Attempts to achieve off-balance-sheet financing. (Adapted from materials by R. Dieter, D. Landsittel, J. Stewart, and A. Wyatt.) Shiraz 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. It is sufficiently solvent and profitable that its bank will lend up to $50 million at the prime interest rate. Shiraz Company’s financial executives have devised six different plans, described in the following paragraphs.
Plan 1: Transfer of Receivables with Recourse. Shiraz Company will transfer to Credit Company its long-term aunts 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 uncollectible as well as a discount, because it pays now but will collect cash later. Shiraz Company must repurchase from Credit Company at face value any receivables that become uncollectible in excess of the allowance. In addition, Shiraz 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 Shiraz Company to benefit if an unexpected drop in interest rates occurs after the transfer.) The accounting issue is whether the transfer is a sale (Shiraz Company debits Cash, credits Accounts Receivable, and debits an expense or loss on transfer) or whether the transfer is merely a loan collateralized by the receivables (Shiraz Company debits Cash and credits Notes Payable at the time of transfer).
Plan. 2: Product Financing Arrangements. Shiraz Company will transfer inventory to Credit Company, who will store the inventory in a public warehouse. Credit Company may use the inventory as collateral for its own borrowings, whose proceeds will be used to pay Shiraz Company. Shiraz Company will pay storage costs and will repurchase all the 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 Shiraz has sold the inventory to Credit Company, with later repurchases treated as new acquisitions for Shiraz’s inventory, or whether Shiraz has merely borrowed from Credit Company, with the inventory remaining on Shiraz’s balance sheet.
Plan 3: Throughput Contract. Shiraz Company wants a branch line of a railroad built from the main rail line to carry raw material directly to its own 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 material each month for 10 years. Even if it 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 Shiraz Company should debit an asset for future rail services and credit a liability for payments to the rdilroad. The alternative is to make no accounting entry except when Shiraz makes payments to the railroad.
Plan 4: Construction Joint Venture. Shiraz Company and Mission Company will jointly build a plant to manufacture chemicals that both companies need in their production processes. Each will contribute $5 million to the project, called Chemical. Chemical will burrow another $44 million from a bank, with Shiraz only guaranteeing the debt. Shiraz and Mission are each to contribute equally to future operating expenses and debt-service payments of Chemical, but in return for guaranteeing the debt, Shiraz will have an option to purchase Mission’s interest for $20 million four years later. The accounting issue is whether Shiraz Company, which will ultimately be responsible for all debt-service payments, should recognize a liability for the funds that Chemical borrowed. Alternatively, the debt guarantee is merely a commitment that Shiraz Company must disclose in notes to its financial statements.
Plan 5: Research and Development Partnership. Shiraz Company will contribute a laboratory and preliminary finding 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 by borrowing $48 million from a bank, with Shiraz Company guaranteeing the debt. Although Venture will operate under the management of Shiraz Company, it will be free to sell the results of its further discoveries and development efforts to anyone, including Shiraz Company. Shiraz Company has no obligation to purchase any of Venture’s output. The accounting issue is whether Shiraz Company should recognize the liability. (Would it make any difference if Shiraz Company did not guarantee the loan but had either the option to purchase or an obligation to purchase the results of Venture’s work?)
Plan 6: Hotel Financing. Shiraz 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. Shiraz Company guarantees the debt. The accounting issue is whether Shiraz Company should record the liability for the guaranteed debt of the partnership.
Discuss whether Shiraz Company should recognize any of these obligations or commitments as a liability on its balance sheet.