Accounting for corporate finance: offsetting: examples
A company, D Ltd, both sells goods to, and buys goods from, another company, E Ltd. At its year end, it owes £300,000 to E Ltd and is owed £50,000. The practice of D Ltd is to settle each invoice from E Ltd as it falls due for payment; E Ltd does the same.
D Ltd cannot net off these amounts in its balance sheet. For offsetting to be possible, there must be a legally enforceable right of set-off - in words, if E Ltd sued for the money it was owed, D Ltd could offset the £50,000 it was owed and pay only £250,000. But even if such a right existed, there is still no intention by the company to settle on a net basis.
A company buys 500 interest rate futures contracts that are traded on LIFFE. The settlement date for the contracts is in March 2007. In February 2007 the company closes out the position by selling 500 identical contracts. Settlement of the contracts in March 2007 will be via the London Clearing House. On the settlement date, the company’s rights and obligations under the two sets of contract will net off to zero. Because settlement is through a clearing house, the cash flows are in effect equivalent to a single net amount (of zero) and there is no exposure to credit or liquidity risk. If the company drew up a balance sheet at, say, 28 February 2007, it could offset the asset and liability in its balance sheet.