Off-Balance Sheet Obligations

Off-balance sheet (OBS) obligations, aka Incognito Leverage, usually refers to a material corporate asset or debt or financing activity not listed on the company's balance sheet, because the company is not required to do that by GAAP/IFRS.

This is one more situation when GAAP becomes BAAP because it allows the corporate management to mislead shareholders – and get away with it. For example, financial obligations of unconsolidated subsidiaries (because they are not wholly owned by the parent) may be kept off-balance sheet. Such obligations were part of the accounting fraud at Enron. Many of the energy traders' problems stemmed from setting up inappropriate off-balance-sheet entities.

Essentially, OBS is a form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants.

Operating leases are one of the most common forms of off-balance-sheet financing. In these cases, the asset itself is kept on the lessor's balance sheet, and the lessee reports only the required rental expense for use of the asset.

Unlike capital lease, an operating lease is a lease whose term is short compared to the useful life of the asset or piece of equipment (an airliner, a ship, etc.) being leased. Thus, for example, an aircraft which has an economic life of 25 years may be leased to an airline for 5 years on an operating lease.

Keeping operating lease obligations off your balance sheet is misleading, because it understates the amount of your long-term liability by the total sum of leasing payments for the duration of the lease. Which must be quite substantial if equipment leasing is the core of your financial strategy. Therefore, you must disclose all operating leasing contracts and your resulting obligations at least in footnotes to your financial statement.

And, obviously, you have to make sure that your investment project financed by operating leasing makes financial and economic sense and is acceptable. Using the solid financial valuation model supported by all relevant documentation, of course.  

Treasury Stock

Treasury Stock (aka ‘reacquired stock’) is corporate common stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market ("open market" including also insiders' holdings). These shares don't pay dividends, have no voting rights, and should not be included in shares outstanding calculations.

Why would you want to buy back your corporate stock? There are a few reasons to do that. Stock repurchases are sometimes used as a tax-efficient method to put cash into shareholders' hands, rather than paying dividends, in jurisdictions that treat capital gains more favorably. Sometimes, companies do it when they feel that their stock is undervalued on the open market.

Other times, companies do it to reduce dilution from incentive compensation plans for employees. Another motive for stock repurchase is to protect the company against a takeover threat.

Treasury stock may be created, when shares of a company are initially issued. In this case, not all shares are issued to the founders; some are kept in the company's treasury to be used to create extra cash for corporate coffers should it be needed.

On your balance sheet, treasury stock is listed under shareholders' equity as a negative number. The accounts may be called "Treasury stock" or "equity reduction". You must choose between two options for accounting for treasury stock – the cost method and the par value method. 

Retained Earnings

In accounting, retained earnings refers to the portion of net income of a corporation that is retained by the corporation rather than distributed to shareholders as dividends. Similarly, if the corporation incurs a loss, then that loss reduces the corporation's retained earnings balance.

If your balance of the retained earnings account is negative it may be called retained losses, accumulated losses or accumulated deficit. Retained earnings and losses are cumulative from year to year.

Retained earnings represent how the company has managed its profits (i.e. whether it has distributed them as dividends or reinvested them in the business). And, therefore, reflect your company’s dividend- and capital structure policy that I will cover in the Cash Flows Statement section.  

Common Stock and Additional Paid-in-Capital

Common Stock (aka ‘ordinary shares’, ‘common shares’ or ‘voting shares’) refers to securities that give their owners (a) voting rights in a company that issued the stock in question and (b) residual (after creditors and holders of hybrid securities) claim to corporate assets. In other words, corporate ownership rights.  

It is called "common" to distinguish it from preferred stock. If both types of stock exist, common stock holders cannot be paid dividends until all preferred stock dividends are paid in full. That’s why the latter are caller ‘preferred’, by the way. Dividends are paid at company’s discretion; therefore, unlike with preferred shares, there is no guaranteed cash inflows for common stock investor. However, statistically, common stock is a better investment than either bonds or preferred stock over long periods of time (in terms of ROI).

Common stock usually carries with it the right to vote on certain matters, such as electing the board of directors. However, a company can have both a "voting" and "non-voting" class of common stock.

Why would you want to issue common stock? First, you absolutely have to issue it when you form (incorporate) your company. Second, you also absolutely have to issue new stock when you take your company public via an IPO on a major stock exchange.

And third, you will have to do it to finance a major expansion of your company (also a quantum leap of sorts) that you simply can not finance in any other way. Because it is way too big and way too risky for any bank loan (even a syndicated one), bond issue or issue of hybrid securities.

In this case, you will have to do a private placement of a minority stake in your company with private (‘direct’) equity investors – either individuals or institutions (private equity investment funds). When choosing your investors, you must make sure that they are a good match with your company in their values, principles, preferences and overall behavioral patterns.

Private placement process requires development of extensive documentation – information memorandum, valuation model, presentations and the like. In practically all cases, you would want to hire a financial advisor – a competent investment bank – to do this job for you.  

Common stock is represented on your balance sheet by not one, but two accounts – ‘Common Stock @ par value’ and ‘Additional Paid-In Capital’. ‘Par value’ (aka ‘stated value’ or ‘face value’) has no relation to market value and, as a concept, is somewhat archaic. But still has to be used and reported.

The par value of a share of stock is the value stated in the corporate charter below which shares of that class cannot be sold upon initial offering; the issuing company promises not to issue further shares below par value, so investors can be confident that no one else will receive a more favorable issue price.

Thus, par value is the nominal value of a security which is determined by the issuing company to be its minimum price. This was far more important in unregulated equity markets than in the regulated markets that exist today.

