New research from the Alberta School of Business shows why reported gains from off-balance-sheet deals deserve a closer look.
To understand what complex financing might look like and how the risk builds, consider a common business scenario:
Many companies sell goods or services and allow customers to pay later. The unpaid bills are known as accounts receivable for the sellers.
Imagine a manufacturer (the seller) is waiting on $10 million in unpaid bills from retailers that have purchased its products. Instead of waiting months to collect the money from its customers, the manufacturer bundles those unpaid bills together and sells them to a separate entity. That separate entity raises money from investors and pays the manufacturer upfront.
This process is known as asset-backed securitization. It is a legitimate tool that can help companies access cash quickly, reduce borrowing costs and access funding that might otherwise be unavailable. However, the way a company records this transaction, such as being kept off the balance sheet or as a one-time profit, can obscure its true financial health.
In the research published in Accounting Horizons and co-authored by Ke Wang from the University of Alberta’s School of Business, the researchers looked at U.S. companies outside the banking industry that turned money owed by customers into immediate cash. While asset-backed securitization can be a useful tool for companies that need cash, the study found that one way of reporting these deals may make it easier to hide poor financial performance.
“Investors, auditors and regulators should pay close attention to these transactions, especially when a company reports an immediate profit from them,” states Wang.
Before 2010, some U.S. companies could keep securitization deals off the balance sheet. In simple terms, the company did not have to show all of the related assets and obligations directly in its main financial statements.
Instead, it could treat the arrangement as if it had sold its customer receivables outright.
That treatment sometimes allowed the company to record an immediate accounting profit, called a gain on sale. The profit could depend on an estimate of what the company expected to receive from its remaining interest in the receivables.
Those estimates could be difficult for outsiders to check because the retained interest was often not traded in an open market.
“Our findings suggest that a reported gain from selling securitized assets can be a warning sign for investors,” says Wang. “It may indicate that financial results are less clear than they appear.”
In some cases, managers may have room to choose which receivables to securitize and when to securitize them. That flexibility could help a company report better earnings at a time when it might otherwise miss an earnings target.
If disappointing information is held back for too long, it may eventually become impossible to hide. When it is released all at once, investors can react quickly and sharply, causing a stock price crash.
The researchers reviewed annual reports from publicly listed U.S. nonfinancial companies between 1998 and 2012, covering 3,455 company-year cases involving off-balance-sheet securitization at 694 firms.
They compared companies using this approach with similar companies that did not.
The researchers found that firms using off-balance-sheet securitization had a higher risk of a future stock price crash. The risk was even greater for companies that reported a positive gain from selling securitized assets.
The study also found that larger securitization deals were linked with higher crash risk among the firms that used them.
This does not mean every company using these arrangements will experience a sharp stock price drop. It also does not prove that the accounting treatment directly caused the crashes. The authors say other, unmeasured differences between companies could have played a role.
Still, the pattern suggests that investors should treat unusually large or complex gains from securitization with care.
In 2010, U.S. accounting regulators tightened the rules, making it more difficult for companies to keep securitization deals off the balance sheets.
The rules worked in one important way: fewer companies continued using the off-balance-sheet approach. Among firms using it before the rules changed, 41 percent continued to treat securitization as a sale afterward. Only five per cent of those firms reported a positive gain from the transaction.
But the overall risk of a future stock price crash did not fall significantly for the former securitizing firms.
The researchers found evidence that some companies may have shifted to a different way of making earnings look stronger. Rather than relying on accounting estimates from securitization deals, they appeared to use real business decisions that can affect reported profits.
For instance, a company might cut advertising, research and development, or other spending to improve short-term earnings. These choices can be real business decisions, but they can also make profits look better temporarily while creating problems later.
“A noteworthy message from the study is that closing one accounting loophole does not necessarily eliminate the pressure or incentive to hide bad news,” says Wang. “Companies may turn to other methods if they remain available.”
For everyday investors, the study is a reminder that a company’s reported profit is not always the same as its underlying financial strength.
A company can report strong earnings while relying on complex transactions or short-term decisions that delay the release of bad news. If the business later performs worse than investors expected, the stock price can fall quickly.
For boards, auditors, and regulators, the findings point to the need to consider the full range of ways companies may make results look better in the short term. Strong rules and clear disclosure remain important, but they must be paired with close attention to management incentives and unusual financial transactions.
The study focused on U.S. nonfinancial companies and historical data. It does not directly assess Canadian companies or Canadian accounting rules. Its broader lesson, however, applies anywhere investors rely on financial statements: the clearer the reporting, the better outsiders can judge a company’s real financial condition.
Read Wang’s full article in Accounting Horizons at DOI:10.2308/HORIZONS-2022-143
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