Accelerating Earnings for Financial Reporting Purposes Generally accepted accounting principles permit a corporation to use a

Accelerating Earnings for Financial Reporting Purposes Generally accepted accounting principles permit a corporation to use a

portfolio of its receivables or assets to accelerate earnings for share- holder reporting. This reason is best described by means of an illustra- tion.

Consider again Farm Equip Corporation, the manufacturer of farm equipment. Suppose that this firm has $200 million in installment sales contracts. For financial reporting purposes, the installment sales con- tracts are not realized as revenue until the installment payments are received. Suppose that the agreement with the buyer of the farm equip- ment requires that the buyer pay 8% interest per annum. Suppose fur- ther that the treasurer of Farm Equip Corporation approaches the firm’s investment banker and is told that it can sell an asset-backed security backed by the installment sales contracts at a cost of 5%. This means that Farm Equip Corporation is receiving from the installment sales contracts 8% and would pay investors in the asset-backed securities 5%. The difference between what Farm Equip Corporation is receiving and paying is 3% or 300 basis points. Part of that difference represents

a cost to Farm Equip Corporation for “servicing” the installment sales contracts. For now, assume that the servicing fee is 1%. Reducing the 300 basis points by the 100 basis point servicing fee, means that there are 200 basis points remaining. This is referred to as the net interest spread. This is a profit to Farm Equip Corporation that will be realized by the sale of the asset-backed securities and it can be booked as income immediately. The income is effectively in the form of an asset referred to as interest-only strip. How much is the income that will be realized by Farm Equip Corporation for financial reporting pur- poses? Or equivalently, what is the value of the interest-only strip? We can apply the basic principle of valuation to determine it. This is done as follows. First, Farm Equip Corporation’s treasurer must determine the dollar amount of the 200 basis points for each year over the expected life of the asset-backed security. Then the present value of this dollar amount for each period is computed.

For example, suppose that the $200 million in installment sales con- tracts call for a repayment of principal of $50 million per year for the next four years. Then assuming that none of the borrowers default on their contractual obligation or pay off their loans earlier than the sched- uled principal repayment date (referred to as a “prepayment”), this means that each year the dollar net interest based on the net interest spread of 200 basis points is as follows:

Borrowing Via Structured Finance Transactions

Beg. of Year Balance Outstanding Dollar Net Interest

The next step is to compute the present value of the dollar net inter- est. The question is: What is the appropriate discount rate? The dis- count rate should reflect the uncertainty of realizing the projected dollar net interest over the next four years. Let’s suppose that a fair market rate is 12%. Then the present value of the dollar net interest 12% is $8,022,088.78 as shown below: 2

Beg. of Balance

PV Factor at Present Year

Dollar Net

635,518.08 Value of interest-only strip $8,022,088.78

The $8,022,088.78 would be reported as income in the year that the asset- backed securities are issued and is the value of the interest-only strip.

The key in the valuation of the interest-only strip is determining the dollar net interest spread each year and the appropriate interest rate at which to discount the dollar amount for each year. Consider first the dol- lar net interest each year. In the analysis above, it is assumed that the $200 million in installment sales contracts will be paid—that is, no defaults are assumed. Suppose instead that, due to defaults, the treasurer projects that the balance outstanding after defaults is as follows:

Beg. of Year Balance Outstanding Dollar Net Interest

2 Notice that calculations have been simplified by assuming that all of the dollar net interest spread is received at the end of the year.

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Then the dollar net interest and the present value at 12% each year are shown below, along with the value of the interest-only strip:

Beg. of Balance

Present Year

Dollar Net

PV Factor

533,835.19 Value of interest-only strip $7,783,539.09

Thus, based on this, the reported income due to the securitization would be $7,783,539.09 (the value of the interest-only strip) versus $8,022,088.78, in the case where no defaults are assumed. If a more appropriate dis- count rate is higher than 12%, then the value of the interest-only strip is reduced. For example, at a 15% rate, the value of the interest-only strip is $7,633,477.58, assuming no defaults and $7,413,485.51, assuming the defaults in the table above.

If there are prepayments, this reduces the value of the interest-only strip. This is because when a borrower repays a loan, this reduces the loan balance. The issuer receives the dollar net interest only on the out- standing loan balance. For example, suppose that there are no defaults but that the borrowers prepay their loans such that the balance out- standing each year is as follows:

Beg. of Balance

Dollar Net

Year Outstanding

It can be shown that the present value of the interest-only strip in this case is $5,099,315.71. When discounted at a 12% rate, the value is less than even the case above, where there are defaults.

It is not a simple task to determine the defaults and therefore the dollar net interest and the appropriate interest rate for discounting. Consequently, the firm’s external auditors must assess the assumptions made by management in determining income resulting from a securitiza- tion. There are shareholder suits against management and its external auditors in cases where shareholders have challenged income generated

Borrowing Via Structured Finance Transactions

from a securitization for a firm that has faced financial difficulties. The issue is whether reasonable assumptions were made regarding defaults and whether the appropriate discount rate was used.

It is important to understand that a corporation can use a struc- tured financing to achieve a target income. Stock analysts project a con- sensus earnings for a corporation. Suppose that management in the absence of securitization needs $0.10 per share to achieve the target earnings. Management can use all or part of its receivables or loans to achieve the targeted amount via securitization.

One more advantage should be noted. Our discussion here deals with realization of income for financial reporting purposes. How about the tax treatment? Under the tax code, the sale of the assets to the SPV and the resulting income need not be recognized for this purpose. That is, income realized for financial reporting purposes need not be realized for tax purposes. So, income can be accelerated for financial reporting purposes by selling financial assets but taxes on that income can be postponed for tax purposes.