Par value is always much lower than the price at which shares are distributed to founders when the company is incorporate or sold to private equity investors or to the public at IPO. The difference between what founder or investor actually paid for common shares and the stated par value of common stock is called ‘Additional Paid-In Capital’ and reported in the corresponding account of your balance sheet. 

Other Hybrid Securities

Hybrid securities are a broad group of securities that combine the elements of the two broader groups of securities, debt and equity. Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has a number of options including converting the securities into the underlying share.

Therefore, unlike a share of stock (equity) the holder has a 'known' cash flow, and, unlike a fixed interest security (debt) there is an option to convert to the underlying equity. More common examples include convertible and converting preference shares.

In addition to preferred stock covered above, the most widely used hybrid securities are bonds convertible into common (or, much less often, preferred) stock. Another broad category is so-called capital notes – debt securities with equity-like features attached. The most common examples of capital notes are perpetual debt securities (debt securities with no fixed maturity date), subordinated debt securities, knock-out debt securities, debt with attached warrants and many others.

Why would you want to issue hybrid securities? For exactly the same reason that you would want to issues preferred stock. Or use any other financial instrument, for that matter. Because from financial valuation standpoint (NPV, IRR, etc.) this financing option is better than any other.

This statement you must, of course, prove with the solid financial model and all necessary supporting documentation. It must also prove that your investment project that you are financing with your preferred stock, is financially and economically acceptable.

The bottom line is that there are literally myriads of financing options available on the market for financing your corporate projects. Your job is to get to know all of them well enough to choose the one that best fits your specific project. From financial value generation perspective, of course. 

Preferred Stock

Preferred Stock is the most common example of a hybrid security (‘hybrid financial instrument’). Like debt, it entitles is owners to regular payments - dividends - which must be paid before owners of the common stock can get theirs (but after debt holders receive their interest payments).

The dividend on preferred shares is usually specified as a percentage of their par value, or as a fixed amount (for example, Pacific Gas & Electric 6% Series A Preferred). Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index (such as LIBOR).

But unlike debt, preferred shares have unlimited life span, which makes preferred shares similar to common ones. Also, if your company defaults on its debts payments (interest and/or principal), it can be forced into bankruptcy.

If it defaults on its dividend payments to its preferred stockholders, in most cases the latter will simply get voting rights or will have their preferred stock converted to common. Regular preferred shares have no voting rights associated with them; however, some preferred shares have special voting rights to approve extraordinary events (such as the issuance of new shares or approval of the acquisition of a company) or to elect directors.

Preferred shares is a very versatile instrument; they may specify nearly any right conceivable. In the U.S. they normally carry a call provision, enabling the issuing corporation to repurchase the share at its (usually limited) discretion.

There are many categories of preferred stock (and Wall Street wizards come up with new ones all the time) - prior preferred stock, preference preferred stock, cumulative and non-cumulative preferred stock, participating preferred stock, exchangeable preferred stock (for some security other than common stock), putable preferred stock and others.  

Of all these, the most interesting is the convertible preferred stock which holders can exchange for a predetermined number of the company's common-stock shares. It is a one-way deal; one cannot convert the common stock back to preferred stock.

This exchange may (but usually does not have to) occur under certain conditions (among which may be the specification of a future date when conversion may begin, a certain number of common shares per preferred share or a certain price per share for the common stock).

Why would you want to issue preferred shares? Because from financial valuation standpoint (NPV, IRR, etc.) this financing option is better than any other – bank loan, bond issue, etc. Or issuing common stock.

This statement you must, of course, prove with the solid financial model and all necessary supporting documentation. It must also prove that your investment project that you are financing with your preferred stock, is financially and economically acceptable.

Specifically, preferred stock carries less risk than a bank loan or bond issue - in some cases, a company can defer dividends by going into arrears with little penalty or risk to its credit rating (although it will negatively affect the overall company image in the eyes of its creditors and other stakeholders). With debt financing, payments are required; a missed payment would put the company in default.

And, unlike with the common stock issue, you will not have to dilute your capital and acquire additional shareholders, who might become quite a nuisance.

Occasionally companies use preferred shares as means of preventing hostile takeovers, creating preferred shares with a ‘poison pill’ (or forced-exchange or conversion features) which are exercised upon a change in control.

Some corporations contain provisions in their charters authorizing the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These "blank checks" are often used as a takeover defense; they may be assigned very high liquidation value (which must be redeemed in the event of a change of control), or may have great super-voting powers.

Shareholders’ Equity

Shareholders’ Equity section of your balance sheet is a little bit trickier than the previous two – Assets and Liabilities. On the surface there is nothing tricky about it; it shows how much of your total assets (of ‘your company’) is owned by your shareholders. The Liabilities section shows how much is owned by your creditors.

‘Owned’ in a sense of who gets what in case of – God forbid – the liquidation of your company. The structure of the ‘right side’ of your balance sheet shows the priority in which external claims on your assets will be satisfied in this grave case. Creditors come first, preferred stockholders second and common stockholders last.

From the standpoint of comprehensive business analysis, your company is a ‘going concern’; therefore, CBA is not interested much in these priorities. What is interesting, concerns the capital structure of your company and its implications on your financial value.

The trick is that, in addition to ‘classic’ common and preferred stock (the latter may or may not be used in your company), your Shareholders’ Equity section may contain a whole lot of ‘hybrid’ securities. Hybrids between debt and equity, that is. Which are not exactly ‘shares’ in your company in the usual meaning.

Therefore, I prefer to call this section just ‘Equity’ or even simply ‘Capital’. Which is perfectly OK with both GAAP and IFRS. Obviously, I will cover hybrid securities in a corresponding section below.