Off-balance sheet financing is an accounting method whereby companies record certain assets or liabilities in a way that prevents them from appearing on their balance sheet.
It is used to keep debt-to-equity and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants. These are agreements between a business and creditor that the business will operate within the rules established by the creditor as a condition for receiving a commercial loan.
Because a large purchase may cause the business to be non-compliant with their debt covenants and consequently trigger a default, they could decide to use off-balance-sheet financing.
Businesses also know that a healthier-looking balance sheet is likely to attract more investors and that banks will charge highly leveraged firms more to borrow money as they are considered more likely to default on payments.
It is a legitimate and permissible accounting method that is recognised by generally accepted accounting principles (GAAP), as long as GAAP classification methods are followed.
Off-balance sheet financing methods
Methods of off-balance-sheet financing include selling receivables under certain conditions, providing guarantees or letters of credit, participating in joint ventures, research and development partnerships and operating leases.
Operating leases have proven to be one of the most popular methods of off-balance-sheet financing. To avoid buying equipment or property outright, a company can rent or lease it and then purchase it at a minimal price at the end of the lease period. Choosing this method allows the company to record only the rental cost. Booking it as an operating expense on their income statement results in lower liabilities on their balance sheet.
Partnerships are another popular method of dressing up balance sheets. When a company creates a partnership, it doesn’t have to show the partnership’s liabilities on its balance sheet, even if it has a controlling interest in it.
Sometimes a company will purchase small ownership positions in special purpose vehicles (SPVs) or special purpose entities (SPEs) that have their own balance sheets, and place any assets of liabilities in question on those balance sheets. As SPEs may have higher credit ratings than the sponsoring firms that create them, this allows the company to receive cheaper financing.
Example of when an off-balance-sheet goes wrong
Enron, the major American energy, commodities, and services company based out of Texas, went bust in 2001 after using SPVs to hide its mountains of debt and toxic assets from investors and creditors.
Enron traded its fast-rising stock for cash or notes from the SPVs, which in turn used the stock for hedging assets on Enron’s balance sheet.
When Enron’s stock began falling, the value of the SPVs dropped and Enron was financially liable for supporting them. But because it could not repay its creditors and investors, Enron was forced to file for bankruptcy in late 2001.
The SPVs were disclosed in the notes on Enron’s financial documents, but few investors knew to look for them and didn’t grasp the gravity of the situation.
Since the ill-fated collapse of Enron, off-balance-sheet financing has been seen as more controversial and subsequently attracted closer regulatory scrutiny.
Off-balance sheet financing reporting requirements
Companies must follow generally accepted accounting principles (GAAP) and Financial Conduct Authority (FCA) requirements by disclosing off-balance-sheet financing in the notes of their financial statements.
Savvy investors know to look at these notes for information and insight, and study them to decipher the depth of potential financial issues.
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