it as collateral, borrow the funds to build the branch line. The accounting issue is whether Patrick Company would increase an asset for future rail services and increase a liability for payments to the railroad. The alternative is to make no accounting entry except when Patrick makes payments to the railroad.
Construction Partnership
Patrick Company and Mission Company will jointly build a plant to manufacture chemi- cals that both need in their production processes. Each will contribute $5 million to the project, called Chemical. Chemical will borrow another $40 million from a bank, with Patrick being the only guarantor of the debt. Patrick and Mission are each to contribute equally to future operating expenses and debt service payments of Chemical, but in return for its guaranteeing the debt, Patrick will have an option to purchase Mission's interest for $20 million four years hence. The accounting issue is whether Patrick Company should rec- ognize a liability for the funds borrowed by Chemical. Because of the debt guarantee, debt service payments ultimately will be Patrick Company's responsibility. Alternatively, the debt guarantee is a commitment merely to be disclosed in notes to Patrick Company's financial statements.
Research and Development Partnership
Patrick Company will contribute a laboratory and preliminary findings about a potentially profitable gene-splicing discovery to a partnership, called Venture. Venture will raise funds by selling the remaining interest in the partnership to outside investors for $2 million and borrowing $48 million from a bank, with Patrick Company guaranteeing the debt.
Although Venture will operate under the management of Patrick Company, it will be free to sell the results of its further discoveries and development efforts to anyone, including Patrick Company. Patrick Company is not obligated to purchase any of Venture's output. The accounting issue is whether Patrick Company would recognize the liability.
Hotel Financing
Patrick Company owns and operates a profitable hotel. It could use the hotel as collateral for a conventional mortgage loan. Instead, it considers selling the hotel to a partnership for $50 million cash. The partnership will sell ownership interests to outside investors for $5 million and borrow $45 million from a bank on a conventional mortgage loan, using the hotel as collateral. Patrick Company guarantees the debt. The accounting issue is whether Patrick Company would record the liability for the guaranteed debt of the partnership.
Required
Discuss the appropriate treatment of each proposed arrangement from the viewpoint of the auditor, who must apply GAAP in deciding whether the transaction will result in a liability to be recorded or whether footnote disclosure will suffice. Does GAAP reporting result in an accurate portrayal of the economics of the arrangement in each case? Explain.