Peeling away financial reporting issues one layer at a time

Executory Contracts: The Root of Most Off-Balance-Sheet-Financing Evils

If I may be permitted to say so myself, my principles-based solution for curing repo accounting abuses is the bomb. The off-balance sheet effects of repo accounting could be obliterated by a simple 'gross up' (i.e., separate presentation) of: (1) the receivable for the return of the securities; and (2) the obligation to pay for the return of those securities.

But, nobody has nominated me for the Nobel Prize just yet – perhaps because I may not have fully explicated the logic of my breakthrough discovery. I came to this realization upon reading the following comment from a friend (and former accounting policymaker):

"I do not understand your reasoning/logic for having the transferor in a repo transaction recognize a receivable and an equivalent payable for the entire/full value of the financial instrument subject to the repo but not having others that make commitments to expend cash to buy other kinds of assets do the same. For example, Chevron commits to buy 100 million bbls of crude oil from the Saudis–no receivable and payable. Walmart commits to buy 100 million T shirts from a vendor in Vietnam–no receivable and payable. Your having the transferor in the financial instrument repo transaction recognize a receivable and an equivalent payable is a low outside curveball."

If I could literally throw a low outside curveball, dear friend and reader, I wouldn't be blogging about accounting!  So, let's discuss your point.

The Sanctuary of Executory Contracts for Window Dressers

Unlike many other topics I have been writing about where the points of contention are approaches to measurement matters, the heart of this matter seems to involve recognition, and most particularly recognition of 'executory contracts'.

Every accountant has been raised to observe two sacred and inviolable commandments: thou shalt not recognize executory contracts on the balance sheet; and thou shalt present on a 'net' basis receivables/payables with the same counterparty. 

While these commandments were once inviolable, leases have become a very notable exception. First came SFAS 13 in 1976, requiring that a very limited number of executory contracts meeting the definition of a 'capital lease' would be grossed up to reflect a leased asset and a corresponding liability. Then, recently, the FASB has finally, finally come to timidly propose that failure to capitalize any lease contract unacceptably distorts financial statements. Even armed with an understanding of the political realities that the FASB operates under, it is hard not to be shocked and awed by the resistance to this simple idea from issuers and the leasing industry en masse.

My point in this an prior postings is that Lehman's repo accounting machinations should be seen as one of numerous clarion calls for the FASB to apply its leasing logic to repurchase agreements and beyond — at least to all financial instruments. To see why, I'm going to start with a variant of my commenter's Chevron example:

  • Company A has no assets and liabilities
  • Oil costs $100 per barrel; and for simplicity, interest rates are zero.
  • Company A borrows $100 million and uses the proceeds to buy one million barrels of oil from Saudi Arabia. The Saudis will store the oil for free and deliver it one year hence.

The Accounting 101 student can tell you that Company A's balance sheet has $100 million in assets and $100 million in liabilities after these two transactions; and the Finance 101 student should notice that if oil prices were to head south prior to delivery, Company A will have a heck of a time repaying its debt. But, at least investors have a pretty good indication of the risk just from reading the balance sheet.

Now, compare the forgoing example to the equivalent of the Chevron example:

  • Company B commits to take physical delivery of one million barrels from Saudi Arabia one year hence, and will pay $100 million upon delivery. A monitor requires that the Saudis have to maintain enough physical inventory of oil at all times to ensure that Chevron will get their delivery.

Again, should oil prices head south over the next year, Company B is in exactly the same kind of trouble as Company A. But, an investor wouldn't have any indication of the risk that Company B is taking from B's balance sheet, which is unaffected by the executory contract.

The only difference between Company A's operations and Company B's operations is the number of counterparties each has dealt with. Yet, the accounting is radically different (one reflects high financial risk and the other does not). I don't think that's right. In fact, I believe it is inevitably harmful for such inconsistencies in accounting to exist.

