About Off Balance Sheet Financing

Off-balance-sheet financing is jwhat the name implies. This accounting technique removes an item from the balance sheet so that it doesn't affect the debt ratio in a negative way. While it's a useful method to use for specific instances, it also was widely abused. Enron, the name that brings visions of bad accounting practices, used it improperly and was eventually discovered.

Significance

Off-balance-sheet financing is a method that places all of the equity and liabilities on another entity's balance sheet. Sometimes it creates an entity often referred to as a special purpose vehicle (SPV) or special purpose entity (SPE). The SPE is an entity that has a limited or temporary purpose. This then removes the asset and liabilities from the parent company's balance sheet and places it on the balance sheet of the SPE.

Function

The firm that creates the SPE seldom keeps a wholly owned entity on its balance sheets. This defeats the purpose of the transfer of liabilities. In order to avoid that dilemma, it often forms partnerships or takes either partial interest in the newly developed entity or no interest at all. This keeps it from going to the balance sheet and hides the debt structure.

Types

The special purpose entity created for off-balance-sheet financing might be another corporation, but it isn't always. It depends on the circumstances and the most beneficial method to the corporation that creates the entity.

Benefits

There are benefits to off-balance-sheet financing besides the removal of the excess debt from the company's balance sheet and the transfer of risk that comes with it. Sometimes, the entity achieves a higher credit rating than the parent company and provides cheaper methods of funding than the parent company can get. This occurs if the sponsoring company supplies the special purpose entity with credit enhancements.

Effects

There are often special purpose vehicles used in off-balance-sheet financing that issue a pass through security. This allows the funds collected to pass directly to the investors in the company. This way the net cash flow goes to the investors, and it automatically matches the assets to liabilities.

Considerations

Some companies use off-balance-sheet financing to get taxation advantages. Often, corporations use it in the form of a synthetic lease. The company retains all the tax benefits of property ownership and the write-offs but doesn't list the lease obligation on the balance sheet. Since corporations expense the lease payments annually, the payments transfer to the income statement. The corporation that creates the SPV still retains all the benefits of the ownership like appreciation and property depreciation for taxes, but it doesn't appear as part of the debt structure.

Warning

While off-balance-sheet financing offers great opportunities to companies that might start a new venture in a new area, it also provides one method of companies hiding their true financial picture. Most companies list a footnote on the balance sheet so that investors understand their true picture, but those that abuse off-balance-sheet financing don't want investors to know the scope of the company's financial picture, particularly if it's bleak. In these cases, like Enron, they abuse good accounting practices to create a deceptive picture.