Firms have a natural desire to reduce the perception of their riskiness. First, when firms borrow money, there is the risk that they will default on the loans. They can obtain loans at a reasonable interest rate only if their financial condition is strong.
One of the most common indicators of a firm’s financial condition is its level of debt, since a high level of debt will require a high level of interest payments. A firm is more likely to default on its loans if it has an excessive amount of debt. If a firm can prove that its debt level is low, it can more easily obtain additional loans at low rates. Second, a firm’s stock may be valued more highly by investors if it is perceived to have a low level of risk. Investors are not as worried that the firm will go bankrupt.
Some firms have used deceptive strategies to reduce their amount of reported debt. In particular, they have used partnerships and leasing, which are explained in this post. Enjoy!
How Partnerships Can Distort Risk Perceptions
Many of the largest firms in the United States own partnerships. A partnership is structured differently from a corporation, in that its ownership is composed of partners, many of which may be managing the firm. In many cases, the ownership of partnerships and the accounting for them are sensible. In other cases, this action was primarily intended to disguise the firm’s debt level and thus enhance the firm’s value. Investors need to determine whether firms have created partnerships for practical business purposes or with the intention of manipulating their financial statements.
A firm may attempt to hide debt by creating a special partnership that will take part ownership of a portion of the firm’s business. Some assets of the firm are transferred to the partnership, along with an equal amount of liabilities plus equity.
Suppose that a firm has $100 million in assets, which is supported with $60 million of borrowed funds (debt) and $40 million of equity. The debt ratio of this firm is
Debt ratio = debt/total assets
Now assume that the firm converts some of its business into a special partnership. It allocates $40 million of assets and $30 million of debt to the partnership. The remainder of the firm now has $60 million in assets, supported by $30 million of debt. Now its debt ratio is:
Revised debt ratio = $60,000,000/$30,000,000
This firm has lowered its debt ratio simply by moving a high proportion of its debt over to a partnership, and therefore removing that debt from its balance sheet. It has not changed its operations. It has reduced the reported debt on paper. Consequently, its debt appears to be reduced if investors focus only on the firm’s financial statements and ignore the partnership’s financial statements. Yet, if the partnership experiences financial problems, the firm may be obligated to the creditors of the partnership. It would be a mistake to ignore the partnership when assessing the firm’s risk.
However, investors who assess publicly traded firms commonly ignore partnerships for convenience or because insufficient information about the partnerships is disclosed.
The Enron scandal serves as a classic case of how partnerships were used to hide debt. Enron transferred some of its assets and liabilities to partnerships that it owned called special-purpose entities (SPEs). It arranged a deal with other outside investors to invest at least 3 percent of the partnership’s capital. When Enron created a partnership that would buy one of its business segments, it would book a gain on its consolidated financial statements from the sale of the asset to the partnership. In this way, the sale enhanced the income on its consolidated income statement. Enron had more than 800 partnerships.
Accounting guidelines allowed firms to exclude this type of partner- ship from its consolidated financial statements. Investors who focused on the consolidated financial statement did not recognize the amount of debt that Enron had.
Enron periodically booked losses from its partnership businesses on the partnership financial statements, while booking gains from its partnership businesses on its consolidated financial statements. On November 8, 2001, Enron announced that it would need to restate its earnings for the previous 5 years because three of its partnerships should have been included in the consolidated financial statements. There is a fine line between manipulating earnings within the accounting guidelines and violating the accounting guidelines. Enron crossed the line in its accounting for these three partnerships. Enron’s previously reported earnings over the previous 5 years were reduced by about $600 million. The restatement confirmed that Enron’s earnings had been inflated. However, by this time, the stock price had already plummeted, and many investors had lost most of their investment.
Since investors cannot control the lack of enforcement concerning accounting methods that are intended to disguise a firm’s financial condition, they may attempt to learn enough accounting to monitor the firm’s financial statements. However, even some accountants would have difficulty figuring out the financial condition of firms that own partnerships. In the case of Enron, even many creditors who focus on assessing creditworthiness did not recognize the amount of Enron’s debt. Enron’s balance sheet showed debt of $13 billion, but when the debt contained within the partnerships was considered, the total debt may have been more than $20 billion.
Since the Enron scandal, investors have become concerned when they learn about some partnership relationships. When Adelphia Communications announced in March 2002 that it had loaned $2.3 billion to some of its partnerships, its stock price declined by more than 40 percent within 1 week.
How Leasing Can Distort Risk Perceptions
Another method by which a firm reduces its perceived risk is to use leasing instead of debt. Consider a firm that needs a new manufacturing plant to produce many of its products. If the firm uses debt to finance its investment in the plant, it will incur large debt payments over the next several years.
The high level of debt may increase the firm’s risk, because it obligates the firm to generate enough cash flow to meet the periodic debt payments. A firm may be able to reduce the concerns of investors and creditors by leasing the plant instead of buying it. It would avoid the use of debt by making periodic lease payments to the owner of the plant in exchange for using the plant. Leasing expenses are a fixed periodic cash outflow, similar to that for debt. Yet, some investors will not recognize these expenses because they simply focus on the firm’s debt. The accounting for leasing is not a gimmick, but investors need to recognize lease payments along with debt payments when estimating future fixed payment obligations.