I actually witnessed the equivalent of Company B a number of years ago during a consulting engagement. The only reason my Company-B-client entered into a contract to sell their oil production forward was because the contract would stay off the balance sheet until settlement – and with no gain or loss to boot! When oil prices went in the wrong direction (up, in this case) my client lost a ton of money because they decided to gamble on future oil prices, which went way up. The off-balance sheet accounting also turned out to be off income statement accounting, because the value-destroying events only resulted in 'opportunity losses'; i.e., reported profits were not as how as they would have been without the forward sale, but no loss was explicitly reported.

I suppose one could argue that all traditions, including inconsistent accounting for executory contracts, are for a good reason, even if one can't put one's finger on it; and that note disclosures might somehow make up for off-balance sheet accounting. But, no serious person believes that mere note disclosure of risks does the trick, do they? It's pretty much a settled fact that no regulator has yet to successfully write disclosure standards that investors are able to read, and that adequately describe off-balance sheet risks.

The Principled Basis for Recognizing Executory Contracts

As I have written here:

  • An "asset" is an economic resource to the reporting entity that satisfies at least one of the following conditions: (1) the reporting entity holds legal title to the resource; (2) the reporting entity holds the legal right (conditional or unconditional) to receive the resource; or (3) the reporting entities holds the legal right (conditional or unconditional) to use the resource for some purpose (specified or unspecified).
  • Liabilities are legally enforceable obligations (conditional or unconditional) to either: (1) deliver an asset or the common stock of the reporting entity; or (2) permit another party to use an asset.

So, in my ideal world, adherence to these definitions would require that all legal rights and obligations, even if they relate to purely executory contracts, be recognized gross – even receivables and payables to the same party. But, for political reasons having nothing whatsoever to do with my own preferences, I would limit the scope of this policy to: (1) financial instruments; and (2) non-ownership rights to non-financial assets. Thus, (gulp), the Chevron contract with the Saudis would be excluded – unless it allowed for net cash settlement.

As the scope of executory contracts recognized on the balance sheet is expanded, the more understandable, relevant, and less manipulable financial reporting will become. That's why it feels good to have 'solved' the repo accounting problem.

Unfortunately, I haven't come close to solving the thorniest problem of financial reporting: how to get around the fact that not everybody is in favor of greater understandability, consistency and transparency. If I could solve that problem, then maybe I might actually get that Nobel Prize.

 

1 Comment

  1. Reply Scott Green January 25, 2011

    Tom:
    Your post elicited a few thoughts-
    I think one reason accountants have gotten tripped up about how to account for “executory contracts” is that they coopted this legal term to describe situations in which the parties have not begun fulfilling performance obligations under sales & service contracts. When the parties are in the initial position, theoretically they could just call the contract off. Therefore, it might be reasonable to not record assets or liabilities yet—everyone is even at zero until one party starts performing. The FASB’s revenue recognition exposure draft has some thinking down these lines.
    But the accountants then took the term “executory contract” that they adapted & began to circle back to the broader legal meaning, while retaining the accounting treatment for the narrower situation of contractual terms not begun on sales & service contracts.
    For example, financing transactions (including many repo arrangements) have characteristics of executory contracts from a lawyer’s perspective. However, the substance, which is what should concern accountants, is a financing transaction. Accountants are challenged to look beyond the legal form of a transaction to its substance, but borrowing a legal term for use in describing situations for accounting purposes does not help with this.
    This is where your former accounting policymaker friend gets tripped up with the oil & t-shirt forward purchase commitments. As you point out, the key point is whether the contract can be settled net. If it can, this is a financial arrangement & the only future (“executory”) matters might be a bit of paper suffling & transfer of a net payment at the time of settlement. (US GAAP literature tries to sort out this specific matter of whether purchase commitments are derivative instruments to be recorded on the balance sheet in its definition of derivative instruments & in the concept of “normal purchases & normal sales”.)
    BTW, I don’t consider a lease to be an executory contract. Once the lessor turns the property over for use by the lessee, it has, in subtance, performed. It is not continuously turning over the property (how would you do that?) & it has no right to take it back, except in exceptional instances of default by the lessee. Leasing is purely a financial transaction. Of course, lessors often provide ancillary services, but these are distinct from the “lease part” of the arrangement.
    Scott

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