Let’s assume that SHIPCO, a fictional shipping company, purchases a new-building vessel with a three-year time charter attached. At the time of purchase, the fair value of similar vessels on a charter-free basis, i.e. without any time charters attached, was $30 million. But the company paid only $27 million for the vessel, a bargain price at the time. Why the $3 million discount you might ask. Well, at the time of purchase the three-year time charter attached was considered below the market rate for a vessel worth $30 million. US GAAP and the auditors step in and guide the company on how to record the transaction in the books. Here is the accounting entry.
Please note that the vessel is recorded in the books not at $27 million, the price SHIPCO actually paid, but at $30 million, the price SHIPCO should have paid if no time charter had been attached.
Please also note that SHIPCO has created a corresponding liability (Fair Value Below Contract Value of T/C Acquired) to balance the difference between what was actually paid and what should have been paid.
Since we have established the book value of the vessel at $30 million, courtesy of US GAAP, let’s see how that cost is being depreciated over time. Vessels are typically depreciated over a period of 25 years. Since the book value was recorded at $3 million more that the actual acquisition price, that means SHIPCO has to take an additional depreciation expense of $120,000 every year for the next 25 years. Here is the annual accounting entry for the extra depreciation expense. Please note that SHIPCO will make the same entry for the next 25 years.
Now comes the juicy part. What about that little liability SHIPCO had recorded in the books, when it first acquired the vessel. Remember, the $3 million “Fair Value Below Contract Value of T/C Acquired”. No worries, US GAAP is here to guide us. The liability will be amortized over three years (the term of the charter). Since SHIPCO has to report a higher depreciation expense, it is entitled to report higher revenue to compensate for it. Here is the annual accounting entry for the revenue recognition. Please note that SHIPCO will only make this entry for the next three years, the duration of the time-charter.
Assuming you are still reading this and haven’t completely lost it, you will realize a small difference over the timing of revenue and expense recognition. Over time, well over the next 25 years assuming both SHIPCO and yours truly are still around, expense and revenue will cancel each other out, as it should. Remember the $3 million figure is purely fictional, an accounting gimmick really to try to assess the “true” vessel value at the time of acquisition.
But, whereas depreciation expense will be recognized over 25 years, revenue will only be amortized over three years. In layman’s terms, SHIPCO will be able to boost its net income over the next three years to the tune of $880,000 per year. Not bad for a day’s work I suppose.
If SHIPCO wants to continue boosting its bottom line out of thin air, it would be foolish not to buy more vessels like the first one. The trick is out of the bag. The more vessels SHIPCO buys with lousy charters, the more money it makes in the short term, at least on paper.
This series of articles on ship finance is the intellectual property of Lambros Papaeconomou. It is a work in progress and is fictional. Any resemblance to real shipping companies or events is purely coincidental.