Question

Matt Ryan Corporation is interested in building its own soda can manufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective would be to ensure a steady supply of cans at a stable price and to minimize transportation costs. However, the company has been experiencing some financial problems and has been reluctant to borrow any additional cash to fund the project. The company is not concerned with the cash flow problems of making payments, but rather with the impact of adding additional long-term debt to its balance sheet.

The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company (ACC), its major supplier, to see if some agreement could be reached. ACC was anxious to work out an arrangement, since it seemed inevitable that Ryan would begin its own can production. The Aluminum Can Company could not afford to lose the account.

After some discussion, a two-part plan was worked out. First, ACC was to construct the plant on Ryan’s land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement. Under the purchase agreement, Ryan would express its intention to buy all of its cans from ACC, paying a unit price which at normal capacity would cover labor and material, an operating management fee, and the debt service requirements on the plant. The expected unit price, if transportation costs are taken into consideration, is lower than current market. If Ryan did not take enough production in any one year and if the excess cans could not be sold at a high enough price on the open market, Ryan agrees to make up any cash shortfall so that ACC could make the payments on its debt. The bank will be willing to make a 20-year loan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years, the plant is to become the property of Ryan.

Instructions

1. What are project financing arrangements using special-purpose entities?
2. What are take-or-pay contracts?
3. Should Ryan record the plant as an asset together with the related obligation?
4. If not, should Ryan record an asset relating to the future commitment?
5. What is meant by off-balance-sheet financing?

Short answer

1. When the companies that constituted the new organization guarantee debt repayment, financing arrangements are created.
2. Project financing arrangements become more formalized through take-or-pay or similar contracts.
3. The plant is to be constructed and operated by ACC.
4. Ryan does not record an asset relating to the future purchase commitment.
5. Off-balance-sheet financing is an attempt to borrow monies so that the obligations are not recorded in a company’s balance sheet.

Step-by-step solution

Meaning of Cash flow Statement

The cash flow statement shows the changes in the company's cash and cash equivalents throughout an accounting period. This modification combines the interests in business, finance, and investing.

(a) Explaining project financing arrangements

The only permissible way to reflect gains or losses is by the prompt recognition principle. Such financing arrangements happen when:

1. Two or more entities create a new entity to build an operating plant that both parties will use.
2. The new entity borrows money to complete the project and pays back the debt with project proceeds.
3. The companies that created the new entity guarantee the debt's repayment.

(b) Explaining take-or-pay contracts

Occasionally, take-or-pay or similar contracts are used to establish project funding agreements. In a straightforward take-or-pay agreement, the buyer of goods commits to the seller to pay predetermined sums regularly in exchange for goods or services. Even if the agreed goods or services are not delivered, the buyer must make minimum payments.

(c) Explanation regarding whether Ryan recorded the plant as an asset together with the related obligation

The factory shouldn't be listed as Ryan's asset. ACC will be responsible for building and running the facility. Ryan does not own the plant and does not have the right to utilize it, even though Ryan pledges to buy all of the cans made by ACC.

(d) Explaining whether Ryan should record an asset relating to the future commitment

It is unclear and debatable how purchase commitments should be accounted for. While some contend that these contracts should be recognized as assets and liabilities at the time of signing, others feel that the delivery date is the most suitable moment for this recognition. FASB Concepts Statement No. 6 states that

“a purchase commitment involves an item that might be recorded as an asset and an item that might be recorded as a liability. It involves both a right to receive assets and an obligation to pay. If both the right to receive assets and the obligation to pay were recorded at the time of the purchase commitment, the nature of the loss and the valuation account that records it when the price falls would be seen.”

Note: While the idea of re-recording assets and liabilities for purchase commitments has not been completely excluded from the discussion in Concept Statement No. 6, there are no conclusions or implications as to whether the company should report it.

Ryan does not report a property about a potential purchase commitment, as is standard procedure. If the dollar amount is significant, the company should report the specified contract in the footnote to the balance sheet. Additionally, losses should be recorded in the accounts when there is a decrease in such price if the contracted price is higher than the purchase market price. The loss is estimated to occur after the purchase is completed.

(e) Explaining the meaning of off-balance-sheet financing

Off-balance-sheet financing is an effort to borrow money without having the debts appear on the organization’s balance sheet. Off-balance-sheet financing is used for a variety of reasons. First, many think that keeping debt off the balance sheet improves the quality of the balance sheet and makes it easier and less expensive to get credit. Second, loan covenants frequently place a cap on the maximum debt that a corporation may have.

Off-balance-sheet financing is used as a result since these agreements might not be taken into account when determining the debt ceiling. Third, some claim that the employment of specific accounting techniques causes the asset side of the balance sheet to be significantly underestimated (like LIFO and accelerated depreciation methods). Some people think that some of the debt doesn't need to be recorded because of these lower values.