Off-Balance-Sheet Financing

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Definition

Off-balance sheet, or Incognito Leverage, usually means an asset or debt or financing activity not on the company’s balance sheet. Total return swaps are an example of an off-balance sheet item.

Off-Balance-Sheet Financing

What is ‘Off-Balance-Sheet Financing’

In off-balance-sheet financing, large capital expenditures are kept off a company’s balance sheet to keep the debt to equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants. Examples of off-balance-sheet financing include joint ventures, research and development (R&D) partnerships, and operating leases, where the asset itself is kept on the lessor’s balance sheet, and the lessee reports only the required rental expense for use of the asset.

Explaining ‘Off-Balance-Sheet Financing’

U.S. generally accepted accounting principles (GAAP) set rules for companies to follow in determining whether a lease should be capitalized or expensed. These rules came into popular use during the Enron bankruptcy, as many of the energy traders’ problems stemmed from setting up inappropriate off-balance-sheet entities.

Enron’s Off-Balance-Sheet Financing

Enron used special purpose vehicles (SPVs) to conceal massive debt loads. The company traded its quickly rising stock for cash or notes from the SPV. The SPV used the stock for hedging assets on Enron’s balance sheet. The company guaranteed the SPVs to reduce the level of risk involved. When Enron’s stock began falling, the values of the SPVs went down, causing the company to enforce its guarantees. Because Enron could not repay its creditors and investors, the company filed for bankruptcy. Although the SPVs were disclosed in the notes on the company’s financial documents, few investors understood the seriousness of the situation.

Example of Off-Balance-Sheet Financing

In February 2016, the Financial Accounting Standards Board (FASB) changed the rules for lease accounting, which affected the balance sheets of many banks, airlines, retailers, telecommunications companies, and hotel and restaurant chains. Because most leases worldwide are not reported on balance sheets, investors have difficulty determining companies’ leasing activities and ability to repay their debts.

Off Balance Sheet Financing FAQ

Is off balance sheet financing legal?

Off-balance sheet financing is legal and it’s recognized by Generally Accepted Accounting Principles, or GAAP, as long as GAAP classification methods are followed. This form of financing is almost always debt financing, so the debt is not recorded as a liability on the balance sheet.

How does an off balance sheet item move onto the balance sheet?

Banks remove assets from its balance sheet through securitization. Loans are banks’ on balance sheet assets. Some companies create special purpose entities (SPEs) to keep assets off the balance sheet.

Where are off balance sheet items reported?

Off-balance sheet (OBS) items is used to describe assets or liabilities that are not on a company’s balance sheet even though they are still assets and liabilities of the company.

How does debt affect the balance sheet?

Raising funds through debt financing adds a positive item in the financing section of the cash flow statement and increases liabilities on the balance sheet. Debt does not dilute ownership but its payments interest reduce net income and cash flow.

What are off balance sheet liabilities?

An off balance sheet liability has no accounting requirement to report it in financial statements. Usually, these liabilities are not firm obligations, but might require settlement by the reporting entity at a future date.

What assets are not shown on the balance sheet?

Off-balance sheet (OBS) assets are assets not shown on the balance sheet. OBS assets can protect financial statements from asset ownership and related debt. Common OBS assets include accounts receivable, leaseback agreements, and operating leases.

Further Reading

  • Taxes and off-balance-sheet financing: research and development limited partnerships – www.jstor.org [PDF]
  • Market Evaluation of Off-Balance sheet financing: You can run but you can't hide – papers.ssrn.com [PDF]
  • An analysis of the relevance of off-balance sheet items in explaining productivity change in European banking – www.tandfonline.com [PDF]
  • The effect of bank capital requirements on bank off-balance sheet financial innovations – www.sciencedirect.com [PDF]
  • Off-balance sheet R&D assets and market liquidity – www.sciencedirect.com [PDF]
  • Contract theoretic analysis of off-balance sheet financing – books.google.com [PDF]
  • Off-Balance-Sheet Financing: Synthetic Leases – www.jstor.org [PDF]
  • Firms' off‐balance sheet and hybrid debt financing: Evidence from their book‐tax reporting differences – onlinelibrary.wiley.com [PDF]

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