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.
BREAKING DOWN '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.
Off-balance-sheet financing may be used when a business is close to its borrowing limit and wants to purchase something, as a method of lowering borrowing rates, or as a way of managing risk. This type of financing may also be used for funding projects, subsidiaries or other assets in which the business has a minority claim. The issue arises when the company follows Securities and Exchange Commission (SEC) and GAAP requirements by disclosing off-balance-sheet financing in the notes on its financial statements. Sophisticated investors study these notes and may decide not to invest in the company due to potential financial issues, such as those that Enron faced.
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.
In the United States, public companies with operating leases carry over $1 trillion in off-balance-sheet financing for leasing obligations. The off-balance-sheet funding practice ends in 2019, when Accounting Standards Update 2016-02 ASC 842 comes into effect. Right-of-use assets and liabilities resulting from leases will be recorded on balance sheets. Enhanced disclosures in qualitative and quantitative reporting in footnotes of financial statements will be required. Additionally, off-balance-sheet financing for sale and leaseback transactions will not be available.